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The IRS has issued proposed regulations (REG-106864-18) providing guidance for tax-exempt organizations on how to calculate unrelated business taxable income (UBTI) on separate unrelated trades or businesses. The proposed regulations largely expand and modify the preliminary guidance issued in Notice 2018-67 (the Notice).

For tax-exempt organizations that invest in private equity and alternative asset management funds, especially in cases where a private equity fund makes multiple, unblocked investments in portfolio companies structured as pass-through entities for tax purposes, these proposed regulations will impact fund Schedule K-1 and tax compliance disclosures, fund investor relations issues, and investment structuring considerations.

Background

IRC Section 512(a)(6)

The Tax Cuts and Jobs Act (TCJA) enacted numerous tax changes for tax-exempt organizations, individuals and businesses, including adding IRC Section 512(a)(6) to the Internal Revenue Code (IRC). IRC Section 512(a)(6) requires organizations operating more than one unrelated trade or business to compute UBTI separately for each trade or business (without regard to the $1,000 specific deduction under IRC Section 512(b)(12)). The organization's UBTI for a tax year is the sum of the amounts (not less than zero) computed for each separate trade or business (less the IRC Section 512(b)(12) specific deduction).

UBTI generally

UBTI is generally defined as the gross income that a tax-exempt organization earns from an unrelated trade or business that it regularly carries on, reduced by any deductions directly connected to the conduct of that trade or business (IRC Section 512(a)(1)).

Notice 2018-67

In August 2018, the IRS issued Notice 2018-67 (the Notice) outlining the content of future regulations under IRC Section 512(a)(6) and requesting public comment. See EY Tax Alert 2018-1700. In drafting the proposed regulations, the IRS considered 24 comments received in response to the Notice.

Proposed regulations

The proposed regulations would establish how to identify and calculate UBTI from separate trades or businesses, for purposes of IRC Section 512(a)(6).

Separate unrelated trade or business

Pending publication of these proposed regulations, the Notice specified that tax-exempt organizations could rely on a reasonable, good-faith interpretation of IRC Sections 511 through 514, considering all the facts and circumstances, when determining whether a tax-exempt organization has more than one unrelated trade or business for purposes of IRC Section 512(a)(6). For this purpose, the Notice stated that a reasonable, good-faith interpretation includes using the North American Industry Classification System (NAICS) 6-digit codes. The Notice requested comments on rules for identifying separate trades or businesses under IRC Section 512(a)(6).

The preamble to the proposed regulations (the Preamble) notes that, having considered comments on the Notice, the IRS and Treasury "continue to view an identification method based on NAICS codes as administrable for tax-exempt organizations and the IRS." Responding to comments that the NAICS 6-digit codes would be too burdensome, the proposed regulations would require that a tax-exempt organization generally must "identify its separate unrelated trades or businesses using the first two digits of the NAICS codes." The Preamble states that "the broad scope of activities covered by the NAICS 2-digit codes should cover all unrelated trade or business activities conducted by tax-exempt organizations," as the 2-digit NAICS codes identify trades or businesses in 20 different sectors.

The proposed regulations would provide that a tax-exempt organization:

1. Must report each NAICS 2-digit code on its Form 990-T only once, meaning that the UBTI of similar unrelated trade or business activities that it has identified using a particular 2-digit code must all be reported in the aggregate under that code
2. May not change the NAICS 2-digit code it has chosen for a particular trade or business, beginning with the codes reported on its first Form 990-T filed after the regulations are published as final in the Federal Register

Allocation of directly connected expenses

Under IRC Section 512(a)(1), a tax-exempt organization with an unrelated trade or business may reduce the income from that trade or business by the expenses directly connected with carrying on that trade or business. Treas. Reg. Section 1.512(a)-1(c) and (d) provides special rules for allocating expenses that are shared between an exempt activity and an unrelated trade or business. The Notice stated that the IRS was considering modifying the underlying reasonable allocation method in Treas. Reg. Section 1.512(a)-1(c) to provide specific standards for allocating such expenses.

Citing concern from the IRS and Treasury that "permitting allocation methods based solely on reasonableness is difficult for the IRS to administer and may not provide certainty for taxpayers," the Preamble states that the IRS intends to publish a separate notice of proposed rulemaking to provide further guidance on expense allocation in calculating UBTI. Further, the proposed regulations would provide that the unadjusted gross-to-gross method (using a ratio of gross income from an unrelated trade or business activity over the total gross income from both related and unrelated activities generating the same indirect expenditures to allocate expenses between them) is not reasonable either under the general allocation rule or for purposes of IRC Section 512(a)(6).

Investment activities

Consistent with the Notice, the proposed regulations generally would permit certain investment activities that are listed in the proposed regulations to be aggregated and treated as a single unrelated trade or business for purposes of IRC Section 512(a)(6). The Preamble states that the IRS is allowing aggregation to lighten the burden on tax-exempt organizations. The Preamble notes that, under the proposed regulations, investment activities that can be aggregated are not identified using the NAICS 2-digit codes.

However, the proposed regulations would provide an exclusive list of investment activities that a tax-exempt organization can aggregate and treat as a single unrelated trade or business for purposes of IRC Section 512(a)(6). These would be generally limited to:

1. Qualifying partnership interests
2. Debt-financed properties
3. Qualifying S corporation interests

Qualifying partnership interests

In response to comments, the proposed regulations generally would retain the approach in the Notice that permits a tax-exempt organization to aggregate its UBTI from certain qualifying partnership interests as a single trade or business, as long as certain qualifications are met. For tax-exempt organizations that invest in alternative asset management funds and can satisfy one of the two tests described below, the proposed regulations would permit UBTI and losses from such qualifying partnership investments to be netted, thereby streamlining the tax reporting and compliance function for both the investors and the funds.

The proposed regulations would clarify that any partnership in which a tax-exempt organization is a general partner for federal tax purposes is not a qualifying partnership interest (QPI) within the meaning of the proposed regulations, regardless of the tax-exempt organization's percentage interest.

The partnership interest would be classified as a QPI if it meets the requirements of either the de minimis test or the control test.

De minimis test

The proposed regulations would retain the Notice's rule that a partnership interest meets the de minimis test requirements if the tax-exempt organization directly holds no more than 2% of the profits interest and no more than 2% of the capital interest of the partnership. Unlike the Notice, which required that an exempt organization aggregate the interests of its disqualified persons, supporting organizations, and controlled entities in a partnership to determine whether it met the 2% thresholds, the proposed regulations would not require an exempt organization to combine any such interests when determining whether its partnership interest meets the de minimis test.

Control test

The proposed regulations also would retain the control test described in the Notice with minor modifications. The Notice provided that a partnership interest meets the requirements of the control test if the tax-exempt organization: (1) directly holds no more than 20% of the capital interest in the partnership; and (2) does not have control or influence over the partnership.

The proposed regulations would modify the Notice's control rule by removing the term "influence," so that the second prong of the test simply would require that the tax-exempt organization does not have control over the partnership, rather than "control or influence." The proposed regulations also would clarify that the partnership agreement is among the facts and circumstances that may be considered when making a control determination. The proposed regulations would list circumstances that evidence control, focusing on four discrete rights or powers:

1. The ability to require a partnership to perform, or prevent it from performing, any act that significantly affects the partnership's operations
2. The ability to appoint or remove any partnership officer or employee or majority of directors
3. The rights of any tax-exempt organization officer, director, trustee or employee to participate in the management of the partnership
4. The rights of any tax-exempt organization officer, director, trustee or employee to conduct the partnership's business at any time

The proposed regulations would retain a modified aggregation rule to address situations in which a tax-exempt organization may control a partnership through the aggregation of interests. Unlike the Notice, the proposed regulations would not require a tax-exempt organization to include the interests of its disqualified persons when determining the tax-exempt organization's percentage interest in the partnership. However, as in the Notice, interests held by the exempt organization's supporting organization or controlled entity in the same partnership would have to be aggregated with the exempt organization's interest in determining whether the partnership interest meets the control test. As a result, because tax-exempt organizations that invest in private equity or alternative asset management funds would still be required to attribute related ownership interests in certain cases, special attention should be paid to co-investment situations in which the organization is invested in a fund that, in turn, makes a flow-through portfolio company investment and the tax-exempt organization also has an additional investment in the same portfolio company via a co-investment vehicle.

Look-through rule

The proposed regulations would add a new look-through rule, which provides that if a tax-exempt organization holds a less-than-2% profits and less-than-2% capital interest in a partnership (the indirectly held interest) through another partnership in which the organization holds more than a 20% capital interest but does not control, then the indirectly held interest may still be treated as a QPI. A tax-exempt organization would then be permitted, but not required, to aggregate its UBTI from such indirectly held QPIs with its UBTI from directly held QPIs and other investment activities as a single trade or business, for purposes of IRC Section 512(a)(6).

Reliance on Schedule K-1 (Form 1065)

The Notice had provided that a tax-exempt organization could rely on the Schedule K-1 (Form 1065) received from the partnership when determining the organization's percentage interest in a partnership. The proposed regulations would continue to allow reliance on a Schedule K-1 if it lists the tax-exempt organization's percentage profits interest and/or percentage capital interest at both the beginning and end of the year. But the regulations also would clarify that the tax-exempt organization may not rely on the Schedule K-1 (Form 1065) to the extent that any information about the tax-exempt organization's percentage interest is not specifically provided (e.g., is listed as "variable").

Transition rule

The Notice allowed a tax-exempt organization to follow a transition rule for partnership interests acquired before August 21, 2018. The transition rule allows a tax-exempt organization to treat each of these partnership interests as comprising a single trade or business for purposes of IRC Section 512(a)(6), whether or not the partnership or its lower-tiered partnerships conducted more than one unrelated trade or business. Partnership interests treated as separate trades or businesses under the transition rule could not be further aggregated into a single trade or business.

The proposed regulations would clarify that a partnership interest acquired before August 21, 2018, would continue to meet the transition rule requirement, even if the tax-exempt organization's percentage interest changes on or after that date. The proposed regulations also would include two additions to the rule, providing that a tax-exempt organization may:

1. Rely on the transition rule only until the first day of the tax-exempt organization's first tax year beginning after the date the regulations are published as final in the Federal Register (transition period)
2. Apply either the transition rule or the look-through rule, but not both, to a partnership interest that meets the requirements for both rules

Income treated as an item of gross income from an unrelated trade or business

IRC Sections 512(b)(4), (13) and (17) treat unrelated debt-financed income, specified payments received from controlled entities, and certain insurance income from controlled foreign corporations, respectively, as items of gross income derived from an unrelated trade or business includable in the calculation of UBTI.

Unrelated debt-financed income

The Preamble to the proposed regulations states that Treasury and the IRS agree with commenters that debt-financed properties are generally held for investment purposes. Therefore, to reduce the reporting burden on exempt organizations, the proposed regulations would include all UBTI under IRC Section 512(b)(4) from a tax-exempt organization's debt-financed property (not just unrelated debt-financed income arising in connection with a QPI as provided in the Notice) in the list of "investment activities" that are aggregated and treated as a separate unrelated trade or business for purposes of IRC Section 512(a)(6).

Specified payments from controlled entities

The proposed regulations would allow a tax-exempt organization to aggregate all specified payments received from a controlled entity and treat them as received from a single separate unrelated trade or business for purposes of IRC Section 512(a)(6). Specifically, the regulations would provide that the specified payments (e.g., rents, royalties, interest) a tax-exempt organization receives from an entity it controls (within the meaning of IRC Section 512(b)(13)(D)) will be treated as gross income from a separate unrelated trade or business for purposes of IRC Section 512(a)(6). Specified payments received from two different controlled entities are treated as two separate unrelated trades or businesses — the separate trade or business determination is made at the controlled entity level, rather than based on the types of specified payments received.

Certain amounts derived from foreign corporations

The IRS states in the Preamble that insurance income received from more than one controlled foreign corporation included in UBTI under IRC Section 512(b)(17) should not be treated as gross income from an investment but rather classified under the 2-digit NAICS category for the provision of insurance. The proposed regulations would aggregate the provision of insurance by all controlled foreign corporations, treating them as one unrelated trade or business. However, the proposed regulations would not allow a tax-exempt organization to aggregate its own insurance income included in UBTI under IRC Section 512(b)(17) with the insurance activity of its controlled foreign corporations.

S corporation interest treated as an interest in an unrelated trade or business

Under the proposed regulations, each S corporation interest held by a tax-exempt organization would generally be treated as an interest in a separate unrelated trade or business, consistent with IRC Section 512(e)(1)(A). The proposed regulations would provide that the UBTI from an S corporation interest is the amount described in IRC Section 512(e)(1)(B), including:

1. Items of income, loss, or deduction taken into account under IRC Section 1366(a)
2. Gain and loss on the disposition of S corporation stock

Qualifying S corporation interests as "investment activities"

To ease the administrative burden, the proposed regulations would permit a tax-exempt organization to aggregate UBTI from an S corporation interest with UBTI from other investment activities if the tax-exempt organization's percentage of stock ownership in the S corporation meets the de minimis test or control test requirements for QPIs (discussed earlier). In other words, to be a qualifying S corporation interest, the exempt organization would have to either:

1. Own no more than 2% of the S corporation's stock
2. Own no more than 20% of the S corporation's stock and meet the facts-and-circumstances requirements of the second prong of the control test

When determining a tax-exempt organization's percentage ownership of stock in an S corporation, the exempt organization would have to apply the same rules for combining related interests that are used to determine whether a partnership interest is a QPI. A tax-exempt organization could rely on the Schedule K-1 (Form 1120-S) that the tax-exempt organization receives from the S corporation when determining its percentage ownership of the stock in the S corporation.

Social clubs, voluntary employee benefit associations and supplemental unemployment benefit trusts

IRC Section 512(a)(3) provides special rules for exempt organizations described as social clubs (IRC Section 501(c)(7)), voluntary employee benefit associations (VEBAs) (IRC Section 501(c)(9)) and supplemental unemployment compensation benefit trusts (SUBs) (IRC Section 501(c)(17)). The Preamble states that a social club, VEBA, or SUB would determine whether it has more than one unrelated trade or business in the same manner as a tax-exempt organization subject to the general UBTI rule in IRC Section 512(a)(1), with a couple of exceptions.

Because UBTI is defined differently for social clubs, VEBAs and SUBs, the proposed regulations would provide that, for purposes of IRC Section 512(a)(6), UBTI from the investment activities of a social club, VEBA or SUB includes any amount that either:

1. Would be excluded from the calculation of UBTI under IRC Section 512(b)(1), (2), (3), or (5) if the social club, VEBA or SUB were subject to IRC Section 512(a)(1)
2. Is attributable to income set aside, but not used, for a purpose described in IRC Section 512(a)(3)(B)(i) or (ii) and exceeds the set-aside limit described in IRC Section 512(a)(3)(E)

Consistent with the Notice, the proposed regulations would provide that the QPI rule and the transition rule do not apply to social clubs, because they should not be invested in partnerships that would generally be conducting nontraditional, unrelated trades or businesses that generate more than a de minimis amount of UBTI.

The proposed regulations would provide that a social club with nonmember income must identify its unrelated trades or businesses under the same rules as an organization subject to the rules of IRC Section 512(a)(1). The proposed regulations note that a social club could not describe all nonmember income under the NAICS 2-digit code for social clubs, because the NAICS codes must describe each unrelated trade or business rather than the purpose for which the organization is exempt from taxation.

Total UBTI and the charitable contribution deduction

IRC Sections 512(b)(10) and (11) state that tax-exempt organizations may take a charitable contribution deduction, subject to limitation, against UBTI regardless of whether the deduction is directly connected with an unrelated trade or business. Prior to the publication of these proposed regulations, there was some uncertainty as to whether, in the case of tax-exempt organizations with more than one unrelated trade or business, the charitable contribution deduction would need to be allocated among the unrelated trades or businesses.

In its General Explanation of the TCJA, the Joint Council on Taxation wrote: "It is not intended that a tax-exempt organization that has more than one unrelated trade or business be required to allocate its deductible charitable contributions among its various unrelated trades or businesses." Consistent with this statement, the proposed regulations would add new Treas. Reg. Section 1.512(b)-1(g)(4) to clarify that the term "unrelated business taxable income" as used in IRC Sections 512(b)(10) and (11) refers to UBTI after application of IRC Section 512(a)(6) (i.e., the special rules for tax-exempt organizations with more than one unrelated trade or business), so that the deduction is taken against total UBTI, rather than allocated among and taken against UBTI from separate unrelated trades or businesses.

Net operating losses and UBTI

The TCJA modified IRC Section 172 to limit deductions for net operating losses (NOLs) incurred in years beginning after December 31, 2017 to the lesser of: (1) the aggregate NOL carryovers to such year, and (2) 80% of taxable income for that year. Furthermore, IRC Section 512(a)(6) changed how an exempt organization with more than one unrelated trade or business calculates and takes into account NOLs for a particular trade or business.

The proposed regulations would provide that an exempt organization with both pre-2018 and post-2017 NOLs should deduct the pre-2018 NOLs from total UBTI under IRC Section 512(a)(6)(B) before deducting any post-2017 NOLs that relate specifically to an unrelated trade or business from the UBTI generated by that same unrelated trade or business. Further, the proposed regulations would clarify that pre-2018 NOLs are deducted from total UBTI in the manner that results in maximum utilization of the pre-2018 NOLs in a tax year.

Section 2303 of the Conronavirus Act, Relief, and Economic Security Act (CARES Act) suspended the 80% income limitation of IRC Section 172(a)(2)(B)(ii) and allows entities to carry back NOLs that arise in tax years beginning after December 31, 2017 and before January 1, 2021 to each of the five tax years preceding the tax year of such loss. The proposed regulations do not address how these changes to IRC Section 172 impact post-2017 NOLs generated by tax-exempt organizations due to the separate trade or business provisions of IRC Section 512(a)(6), but the IRS has requested comments on how to best to address this issue.

Individual retirement accounts

The proposed regulations would add new Treas. Reg. Section 1.513-1(f) to clarify that the "unrelated trade or business" definition in IRC Section 513(b) applies to individual retirement accounts.

Inclusions of subpart F income and global intangible low-taxed income

The Notice provided that an inclusion of global intangible low-taxed income (GILTI) under IRC Section 951A(a) should be treated in the same manner as an inclusion of subpart F income under IRC Section 951(a)(1)(A) for purposes of IRC Sections 512(b)(1) and (4). Under the Notice, an inclusion of GILTI was treated as a dividend, which is generally excluded from UBTI under IRC Section 512(b)(1).

Consistent with the Notice, the proposed regulations would revise Treas. Reg. Section 1.512(b)-1(a) to clarify that:

1. An inclusion of subpart F income under IRC Section 951(a)(1)(A) is treated in the same manner as a dividend for IRC Section 512(b)(1) purposes and is therefore generally excluded from UBTI.
2. An inclusion of GILTI under IRC Section 951A(a) is treated in the same manner as an inclusion of subpart F income under IRC Section 951(a)(1)(A) for IRC Section 512(b)(1) purposes and is therefore excluded from UBTI.

Public support test

The Preamble notes that IRC Section 512(a)(6) could affect two aspects of the public support test:

1. The calculation of total support under IRC Section 509(d)
2. The not-more-than-one-third support test under IRC Section 509(a)(2)(B)

IRC Section 509(d)(3) includes a tax-exempt organization's net income from unrelated business activities when calculating total support, whether or not such activities are carried on regularly as a trade or business. While not directly cross-referenced, unrelated business activities in this context can be read broadly to include UBTI within the meaning of IRC Section 512. If this holds true, a tax-exempt organization with more than one unrelated trade or business could be required to apply IRC Section 512(a)(6) when determining total support, increasing the amount of total support since losses from one unrelated trade or business cannot offset gains of another unrelated trade or business.

Because the not-more-than-one-third support test specifically cross-references IRC Section 512, a tax-exempt organization with more than one unrelated trade or business could be required to apply IRC Section 512(a)(6) when determining whether it receives more than one-third of its support from nonpublic sources. This could result in an increase in support received from nonpublic sources, as the tax-exempt organization cannot offset income from one unrelated trade or business with losses from another unrelated trade or business, thus making it difficult to qualify as publicly supported.

The Preamble states that because it does not appear that Congress intended to change the public support test when it enacted IRC Section 512(a)(6), the proposed regulations would revise Treas. Reg. Sections 1.170A-9(f) and 1.509(a)-3 to permit a tax-exempt organization with more than one unrelated trade or business to aggregate net income and net losses from all of its unrelated business activities in determining whether it meets the public support test.

Comments requested

The Preamble outlines a number of areas in which Treasury and the IRS request comments, including:

• Whether another method of classifying separate unrelated trades or businesses other than 2-digit NAICS codes would most accurately describe unrelated trades or businesses for purposes of IRC Section 512(a)(6)
• Whether circumstances exist where the change of NAICS code classification should be permitted
• Whether exempt organizations pay any state income taxes that are not directly connected with any separate unrelated trade or business and, therefore, should be deductible against total UBTI
• Whether any methods of allocating expenses between related and unrelated activities and separate businesses, other than the gross-to-gross method, should be considered unreasonable
• The methods that could be adopted instead of a reasonableness standard for allocations between related and unrelated activities and two separate unrelated trades or businesses
• Specific factors that should be considered when determining whether an activity constitutes an "investment activity" for purposes of IRC Section 512(a)(6)
• Whether certain permitted rights or actions should be disregarded in determining whether a partnership interest is a QPI, for purposes of IRC Section 512(a)(6)
• The administrability of permitting the aggregation of indirectly held partnership interests that meet the requirements of the de minimis test
• Whether all the rights or powers indicating control should be weighted the same or whether there are certain circumstances in which a particular right or power would never indicate control
• Whether to permit an exempt organization to hold a higher percentage interest in a partnership, for purposes of meeting the de minimis or control test, in tax years in which its percentage interest increases because of the actions of other partners during that year
• Whether additional transitional relief is necessary for aggregation of partnership interests
• Whether there are any unintended consequences, in areas other than UBTI, resulting from treating investment activity as an unrelated trade or business for purposes of IRC Section 512(a)(6) for VEBAs and SUBs
• Particular facts and circumstances that a social club should consider when determining whether a nonrecurring event should be treated as a separate unrelated trade or business, part of a larger trade or business, or as part of a social club's investment activities for purposes of IRC Section 512(a)(6)
• Whether an ordering rule is necessary to clarify how the special rule in IRC Section 170(d)(1)(B) operates when an exempt organization has both NOL carry overs and charitable contribution carry overs in more than one unrelated trade or business
• How IRC Section 512(a)(6) should be applied with regard to the public support test, given that requiring different calculations to determine public support and UBTI may impose a significant administrative burden on organizations that have more than one unrelated trade or business

Written comments and requests for a public hearing must be submitted to the IRS within 60 days of April 24, 2020, when the proposed regulations were published in the Federal Register.

Implications

2- Digit NAICS codes

The IRS and Treasury Department have made a favorable decision in concluding that a tax-exempt organization should classify each of its separate unrelated trades or businesses using the NAICS 2-digit code that most accurately describes the unrelated trade or business, rather than using the NAICS 6-digit code as outlined in Notice 2018-67. This 2-digit code classification creates a limited number of business sectors and the opportunity to aggregate income and losses from similar operations in a single unrelated trade or business. However, the identification of which NAICS 2-digit code to use requires careful planning because once a code has been assigned, the tax-exempt organization may not change the code unless it can show that the code was chosen due to unintentional error, and that another code more accurately describes the unrelated trade or business.

Investment activities

The proposed regulations would provide that investment activities and partnership interests (both qualifying and non-qualifying) should not be classified as separate trades or businesses using 2-digit NAICS codes. Instead, investment activities permitted to be aggregated as one separate unrelated trade or business would be limited to: (i) QPIs, (ii) debt-financed properties, and (iii) qualifying S corporation interests, but would not include controlled foreign corporations under IRC Section 512(b)(17) or controlled entities under IRC Section 512(b)(13).

In determining whether a partnership interest is a QPI, the interest would have to meet either the de minimis test or the control test. Because both tests include ownership thresholds, tax-exempt organizations should pay close attention to their ownership levels in partnerships throughout the tax year, especially because the proposed regulations do not include a grace period for the tax-exempt organization to adjust ownership levels, even if ownership changes are out of the tax-exempt organization's control.

If either test is satisfied, the tax-exempt organization's investment in a private equity fund would qualify as a QPI and therefore the tax-exempt organization would generally be permitted to aggregate unrelated business taxable income and loss from such fund (and its lower-tier portfolio company investments that are engaged in unrelated trades or businesses) with other investments that similarly qualify as QPIs.

The proposed regulations would make two notable changes to the de minimis test: (1) taxpayers may disregard partnership interests of disqualified persons, controlled entities, and supporting organizations when determining whether a given interest meets the de minimis test, and (2) tax-exempt organizations may use a look-through approach to aggregate indirectly-held partnership interests. These changes serve to further reduce administrative burden and compliance costs; however, taxpayers should take care to consider the de minimis and control tests separately, as the latter is not covered by the look-through approach and still requires the consideration of certain related interests.

The look-through rule would be especially helpful for tax-exempt organizations that have non-QPI investments in funds with multiple lower-tier pass-through portfolio companies, or certain fund-of-funds investments, and in which the tax-exempt organization can satisfy the de minimis test. However, if the tax-exempt organization cannot meet the de minimis test for a partnership portfolio company, then each partnership portfolio company would constitute a separate trade or business, depending on the type of business or industry (determined based on the NAICS 2-digit codes), with the ability to net unrelated business taxable income and losses limited to the portfolio company level (on a NAICS-code-by-NAICS-code basis). In such cases, the tax-exempt organization would be unable to net unrelated business taxable income and loss across the fund's other portfolio companies or with the tax-exempt organization's other QPI investments, which would affect the internal rate of return on their fund investments. If neither the de minimis test nor the control test is met for a partnership and therefore the investment is not a QPI, then the tax-exempt organization would need to classify its UBTI from that partnership's underlying activities using one or more 2-digit NAICS codes.

The proposed regulations would include a transition rule for partnership interests acquired before August 21, 2018 that do not meet the requirements of either the de minimis test or the control test. The rule would provide that such interests may be treated as a single trade or business for purposes of IRC Section 512(a)(6). However, because this transition rule would end on the first day of the tax-exempt organization's tax year beginning after final regulations are published, exempt organizations should evaluate the tax and nontax considerations of proactive planning strategies such as reducing their ownership interests in partnerships qualifying under this rule so that they meet the de minimis or control test and, therefore, can be treated as a single trade or business once the final regulations are adopted.

For private equity and alternative asset fund managers, the de minimis and control tests would require an analysis of a fund's investor composition and ownership percentages in various fund entities (e.g., the main fund and any alternative investment vehicles). Funds would also need to evaluate the application of the proposed regulations as well as other tax and nontax considerations when allocating their tax-exempt organization investor base into various holding company structures and to make distinctions between passive interests in funds (i.e., investment funds that are not directly or indirectly engaged in a trade or business) and flow-through portfolio companies that are engaged in an active trade or business (e.g., private equity backed energy and real estate portfolio companies). Funds and their tax-exempt organization investors should focus in particular on situations in which tax-exempt organization investors have personnel/officers that are on the board of either the fund or on partnership portfolio companies, and on any co-investment scenarios.

NOLs

The proposed regulations would provide that a tax-exempt organization with losses arising in a tax year beginning before January 1, 2018 (pre-2018 NOLs), and with losses arising in a tax year beginning after December 31, 2017 (post-2017 NOLs) deducts its pre-2018 NOLs from total UBTI before deducting any post-2017 NOLs with regard to a separate unrelated trade or business against the UBTI from that trade or business. This rule is intended to enable exempt organizations to apply all of their pre-2018 NOLs before the 20-year expiration date of those NOLs. However, the rule may make UBTI calculations more challenging for organizations that carry both pre-2018 and post-2017 NOLs. If an organization were to first calculate total UBTI from an unrelated trade or business without regard to post-2017 NOLs for a given tax year, then aggregate UBTI from all unrelated business to determine total UBTI, and only then deduct pre-2018 NOLs from total UBTI, as the proposed regulations direct, it is unclear how the tax-exempt organization could subsequently allocate post-2017 NOLs from different unrelated trades or businesses to offset any remaining UBTI for the tax year in which all pre-2018 NOLs have been fully utilized.

This new ordering rule likely will require significant revisions to Form 990-T, which currently directs filers to first deduct post-2017 NOLs from each separate trade or business's UBTI (see Part II, line 30), then deduct pre-2018 NOLs from total UBTI (see Part III, line 36).

Expense allocation

Though Treasury and the IRS declined to provide guidance in the proposed regulations on the proper method of allocating expenses between a tax-exempt organization's core exempt activities and its unrelated trades or businesses, they do state that an "unadjusted gross-to-gross" method is not a reasonable method. Tax-exempt organizations should continue to take a reasonable, consistent approach in allocating to unrelated trade or business activities only expenses that are primarily and proximately related to those activities and documenting their allocation methods while awaiting further guidance regarding what constitutes a reasonable method.

Subpart F and GILTI

The proposed regulations reaffirm the conclusion of Notice 2018-67 that inclusions of Subpart F income under IRC Section 951(a)(1)(A) and GILTI under IRC Section 951A are treated in the same manner as dividends for purposes of IRC Section 512(b)(1) and, therefore, do not constitute UBTI.

Public support

The proposed regulations state that Treasury and the IRS are not aware of any intent by Congress to change the public support test calculation via IRC Section 512(a)(6). Accordingly, the proposed regulations would provide that exempt organizations should aggregate income and losses from unrelated business activities for purposes of the public support calculation, rather than applying the 512(a)(6) rules in calculating UBTI separately for each trade or business, for purposes of the public support test.

Issues not addressed

Although the proposed regulations are very extensive, they are not comprehensive, as they do not provide guidance on several significant issues regarding IRC Section 512(a)(6), including:

• What methods are reasonable for allocating expenses between related and unrelated activities, and between separate unrelated trades or businesses
• Whether exempt organizations may carry back 2018, 2019, and 2020 NOLs from particular unrelated trades or businesses to offset total UBTI in pre-2018 tax years, pursuant to the CARES Act, without violating IRC Section 512(a)(6)
• Whether the 80% limitation on offsetting UBTI with post-2017 NOLs should be applied against (i) an exempt organization's total UBTI for a given tax year, or (ii) the UBTI of each separate unrelated trade or business, before calculating total UBTI for that tax year
• How to deduct post-2017 NOLs against UBTI after deducting pre-2018 NOLs from total UBTI for a given tax year

Comments

The proposed regulations clarify that for tax years beginning before the date these regulations are published as final, an exempt organization may rely upon a good faith interpretation of IRC Section 512(a)(6) in determining how to identify separate trades or businesses in calculating UBTI. Accordingly, although a tax-exempt organization may rely on these proposed regulations in calculating UBTI, it should consider whether alternative positions are available to it that are predicated on a good-faith interpretation of the Code that diverge in some respects from the proposed regulations (e.g., means of determining separate trades or businesses, aggregating investments as a single trade or business, ordering deduction of pre-2018 and post-2017 NOLs).

Any tax-exempt organization that may be impacted by these proposed regulations should review them, consider the implications to the organization, and determine whether it should submit comments. As evidenced by the Preamble's numerous references to comments considered, the IRS and Treasury review and consider all comments that are timely submitted. Given that the IRS and Treasury have indicated their desire to finalize all regulations relating to the TCJA as soon as possible, we anticipate these regulations will be finalized prior to the end of this calendar year, and that any comments would need to be submitted by the June 23, 2020 deadline to be considered.

Please contact your Ernst & Young LLP professional for further information.

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RELATED RESOURCES

— For more information about EY's Exempt Organization Tax Services group, visit us here.

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