Menu
Tax Notes logo
HOMETax Notes ResearchFederalOther Documentspublic comments on regulations

Individual Offers Fine-Tuning Options for Proposed UBTI Regs

JUN. 23, 2020

Individual Offers Fine-Tuning Options for Proposed UBTI Regs

DATED JUN. 23, 2020
DOCUMENT ATTRIBUTES

June 23, 2020

Internal Revenue Service
CC:PA:LPD:PR (REG-106864-18)
Room 5203
P.O. Box 7604
Ben Franklin Station
Washington DC, 20044

Re: Comments on Proposed Regulations Unrelated Business Taxable Income Separately Computed for Each Trade or Business Under Section 512(a)(6)

Dear Sir or Madam:

I am writing to comment on the Proposed Regulations regarding the Section 512(a)(6) regarding exempt organizations that derive unrelated business taxable income from two or more unrelated trades or businesses.

As background, I am a tax professional who has spent more than 25 years providing tax services to hundreds of tax-exempt organization clients, primarily educational institutions and other public charities, through my employment at mid-size and large public accounting firms. The comments in this letter are my personal views rather than the views of any employer or client.

Background

Section 512(a)(6) of the Internal Revenue Code was enacted as part of the Tax Cuts and Jobs Act (TCJA) at the end of 2017. It requires exempt organizations with more than one unrelated trade or business to calculate unrelated business taxable income (UBTI) separately for each trade or business and doesn't allow losses from one unrelated business activity to offset income from another. These are often called the unrelated business income (UBI) “silo” rules.

The Department of Treasury and Internal Revenue Service (IRS) issued significant proposed regulations on April 23, 2020 to provide guidance and bright lines regarding the UBI silo rules.

The IRS had previously asked for comments when it issued interim guidance in Notice 2018-67 (the Notice) in August 2018. The proposed regulations recently issued are responsive to commentators to the Notice and provide greater certainty to tax-exempt organizations on how to calculate the tax. They help ensure consistent treatment by exempt organizations that are similar in nature but might otherwise make different reasonable, good-faith assumptions on how to calculate UBTI. In addition, they are more administrable for the IRS.

I am greatly appreciative of the care, diligence and effort made in these proposed regulations and am especially grateful for two beneficial changes included in the proposed regulations: 1) The use of two-digit North American Industry Classification System (NAICS) codes, and 2) removal of the requirement to aggregate ownership interests of disqualified persons along with exempt organizations' ownership interests to qualify for the 2% de minimis and 20% control tests for aggregating UBTI generated from investment partnership interests as one activity.

Investment Activities

The proposed regulations provide an exclusive list of an exempt organization's investment activities that can be treated as one separate unrelated business activity for purposes of section 512(a)(6).

The preamble to the proposed regulations request comments regarding specific factors that should be considered when determining whether an activity is an investment activity for purposes of section 512(a)(6).

Therefore, I will provide 2 examples of situations for your consideration to be included in investment activity.

1) Suppose that, rather than an exempt organization (EO) investing its endowment funds directly into 100 investment partnerships, the EO holds one investment partnership (the Partnership) that holds the interests in the 100 lower-tier investment partnerships.

The EO has a 70% interest in the Partnership, and the other 30% is owned by many smaller tax-exempt organizations in the community which the EO supports. Because of the critical mass, the smaller tax-exempt organizations are able to invest their funds more efficiently pooled with the larger EO's investment Partnership.

The Partnership does not own more than 2% of any of the 100 investment partnerships it holds and therefore, all of them would meet the de minimis test if held directly by the EO.

If an exempt organization does not control a partnership in which it holds a direct interest but that is not a Qualifying Partnership Investment (QPI) because the organization holds more than 20 percent of the capital interest, any lower tier partnership (indirectly-held partnership interest) may be considered a QPI if the indirectly-held partnership interest meets the requirements of the de minimis test. This is the favorable “look-through rule” for the de minimis test in section 1.512(a)-6(c)(2) of the proposed regulations which is meant to “improve administrability and to provide more appropriate relief.” It allows the lower tier investment partnerships to be aggregated with an exempt organization's investment activity for UBI purposes.

My suggestion is to expand this “look-through rule” and allow it to apply even for an exempt organization that does control a partnership in which it holds a direct interest. Allowing the EO to aggregate the UBI from the lower tier investment partnerships that qualify for the de minimis test with the EO's investment activity for section 512(a)(6) purposes should serve to increase administrability for both the IRS and taxpayers.

2) Suppose an exempt organization (EO) holds an S corporation interest in its investment portfolio along with several investment partnerships that qualify as QPIs. The S corporation generates only interest, dividends and capital gain income in this example. The EO holds 60% of the S corporation interest, but all of its holding in the S corporation is non-voting stock. The EO does not have any opportunity to participate in the management of the S corporation in any way and the S corporation does not operate any trade or business other than holding investments.

The S corporation investment income would not otherwise be taxable to the EO but for section 512(e), which says that an exempt organization holding stock in an S corporation will be treated as an interest in an unrelated trade or business.

As indicated in the preamble to the proposed regulations, “(n)otwithstanding the general rule that each S corporation interest is treated as a separate unrelated trade or business, the Treasury Department and the IRS recognize that an exempt organization may hold S corporation stock for different purposes, including investment purposes.”

My suggestion is to consider expanding the definition of a Qualifying S Corporation Interest (QSI) in this situation since the EO does not control the S corporation. This would allow an exempt organization to aggregate its UBTI from an S corporation interest with other QPI investment activities — even though the ownership in the S Corporation does not meet either the de minimis test or the 20% control test for qualifying partnership interests. Since the EO cannot control the S corporation, there does not appear to be a reason to differentiate this S corporation from those defined as QSIs under the proposed regulations, which would be permitted aggregation with an exempt organization's other investment activity for purposes of UBI.

Although I agree with the Treasury and the IRS that “. . . an exempt organization's investment intent is not sufficient to treat the overall non-QPI as part of its investment activities,” these are at least two instances that the facts and circumstances, rather than the exempt organization's mere intent, would support aggregating the activities with investment activities for purposes of section 512(a)(6).

Aggregation of S Corporation Activities

The proposed regulations generally provide that each S corporation interest will be treated as a separate unrelated trade or business, which is consistent with the section 512(e)(1)(A).

My suggestion for your consideration is to give taxpayers the option of treating each S corporation interest as a separate unrelated trade or business or treating each income item from an S corporation as a separate trade or business that can be aggregated with the same trade or business from other sources of UBI for purposes of section 512(a)(6).

For example, if an exempt organization has more than one S corporation interest, and they all have the same trade or business, then treat them as one UBI activity rather than as 3 separate activities. Say an EO has interests in three S corporations and each operates a restaurant, then allow the taxpayer to aggregate the restaurant activities as one UBI activity rather than as three separate activities.

To expand on the example above in the investment section, suppose the EO has an S corporation that generates interest and dividend income as well as trade or business income from a restaurant. Allow the taxpayer to treat the restaurant activity as one UBI activity and treat the investment activity as a separate activity. And to follow along with the logic of the example above, if the EO has control of the S corporation, then treat that investment activity from the S corporation as a separate activity. But if the EO does not control the S corporation, that is, owns not more than 50% of the voting stock, then allow the investment income from the S corporation to be aggregated with other QPIs and QSIs.

Common Unrelated Business Activities for Educational Institutions

I fully support the use of 2 digits from the NAICS as allowed in the proposed regulations. This is extremely helpful for taxpayers and should provide greater consistency among exempt organizations. Using the 2 digits is much more administrable for both taxpayers and the IRS.

For example, all exempt organizations with UBI from gifts stores, bookstores and pharmacies will likely categorize the UBI activity using a two digit NAICS code(1), 44 or 45, for “Retail Trade” as that is clear and straightforward.

I also think that adding some illustrative examples to the proposed regulation would be very useful, especially for certain common activities undertaken by educational institutions that are not as straightforward.

For example, some of the common unrelated business income activities for educational institutions include facilities rentals, such as for conferences and weddings, rental of sports facilities and sports camps.

Weddings and conferences

An exempt organization such as an educational institution may operate a for-profit trade or business through their facilities/functions departments. The functions department may run conferences and weddings for outside parties that are looking for venues to host their events.

Theatres, sports camps

Exempt organizations may rent out their auditorium space to outside groups for theatre presentations or may rent out their fields and facilities to outside groups to run sports camps. On the other hand, exempt organizations may run their own sports camps for participants falling outside of their exempt mission, for example an adult soccer camp run by a private high school.

Sport facilities

Exempt organizations may have gymnasiums, hockey rinks and/or swimming pools for their students. They may rent these facilities out to outside groups.

Weddings and conferences would normally include function planning and scheduling, AV equipment, use and set up of chairs, tables and bars, food, drink and food service, whether outsourced or not. Gymnasiums, ice skating rinks and swimming pools rentals may include significant personal property and services such as schedulers, benches, bleacher stands, lockers, score boards, Zambonis, Zamboni operators, lifeguards, chemical treatments, showers and pool lifeguard equipment.

Assuming that there are services involved and/or that the facilities rentals include sufficient personal property to cause these activities to be considered unrelated business income, there may be significant good faith inconsistencies as well as tax manipulation in how different exempt organizations categorize and aggregate these activities.

Some exempt organizations may categorize all such activities under NAICS code 53 for “Real Estate and Rental and Leasing” as Rental and Other Activities Related to Real Estate, aggregating loss activities against profitable activities. However, others may classify some of these activities under codes for “Accommodation and Food Services,” (72) or as “Business Support Services,” (under code 55) or as “Arts, Entertainment, and Recreation” (71) or as “Educational Services” (61).

For example, instead of classifying them all as “Rental and Other Activities Related to Real Estate”, those colleges and universities holding weddings on their campuses may consider the activity to be similar to Restaurants and Other Eating Places under “Accommodation and Food Services” (code 72). Conference activities may be considered as All Other Business Support Services under the “Management of Companies and Enterprises” (code 55) or as Professional and Management Development Training under the “Educational Services” (code 71).

Operation of unrelated sports camps by the educational institution would appear to more appropriately fall under the “Educational Services” code 61 of the NAICS as Sports and Recreation Instruction,” rather than Real Estate and Rental and Leasing. This is unlike unrelated business taxable income generated from an agreement with an outside party to run the sports training camps, which may be considered Real Estate and Rental and Leasing.

Some of the sports facilities rentals, such as rental of swimming pools and rental of ice skating rinks, may be more appropriately classified as Fitness and Recreational Sports Centers under NAICS code 71 for “Amusement, Gambling, and Recreation Industries” as they appear to be analogous to the golf courses, skiing facilities and bowling centers which are explicitly listed under this code 71.

I believe that providing illustrative examples in the final regulations regarding these common unrelated business activities would be very helpful in the Treasury Department and Internal Revenue's goals of promoting consistency, fairness, bright line tests and providing additional guidance to ease the administrative burdens for taxpayers and the IRS.

Thank you kindly for requesting comments on the proposed regulations and I respectfully make these suggestions.

Sincerely,

Laura J. Kenney, CPA, MST
617-717-0831
lkenney@blumshapiro.com

(1) Footnote — Here are the 20 NAICS codes

1. Agriculture, Forestry, Fishing, Hunting (11)

2. Mining, Quarrying, Oil & Gas Extraction (21)

3. Utilities (22)

4. Construction (23)

5. Manufacturing (31‐33)

6. Wholesale Trade (42)

7. Retail Trade (44‐45)

8. Transportation & Warehousing (48‐49)

9. Information (51)

10. Finance and Insurance (52)

11. Real Estate and Rental & Leasing (53)

12. Professional, Scientific & Tech Svc 54)

13. Management of Cos. & Enterprises (55)

14. Administrative and Support (56)

15. Educational Services (61)

16. Health Care and Social Assistance (62)

17. Arts, Entertainment & Recreation (71)

18. Accommodation & Food Services (72)

19. Other Services (81)

20. Public Administration (92)
DOCUMENT ATTRIBUTES
Copy RID