The 2017 Tax Cuts and Jobs Act contained a provision which disallows exempt entities with multiple unrelated trades or businesses from deducting the losses from one unrelated business against the income from another, separate trade or business. However, clarification is needed when it comes to distinguishing what constitutes as a separate trade or business (“siloing”). The Treasury intends to provide regulations that resolve any lingering confusion. In the interim, the IRS has issued Notice 2018-67 (The Notice) which provides some limited guidance on complying with the new Unrelated Business Taxable Income (UBTI) rules.
The Notice states that taxpayers may rely on reasonable, good-faith interpretation of what a separate trade or business is, and may use the North American Industry Classification System (NAICS) as a guide. Therefore, if two activities have different codes within the NAICS system, they would need to be treated as separate activities. Additionally, it suggests the use of the fragmentation principle under Reg Section 1.513-1(b). This principle states that an unrelated activity does not lose its identity as unrelated because it occurs within a larger, related activity.
The Notice does not indicate how to handle items such as debt financed properties, or payments from controlled corporations. For example, is each rental property considered a separate trade or business, or should income from all debt financed property be aggregated and treated as a single trade or business? The Notice does indicate that separate treatment of each debt financed property would be an administrative burden, and that there might be circumstances where aggregation would be appropriate. Due to the uncertainty in this area, the Notice requests comments regarding the treatment of unrelated income as defined in Sections 512(b)(4), (13) and (17). These code sections refer to debt financed income, income from controlled entities and income from foreign controlled entities.
Another area of confusion under the separate trade or business rules is the treatment of income from multiple partnership investments. The Notice states that Regulations will be issued that will allow for the aggregation of activities that are in the nature of investments. Until the Regulations are issued, the determination of whether a partnership interest is in the nature of an investment will be determined if it meets one of two tests.
De Minimis Test. The first test is the de minimis test. Under this test, a partnership interest will qualify as an investment if the organization’s interest in profits and capital are no more than two percent. This determination must be made by including the ownership interests held by controlled entities, supporting organizations and disqualified persons.
Control Test. The second test is the control test. This is a facts and circumstances test which is met if the exempt organization cannot influence or control the partnership. If either the de minimis or control tests are met, then a partnership’s activities can be combined with other qualifying partnership activities. According to the Notice, any debt financed income or loss within a qualifying partnership should be aggregated with other partnership activities, and not with debt financed income from non-partnership sources.
Until Regulations are issued, exempt organizations may rely on Notice 2018-67 for guidance. Additionally, Treasury is seeking comments about the implications of the new law which requires the separation of UBI activities into separate trades and businesses. If you have questions about the Notice, or would like to make a comment, please contact us for assistance.