Tax News Update    Email this document    Print this document  

December 3, 2020

Final regulations on unrelated trades or businesses affect tax-exempt organizations, as well as asset managers with exempt organizations as investors

In final regulations (TD 9933), the IRS provides guidance on how an exempt organization determines if it has more than one unrelated trade or business and, if it has more than one, how to calculate unrelated business taxable income (UBTI).

The regulations are relevant not only to tax-exempt organizations, but also to private equity and alternative asset management funds with tax-exempt investors, as the regulations may impact funds' Schedules K-1 and tax compliance disclosures and structuring of the funds' investments.


The underlying proposed regulations (REG-106864-18), published in May 2020, generated 17 sets of comments. The IRS reviewed these comments but adopted few of them, so the final regulations generally track the proposed regulations. This Alert highlights the handful of substantive changes made to the proposed regulations. (For more on the proposed regulations, see Tax Alert 2020-1220.)

Two reserved issues

The Preamble to the final regulations (Preamble) states that the IRS and Treasury plan to publish a separate notice of proposed rulemaking that will address two issues reserved under the proposed regulations. The two issues pertain to: (1) the allocation of expenses, depreciation and similar items shared between an exempt activity and an unrelated trade or business and between more than one unrelated trade or business; and (2) changes that the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) made to the IRC Section 172 NOL deduction rules.

Changes reflected in final regulations

Using NAICS codes to identify regularly carried on trades or businesses

The final regulations provide that, after an exempt organization applies IRC Sections 511 through 514 to determine whether it carries on unrelated trades or businesses, the organization then identifies any separate unrelated trades or businesses for purposes of IRC Section 512(a)(6), using methods outlined in the final regulations. Once the separate trades or businesses are identified, the exempt organization then calculates UBTI for each separate trade or business. Generally, whether activities are considered separate trades or businesses depends on whether differences exist between the 2-digit North American Industry Classification System (NAICS) codes that most accurately describe the activities. The final regulations add that:

  • Determining what 2-digit NAICS code to use in classifying each separate unrelated trade or business "is based on the more specific NAICS code, such as at the 6-digit level, that describes the activity that it conducts."
  • Entities should use trade or business descriptions in the current NAICS manual (on when making these determinations.
  • "[The] separate unrelated trade or business" of selling goods online and in stores "is identified by the goods sold in stores if the same goods generally are sold both online and in stores."
  • Entities should use different 2-digit NAICS codes to describe multiple trade or business activities if that is most accurate and treat the activities as separate trades or businesses.
  • Entities may change 2-digit NAICS codes to accurately identify separate unrelated trades or businesses but must report the change on Form 990-T for the tax year in which the entity made the change.
  • A correction to a partnership interest that had been incorrectly designated as a qualifying partnership interest is considered a change in the identification of a separate unrelated trade or business that should be reported on Form 990-T.
  • Exempt organizations may choose, but are not required, to amend previously filed Forms 990-T to report separate trades or businesses using 2-digit NAICS codes, as shifting from 6-digit NAICS codes to 2-digit NAICS codes may result in the combination of trades or businesses that were previously reported as separate trades or businesses.

Allocation of directly connected deductions

The Preamble notes that the IRS and Treasury expressed concerns in the proposed regulations about the administrability of the reasonable basis standard. They also stated they "would continue to consider whether the reasonable basis standard should be retained" and intended to publish "a separate notice of proposed rulemaking."

The IRS received several comments asserting that the gross-to-gross unadjusted method should not be considered unreasonable and "can be reasonable if there is no price difference for goods or services provided in related and unrelated activities or if adjustments are made for any price differences." In response, the final regulations clarify that an allocation of expenses, depreciation and similar items will not be considered reasonable if (1) the cost that a related and an unrelated activity incur in providing a good or service is substantially the same; (2) the organization charges more for the good or service in the unrelated activity; and (3) "no adjustment is made to equalize the price difference for purposes of allocating expenses, depreciation, and similar items based on revenue between related and unrelated activities."

Determination of qualifying partnership interests

Like the proposed regulations, the final regulations allow an organization's "qualifying partnership interests" (QPIs) that generate UBTI to be aggregated as a single trade or business. The final regulations also define QPIs as those meeting either the de minimis test (exempt organization holds no more than a 2% capital interest and no more than a 2% profits interest in the partnership) or what was described in the proposed regulations as the "control test." The Preamble explains that the control test has been renamed "the participation test" because it focuses on determining whether an exempt organization significantly participates in a partnership. Therefore, the final regulations treat a partnership interest as a QPI if it meets the requirements of the participation test — that is, if the exempt organization (i) directly holds no more than 20% of the capital interest in the partnership; and (ii) does not significantly participate in the partnership.

If either the participation test or the de minimis test is satisfied with respect to an investment in a partnership, the tax-exempt organization's investment in that partnership would qualify as a QPI. The exempt organization would generally be permitted to net UBTI (and loss) from such partnership investment (and its lower-tier partnership investments that are engaged in unrelated trades or businesses) with other investments that similarly qualify as QPIs.

Determining percentage interest

Consistent with the proposed regulations, the percentage interest for purposes of both the de minimis test and the participation test is generally based on the average of the exempt organization's percentage interest at the beginning and at the end of the partnership's tax year. For purposes of the de minimis test, the final regulations clarify that an exempt organization's profits interest in a partnership is determined in the same manner as its distributive share of partnership taxable income. For purposes of both the de minimis test and the participation test, the final regulations require an exempt organization to determine its capital interest in a partnership (absent a provision in the partnership agreement) based upon its interest in the partnership's assets at the time of its withdrawal from the partnership, or upon liquidation of the partnership, whichever is greater.

Defining 'significant participation'

The Preamble notes that the proposed regulations provided a two-part test for control — a general facts-and-circumstances test "based on the well-defined concept in the Code of 'control'" and a more specific test involving factors evidencing per se control. Noting that the Code does not define "participation," the Preamble explains that a facts-and-circumstances test "to determine whether an exempt organization partner significantly participates in a partnership could have a broader application than intended" would increase uncertainty and impose an unnecessary administrative burden on exempt organizations and the IRS. As a result, the final regulations do not include the facts-and-circumstances test. Determining an exempt organization's significant participation under the final regulations is accomplished by considering four factors, two pertaining to the organization's power to act and two pertaining to the rights of individuals within the organization to act:

  • The exempt organization has the power to:
    • Appoint or remove any of the partnership's officers or employees or a majority of directors or
    • Require the partnership to perform, or prevent the partnership from performing, any act that significantly affects the operations of the partnership
  • Any of the exempt organization's officers, directors, trustees or employees have rights to:
    • Participate in the partnership's management or
    • Conduct the partnership's business at any time

Combining related interests

The proposed regulations provided an aggregation rule for determining whether an exempt organization controlled a partnership by taking into consideration interests held by supporting organizations (as described in IRC Section 509(a)(3)) and controlled entities (as described in IRC Section 512(b)(13)). The aggregation rule applied for purposes of the control test, but not the de minimis test.

The IRS generally rejected commenters' suggested modifications to the aggregation rule. Instead, the final regulations require an exempt organization, in determining its percentage interest for purposes of the participation test, to aggregate the ownership interests of a supporting organization — other than a Type III supporting organization that is not a parent of its supported organizations — and a controlled entity with its own interest in a given partnership.

General partner prohibition from favorable QPI treatment

If an exempt organization or any of its controlled or supporting organizations is a general partner of a partnership, the final regulations clarify that the partnership is not a QPI, regardless of the organization's percentage interest in the partnership.

Unrelated debt-financed income

The final regulations adopt the proposed regulations' treatment of debt-financed income (UDFI) without change. For purposes of aggregating debt-financed UBTI with income from other qualifying investment activities as a single unrelated trade or business under IRC Section 512(a)(6), the proposed regulations included unrelated debt-financed property or properties described in IRC Sections 512(b)(4) and 514 as part of a tax-exempt investor's "investment activities." This will permit tax-exempt investors to treat any debt-financed income from investments, regardless of a tax-exempt investor's percentage ownership in the investment, as part of the investor's qualifying investment activities. When a partnership that is a not a QPI generates UBTI from multiple unrelated trades or businesses, however, the UBTI from those trades or businesses would need to be calculated separately rather than netted with any debt-financed income attributable to the investment, which may create complexities and adverse tax consequences for tax-exempt investors and reporting complexities for fund managers.

Look-through rule

A look-through rule in the proposed regulations treated an exempt organization's indirectly held interest in a partnership as a QPI if the exempt organization indirectly held a no-more-than-2%-profits interest and a no-more-than-2% capital interest in the partnership through another partnership in which the organization directly holds more than a 20% capital interest but does not control/significantly participate. The exempt organization would then be permitted, but not required, to aggregate its UBTI from the 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). In response to certain comments on the look-through rule, the Preamble explains that the final regulations expand the rule to apply when the exempt organization significantly participates in the directly held partnership but holds no-more-than 2%-capital-and-profits interests in an indirectly held partnership.

Grace period

Agreeing with commenters that "a change in an exempt organization's percentage interest in a partnership that is due entirely to the actions of other partners may present significant difficulties for the exempt organization," the IRS added a one-year grace period to the final regulations. This grace period allows a partnership interest to be treated as meeting the requirements of the de minimis test or the participation test in a given tax year if certain requirements are met. Generally, these requirements are:

  1. The partnership interest satisfied the de minimis test or participation test in its prior tax year without applying the grace period.
  2. The increase in percentage interest is due to the actions of a partner or partners other than the exempt organization or any of its controlled organizations or supporting organizations.
  3. With regard to a partnership interest that satisfied the participation test in the prior tax year, the interest of the partner(s) that caused the increase in percentage interest described in (2) was not combined for the prior tax year and is not combined for the tax year of the change with the exempt organization's partnership interest.

S corporation interest treated as interest in unrelated trade or business

The proposed regulations generally treated each S corporation interest that an exempt organization held as an interest in a separate unrelated trade or business, consistent with IRC Section 512(e)(1)(A). Under the proposed regulations, UBTI from an S corporation interest was 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); and (2) gain and loss on the disposition of S corporation stock.

Qualifying S corporation interests: To ease the administrative burden, the proposed regulations permitted an exempt organization to aggregate UBTI from an S corporation interest with UBTI from other investment activities if the organization's ownership percentage in the S corporation met the de minimis test or control test for QPIs.

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. An exempt organization could rely on the Schedule K-1 (Form 1120-S) that it receives from the S corporation when determining its percentage ownership of the stock in the S corporation.

The final regulations clarify how the QPI rules apply to S corporation interests by (1) substituting certain terms to make the regulations easier to understand; (2) clarifying that, when determining whether an S corporation interest is a qualifying S corporation interest, the rules for determining an exempt organization's capital interest and profits interest in a partnership do not apply but "the average percentage stock ownership is determinative"; (3) clarifying that a grace period may apply for changes in an exempt organization's percentage of stock ownership in an S corporation; and (4) clarifying that an exempt organization can rely on the Schedule K-1 (Form 1120-S) it receives from an S corporation if the form provides enough information to determine the organization's percentage of stock ownership for the year. The Preamble notes that the IRS and Treasury are considering whether Schedule K-1 (Form 1120-S) should be revised "to provide the information needed to determine whether an S corporation interest is a QPI."


The final regulations, like the proposed regulations, require an exempt organization with both pre-2018 and post-2017 NOLs to 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. They also require exempt organizations to deduct pre-2018 NOLs from total UBTI in the manner that results in maximum utilization of the pre-2018 NOLs in a tax year. By allowing maximum utilization of the pre-2018 NOLs in a tax year, the Preamble explains, the IRS and Treasury intend to provide exempt organizations with the flexibility to choose how to allocate pre-2018 NOLs among separate unrelated trades or businesses and to permit an exempt organization to maximize post-2017 NOLs after taking pre-2018 NOLs.

The TCJA modified IRC Section 172 to limit deductions for 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. The CARES Act suspended the 80% income limitation of IRC Section 172(a)(2)(B)(ii) for NOL application, 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 the loss. The proposed regulations did not address how these changes to IRC Section 172 impact post-2017 NOLs generated by tax-exempt organizations, but the IRS requested comments on this issue.

Treatment of NOLs upon sale, transfer, termination, or other disposition of a separate unrelated trade or business:Noting that IRC Section 512(a)(6) allows only pre-2018 NOLs to be taken against UBTI and only losses attributable to a separate unrelated trade or business to be taken against that business's income, the Preamble states that the IRS and Treasury recognize that an exempt organization that terminates, sells, or otherwise transfers an unrelated trade or business may later recommence that separate unrelated trade or business or acquire a separate unrelated trade or business identified in the same manner. As a result, the final regulations (1) suspend any remaining NOLs after an exempt organization has offset any gain from the termination, sale, exchange or other disposition of a separate unrelated trade or business, but (2) allow the suspended NOLs to be used if the exempt organization either resumes the previous separate unrelated trade or business or begins or acquires a new unrelated trade or business that is accurately identified with the same NAICS 2-digit code in a later tax year.

Treatment of NOLs upon changing identification of a separate unrelated trade or business: The final regulations generally provide the following:

  • For purposes of IRC Section 512(a)(6), a separate unrelated trade or business that changes identification is treated as if the originally identified separate unrelated trade or business is terminated and a new separate unrelated trade or business is commenced; none of the NOLs from the previously identified separate unrelated trade or business will be carried over.
  • The change in identification may apply to all or a part of the originally identified separate unrelated trade or business.
  • A change in identification is effective as of the first day of the tax year in which the change is made; therefore, the newly identified separate unrelated trade or business is treated as commencing on this date.
  • An exception applies when an exempt organization determines that a different 2-digit NAICS code would more accurately identify an unrelated trade or business to which there has been no material change — the NOLs from that trade or business would continue to be attributable to that same, though differently identified, trade or business.

Public support

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) and (2) the calculation of not-more-than-one-third support under IRC Section 509(a)(2)(B). Comments on the proposed regulations generally agreed with the IRS that Congress probably did not intend to change the public support test when it enacted IRC Section 512(a)(6). To reduce administrative burden in determining whether the public support test is met, however, some commenters recommended allowing exempt organizations to choose whether to use their UBTI calculated under IRC Section 512(a)(6) or calculated in the aggregate. The final regulations adopt these suggestions, giving exempt organizations the option to calculate public support using either method.


The final regulations and the Preamble clarify that:

  • The "unrelated trade or business" definition applies to individual retirement accounts.
  • Inclusions of subpart F income and global intangible low-taxed income (GILTI) are treated like dividends in determining UBTI.
  • The IRS and Treasury decline to waive any underpayment penalties on the calculation of UBTI under IRC Section 512(a)(6).
  • The final regulations apply to an exempt organization for its first tax year beginning on or after the date those regulations are published in the Federal Register (i.e., tax years beginning in 2021 if the regulations are published in the Federal Register by the end of 2020).


Exempt organizations with unrelated trades or businesses have been adapting to the provisions of IRC Section 512(a)(6) for years. The issuance of final regulations will now enable these organizations to refine their adoption of the Code section and properly plan for future unrelated trade or business activities. For example, organizations may wish to revisit their prior classification and reporting of trades or businesses as separate trades or businesses under the 6-digit NAICS classification system to determine if there is a more favorable result under the 2-digit NAICS classification system; if so, they may wish to consider amending their prior Forms 990-T to either (a) offset UBTI with previously reported NOLs or (b) combine NOLs that were previously reported as separate.

The allocation of expenses between similar related and unrelated activities continues to vex the Service, which has reserved allocation of expenses for additional consideration, though it did provide guidance on one allocation method in the final regulations: the gross-to-gross allocation of costs for providing similar goods or services as both a related and unrelated trade or business, but for which the price for unrelated goods or services differs, will not be considered a reasonable method of allocation unless there is a corresponding adjustment. Thus, organizations that have been relying on this expense allocation method may want to reassess the methodology being used.

Similarly, exempt organizations that have been evaluating whether their investment activities meet the definition of a QPI must now review whether the elimination of the facts-and-circumstances test and/or the modification of the look-through rule changes their results. If an organization's interest in a partnership doesn't meet either the de minimis or participation test, the organization must treat that interest as a separate trade or business and assign an NAICS code to any unrelated trade or business activity conducted by the partnership. It must also treat as separate trades or businesses any second-tier, downstream partnership interests that it indirectly owns, unless they meet the de minimis or participation test using the look-through rule. If not, the organization and its fund manager would need to obtain information from each downstream partnership on its trade or business activities and UBTI attributable to those activities, then classify each activity using NAICS codes. Thus, the determination of a QPI requires a thorough review of the applicability of the final regulations and close coordination with fund managers and general partners of an organization's partnership investments.

The QPI aggregation rules should limit the extent to which tax-exempt investors and their fund managers need to review downstream partnership UBTI-generating activity and should reduce their related administrative reporting burdens. However, tax-exempt investors that are subject to IRC Section 512(a)(6) (and fail the de minimis test, but have a less-than-20% capital interest in a partnership) should focus on their personnel/officers who sit on the board of either the partnership or partnership portfolio companies, and on co-investment scenarios, to determine if they meet or fail the participation test for QPI aggregation.

The new one-year grace period for complying with the de minimis or participation test is a welcome addition for tax-exempt investors in open-ended funds or other funds in which a transfer of another investor's interest may unexpectedly cause the tax-exempt investor's ownership to exceed the de minimis or participation test ownership thresholds in a given tax year. Tax-exempt investors should consider requesting from their fund managers the ability to transfer or redeem their partnership investment if an event beyond their control occurs and results in such partnership investment no longer qualifying as a QPI.

Similarly, these final regulations may impact private equity and alternative asset management funds with tax-exempt investors and could create investor-relations considerations and investment-structuring challenges for funds. In particular, funds will need to take the regulations into account in preparing Schedules K-1 for tax-exempt investors and in preparing tax compliance disclosures. For instance, funds will likely need to inform US tax-exempt investors of their profits and capital percentage interest in funds/partnerships (including any direct investments in alternative investment vehicles) when furnishing Schedule K-1s and tax information packages.

Private equity and alternative funds should consider the regulations when structuring their investments. In particular, funds need to consider the regulations' QPI aggregation rules when slicing and dicing their investor base into various holding company structures; they also need to distinguish between passive investments (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 operating companies, energy companies and certain real estate portfolio companies). In addition, funds should consider the regulations when drafting or revising partnership agreements and tax-exempt investor side letters.

Finally, the final regulations do provide some additional guidance on the use of pre-2018 and post-2017 NOLs, noting that pre-2018 NOLs are taken against total UBTI in a manner that allows for maximum utilization of post-2017 NOLs in a tax year. In addition, the Service provided helpful guidance regarding the treatment of NOLs upon the sale, transfer or termination (and potential subsequent resumption) of an unrelated trade or business. Organizations that have gone through such transactions should revisit the treatment of any NOLs to determine the continued viability of these tax attributes and how they can be applied against future UBTI.


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


Contact Information
For additional information concerning this Alert, please contact:
Exempt Organization Tax Services
   • Terence Kennedy (
   • Steve Clarke (
   • Melanie McPeak (
   • Kristen Farr Capizzi (
   • Jack Miya (
FSO – Private Equity Tax
   • Gerald Whelan (
   • Morgan Anderson (