New Section 512 Regulations: UBTI Reporting
The Tax Cuts and Jobs Act added section 512(a)(6) to the Internal Revenue Code in 2017, requiring any exempt organization with more than one unrelated trade or business to report the net income from each activity separately, and no longer allowing a net loss from one activity to offset income from another.
We previously wrote about the proposed regulations the Treasury Department released in early 2020. In late 2020, the Treasury Department issued final regulations on how to apply section 512(a)(6), incorporating comments received regarding the proposed regulations. Significant changes from, and clarifications of, the proposed regulations include:
Test for Qualifying Partnership Interests
For purposes of identifying qualifying partnership interests (“QPIs”), the “control test” was renamed the “participation test” to eliminate confusion around the use of the 20-percent threshold established as part of the test. Commenters advocated for a higher threshold since > 50 percent is used in other parts of the Code as a metric to identify control. Treasury responded by renaming the test since its intention was to provide a means to reduce administrative burden but not necessarily to allow an organization to aggregate the unrelated business taxable income (“UBTI”) from all partnership interests that it doesn’t control.
The look-through rule provided for partnership interests that are not QPIs was expanded to include partnership interests in which the organization significantly participates (the proposed regulations only allowed partnership interests that exceeded the ownership percentage threshold but not the “control” factors) and to permit partnership interests held indirectly through such partnership interests to qualify as QPIs if the participation test is met with respect to the partnership which is the direct holder of the interest (proposed regulations only allowed indirectly held partnership interests that satisfied the de minimis test to potentially qualify).
Although reporting of trade or business activities on the Form 990-T is at the 2-digit NAICS code level, an organization should categorize its activities by the more specific 6-digit NAICS codes. An organization will only report each 2-digit NAICS code once, so this would result in the combination of two activities with different 6-digit NAICS codes if they have the same 2-digit code. Organizations are no longer barred from changing the 2-digit NAICS code used to report a trade or business activity – they just are required to report the change on the Form 990-T in accordance with instructions to be issued.
The Action on Decision relating to Rensselaer Polytechnic Institute v. Commissioner stated that the IRS would not litigate the reasonableness of an expense allocation method until the allocation rules of Treasury Regulations §1.512(a)(-1(c) were amended. As part of these regulations, the IRS rescinds this AOD to the limited extent of any expense allocation method that fails to equalize price differences between related activities and unrelated trade or business activities. (This is otherwise known as the “gross-to-gross method” of allocating the expenses of an activity that generates related and unrelated revenue based on relative revenue rather than other criteria such as direct costs or time spent.) The IRS will continue to refrain from litigating the reasonableness of other allocation methods pending the publication of further guidance which should be considered to be forthcoming soon.
Net Operating Losses
Pre-2018 net operating losses (“NOLs”) are to be taken against UBTI in a manner that allows for maximum utilization of post-2017 NOLs (limited by trade or business activity), rather than pre-2018 NOLs. For example, an organization may allocate all of its pre-2018 NOLs to one of its separate unrelated trades or businesses or it may allocate its pre-2018 NOLs ratably among its separate unrelated trades or businesses, whichever results in the greater utilization of the post-2017 NOLs in that taxable year. The regulations also clarify what happens to NOLs generated by business activities that are disposed of or otherwise changed.
The final regulations are applicable to tax years beginning after the date the final regulations were published in the Federal Register (December 2, 2020), or generally speaking, the 2021 tax year. Therefore, for earlier tax years, an exempt organization may choose either to rely on the final regulations or one of the following:
- A reasonable, good-faith interpretation of sections 511 through 514, considering all the facts and circumstances, when identifying separate unrelated trades or businesses for purposes of section 512(a)(6).
- The proposed regulations in their entirety.
- Notice 2018-67.
The final regulations in their entirety can be viewed here.
If you have questions or concerns on how this may affect your organization, please contact Amanda Adams.