A tax-exempt organization, such as a university, foundation, or pension fund, generally is not taxed on income earned from its tax-exempt activities, but is taxed at regular corporate rates on its unrelated business taxable income (UBTI). UBTI generally includes income or gain from “debt-financed” investments. If a tax-exempt organization invests in the equity of a partnership that borrows money to make investments, its allocable share of income or gain from the partnership's debt-financed investments generally will be UBTI.
The Tax Cuts and Jobs Act added Section 512(a)(6) to the tax code. Under that section, an exempt organization with more than one unrelated trade or business must compute UBTI separately with respect to each business, and cannot offset income from one business with losses from another.
Proposed Regulations
Very generally, under the proposed regulations, tax-exempt organizations identify separate businesses by reference to the first two digits of the North American Industry Classification System (NAICS) to which each business corresponds, and allocate deductions among those businesses using a reasonable method. The "gross-to-gross" method, which allocates deductions proportionately based on the gross income that each business generates, is not reasonable.
Qualifying partnership interests and debt-financed properties are treated as a single business. An interest in a partnership is a qualifying partnership interest if the tax-exempt organization either (1) directly and indirectly holds no more than 2% of the partnership's profits and capital interests, or (2) directly holds no more than 20% of the partnership's capital interests and, under applicable facts and circumstances, does not control the partnership's activities. For purposes of determining its ownership percentage, a tax-exempt organization may rely on the Schedule K-1 that it receives from a partnership.
Effective Dates
The proposed regulations will apply to taxable years beginning on or after the date they are finalized. Before that, taxpayers may either (1) apply any reasonable, good-faith interpretation of the relevant code provisions, (2) rely on the proposed regulations in their entirety, or (3) rely on IRS Notice 2018-67, which is similar to the proposed regulations but tends to treat more businesses as separate from each other.
Originally published Cadwalader, May 2020
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