Federal Register, Volume 85 Issue 232 (Wednesday, December 2, 2020)

[Federal Register Volume 85, Number 232 (Wednesday, December 2, 2020)]
[Rules and Regulations]
[Pages 77952-77984]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-25954]

[[Page 77951]]

Vol. 85

Wednesday,

No. 232

December 2, 2020

Part V

Department of the Treasury

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Internal Revenue Service

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26 CFR Parts 1 and 602

Unrelated Business Taxable Income Separately Computed for Each Trade
or Business; Final Rule

Federal Register / Vol. 85 , No. 232 / Wednesday, December 2, 2020 /
Rules and Regulations

[[Page 77952]]

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9933]
RIN 1545-BO79

Unrelated Business Taxable Income Separately Computed for Each
Trade or Business

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final rule.

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SUMMARY: This document contains final regulations that provide guidance
on how an exempt organization subject to the unrelated business income
tax determines if it has more than one unrelated trade or business,
and, if so, how the exempt organization calculates unrelated business
taxable income. The final regulations also clarify that the definition
of ``unrelated trade or business'' applies to individual retirement
accounts. Additionally, the final regulations provide that inclusions
of ``subpart F income'' and ``global intangible low-taxed income'' are
treated in the same manner as dividends for purposes of determining
unrelated business taxable income. The final regulations affect exempt
organizations that are subject to the unrelated business income tax.

DATES:
Effective date: The final regulations are effective on December 2,
2020.
Applicability date: For dates of applicability, see Sec. Sec.
1.170A-9(k)(3), 1.509(a)-3(o), 1.512(a)-1(h), 1.512(a)-6(i), 1.512(b)-
1(a)(3), 1.512(b)-1(g)(5), and 1.513-1(h).

FOR FURTHER INFORMATION CONTACT: Jonathan A. Carter at (202) 317-5800
or Stephanie N. Robbins at (202) 317-4086 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document amends the Income Tax Regulations (26 CFR part 1) by
adding final regulations under section 512(a)(6) of the Internal
Revenue Code (Code). Section 512(a)(6) was added to the Code by section
13702 of Public Law 115-97, 131 Stat. 2054 (2017), commonly referred to
as the Tax Cuts and Jobs Act (TCJA). Section 512(a)(6) requires an
exempt organization subject to the unrelated business income tax under
section 511 (UBIT) that has more than one unrelated trade or business,
to calculate unrelated business taxable income (UBTI), separately with
respect to each such trade or business including for purposes of
determining any net operating loss (NOL) deduction.
In August 2018, the Department of the Treasury (Treasury
Department) and the IRS released Notice 2018-67 (2018-36 IRB 409 (Sept.
4, 2018)), which discussed and solicited comments regarding various
issues arising under section 512(a)(6) and set forth interim guidance
and transition rules relating to that section. The Treasury Department
and the IRS received 24 comments in response to Notice 2018-67.
On April 24, 2020, the Treasury Department and the IRS published a
notice of proposed rulemaking (REG-106864-18) in the Federal Register
(85 FR 23172) that proposed regulations to provide guidance regarding
how an exempt organization subject to UBIT (hereinafter referred to as
an exempt organization) determines if it has more than one unrelated
trade or business, and, if so, how the exempt organization calculates
UBTI under section 512(a)(6) (proposed regulations). No public hearing
was requested or held. The Treasury Department and the IRS received 17
comments in response to the proposed regulations.
The proposed regulations reserved two issues for additional
consideration. The first issue relates to the allocation of expenses,
depreciation, and similar items shared between an exempt activity and
an unrelated trade or business or between more than one unrelated trade
or business. The second issue relates to changes made to the section
172 NOL deduction by the Coronavirus Aid, Relief, and Economic Security
Act, Public Law 116-136, 134 Stat. 281 (2020) (CARES Act). The Treasury
Department and the IRS anticipate publishing a separate notice of
proposed rulemaking that will address these issues.
After consideration of the comments received, the proposed
regulations are adopted as modified by this Treasury Decision. The
major areas of comment and the revisions to the proposed regulations
are discussed in the following Summary of Comments and Explanation of
Revisions. The comments are available for public inspection at
www.regulations.gov or on request. Other minor, non-substantive
modifications made to the proposed regulations and adopted in these
final regulations are not discussed in the Summary of Comments and
Explanation of Revisions.

Summary of Comments and Explanation of Revisions

These final regulations provide guidance on how an exempt
organization determines if it has more than one unrelated trade or
business, and, if so, how the exempt organization calculates UBTI under
section 512(a)(6). The final regulations also clarify that the
definition of ``unrelated trade or business'' in section 513(b) applies
to individual retirement accounts and that inclusions of subpart F
income and global intangible low-taxed income are treated in the same
manner as dividends for purposes of section 512.

1. Separate Unrelated Trade or Business

Consistent with section 512(a)(6) and the proposed regulations, the
final regulations provide that an exempt organization with more than
one unrelated trade or business must compute UBTI separately with
respect to each unrelated trade or business, without regard to the
specific deduction in section 512(b)(12), including for purposes of
determining any NOL deduction.
a. NAICS 2-Digit Codes Retained
The proposed regulations generally provided that an exempt
organization must identify each of its separate unrelated trades or
businesses using the first two digits of the North American Industry
Classification System code (NAICS 2-digit code) that most accurately
describes the unrelated trade or business. Most commenters agreed with
the proposed regulations' adoption of NAICS 2-digit codes over NAICS 6-
digit codes, which Notice 2018-67, for purposes of interim guidance,
provided was a reasonable way to identify separate trades or
businesses. One commenter discussed how the use of NAICS 2-digit codes
balances legislative intent of not allowing the losses from one
unrelated trade or business to offset the income from another unrelated
trade or business with the need for an administrable and efficient
method of identifying separate unrelated trades or businesses. Other
commenters agreed that NAICS 2-digit codes offer the most administrable
and least burdensome method of identifying separate unrelated trades or
businesses for both exempt organizations and the IRS.
One commenter disagreed with the use of NAICS 2-digit codes to
identify separate unrelated trades or businesses. This commenter noted
that, in passing the TCJA, Congress intended to limit exempt
organizations' use of tax benefits that are unrelated to their tax-
exempt purpose or purposes, and the commenter asserted that the
proposed regulations reversed this congressional intent by identifying
separate unrelated trades or businesses using the twenty broad
categories provided by NAICS 2-digit codes. This commenter

[[Page 77953]]

recommended instead that the rules relating to the qualified business
deduction under section 199A for identifying a separate trade or
business should be used for purposes of section 512(a)(6). The
regulations under section 199A provide that the term ``trade or
business'' has the same meaning as in section 162. The commenter
contended that enough case law exists with respect to section 162 to
define ``trade or business'' and that the section 199A regulations have
provided practitioners with enough experience to identify a trade or
business using this definition.
The final regulations do not adopt the approach taken by the
section 199A regulations as a method of identifying separate unrelated
trades or businesses for purposes of section 512(a)(6) because,
although sections 199A and 512(a)(6) were both enacted as part of the
TCJA, they serve different purposes. Section 199A, in part, provides
individuals, estates, and certain trusts a deduction of up to 20
percent of business income from certain domestic trades or businesses.
Such taxpayers might be engaged in one or more trades or businesses for
which they may be entitled to the section 199A deduction. For purposes
of computing the section 199A deduction, taxpayers are required to
determine the specific lines between trades or business to ensure that
only qualified items of income and expense traced to each qualified
trade or business are used to compute the deduction and that the W-2
wage and unadjusted basis immediately after acquisition (UBIA)
limitations are properly applied. Therefore, the section 199A
regulations look to section 162 to determine how these lines should be
drawn. By contrast, section 512 looks to section 162 to determine
whether a trade or business exists but employs a simplified regime to
identify separate unrelated trades or businesses under section
512(a)(6) for exempt organizations because they are not primarily
engaged in section 162 for-profit trades or businesses. The regime also
applies for a more limited purpose, that is preventing exempt
organizations from using losses of one unrelated trade or business to
offset the gains of any other unrelated trade or business, and
uniformly to all of an exempt organization's separate unrelated trades
or businesses. The Treasury Department and IRS believe that using NAICS
2-digit codes in this context provides an objective means to identify
separate trades or businesses consistent with Congress's intent without
imposing an undue burden on exempt organizations. Accordingly, the
final regulations under section 512(a)(6) do not adopt this comment.
b. No Additional Methods of Identifying Separate Unrelated Trades or
Businesses
One commenter recommended that NAICS 2-digit codes be used as a
safe-harbor and that a facts and circumstances test be applied as the
primary method of identifying separate unrelated trades or businesses.
This commenter asserted that a facts and circumstances test would be
more consistent with other parts of the Code (including the regulations
under section 199A) and would provide a more flexible framework for
variations in activities across exempt organizations. This commenter
proposed considering multiple factors for identifying separate trades
or businesses that would include the interdependence of the activities,
the geographic location of the activities, and the relationship the
exempt organization has with the operation of the activity. The
commenter opined that a facts and circumstances test would help
alleviate any inequity caused by section 512(a)(6).
As explained both in Notice 2018-67 and the preamble to the
proposed regulations, Congress did not provide any explicit criteria
for determining whether an exempt organization has ``more than one
unrelated trade or business'' or for identifying ``separate'' unrelated
trades or businesses for purposes of calculating UBTI in accordance
with section 512(a)(6). The Joint Committee on Taxation (JCT) noted
that ``it is intended that the Secretary issue guidance concerning when
an activity will be treated as a separate unrelated trade or business
for purposes of [section 512(a)(6)].'' Staff of the Joint Committee on
Taxation, General Explanation of Public Law 115-97 (December 2018), at
293 (General Explanation). Notice 2018-67 stated that the Treasury
Department and the IRS would like to set forth a more administrable
method than a facts and circumstances test for identifying separate
unrelated trades or businesses. Nonetheless, the Treasury Department
and the IRS considered a facts and circumstances test as a method of
identifying separate unrelated trades or businesses in response to
comments received following the enactment of section 512(a)(6) and
again in response to Notice 2018-67. The factors suggested by
commenters, and previously considered, generally were derived from
other Code provisions, such as sections 132, 162, 183, 414, and 469.
However, these Code provisions primarily consider whether an activity
is a trade or business and not whether one trade or business is
``separate'' from another. Accordingly, the Treasury Department and the
IRS continue to consider these Code provisions, alone or in conjunction
with each other, as unhelpful models for identifying separate trades or
businesses for purposes of section 512(a)(6).
It continues to be the case that adoption of a facts and
circumstances test, as the only identification method or in addition to
a safe harbor using NAICS 2-digit codes, would increase the
administrative burden on exempt organizations in complying with section
512(a)(6) because a fact-intensive analysis would be required with
respect to each unrelated trade or business. Additionally, adoption of
a facts and circumstances test would offer exempt organizations less
certainty and likely result in inconsistency among exempt organizations
conducting more than one unrelated trade or business because of
differing approaches exempt organizations would take in applying such a
test. Also, a facts and circumstances test would increase the
administrative burden on the IRS, which, upon examination, must perform
the same fact-intensive analysis with respect to each of the unrelated
trades or businesses identified by the exempt organization for purposes
of calculating UBTI. Accordingly, the final regulations do not adopt a
facts and circumstances test in addition to or in place of NAICS 2-
digit codes as a method of identifying separate unrelated trades or
businesses for purposes of section 512(a)(6).
c. Identifying the Appropriate NAICS 2-Digit Code
The proposed regulations provided that an exempt organization's
separate unrelated trades or businesses are determined based on the
applicable NAICS 2-digit code. Before an exempt organization can
identify its ``separate'' unrelated trades or businesses, it must first
determine whether it regularly carries on unrelated trades or
businesses within the meaning of sections 511 through 514. Section
1.513-1(a) clarifies that, unless one of the specific exceptions of
section 512 or 513 applies, gross income of an exempt organization is
includible in the computation of UBTI if: (1) It is income from a trade
or business; (2) such trade or business is regularly carried on by the
organization; and (3) the conduct of such trade or business is not
substantially related (other than through the production of funds) to
the organization's performance of its exempt functions. Accordingly,
the final regulations provide that an exempt organization determines
whether it carries on unrelated trades or

[[Page 77954]]

businesses by applying sections 511 through 514. Under the final
regulations, the exempt organization then identifies its separate
unrelated trades or businesses for purposes of section 512(a)(6) using
the methods described in the final regulations. With respect to most
unrelated trade or business activities, an exempt organization
determines whether those activities are separate unrelated trades or
businesses for purposes of section 512(a)(6) based on the most accurate
NAICS 2-digit codes describing the activities.
Several commenters requested additional guidance regarding how to
choose the ``most accurate'' NAICS 2-digit code. These commenters
suggested that strict adherence to NAICS 2-digit codes can result in
unrelated trade or business activities that the exempt organization
considers to be one unrelated trade or business being separated into
two or more unrelated trades or businesses. Other commenters requested
that aggregation of NAICS 2-digit codes be allowed in certain
circumstances. The commenters provided examples of unrelated trade or
business activities that they considered to be one unrelated trade or
business but that may be identified as more than one unrelated trade or
business when using NAICS 2-digit codes.
For example, one commenter stated that an organization operating a
gift shop that sells clothing, electronics, and books in a bricks-and-
mortar store and online would report those activities under two
different NAICS 2-digit codes--one for the sale of clothing and
electronics (44) and one for books and online sales (45). Another
example provided by a commenter is a museum that provides catering
services, valet parking, and personal property rentals as part of a
package for special events, such as weddings, held on its premises. The
commenter noted that the museum may be required to identify these
activities using three different NAICS 2-digit codes--one for catering
(72), one for parking (81), and one for rentals (53). The commenter
posited that the museum should be able to treat this activity as one
trade or business based on a reasonable and common sense understanding
of the service provided (hosting an event), rather than the various
components of the provided services.
The Treasury Department and the IRS note that NAICS 2-digit codes
aggregate trade or business activities into only 20 separate trades or
businesses, compared to the more than 1,000 trades or businesses
identified at the NAICS 6-digit code level. Like the proposed
regulations, the final regulations provide that a separate unrelated
trade or business is identified by the NAICS 2-digit code that most
accurately describes the exempt organization's trade or business
activity. In addition, the final regulations add that this
determination is based on the more specific NAICS code, such as at the
6-digit level, that describes the activity that it conducts. The final
regulations also state that the descriptions in the current NAICS
manual (available at www.census.gov) of trades or businesses using more
than two digits of the NAICS codes are relevant in this determination.
In response to commenter examples, the final regulations incorporate a
rule used in NAICS for identifying certain industries \1\ and provide
that, in the case of the sale of goods, both online and in stores, the
separate unrelated trade or business is identified by the goods sold in
stores if the same goods generally are sold both online and in stores.
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\1\ The NAICS code for ``Electronic Shopping and Mail-Order
Houses'' provides that ``Store retailing or a combination of store
retailing and nonstore retailing in the same establishment--are
classified in Sector 44-45, Retail Trade, based on the
classification of the store portion of the activity.''
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With respect to the museum example, the Treasury Department and the
IRS note that income from activities that is appropriately
characterized as income from rentals is generally exempt from UBTI
under section 512(b)(3). The analysis of whether an activity produces
rental income depends, in part, on whether other services are provided
by the exempt organization in connection with the possible rental
activity (such as providing space for a wedding). To the extent other
services are provided, income from the use of space may cease to be
rent from real property and instead take on the character of the
services provided. See Sec. 1.512(b)-1(c)(5). Exempt organizations
already need to do this analysis of the facts and circumstances to
determine their UBTI. Similarly, whether services provided in
connection with hosting an event should be aggregated or not depends on
the facts and circumstances, including the language of the contract or
contracts, the services provided, who is providing the services, etc.
It is possible that the activities could be separate trades or
businesses based on the fragmentation rule contained in section 513(c)
and Sec. 1.513-1(b) (``[a]ctivities of producing or distributing goods
or performing services from which a particular amount of gross income
is derived do not lose identity as trade or business merely because
they are carried on within a larger aggregate of similar activities or
within a larger complex of other endeavors which may, or may not, be
related to the exempt purposes of the organization'').
Because the NAICS at the 2-digit code level aggregates all trade or
business activities into only 20 separate trades or businesses, many
trade or business activities that could be considered separate trades
or businesses, such as the provision of food or lodging, are already
aggregated into broad categories (NAICS code 72 includes both lodging
and food services) and therefore treated as one trade or business under
the final regulations. Accordingly, if an exempt organization
determines that, based on the facts and circumstances, its trade or
business activities must be separated into two or more unrelated trades
or businesses under NAICS 2-digit codes, the Treasury Department and
the IRS view that result as appropriate to achieve the balance of tax
administrability and carrying out the purposes of section 512(a)(6).
Thus, under the final regulations, if trade or business activities
would be best described by different NAICS 2-digit codes, those
activities should be identified using different NAICS 2-digit codes and
treated as separate unrelated trades or businesses.
In addition, consistent with the proposed regulations, the final
regulations continue to provide that the NAICS 2-digit code must
identify the separate unrelated trade or business in which the exempt
organization engages (directly or indirectly). The NAICS 2-digit code
cannot describe activities the conduct of which are substantially
related to the exercise or performance by such organization of its
charitable, educational, or other purpose or function constituting the
basis for its exemption under section 501 (or, in the case of an
organization described in section 511(a)(2)(B), to the exercise or
performance of any purpose or function described in section 501(c)(3)).
For example, a college or university described in section 501(c)(3) or
511(a)(2)(B) cannot use the NAICS 2-digit code for educational services
to identify all of its separate unrelated trades or businesses, and a
qualified retirement plan described in section 401(a) cannot use the
NAICS 2-digit code for finance and insurance to identify all of its
unrelated trades or businesses.
Also consistent with the proposed regulations, the final
regulations continue to provide that an organization will report each
NAICS 2-digit code only once. The Treasury Department and the IRS note
that this rule permits exempt organizations to aggregate trade or
business activities that may occur in

[[Page 77955]]

different geographic locations. The final regulations include the same
example as provided by the proposed regulations--the pharmacies
operated in different geographic locations that are one unrelated trade
or business for purposes of section 512(a)(6) because the pharmacy
trade or business is identified using one NAICS 2-digit code.
d. Changing NAICS 2-Digit Codes
The proposed regulations generally provided that, once an
organization has identified a separate unrelated trade or business
using a particular NAICS 2-digit code, the organization cannot change
the NAICS 2-digit code describing that separate unrelated trade or
business unless two requirements are met. First, the exempt
organization must show that the NAICS 2-digit code chosen was due to an
unintentional error. Second, the exempt organization must show that
another NAICS 2-digit code more accurately describes the unrelated
trade or business. The preamble to the proposed regulations stated that
the instructions to the Form 990-T, ``Exempt Organization Business
Income Tax Return,'' would be updated to describe how an exempt
organization notifies the IRS of a change in a NAICS 2-digit code due
to an unintentional error.
At least one commenter requested clarification regarding what is
meant by ``unintentional error.'' Commenters also suggested that the
final regulations should include additional circumstances in which
exempt organizations can change the NAICS 2-digit code describing a
separate unrelated trade or business. Several commenters explained that
the nature of a separate unrelated trade or business may change or
evolve to the extent that the unrelated trade or business would be more
accurately reported under a different NAICS 2-digit code. One commenter
likened this shift in trade or business activities to the commencement
of a new unrelated trade or business. Accordingly, these commenters
recommended that an exempt organization be permitted to change the
NAICS 2-digit code identifying a separate unrelated trade or business
if a change in the unrelated business activity results in it being
better described by a different NAICS 2-digit code. Finally, one
commenter requested that a code change be permitted if the exempt
organization's tax preparer reasonably believes that an unrelated trade
or business activity is more accurately described by a different NAICS
2-digit code.
Several commenters also requested clarification of the process for
reporting an erroneous code. One commenter recommended that the
instructions to the Form 990-T clarify that an exempt organization
should provide such notification to the IRS on the Form 990-T--
including an explanation of the change and any necessary supporting
information--and that such change would be effective on the first day
of the taxable year beginning after the taxable year for which the Form
990-T providing such notification is filed. This commenter also
questioned whether reconciliation was required for the prior taxable
year or years in which the erroneous code was used and, if so, how an
adjustment resulting from such reconciliation would be applied.
In response to these comments, the final regulations remove the
restriction on changing NAICS 2-digit codes. Instead, the final
regulations require an exempt organization that changes the
identification of a separate unrelated trade or business to report the
change in the taxable year of the change in accordance with forms and
instructions. See section 6012(a)(2) and Sec. 1.6012-2(e). The final
regulations clarify that a change in identification of a separate
unrelated trade or business includes the changed identification of the
separate unrelated trade or business with respect to a partnership
interest that was incorrectly designated as a qualifying partnership
interest (discussed in part 2.b of this Summary of Comments and
Explanation of Revisions). To report the change in identification, the
final regulations require an organization to provide certain
information with respect to each separate unrelated trade or business
the identification of which changes: The identification of the separate
unrelated trade or business in the previous taxable year, the
identification of the separate unrelated trade or business in the
current taxable year, and the reason for the change. The Treasury
Department and the IRS anticipate that the instructions to the Form
990-T will be revised for taxable years for which the final regulations
are effective to provide instructions regarding where and how changes
in identification are reported. The effect on NOLs caused by changes of
the identification of separate unrelated trades or businesses are
discussed in part 6.d of this Summary of Comments and Explanation of
Revisions.
e. Transition From NAICS 6-Digit Codes to NAICS 2-Digit Codes
The preamble to the proposed regulations provided that, for taxable
years beginning before the date the proposed regulations are published
in the Federal Register as final regulations, an exempt organization
may rely on 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 preamble to the proposed regulations provided
that an exempt organization could rely on the proposed regulations in
their entirety or, alternatively, the methods of aggregating or
identifying separate trades or businesses provided in Notice 2018-67,
which provided that a reasonable, good-faith interpretation included
using NAICS 6-digit codes.
One commenter recommended that the final regulations confirm that
an exempt organization that reported separate unrelated trades or
businesses using NAICS 6-digit codes in taxable years beginning prior
to the exempt organization's first taxable year for which the final
regulations are effective can reclassify their activities using NAICS
2-digit codes without having to report an unintentional error.
As discussed in the Applicability Dates section of this preamble,
these final regulations are applicable to taxable years beginning on or
after December 2, 2020. Although an exempt organization may have used
NAICS 6-digit codes to identify its separate unrelated trades or
businesses in taxable years beginning before this date, the transition
from NAICS 6-digit codes to NAICS 2-digit codes does not require the
reporting of a code change because the exempt organization will be
using the same NAICS code to identify its separate unrelated trades or
businesses--just with fewer digits. The move from NAICS 6-digit codes
to NAICS 2-digit codes may result in the combination of NOLs if an
exempt organization has trade or business activities that would be
separate unrelated trades or businesses if identified using NAICS 6-
digit codes but would be one unrelated trade or business if identified
using NAICS 2-digit codes. An exempt organization may choose, but is
not required, to amend Forms 990-T filed prior to December 2, 2020 to
report separate unrelated trades or businesses using NAICS 2-digit
codes.
f. No De Minimis Exception Provided
The preamble to the proposed regulations discussed one comment with
respect to Notice 2018-67 that suggested the Treasury Department and
the IRS adopt a de minimis exception for exempt organizations reporting
less than $100,000 of gross UBTI. The preamble to the proposed
regulations explained that the Treasury Department

[[Page 77956]]

and the IRS declined to adopt the comment because section 512(a)(6)
does not provide discretionary authority for the Treasury Department
and the IRS to establish a de minimis exception. Further, the preamble
to the proposed regulations explained that, even at a lower threshold,
a de minimis rule would be contrary to the stated congressional intent
of not permitting exempt organizations to use losses from one unrelated
trade or business to offset the gains from another unrelated trade or
business.
One commenter on the proposed regulations nonetheless recommended
the adoption of a de minimis exception. This commenter proposed that an
exempt organization with less than $10,000 of total gross revenues from
all unrelated trade or business activities be permitted to treat all
its unrelated trades or businesses as one trade or business for
purposes of section 512(a)(6). For exempt organizations with more than
$10,000 of total gross revenues from all unrelated trade or business
activities, the commenter suggested aggregation of all separate
unrelated trades or businesses with less than $1,000 of total gross
revenues. The commenter reasoned that exempt organizations with less
than $10,000 of total gross revenues from unrelated trade or business
activities likely lack the resources necessary to comply with section
512(a)(6).
The commenter attempted to refute the argument that the Treasury
Department and the IRS lack the authority to promulgate a de minimis
exception by noting that the Treasury Department and the IRS already
exercised discretion by permitting exempt organizations to treat their
activities in the nature of investments as a separate unrelated trade
or business for purposes of section 512(a)(6). The commenter cites the
JCT General Explanation as confirmation that the Treasury Department
and the IRS are authorized to permit the aggregation of separate
unrelated trades or businesses.
Permitting the aggregation of certain investment activities is an
administrative rule premised on the difficulty an exempt organization
partner may experience in certain situations in obtaining the
information needed to determine whether the trades or businesses
conducted by the partnership are separate unrelated trades or
businesses with respect to the exempt organization partner (see part 2
of this Summary of Comments and Explanation of Revisions for a more in
depth discussion). By contrast, permitting the aggregation of ``de
minimis'' separate unrelated trades or businesses is contrary to the
congressional intent of not permitting exempt organizations to offset
the losses from one unrelated trade or business with the gains from
another, without regard to the amount of the gross receipts in either
trade or business. Finally, the concept of a de minimis amount of UBTI
is incompatible with the fragmentation rule in section 513(c); Sec.
1.513-1(b). That is, the fragmentation rule requires the identification
of unrelated trade or business activities no matter the size.
To the extent that smaller exempt organizations may have difficulty
complying with section 512(a)(6), the Treasury Department and the IRS
expect that adoption of NAICS 2-digit codes, as opposed to NAICS 6-
digit codes, may relieve much of this burden because smaller exempt
organizations are unlikely to have numerous unrelated trades or
businesses under these final regulations. Furthermore, under Sec.
1.6012-2(e), an exempt organization is required to file Form 990-T only
``if it has gross income, included in computing [UBTI] for such taxable
year, of $1,000 or more.'' This filing threshold, which applies
regardless of the number of separate unrelated trades or businesses
conducted by the exempt organization, serves as a de minimis rule for
small exempt organizations. Accordingly, the Treasury Department and
the IRS do not adopt this comment in the final regulations for these
reasons as well as the reasons cited in the preamble to the proposed
regulations.
g. Allocation of Directly Connected Deductions
i. In General
Section 512(a)(1) permits an exempt organization with an unrelated
trade or business to take the deductions allowed under chapter 1 of the
Code (chapter 1) that are directly connected with the carrying on of
such unrelated trade or business. Section 512(a)(3) similarly permits a
social club described in section 501(c)(7), a voluntary employees'
beneficiary association (VEBA) described in section 501(c)(9), or a
supplemental unemployment benefits trust (SUB) described in section
501(c)(17) to take the deductions allowed under chapter 1 that are
directly connected with the production of gross income (excluding
exempt function income). To the extent that an exempt organization may
have items of deduction that are shared between an exempt activity and
an unrelated trade or business, Sec. 1.512(a)-1(c) provides special
rules for allocating such expenses. For example, if facilities are used
both to carry on exempt activities and to conduct unrelated trade or
business activities, then expenses, depreciation, and similar items
attributable to such facilities must be allocated between the two uses
on a reasonable basis (reasonable basis standard).
The preamble to the proposed regulations noted that an exempt
organization with more than one unrelated trade or business must not
only allocate shared expenses among exempt and taxable activities as
described in Sec. 1.512(a)-1(c) but also among separate unrelated
trades or businesses. Accordingly, the proposed regulations
incorporated the existing allocation standard in Sec. 1.512(a)-1(c)
for purposes of section 512(a)(6). No comments were received regarding
this approach. Accordingly, the final regulations continue to provide
that an exempt organization with more than one unrelated trade or
business must allocate deductions between separate unrelated trades or
businesses using the reasonable basis standard described in Sec.
1.512(a)-1(c).
ii. The Unadjusted Gross-to-Gross Method Unreasonable in Certain
Circumstances
The preamble to the proposed regulations did, however, describe the
concerns of the Treasury Department and the IRS regarding the
administrability of the reasonable basis standard. The preamble to the
proposed regulations announced that the Treasury Department and the IRS
would continue to consider whether the reasonable basis standard should
be retained and announced the intention to publish a separate notice of
proposed rulemaking. As an initial matter, however, the proposed
regulations stated that allocation of expenses, depreciation, and
similar items using an unadjusted gross-to-gross method is not
reasonable. In general, a gross-to-gross method of allocation uses a
ratio of gross income from an unrelated trade or business activity over
the total gross income from both unrelated and related activities
generating the same indirect expenditures. The percentage resulting
from this ratio is used to determine the percentage of the shared costs
attributable to the unrelated trade or business activity (or
activities). If a price difference exists between the provision of a
good or service to different populations and no adjustment is made, the
gross-to-gross ratio may be described as ``unadjusted.''
Several commenters asserted that the unadjusted gross-to-gross
method should not be considered unreasonable.

[[Page 77957]]

Of these commenters, two stated that the gross-to-gross method 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. One commenter further argued that no
allocation method should be per se unreasonable because what is
unreasonable with respect to one set of facts and circumstances may be
reasonable with respect to another.
In response to these commenters' recommendations, the final
regulations clarify that allocation of expenses, depreciation, and
similar items is not reasonable if the cost of providing a good or
service in a related and an unrelated activity is substantially the
same, but the price charged for that good or service in the unrelated
activity is greater than the price charged in the related activity and
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. For example, if a social club
described in section 501(c)(7) charges nonmembers a higher price than
it charges members for the same good or service, but does not adjust
the price of the good or service provided to members for purposes of
allocating expenses, depreciation, and similar items attributable to
the provision of that good or service, the allocation method is not
reasonable.
The Action on Decision (AOD) relating to Rensselaer Polytechnic
Institute v. Commissioner stated that the IRS would not litigate the
reasonableness of an allocation method ``until the allocation rules of
[Sec. 1.512(a)-1(c)] are amended.'' 732 F.2d 1058 (2d Cir. 1984),
aff'g 79 T.C. 967 (1982); AOD 1987-014 (Jun. 18, 1987). The final
regulations amend the rules of Sec. 1.512(a)-1(c) and, as discussed in
the Applicability Dates section of this preamble, are effective for
taxable years beginning on or after December 2, 2020. Accordingly, the
IRS rescinds the AOD to the limited extent of any allocation method
that fails to equalize price differences between related activities and
unrelated trade or business activities for such taxable years. The IRS
will continue to refrain from litigating the reasonableness of other
allocation methods pending the publication of further guidance, which
the Treasury Department and the IRS continue to consider and expect to
publish in a separate notice of proposed rulemaking.

2. Activities in the Nature of Investments

The proposed regulations treat an exempt organization's activities
in the nature of an investment (investment activities) as a separate
trade or business for purposes of section 512(a)(6). Several commenters
repeated the suggestion previously made in response to Notice 2018-67
that the Treasury Department and the IRS should not treat an exempt
organization's investment activities as an unrelated trade or business,
and therefore the income and losses from these activities should not be
considered for purposes of applying section 512(a)(6). The preamble to
the proposed regulations explained that the Treasury Department and the
IRS concluded that the structure and purposes of sections 511 through
514 indicate that an exempt organization's investment activities are an
unrelated trade or business for purposes of section 512(a)(6), although
certain income from such investment activities (investment income) is
excluded from the calculation of UBTI under modifications in section
512(b). The Treasury Department and the IRS also noted that the
language of section 512(a)(6)(B) states an organization's total UBTI is
the sum of the UBTI computed for each separate unrelated trade or
business under section 512(a)(6)(A). To conclude that investment income
is not included in the separately computed UBTI under section
512(a)(6)(A) would be to remove such income entirely from UBTI under
section 512(a)(6)(B), even when no modification in section 512(b)
applies to the income. Nothing in the legislative history or the
statute suggests that Congress intended to amend the items of income
that are taxable under section 511. Accordingly, the final regulations
continue to treat an exempt organization's investment activities that
are subject to UBIT as a separate unrelated trade or business for
purposes of section 512(a)(6).
a. Exclusive List of Investment Activities
The proposed regulations provided an exclusive list of an exempt
organization's investment activities that may be treated as a separate
unrelated trade or business for purposes of section 512(a)(6). Under
the proposed regulations, for most exempt organizations, such
investment activities are limited to: (i) Qualifying partnership
interests (see part 2.b of this Summary of Comments and Explanation of
Revisions); (ii) qualifying S corporation interests (see part 3.a of
this Summary of Comments and Explanation of Revisions); and (iii) debt-
financed properties (see part 2.d of this Summary of Comments and
Explanation of Revisions).\2\ Although commenters recommended
modifications to the rules regarding the individual items included in
this list, no commenters objected to the treatment of these items as
investment activities. Accordingly, the final regulations adopt the
list of investment activities provided in the proposed regulations
without change.
---------------------------------------------------------------------------

\2\ Special rules discussed in part 4 of this Summary of
Comments and Explanation of Revisions apply to social clubs
described in section 501(c)(7).
---------------------------------------------------------------------------

Nonetheless, some commenters recommended that this exclusive list
be expanded to include specified payments from controlled entities that
are included in UBTI under section 512(b)(13) (discussed in part 2.a.i
of this Summary of Comments and Explanation of Revisions) and certain
amounts from controlled foreign corporations that are included in UBTI
under section 512(b)(17) (discussed in part 2.a.ii of this Summary of
Comments and Explanation of Revisions).
i. Specified Payments From Controlled Entities
Section 512(b)(13)(A) requires an exempt organization, referred to
as a ``controlling organization,'' that receives or accrues (directly
or indirectly) a specified payment from another entity which it
controls, referred to as a ``controlled entity,'' to include such
payment as an item of gross income derived from an unrelated trade or
business to the extent such payment reduces the net unrelated income of
the controlled entity (or increases any net unrelated loss of the
controlled entity). See also Sec. 1.512(b)-1(l)(1). Section
512(b)(13)(C) defines the term ``specified payment'' as any interest,
annuity, royalty, or rent. Accordingly, section 512(b)(13) treats
certain amounts that would ordinarily be excluded from the calculation
of UBTI under section 512(b)(1), (2), and (3) as income derived from an
unrelated trade or business.
The proposed regulations provided that, if an exempt organization
controls another entity (within the meaning of section 512(b)(13)(D)),
the specified payments from that controlled entity will be treated as
gross income from a separate unrelated trade or business for purposes
of section 512(a)(6). If a controlling organization receives specified
payments from two different controlled entities, the proposed
regulations treated the payments from each controlled entity as
separate unrelated trades or businesses.

[[Page 77958]]

Two commenters recommended that income included in UBTI under
section 512(b)(13) should be part of the investment activities trade or
business under section 512(a)(6). These commenters noted that different
fact patterns can produce different tax results because of the
interaction between section 512(b)(13) and the debt-financed property
rules of section 514. For example, one commenter provided a series of
examples in which a wholly owned taxable subsidiary rented space from
its exempt organization parent in a debt-financed property owned by the
parent.
Section 1.514(b)-1(b)(2)(ii) of the current regulations states that
section 514 does not apply to amounts specifically taxable under other
provisions of the Code, such as rents and interest from controlled
organizations includible pursuant to section 512(b)(13). Thus, if a
controlling organization leases debt-financed property to a controlled
organization, the amount of rents includible in the controlling
organization's UBTI shall first be determined under section 512(b)(13),
and only the portion of such rents not taken into account by operation
of section 512(b)(13) are taken into account by operation of section
514. See Sec. 1.512(b)-1(l)(5)(ii). Because the regulations provide a
clear ordering rule that sets section 512(b)(13) income apart from the
rules of section 514, section 512(b)(13) taxable income can never be
debt-financed investment income.
The Treasury Department and the IRS considered in the preamble to
the proposed regulations whether specified payments should be included
with an exempt organization's investment activities and concluded that
this treatment would be inconsistent with the purpose of section
512(b)(13)(A), which is to prevent a controlled entity from gaining a
competitive advantage (in contravention of the purposes of section 512)
through making deductible payments to a controlling organization that
is exempt from tax. See S. Rep. No. 91-552, at 73 (1969) (explaining
that certain ``rental'' arrangements between exempt organizations and
taxable subsidiaries ``[enable] the taxable [subsidiary] to escape
nearly all of its income taxes''). Consistent with this purpose,
section 512(b)(13)(A) treats specified payments as income from an
unrelated trade or business only ``to the extent such payment reduces
the net unrelated income of the controlled entity (or increases any net
unrelated loss of the controlled entity).'' Additionally, the required
degree of control of the controlling organization over the controlled
entity indicates that the controlled entities are not a part of the
controlling organization's otherwise appropriately characterized
investment activities.
Alternatively, if specified payments are not included with an
exempt organization's investment activities, these commenters requested
that specified payments from any source be treated as one unrelated
trade or business for purposes of section 512(a)(6). The commenters
asserted that the aggregation of specified payments would reduce the
incentive to restructure financial transactions to obtain more
favorable tax results. One commenter set out an example in which the
UBTI from the separate unrelated trades or businesses for specified
payments received from two controlled entities of an exempt
organization differed under section 512(b)(13) depending on whether the
exempt organization owned both subsidiaries directly or one subsidiary
directly and the other subsidiary indirectly through the first
subsidiary. The commenter asserted that aggregating the UBTI from all
the controlled entities would create the same tax result for all exempt
organizations with these facts regardless of the structure of the
subsidiaries and the rental payments.
The Treasury Department and the IRS continue to view specified
payments as not appropriately characterized as part of an exempt
organization's investment activities. Furthermore, because section
512(b)(13) views specified payments as stemming from the trade or
business activity of the controlled entity rather than from its
investment activities, the Treasury Department and the IRS decline to
adopt the suggestion that all specified payments be treated as one
unrelated trade or business for purposes of section 512(a)(6). Rather,
because section 512(b)(13)(A) provides that specified payments from a
controlled entity are income derived from an unrelated trade or
business, the final regulations adopt the proposed regulations
regarding specified payments without modification.
ii. Certain Amounts From Controlled Foreign Corporations
Section 512(b)(17) requires any amount included in gross income
under section 951(a)(1)(A) to be included as an item of gross income
derived from an unrelated trade or business to the extent the amount so
included is attributable to insurance income (as defined in section
953) which, if derived directly by the exempt organization, would be
treated as gross income from an unrelated trade or business. Section
953(a)(1) defines ``insurance income'' as any income that (A) is
attributable to the issuing (or reinsuring) of an insurance or annuity
contract, and (B) would (subject to certain modifications not relevant
here) be taxed under subchapter L of chapter 1 if such income were the
income of a domestic insurance company. Thus, section 512(b)(17)
``applies a look-through rule in characterizing certain subpart F
insurance income for unrelated business income tax purposes.'' H. R.
Rep. No. 104-586 (1996), at 137.
The proposed regulations treated the provision of insurance by all
controlled foreign corporations (CFCs) as one trade or business,
regardless of whether such insurance income is received from more than
one CFC, which is consistent with how NAICS would categorize the
provision of insurance (52--Finance and Insurance). However, the
proposed regulations did not permit the aggregation of an exempt
organization's insurance income included in UBTI under section
512(b)(17) with any insubstantial commercial-type insurance activities
conducted directly by the exempt organization because the CFC, not the
exempt organization, is engaged in the activity giving rise to the
insurance income included in UBTI under section 512(b)(17). The
insurance activity described in section 512(b)(17) is not attributed to
the exempt organization and thus is distinguishable from any
commercial-type insurance activity engaged in directly by the exempt
organization.
One commenter recommended that amounts included in income under
section 512(b)(17) should be part of an exempt organization's
investment activities. This commenter questioned the statement in the
preamble to the proposed regulation that ``the required degree of
control of the exempt organization over the controlled foreign
corporation indicates that the exempt organization's interest in a
controlled foreign corporation is probably not part of the exempt
organization's otherwise appropriately characterized investment
activities.'' The commenter explained that, with respect to insurance
income specifically, the required ownership by United States
shareholders for CFC status is reduced to 25 percent from the usual 50
percent. The commenter asserted that an exempt organization shareholder
therefore could hold less than a 10 percent interest in a CFC that as a
whole is owned by United States shareholders. The commenter stated that
the low percentage of ownership necessary to have such amounts included
in UBTI should warrant inclusion with an exempt organization's

[[Page 77959]]

investment activities, based on the similarity to the ownership
percentages for qualifying partnership interest status discussed in
part 2.b of this Summary of Comments and Explanation of Revisions.
However, another commenter recommended retention of the rules in the
proposed regulations for amounts included in income under section
512(b)(17).
As explained in the preamble to the proposed regulations, the
reasons for not treating amounts included in income under section
512(b)(17) as an exempt organization's investment activities extend
beyond the amount of control the exempt organization may have over the
CFC. In particular, that preamble explained that insurance income
included in UBTI under section 512(b)(17) should not be treated as
gross income from an exempt organization's investment activities
because the provision of insurance generally is an unrelated trade or
business. See section 501(m) (providing that, in the case of an exempt
organization described in section 501(c)(3) or (4) that does not
provide commercial-type insurance as a substantial part of its
activities, the activity of providing commercial-type insurance is
treated as an unrelated trade or business (as defined in section 513)).
Further, the percentage interest prongs of the qualifying partnership
interest rules, discussed in parts 2.b.iii and 2.b.iv.A of this Summary
of Comments and Explanation of Revisions, serve as a proxy for an
exempt organization's ability to obtain the information necessary to
identify the underlying trade or business of the partnership. For
amounts included in income under section 512(b)(17), the underlying
trade or business is known because the only amounts included are from
the insurance activity of the CFC. Thus, the same treatment of income
under section 512(b)(17) is not needed for administrative convenience.
Accordingly, the final regulations adopt without change the
proposed regulations regarding the treatment of amounts included in
UBTI under section 512(b)(17) for purposes of section 512(a)(6).
b. Qualifying Partnership Interests
In general, for exempt organizations, the activities of a
partnership are considered the activities of the exempt organization
partners.\3\ Specifically, section 512(c) states that if a trade or
business regularly carried on by a partnership of which an exempt
organization is a member is an unrelated trade or business with respect
to such organization, such organization shall include its share of the
gross income of the partnership in UBTI. However, commenters on both
Notice 2018-67 and the proposed regulations explained the difficulty of
obtaining information regarding the trade or business activities of
lower-tier partnerships. Therefore, as a matter of administrative
convenience for both the exempt organization and the IRS, the proposed
regulations permitted, but did not require, an exempt organization to
aggregate its UBTI from an interest in a partnership with more than one
unrelated trade or business (including unrelated trades or businesses
conducted by lower-tier partnerships) if it met certain requirements
(qualifying partnership interest, or QPI). Additionally, the proposed
regulations permitted the aggregation of any QPI with all other QPIs,
resulting in the treatment of the aggregate group of QPIs (along with
associated debt-financed income under section 514 and qualifying S
corporation interests, both discussed in parts 2.d and 3.a,
respectively, of this Summary of Comments and Explanation of Revisions)
as a single ``investment activities'' trade or business for purposes of
section 512(a)(6)(A).
---------------------------------------------------------------------------

\3\ See sections 512(c), 513(a); Sec. 1.513-1(d)(1) and (2);
Plumstead Theatre Society, Inc. v. Commissioner, 74 T.C. 1324
(1980); 675 F.2d 244 (9th Cir. 1995); Service Bolt & Nut Co. Profit
Sharing Trust v. Commissioner, 724 F.2d 519 (6th Cir.1983), affg, 78
T.C. 812 (1982); Rev. Rul. 98-15, 1998-1 C.B. 718.
---------------------------------------------------------------------------

The proposed regulations identified a partnership interest as a QPI
if it met the requirements of either the de minimis test (discussed in
part 2.b.iii of this Summary of Comments and Explanation of Revisions)
or the control test (discussed in part 2.b.iv of this Summary of
Comments and Explanation of Revisions). A few commenters recommended
alternative or additional tests to identify a QPI. Three commenters
suggested that the generally accepted accounting principles (GAAP)
codified by the Financial Accounting Standards Board (FASB) should
replace the de minimis and the control tests to identify partnership
interests as QPIs. These commenters recommended that any interest that
is reported as ``fair value'' under these standards should be
considered a QPI and included as part of the exempt organization's
investment activities. Two other commenters recommended that a
partnership that uses an investment manager should be a QPI. For this
purpose, one of these commenters recommended defining an investment
manager as someone who is either (i) included in a listing of
investment managers with the Securities and Exchange Commission (SEC),
(ii) in the business of providing investment advice for compensation
and manages at least $150 million in client assets, or (iii) has filed
a Form D notice with the SEC with respect to the partnership at issue
indicating that interests in such partnership are offered under an
exemption from SEC registration requirements. Finally, one commenter
provided a general list of facts and circumstances that should be
considered when determining whether a partnership interest is a QPI,
such as whether the exempt organization is a limited partner, whether
the exempt organization has the right to be involved in the day-to-day
management or operations of the partnership, and whether the exempt
organization formed the partnership.
As noted in Notice 2018-67, the purpose of permitting the
aggregation of QPIs is to reduce the administrative burden of obtaining
information from the partnership regarding the trade or business
activities of the partnership in which the exempt organization holds a
modest interest, and particularly of lower-tier partnerships under such
partnership. As stated in the preamble to the proposed regulations, the
percentage interest level for QPIs was intended as a proxy to identify
partnership interests in which the exempt organization does not
significantly participate. 85 FR at 23180. Taking into account the
comments received, the Treasury Department and the IRS have determined
that, for purposes of section 512(a)(6), if the percentage interest
level indicates that an exempt organization does not significantly
participate in a partnership, the exempt organization is not likely to
be able to easily obtain the information required to identify the
trades or businesses conducted, directly or indirectly, by the
partnership that are unrelated trades or businesses with respect to the
exempt organization partner.
The recommendations of the commenters regarding alternate or
additional methods to determine whether a partnership interest is a QPI
do not provide administrable methods for proximately measuring an
exempt organization's ability to obtain information about the
partnership's trades or businesses. Under GAAP, an exempt organization
accounts for a partnership interest using ``fair value'' if it does not
control a partnership or have ``significant influence'' in the
partnership or if it holds an interest the value of which is ``readily
determinable.'' FASB, 2020, ASC par. 958-810-15-4. As discussed in more
detail in part 2.b.iv.B of this Summary

[[Page 77960]]

of Comments and Explanation of Revisions, determining ``significant
influence'' under GAAP is substantially similar to determining
significant participation under the participation test. By FASB's own
admission, however, determining significant influence is not always
clear. FASB, 2020, ASC par. 323-10-15-7. Further, whether a partnership
interest has a readily determinable value does not indicate whether an
exempt organization has access to the information needed to identify
trades or businesses conducted by the partnership that are unrelated
trades or businesses with respect to the exempt organization partner.
The de minimis and control tests provide a substantially similar
standard to that found in GAAP that is more objective and that does not
include additional factors outside the scope of the QPI test.
Additionally, unlike the adoption of NAICS 2-digit codes, adopting GAAP
would mean using a set of rules that are maintained and amended
frequently by a non-governmental third party. Furthermore, GAAP does
not always align with tax standards.
Similarly, the presence of an investment manager does not indicate
whether an exempt organization can obtain information to identify
separate unrelated trades or businesses conducted by a partnership. In
addition, the requirements for being an investment manager, as outlined
by the commenter, require reliance on an SEC system that is designed
for purposes that do not align with the those of the QPI tests. As a
result, the investment manager test does not satisfy the purpose of the
QPI tests and the Treasury Department and the IRS do not adopt this
suggestion. Finally, the facts and circumstances test suggested by
commenters relies on factors that do not tend to relate to the exempt
organization's ability to obtain the information from the partnership
needed to identify separate unrelated trades or businesses and
therefore do not advance the administrative convenience purpose of the
QPI test. Accordingly, the Treasury Department and the IRS do not adopt
these suggestions as a reliable method for identifying QPIs.
Other commenters suggested the inclusion of all limited
partnerships or limited liability companies (LLCs) in which the exempt
organization is not a general partner or managing member (regardless of
the exempt organization's percentage interest or other participation in
the partnership) as QPIs. As discussed in the preamble to the proposed
regulations, the Treasury Department and the IRS decline to adopt this
standard because of the variation in state law for determining non-
managing member equivalent interests and the administrative burden that
reliance on state law places on the IRS.
Accordingly, the Treasury Department and the IRS do not adopt the
recommended alternative or additional methods for identifying a QPI.
i. Designation of a QPI
The proposed regulations provided that, once an organization
designates a partnership interest as a QPI (in accordance with forms
and instructions), it cannot thereafter identify the trades or
businesses conducted by the partnership that are unrelated trades or
businesses with respect to the exempt organization using NAICS 2-digit
codes unless and until the partnership interest is no longer a QPI. For
example, if an exempt organization has a partnership interest that is a
QPI and the exempt organization designates that partnership interest as
a QPI on its Form 990-T, the exempt organization cannot, in the next
taxable year, identify the trades or businesses of the partnership that
are unrelated trades or businesses with respect to the exempt
organization using NAICS 2-digit codes. However, if, in a future
taxable year, the exempt organization's partnership interest is no
longer a QPI, then the exempt organization would be required to
identify the trades or businesses of the partnership that are unrelated
trades or businesses with respect to the exempt organization using
NAICS 2-digit codes. No comments were received regarding this
provision. Accordingly, the final regulations adopt the proposed
regulations regarding the designation of QPIs without change.
ii. General Partner Prohibition
The proposed regulations clarified that any partnership in which an
exempt organization is a general partner is not a QPI, regardless of
the exempt organization's percentage interest. One commenter noted
that, while related parties are considered for determination of the
percentage interest prong of the control test, these same related
parties are not considered when determining the general partner status
of the exempt organization under the de minimis test or for determining
control under the second prong of the control test. Thus, a related
entity may be a general partner in or may control the partnership in
which an exempt organization has an interest and such control by the
related party would not affect the outcome under the proposed
regulations.
The Treasury Department and the IRS agree with the commenter that
the determination of whether an exempt organization is a general
partner should include related organizations. Thus, the final
regulations clarify that, if an organization the interest of which must
be taken into account when determining the exempt organization's
percentage interest for purposes of the first prong of the control test
is a general partner in a partnership in which an exempt organization
holds an interest, then such interest is not a QPI.
One commenter recommended that the per se prohibition against
general partner status for a partnership interest to be a QPI should be
extended to status as a managing member of a limited liability company
(LLC). The Treasury Department and the IRS agree that the term
``partnership'' includes all entities, including LLCs, treated as
partnerships for Federal tax purposes. Accordingly, an interest in an
LLC treated as a partnership for Federal tax purposes can be a QPI.
However, the rule in the proposed regulations precluding a general
partner interest from being a QPI was intended to apply only to
interests held by partners classified as general partners under
applicable state law. The Treasury Department and the IRS do not
believe it is appropriate to expand the per se prohibition to persons
classified as managing members under applicable state law without the
opportunity for further notice and comment, although managing members
are unlikely to satisfy the participation test due to their significant
participation in the LLC. Accordingly, the final regulations adopt the
proposed regulation with the clarification that general partner status
is determined under applicable state law.
iii. De Minimis Test
The proposed regulations provided that a partnership interest is a
QPI that meets the requirements of the de minimis test if the exempt
organization holds directly or indirectly no more than 2 percent of the
profits interest and no more than 2 percent of the capital interest.
One commenter recommended removing the de minimis test. The
Treasury Department and the IRS have concluded that the de minimis test
reduces administrative burden by establishing a clear limit below which
no other factors need to be considered for inclusion of such interest
as a part of an exempt organization's investment activities. Therefore,
the Treasury

[[Page 77961]]

Department and the IRS retain the de minimis test in the final
regulations.
One commenter recommended that the percentage interest threshold of
the de minimis test should be increased to 5 percent consistent with
other sections of the Code and regulations. The commenter notes that,
not only have other parts of the Code determined that 5 percent is
sufficiently de minimis, but also that increasing the amount from 2
percent to 5 percent would reduce administrative burden by potentially
increasing the number of partnership interests that would meet the
requirements of the de minimis test.
The Treasury Department and the IRS do not adopt this commenter's
suggestion for the following reasons. For purposes of administrative
convenience, the de minimis test allows certain partnership investments
to be treated as an investment activity and aggregated with other
investment activities. Otherwise, as previously discussed in this
section of the preamble, section 512(c) mandates that any partnership
interest, even a de minimis interest, must be analyzed to determine
whether it is an unrelated trade or business with respect to the exempt
organization partner and, by extension, how many unrelated trades or
businesses for purposes of section 512(a)(6). Accordingly, any
exception made in the interest of the administrative convenience of
taxpayers must be narrowly tailored to achieving that purpose.
Furthermore, under the control test, partnership interests that
exceed 2 percent are QPIs if those interests meet the requirements of
the control test (now renamed the participation test, as discussed in
part 2.b.iv of this Summary of Comments and Explanation of Revisions).
Many exempt organizations with partnership interests between 2 percent
and 5 percent should be able to determine, without much additional
burden, that they do not significantly participate in the partnership
and thus the partnership interest is a QPI; thus, not much additional
convenience would be gained for exempt organizations by increasing the
de minimis percentage amount from 2 percent to 5 percent. On the other
hand, increasing the percentage under which an exempt organization does
not have to demonstrate a lack of significant participation to be able
to treat the partnership interest as a QPI would extend the
administrative convenience exception to identifying the separate
unrelated trades or businesses of the partnership (in accord with
section 513(c)) farther than necessary and undermine the statutory
requirement of section 512(a)(6). Therefore, the final regulations
follow the proposed regulations and provide that a partnership interest
is a QPI that meets the requirements of the de minimis test if the
exempt organization holds, directly or indirectly, no more than 2
percent of the profits interest and no more than 2 percent of the
capital interest. Additionally, the final regulations clarify that the
exempt organization must meet the percentage interest requirement of
the de minimis rule during the exempt organization's taxable year with
which or in which the partnership's taxable year ends.
iv. Control Test Renamed the ``Participation Test''
The proposed regulations provided that a partnership interest is a
QPI that meets the requirements of the control test if the exempt
organization (i) directly holds no more than 20 percent of the capital
interest; and (ii) does not have control over the partnership. As
previously discussed in this section, the QPI tests focus on
determining whether an exempt organization significantly participates
in a partnership, thereby indicating an ability to obtain the
information needed from the partnership to determine whether a trade or
business conducted by the partnership is an unrelated trade or business
with respect to the exempt organization partner. To better reflect this
intent, the control test has been renamed in these final regulations as
the ``participation test.'' Accordingly, the final regulations modify
the participation test so that a partnership interest is a QPI that
meets the requirements of the participation test if the exempt
organization (i) directly holds no more than 20 percent of the capital
interest; and (ii) does not significantly participate in the
partnership.
A. Percentage Interest
Numerous commenters made recommendations regarding the first prong
of the control test, most of which recommended increasing the
percentage threshold to 50 percent to conform with the definition of
control in section 512(b)(13). These commenters noted that the 50
percent threshold for capital interest is more in line with other
definitions of control found in the Code. Other commenters suggested
that the percentage interest requirement be eliminated entirely because
an exempt organization may control a partnership regardless of its
percentage interest.
The final regulations retain the 20 percent threshold used in the
proposed regulations. As explained in the preamble to the proposed
regulations, the percentage interest prong of the control test was
intended to identify partnership interests in which the exempt
organization does not have the ability to significantly participate in
any partnership trade or business and therefore may be considered an
investment activity for purposes of section 512(a)(6). Although an
exempt organization may not significantly participate in a partnership
in which it has more than a 20 percent interest, the Treasury
Department and the IRS note that, as an exempt organization's
percentage interest in a partnership increases, so too does the exempt
organization's ability to obtain the information necessary to identify
the trades or businesses conducted by the partnership that are separate
unrelated trades or businesses with respect to the exempt organization
partner. Thus, the Treasury Department and the IRS have determined
that, for purposes of this aspect of the administrative exception for
investment activities, a 20 percent capital interest is a threshold
below which the exempt organization may not be able to obtain the
needed information if it does not otherwise significantly participate.
The preamble to the proposed regulations noted that the 20 percent
threshold is consistent with the administrative exception found in the
regulations under section 731 for certain investment activities. See
section 731(c)(3)(C)(i) & Sec. 1.731-2(e). Some commenters noted that
this was not a relevant standard because section 731(c)(3)(C)(i) does
not define control. Section 731 defines investment partnerships, in
part, as any partnership that has never been engaged in a trade or
business.
The regulations under section 731(c)(3)(C)(i) identify situations
in which the trade or business activities of a lower tier partnership
should not be attributed to an upper tier partnership for purposes of
determining whether the upper tier partnership is engaged in a trade or
business. Similarly, the QPI rules in the proposed regulations seek to
determine when the trade or business of a partnership should not be
attributed to the exempt organization such that the partnership may be
counted as part of an investment activity rather than as the
participation in any underlying trade or business. Thus, the purpose of
the regulations under section 731 and the QPI rules in the proposed
regulations is similar.
The 20 percent capital interest threshold is further supported by
the GAAP standard for ``significant influence'' that some commenters

[[Page 77962]]

recommended as an alternative to the de minimis and participation tests
(see parts 2.b.iii and 2.b.iv of this Summary of Comments and
Explanation of Revisions). Due to the difficulty of the significant
influence determination, GAAP provides that holding 20 percent voting
stock in an investee is presumed, without more, to constitute a
significant influence. FASB, 2020, ASC par. 323-10-15-8. The 20 percent
voting stock standard in GAAP was written for determining whether the
investor has ``significant influence'' in a corporation. FASB, 2020,
ASC par. 323-10-15-5. For tax purposes, it is common in the Code, when
applying corporate standards to partnerships, to substitute ``capital
interest'' for ``voting stock.'' See, e.g., sections 4943(c)(3),
6166(b), & 6038(e)(3). Thus, the 20 percent capital interest threshold
in the proposed regulations is consistent with FASB's determinations of
the percentage interest that represents ``significant influence,''
which is similar to the significant participation standard found in
these regulations.
Accordingly, the final regulations retain the 20 percent capital
interest threshold provided by the proposed regulations but clarify
that the exempt organization must meet the percentage interest
requirement for the exempt organization's taxable year with which or in
which the partnership's taxable year ends.
No comments were received regarding how an exempt organization
determines its percentage interest in a partnership. Therefore,
consistent with the proposed regulations and for purposes of both the
de minimis test and the participation test, the final regulations
continue to provide that an exempt organization determines its
percentage interest by taking the average of the exempt organization's
percentage interest at the beginning and the end of the partnership's
taxable year, or, in the case of a partnership interest held for less
than a year, the percentage interest held at the beginning and end of
the period of ownership within the partnership's taxable year. However,
the final regulations clarify that, for purposes of the de minimis
test, an exempt organization's profits interest in a partnership is
determined in the same manner as its distributive share of partnership
taxable income (see section 704(b) relating to the determination of the
distributive share by the income or loss ratio, and Sec. Sec. 1.704-1
through 1.704-4). For purposes of both the de minimis test and the
participation test the final regulations provide that, in the absence
of a provision in the partnership agreement, an exempt organization's
capital interest in a partnership is determined on the basis of its
interest in the assets of the partnership which would be distributable
to such organization upon its withdrawal from the partnership, or upon
liquidation of the partnership, whichever is the greater.\4\
---------------------------------------------------------------------------

\4\ These clarifying rules for determining an exempt
organization's partnership interest are consistent with longstanding
rules in Sec. 53.4943-3(c)(2) for purposes of a private
foundation's determination of whether it has excess business
holdings.
---------------------------------------------------------------------------

B. Definition of ``Significant Participation''
Under the proposed regulations, a partnership interest met the
requirements of the control test if the exempt organization holds no
more than a 20 percent of the capital interest and does not control the
partnership. The proposed regulations provided that all the facts and
circumstances are relevant for determining whether an exempt
organization controls a partnership. The proposed regulations clarified
that the partnership agreement is among the facts and circumstances
that may be considered when determining control. The proposed
regulations also listed four specific circumstances that evidence
control. Two of the circumstances focused on the exempt organization's
ability to perform certain actions on its own. Specifically, the
proposed regulations provided that an exempt organization controls a
partnership if the exempt organization, by itself, may require the
partnership to perform, or may prevent the partnership from performing,
any act that significantly affects the operations of the partnership or
has the power to appoint or remove any of the partnership's officers or
employees or a majority of directors. The remaining two circumstances
focused on whether any of the exempt organization's officers,
directors, trustees, or employees have rights to participate in the
management of the partnership at any time or to conduct the
partnership's business at any time.
In essence, the proposed regulations provided a two-part test for
determining control: (1) A general facts and circumstances test based
on the well-defined concept in the Code of ``control,'' and (2) factors
evidencing ``per se'' control. As discussed in the introduction to part
2.b.iv of this Summary of Comments and Explanation of Revisions, the
Treasury Department and the IRS have renamed the ``control test'' the
``participation test'' to better capture the purpose of the test, which
is to identify partnerships in which exempt organization partners
significantly participate. However, unlike ``control,'' ``significant
participation'' generally is not a defined term in the Code. A test
considering all the facts and circumstances to determine whether an
exempt organization partner significantly participates in a partnership
could have a broader application than intended. Furthermore, a general
facts and circumstances standard for a test that is not well-defined
increases uncertainty and, as a result, the administrative burden on
exempt organizations and the IRS. Therefore, the final regulations do
not include a general facts and circumstances test as part of the
significant participation prong of the participation test, but instead
retain only the four factors, which, in the final regulations, evidence
significant participation rather than control.
Some commenters stated that the list of factors indicating control
was too broad. One commenter contended that the factors focusing on
whether an officer, director, or employee of an exempt organization has
rights to manage the partnership or conduct the business of the
partnership should be removed entirely as the presence of these factors
does not indicate control by the exempt organization. While the factors
identified by this commenter and the factors other commenters
characterized as too broad may not always represent control, these
factors do indicate when an exempt organization participates in the
partnership to an extent that would allow the exempt organization to
obtain sufficient information to identify the underlying separate
trades or businesses.
Another commenter suggested that the factors listed as indicating
control may not always result in control, and thus, the factors listed
should create a rebuttable presumption of control rather than being
``per se'' indicators of control. The Treasury Department and the IRS
retain the factors listed in the proposed regulations as ``per se''
indicators of significant participation because the QPI rules,
including the participation test, are designed to provide
administrative convenience for both the IRS and exempt organizations.
In this way, firm standards that indicate significant participation
allow both the IRS and exempt organizations to have more certainty in
the decision whether to include such interests with an exempt
organization's investment activities. A rebuttable presumption would
introduce more uncertainly, rely more on facts and circumstances, and
be

[[Page 77963]]

more difficult for both the IRS and exempt organizations to administer.
The Treasury Department and the IRS note that the factors provided
in the regulations are similar to the factors indicating ``control''
and ``significant influence'' under FASB's codification of GAAP, which
several commenters proposed as an alternative test. For partnership
interests, GAAP determines that enough control exists to require the
consolidation of partnership interests with the investor if the
investor has substantive kick-out or participating rights. A kick-out
right is the ability of limited partners to dissolve (liquidate) the
limited partnership or otherwise remove the general partners without
cause. FASB, 2020, ASC section 958-810-20. These rights are included,
in the proposed regulations, in an exempt organization's ability to
require, by itself, the partnership to perform, or prevent the
partnership from performing, any act that significantly affects the
operations of the partnership.
Further, under GAAP, certain participating rights are considered
per se substantive rights and overcome the presumption of control by a
general partner. These include:
Selecting, terminating, and setting the compensation of
management responsible for implementing the limited partnership
policies and procedures; and
Establishing operating and capital decisions of the
limited partnership, including budgets, in the ordinary course of
business. ASC paragraph 958-810-25-22.
These substantive participating rights are similar to an exempt
organization's ability to appoint or remove, by itself, any of the
partnership's officers or employees or a majority of directors; or its
officers, directors, trustees, or employees' rights to conduct the
partnership's business at any time, respectively. As such, these
substantive participating rights found in GAAP are covered by the four
factors listed in the proposed regulations as indicating control (here
renamed significant participation).
Additionally, some of the factors relevant to ``significant
influence'' included in GAAP are representation on the board, the
ability to participate in the policy-making process, and the
interchange of managerial personnel. FASB, 2020, ASC par. 323-10-15-6.
These factors are also similar to the factors in the proposed
regulations, which focus on whether an exempt organization's officers,
directors, trustees, or employees have rights to participate on the
partnership's board or participate in management of the business.
Moreover, the ability to participate in the policy-making process could
stem from the investor's ability to require the partnership to perform,
or prevent the partnership from performing, any act that significantly
affects the operations of the partnership. Consequently, the factors
for determining ``significant influence'' under GAAP are also covered
by the factors listed in the proposed regulations.
Accordingly, the Treasury Department and the IRS have concluded
that the list of factors indicating significant participation (renamed
from ``control'' as used in the proposed regulations) is consistent
with other standards recommended by commenters for making similar
determinations. Therefore, the Treasury Department and the IRS continue
to believe that, for purposes of the administrative exception for
investment activities, the factors listed in the proposed regulations
appropriately identify partnerships in which the exempt organization
significantly participates such that it can obtain the information
needed to identify the trades or businesses conducted by the
partnership that are separate unrelated trades or businesses with
respect to the exempt organization.
Commenters pointed out that the exercise of certain rights common
to all partners in a partnership may be construed to come within the
ambit of the list of factors indicating significant participation.
Specifically, these commenters explained that an exempt organization
with voting rights equal to those of a large number of other limited
partners might be considered to be able to prevent the actions of a
partnership if the vote requires a unanimous vote. The Treasury
Department and the IRS agree with these commenters that the ability to
prevent an action of the partnership due to a unanimous vote
requirement or through minority consent rights was not intended to be
covered by the proposed regulations. Accordingly, the final regulations
modify the proposed regulations' treatment of the ability of an exempt
organization, by itself, to prevent a partnership from performing an
act as a factor that indicates significant participation. As modified,
the final regulations provide that an exempt organization significantly
participates in a partnership if--
The exempt organization, by itself, may require the
partnership to perform, or prevent the partnership from performing
(other than through a unanimous voting requirement or through minority
consent rights), 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 management of
the partnership at any time;
Any of the organization's officers, directors, trustees,
or employees have rights to conduct the partnership's business at any
time; or
The organization, by itself, has the power to appoint or
remove any of the partnership's officers or employees or a majority of
directors.
Some commenters recommended that instead of, or in addition to, a
list of factors that indicate significant participation, the
regulations should provide a list of powers that do not indicate
significant participation, such as the ability to remove or replace a
fund manager who manages partnership investments, to approve the
selection or removal of a general partner, to appoint a member of an
advisory board of the partnership, to withdraw from a partnership, or
to dissolve or terminate the partnership.
The Treasury Department and the IRS expect that, because the
participation test no longer includes a general facts and circumstances
test, the need to define actions that do not evidence significant
participation is significantly reduced or eliminated. An exempt
organization need not consider rights or powers other than the four
specifically listed in the participation test when determining whether
a partnership interest is a QPI. Accordingly, the Treasury Department
and the IRS decline to adopt the suggestion to include a list of powers
that do not indicate significant participation.
C. Combining Related Interests
The proposed regulations provided a rule to address situations in
which an exempt organization may control a partnership through the
aggregation of interests (aggregation rule). The aggregation rule in
the proposed regulations applied only for purposes of the control test
and not for purposes of the de minimis test. The aggregation rule in
the proposed regulations required an exempt organization to consider
the interests of supporting organizations (as defined in section
509(a)(3)) and controlled entities (as defined in section 512(b)(13))
in the same partnership. The preamble to the proposed regulations
stated that the Treasury Department and the IRS would continue to
consider whether the aggregation of the interests of supporting
organizations is appropriate in the circumstance in which the

[[Page 77964]]

exempt organization is a supported organization that has little to no
control over its supporting organizations.
A supporting organization is characterized as a Type I, Type II, or
Type III supporting organization depending on its relationship with its
supported organization. The supporting organization may be (i)
operated, supervised, or controlled by (Type I), (ii) supervised or
controlled in connection with (Type II), or (iii) operated in
connection with (Type III), its supported organization.
For a Type I relationship to exist, a supported organization must
have a substantial degree of direction over the policies, programs, and
activities of its supporting organization. The relationship of the
supported organization to the Type I supporting organization is
comparable to that of a parent and subsidiary, where the subsidiary is
under the direction of, and accountable or responsible to, the parent
organization.
For a Type II relationship to exist, there must be common
supervision or control by the persons supervising or controlling both
the supporting organization and the publicly supported organizations to
ensure that the supporting organization will be responsive to the needs
and requirements of the publicly supported organizations. The
relationship of the supported organization to the Type II supporting
organization is comparable to that of a brother and sister, where the
supporting organization and the supported organization are subject to
common control. Polm Family Foundation, Inc. v. United States, 655 F.
Supp. 2d 125, 128 (D.C. Cir. 2009) (quoting Cockerline Memorial Fund v.
Commissioner, 86 T.C. 53, 59 (1986)).
For a Type III relationship to exist, a supporting organization
must, among other things, maintain significant involvement in the
operations of a supported organization or provide support on which the
supported organization is dependent. A Type III supporting organization
can either be functionally integrated or non-functionally integrated. A
functionally integrated Type III supporting organization can support
its supported organization through engaging in activities substantially
all of which directly further the exempt purposes of the supported
organization, being the parent of the supported organization, or by
supporting certain types of governmental supported organizations. A
functionally integrated Type III supporting organization is a parent of
the supported organization if the supporting organization exercises a
substantial degree of direction over the policies, programs, and
activities of the supported organization and a majority of the
officers, directors, or trustees of the supported organization is
appointed or elected, directly or indirectly, by the governing body,
members of the governing body, or officers (acting in their official
capacity) of the supporting organization. A non-functionally integrated
Type III supporting organization provides financial support to the
supported organization that meets the distribution requirements found
in Sec. 1.509(a)-4(i)(5)(ii).
Two commenters addressed whether partnership interests of related
supporting organizations should be considered in determining the
supported organization's percentage interest for purposes of
determining whether the supported organization meets the control test.
One commenter recommended that none of the partnership interests of a
supporting organization should be considered when determining the
supported organization's percentage interest. Another made the same
recommendation but only with respect to Type III supporting
organizations.
An exempt organization with more than one unrelated trade or
business may be a supporting organization or a supported organization.
If the exempt organization is a supported organization, the exempt
organization, or individuals that control the exempt organization, may
control the investment activities (including any partnership interests)
of its Type I or Type II supporting organizations due to the parent/
subsidiary relationship required for a Type I relationship to exist or
the brother/sister relationship required for a Type II relationship to
exist. In any event, these close relationships increase the likelihood
that the exempt organization can obtain the information about its Type
I or Type II supporting organization's partnership investments and that
the exempt organization significantly participates in the partnership,
even if indirectly. Accordingly, the final regulations continue to
require an exempt organization that is a supported organization to
include the partnership interests of its Type I or II supporting
organizations when determining whether its partnership interests of the
supported organization meet the percentage interest threshold of the
participation test.
On the other hand, in the case of a Type III supporting
organization, the exempt organization that is a supported organization
is required to have a ``significant voice'' in the investment policies
of its Type III supporting organization; nevertheless, depending on the
basis for this Type III relationship, this relationship may not permit
the supported organization to obtain detailed information regarding its
Type III supporting organization's partnership interests or to
significantly participate in the partnership. In the case of a Type III
supporting organization that is the parent of its supported
organizations, the relationship between the supported and supporting
organizations is similar to that of a Type I supporting organization,
except the supporting organization controls the supported organizations
instead of the opposite. Due to this close relationship, the final
regulations continue to require the aggregation of partnership
interests held by a Type III supporting organization that is the parent
of its supported organizations for the purposes of determining whether
the supported organization's partnership interest meets the percentage
interest threshold of the participation test. However, the interests
held by nonparent Type III supporting organizations are not so
aggregated.
One commenter recommended adding additional interests to the list
of related interests that must be considered when determining
percentage interest for purposes of the control test. This commenter
recommended including related persons within the definition of section
267(b)(9) and ``controlled taxpayers'' within the principles of section
482 to the list of organizations with which partnership interests must
be aggregated. The same commenter also recommended adding indirect
interests owned by an exempt organization for the purposes of
determining the organization's percentage interest.
As mentioned previously, the QPI rules were created to reduce the
administrative burden of obtaining the information needed to determine
whether trades or businesses conducted--directly or indirectly--by the
partnership are separate unrelated trades or businesses with respect to
the exempt organization partner. The addition of the interests
recommended to be included by this commenter would significantly
increase the administrative burden of the rule but would not
necessarily capture interests that demonstrate an increased ability for
the exempt organization to obtain the information needed to identify
separate underlying trades or businesses. Accordingly, the Treasury
Department and the IRS do not adopt these recommended additions to the
aggregation rule. Accordingly, the final regulations provide that, when

[[Page 77965]]

determining an organization's percentage interest for purposes of the
participation test (formerly the control test), the interests of a
supporting organization (other than a Type III supporting organization
that is not a parent of its supported organizations) or a controlled
entity in the same partnership are taken into account.
v. Look-Through Rule
The proposed regulations provided that, if an exempt organization
does not control a partnership in which the exempt organization holds a
direct interest (directly-held partnership interest) but the directly-
held partnership interest is not a QPI because the exempt organization
holds more than 20 percent of the capital interest, any partnership in
which the exempt organization holds an indirect interest through the
directly-held partnership interest (indirectly-held partnership
interest) may be a QPI if the indirectly-held partnership interest
meets the requirements of the de minimis test (look-through rule).
Accordingly, the proposed regulations permitted (but did not require)
an exempt organization to aggregate the UBTI from de minimis
indirectly-held QPIs with its directly-held QPIs. However, the proposed
look-through rule did not apply to indirectly-held QPIs that do not
meet the requirements of the de minimis test but might meet the
requirements of the control test (now renamed participation test).
Several commenters recommended expanding the look-through rule to
permit use of the control test for indirectly-held partnership
interests and to permit use of the look-through rule even if the exempt
organization controls the directly-held partnership. These commenters
stated that, even if an exempt organization controls a directly-held
partnership, if the lower-tier partnerships meet the de minimis test or
the control test, an exempt organization would be prevented from
controlling the lower-tier partnerships. Further, the commenters noted
that, preventing the use of such look-through rules would treat
organizations holding the same level and type of partnership interests
differently depending on whether they owned them directly or
indirectly. Another commenter, however, stated that the look-through
rule is unhelpful and that it is extremely difficult, if not
impossible, to determine ownership percentages in lower-tier
partnerships, especially multiple tiers down.
Based on these comments, the final regulations do not prevent
application of the look-through rule if the exempt organization
significantly participates in the directly-held partnership. The final
regulations otherwise retain the look-through rule for indirectly-held
partnership interests that meet the requirements of the de minimis test
with regard to the exempt organization. Additionally, the final
regulations expand application of the look-through rule to indirectly-
held partnership interests that meet the requirements of the
participation test with regards to the immediately higher-tier
partnership that owns interest in that partnership. Thus, for purposes
of the look-through rule, the participation test will apply tier-by-
tier to the exempt organization's indirectly-held partnership
interests. The regulations explain how the second prong of the
participation test--the significant participation prong--applies within
this context and provides an example of the application of this test.
vi. Grace Period
The preamble to the proposed regulations stated that the Treasury
Department and the IRS recognize that an exempt organization may not be
aware of changes in its partnership interest until it receives a
Schedule K-1 (Form 1065) from the partnership at the end of the
partnership's taxable year. In such a circumstance, it may be
appropriate to permit a higher percentage interest in taxable years in
which the increase in an exempt organization's percentage interest
during a taxable year is the result of the actions of other partners.
The Treasury Department and the IRS requested comments regarding
whether a higher percentage interest should be permitted in taxable
years in which the increase occurs as the result of the actions of
other partners.
One commenter stated that private investment funds often admit
limited partners in waves (``closings'') over the course of several
months at the beginning of the fund's term. Therefore, the commenter
recommended a phase-in period that would provide that the percentage
interest in a newly formed partnership not be considered for purposes
of the control test until the end of the partnership's initial closing
period (as long as that period is no later than 18 months following the
exempt organization becoming a partner). The final regulations do not
adopt an initial phase-in period because the aggregation of an exempt
organization's investment activities, including QPIs, is a rule of
administrative convenience and a phase-in rule would increase the
complexity of the rule. Additionally, as discussed in part 2.b.iv.A of
this Summary of Comments and Explanation of Revisions, the final
regulations adopt, without change, the rule that an exempt
organization's percentage partnership interest is determined by
averaging the exempt organization's percentage partnership interest at
the beginning of the partnership's taxable year with its partnership
percentage interest at the end of that same taxable year. Thus, an
exempt organization's percentage interest may vary during a period but
still meet the requirements of the participation test.
The commenter also recommended that an exempt organization be
granted 90 days to reduce its interest in a partnership to the
appropriate amount should its interest exceed that amount at the end of
the year through the actions of other partners. Two other commenters
recommended that an exempt organization should be permitted to count a
partnership interest that exceeds the percentage interest threshold of
the participation test due to the actions of other partners as a QPI
for a period of time following that change in interest amount. One of
the commenters recommended that such interests should be permitted to
be QPIs through the end of the tax year in which it learns that the
percentage interest exceeds the permitted threshold. The other
commenter recommended that such interest should continue to be QPI
through the later of (1) the end of the tax year immediately following
the year an increase occurs through no fault of the E.O.; or (2) 120
days after the date on which the partnership issues the Schedule K-1.
The Treasury Department and the IRS agree 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. Further, requiring such an
interest to be removed from the exempt organization's investment
activities in one year but potentially included as a QPI in the next
would create further administrative difficulty. Accordingly, the final
regulations adopt a grace period that permits a partnership interest to
be treated as meeting the requirements of the de minimis test or the
participation test, respectively, in the exempt organization's prior
taxable year if certain requirements are met.
The final regulations provide that a partnership interest that
fails to meet the requirements of either the de minimis test or the
participation test because of an increase in percentage interest in the
organization's current taxable year may be treated as meeting the
requirements of the test it met in the prior taxable year for the
taxable year of the change if: (1) The partnership

[[Page 77966]]

interest met the requirements of the de minimis test or participation
test, respectively, in the organization's prior taxable year without
application of the grace period; (2) the increase in percentage
interest is due to the actions of one or more partners other than the
exempt organization; and (3) in the case of a partnership interest that
met the requirements of the participation test in the prior taxable
year, the interest of the partner or partners that caused the increase
in percentage interest described in (2) was not combined for the prior
taxable year and is not combined for the taxable year of the change
with the exempt organization's partnership interest under the rules
discussed in part 2.b.iv.C of this Summary of Comments and Explanation
of Revisions. An exempt organization can treat such interest as a QPI
in the taxable year that such change occurs, but the exempt
organization would need to reduce its percentage interest prior to the
end of the following taxable year to meet the requirements of either
the de minimis test or the participation test in that succeeding
taxable year for the partnership interest to remain a QPI.
vii. Reliance on Schedule K-1 (Form 1065)
The proposed regulations provided that, when determining an exempt
organization's percentage interest for purposes of the de minimis test
or the control test (now renamed the participation test), the exempt
organization may rely on the Schedule K-1 (Form 1065) it receives from
the partnership if the form lists the exempt organization's percentage
profits interest or its percentage capital interest, or both, at the
beginning and end of the year. However, the proposed regulations
clarified that the organization may not rely on the form to the extent
that any information about the organization's percentage interest is
not specifically provided. For example, if the Schedule K-1 (Form 1065)
an exempt organization receives from a partnership lists the
organization's profits interest as ``variable'' but lists its
percentage capital interest at the beginning and end of the year, the
organization may rely on the form only with respect to its percentage
capital interest. Generally, this information can be found in Part II,
line J (partner's share of profit, loss, and capital), of Schedule K-1
(Form 1065). No comments were received with respect to reliance on the
Schedule K-1 (Form 1065). Accordingly, the final regulations adopt
these proposed regulations without change, other than minor edits for
clarity.
Nonetheless, commenters made recommendations with respect to other
aspects of the Schedule K-1 (Form 1065) and other partnership or S
corporation forms. A few commenters recommended that updates be made to
the regulations under section 6031 or on the forms and instructions of
the Form 1065, ``U.S. Return of Partnership Income,'' or Form 1120-S,
``U.S. Income Tax Return for an S Corporation,'' including the
respective Schedules K-1 provided to partners or S corporation
shareholders. These commenters requested updates that would require
partnerships to provide information to exempt organization partners (1)
on the NAICS 2-digit codes of the underlying activity, (2) separately
reporting debt-financed income, and (3) requiring a specific capital
interest amount rather than stating ``various.'' Alternatively, another
commenter specifically recommended that partnerships not be required to
provide the NAICS 2-digit code of the underlying activity.
Section 6031(d) provides that partnerships must provide exempt
organization partners with such information as is necessary to enable
each partner to compute its distributive share of partnership income or
loss from such trade or business in accordance with section 512(a)(1).
Following the passage of section 512(a)(6), exempt organization
partners will need additional information to compute their UBTI from
partnerships under section 512(a)(1). The Treasury Department and the
IRS have concluded that the requirement found in section 6031(d) is
sufficient for requiring partnerships to provide this information.
Accordingly, the Treasury Department and the IRS do not adopt any
regulatory changes under section 6031 at this time. The IRS may amend
the forms and instructions in the future, however.
viii. Additional Recommended Changes
A. Capital Account Threshold
One commenter recommended that a capital accounts threshold be
added to the control test. The commenter recommended that the threshold
be based on the average capital account amount throughout the year and
that the threshold be $500,000. A capital account threshold does not
further the purposes of the QPI tests. A capital accounts threshold
added to the control test provided by the proposed regulations (now
renamed the participation test) is not an effective proxy for an exempt
organization's ability to obtain information from a partnership because
the size of a capital account has no correlation to a partner's ability
to participate in a partnership. Further, capital accounts can be
calculated under various standards, which would result in an
inconsistent application of such a rule. Additionally, if the
commenter's level of $500,000 capital accounts were accepted, IRS data
for the 2018 taxable year indicates that it would encompass over 75
percent of all partnerships held by exempt organizations. Such a
threshold therefore likely would not serve as an additional limitation
on the ability to use the participation test. Accordingly, the Treasury
Department and the IRS do not adopt a capital accounts threshold as
part of the participation test.
B. ERISA-Covered Trusts
One commenter recommended that QPI treatment be extended to all
partnership interests held by trusts that are subject to the Employee
Retirement Income Security Act of 1974, Public Law 93-406, 88 Stat. 829
(1974) (ERISA). The commenter stated that because the fiduciary duty
and prohibited transaction rules under ERISA would make it difficult to
operate a trade or business through the trust itself, or through an
entity that is treated under ERISA as holding ``plan assets'' subject
to ERISA, the primary source of UBTI for these plans is investment
vehicles that are taxed as partnerships. In addition, the fiduciary and
prohibited transaction rules (and related penalties) create an
incentive for the investment vehicles to limit the participation of
ERISA plans. If 25 percent or more of the value of any class of equity
interests in a private investment fund is held by benefit plan
investors, the plan assets of a benefit plan investor will generally
include not only the plan's investment, but also an undivided interest
in each of the underlying assets of the investment fund. Anyone who
exercises authority or control with respect to the disposition of plan
assets or who provides investment advice with respect to those assets
will be a fiduciary of the investing plan. See 29 CFR 2510.3-101. Many
investment funds seek to avoid this status by limiting ERISA plan
investment or qualifying for an exemption. The commenter posited that
under the proposed regulations, significant administration would be
required to separate investments between QPIs and other partnerships
that may be subject to the look-through rule or NAICS codes, and in
which the ultimate, bottom-tier investments are almost certainly under
the 2 percent ownership threshold for the de minimis test.

[[Page 77967]]

To the extent that ERISA-covered trusts' interests in partnerships
meet either the de minimis or the participation tests, then those
interests will be treated as investment activities. To the extent that
the partnership interests of ERISA-covered trusts do not meet the de
minimis or the participation test, nothing about ERISA-covered trusts
suggests that they are in greater need of the administrative
convenience provided by such tests. Consequently, the Treasury
Department and the IRS do not adopt this recommendation.
C. Anti-Abuse Rule
One commenter noted that an exempt organization with a directly-
held partnership interest in a partnership that is not a QPI (non-QPI
partnership) could also have one or more indirectly-held partnership
interests in that same partnership through interests that are QPIs (QPI
partnerships), which would effectively permit the exempt organization
to significantly participate in a partnership but structure its
partnership interest such that most of the distributable share of the
partnership's income, losses, etc. would be aggregated with its other
investment activities. The commenter recommended requiring an exempt
organization receiving income through a QPI partnership that derives
income from a non-QPI interest in the same partnership to segregate
that income from the ``investment activities'' trade or business and
report it separately for each underlying trade or business.
Under the situation described by the commenter, an exempt
organization's indirectly-held partnership interest (through a QPI
partnership) in the non-QPI partnership would necessarily be limited by
the fact that the exempt organization may own no more than 20 percent
of the QPI partnership and the exempt organization cannot control the
QPI partnership; therefore it would be difficult, and perhaps unlikely,
for an exempt organization to actively arrange such a scenario for the
purposes of avoiding the application of section 512(a)(6). Further, the
application of such rule would reduce the administrative convenience
that these rules seek to achieve. Accordingly, the Treasury Department
and the IRS do not adopt the recommendation.
The same commenter, noting that such a rule would reduce the
administrative burden of the QPI rules, recommended the creation of an
anti-abuse rule in the alternative. The Treasury Department and the IRS
recognize that some situations, similar to the situation posited by the
commenter or otherwise, may exist whereby an exempt organization may
arrange partnership structures to avoid application of section
512(a)(6). It is always the case that, upon examination, the IRS may
determine whether partnership interests are QPIs under the application
of the law to the facts and characterize such interests accordingly.
Accordingly, the Treasury Department and the IRS do not consider a
specific anti-abuse rule necessary for purposes of the QPI rules and
the final regulations do not incorporate this comment.
c. Transition Rule
Both Notice 2018-67 and the proposed regulations permitted an
exempt organization to treat each partnership interest acquired prior
to August 21, 2018, that met the requirements of neither the de minimis
test nor the control test, as one trade or business for purposes of
section 512(a)(6), regardless of whether there was more than one trade
or business directly or indirectly conducted by the partnership or
lower-tier partnerships (transition rule). This transition rule was
proposed to apply until the first day of the organization's first
taxable year beginning after the date the proposed regulations are
published as final regulations (transition period). The proposed
regulations clarified that a partnership interest acquired prior to
August 21, 2018, will continue to meet the requirement of the
transition rule even if the exempt organization's percentage interest
changes on or after August 21, 2018. Further, the proposed regulations
provided that an exempt organization may apply either the transition
rule or the look-through rule, but not both, to a partnership interest
that meets the requirements for both rules.
Three commenters recommended that the transition rule become a
grandfather rule such that any partnership interest meeting the
requirements of the transition rule would be a single unrelated trade
or business in perpetuity for purposes of section 512(a)(6). One
commenter stated that the rationale for the transition rule outlined in
Notice 2018-67 that ``[a] previously acquired partnership interest may
be difficult to modify to the de minimis test or control test and the
exempt organization may have to incur significant transaction costs to
do so'' will continue to be an accurate reflection of the difficulty of
transitioning such previously owned partnership interests even after
the final regulations are published.
Changing the transition rule to a grandfather rule is contrary to
the congressional intent of section 512(a)(6) to prevent losses of one
unrelated trade or business from offsetting gains of another unrelated
trade or business. Exempt organizations have been on notice since the
announcement of the transition rule in Notice 2018-67 that the
transition rule would sunset after publication of final regulations and
have had over two years since the release of Notice 2018-67 to
anticipate the requirement to account for the income from such
partnership interests differently. The Treasury Department and the IRS
disagree that the rationale for the transition rule justifies
perpetually excluding previously held partnership interests from the
application of section 512(a)(6) to the unrelated trade or business
activities of the partnership. Accordingly, the Treasury Department and
the IRS do not adopt the transition rule as a grandfather rule.
d. Unrelated Debt-Financed Income
The proposed regulations included unrelated debt-financed property
or properties described in sections 512(b)(4) and 514 in the list of
``investment activities'' treated as a separate unrelated trade or
business for purposes of section 512(a)(6). One commenter recommended
that the reference to the definition of debt-financed property ``within
the meaning of section 514'' exclude section 514(b)(1)(B) because that
paragraph removes from the definition of debt-financed property any
property that is used in the production of income from an unrelated
trade or business and proposed Sec. 1.512(a)-6(c)(1)(iii) includes
income from debt-financed property in the ``investment activities trade
or business.'' The commenter further recommended that ``debt-financed
property'' exclude debt-financed property used in the production of
income from an unrelated trade or business that is reported under a
NAICS two-digit code by the exempt organization. Two other commenters
recommended allowing exempt organizations to opt out of inclusion of
debt-financed property as part of an exempt organization's investment
activities and to instead include that income as part of a separate
unrelated trade or business identified by the relevant NAICS 2-digit
code.
Section 512(b)(4) includes as UBTI any unrelated debt-financed
income as defined in section 514. As part of the definition of debt-
financed property, section 514(b)(1)(B) provides that ``any property
[is not debt-financed property] to the extent that the income from such
property is taken into account in computing the gross income of any

[[Page 77968]]

unrelated trade or business'' without application of section 512(b)(4).
For example, if an exempt organization runs a hotel, but it has taken
out a loan to acquire the hotel, then the income from the hotel is UBTI
regardless of section 512(b)(4) and the hotel is not ``debt-financed
property.'' Sections 1.512(b)-1(c)(5) and 1.514(b)-1(b)(2)(ii). Thus,
the income from the hotel is not ``debt-financed income.'' As a result,
any income included in UBTI as ``debt-financed income'' necessarily
derives from an activity that has otherwise been excluded from the
definition of UBTI in section 512(a)(1), for reasons other than the
exempt nature of the activity. Section 514 taxes otherwise nontaxable
income, derived from leveraged income-producing assets, that are not
related to an organization's exempt purposes. Debt-financed income is,
therefore, of a different nature than income that is otherwise
described in section 512(a)(1) and is more appropriately classified as
investment rather than being tied to an underlying trade or business or
NAICS 2-digit code.
Furthermore, allowing an exempt organization to elect to treat the
debt-financed income as part of a 2-digit NAICS code, instead of
including such income as part of an organization's investment
activities, would not reduce the burden upon the exempt organization or
the burden on the IRS. Such income would still need to be identified as
debt-financed income and an additional determination of the underlying
activity would also need to be made to determine a 2-digit NAICS code.
Furthermore, the inconsistent treatment of debt-financed income by
different exempt organizations would increase the administrative burden
for the IRS.
Accordingly, the Treasury Department and the IRS adopt the proposed
regulation regarding the treatment of debt-financed income without
change.

3. S Corporation Interest Treated as an Interest in an Unrelated Trade
or Business

For purposes of the unrelated business income tax, section 512(e)
provides special rules applicable to S corporations. Section
512(e)(1)(A) provides that if an exempt organization permitted to be an
S corporation shareholder (as described in section 1361(c)(2)(A)(vi) or
(6)) holds stock in an S corporation, such interest will be treated as
an interest in an unrelated trade or business. Thus, notwithstanding
any other provision in sections 511 through 514, section 512(e)(1)(B)
requires an exempt organization permitted to hold S corporation stock
to take the following amounts into account in computing the UBTI of
such exempt organization: (i) All items of income, loss, or deduction
taken into account under section 1366(a) (regarding the determination
of an S corporation shareholder's tax liability); and (ii) any gain or
loss on the disposition of the stock in the S corporation.
a. Qualifying S Corporation Interests
As discussed in part 2.a.i of this Summary of Comments and
Explanation of Revisions, the proposed and final regulations include
qualifying S corporation interests (QSI) in an exempt organization's
investment activities. The proposed regulations explained that an S
corporation interest is a QSI if the exempt organization's ownership
interest (by percentage of stock ownership) in the S corporation meets
the requirements for a QPI--that is, the requirements of either the de
minimis test or the control test (now renamed the participation test).
The final regulations provide greater clarity regarding how the QPI
rules apply to S corporation interests. First, the final regulations
provide a number of term substitutions. Specifically, the final
regulations provide that, when applying the QPI rules to an S
corporation interest, ``S corporation'' is substituted for
``partnership'' and ``shareholder'' or ``shareholders'' is substituted
for ``partner'' or ``partners.'' When applying the de minimis test,
``no more than 2 percent of stock ownership'' is substituted for ``no
more than 2 percent of the profits interest and no more than 2 percent
of the capital interest'' and, when applying the participation test,
``no more than 20 percent of stock ownership'' is substituted for ``no
more than 20 percent of the capital interest.'' When applying the
reliance rule, ``Schedule K-1 (Form 1120-S)'' is substituted for
``Schedule K-1 (Form 1065).''
Second, the final regulations clarify that the rules regarding the
determination of an exempt organization's capital interest and profits
interest in a partnership do not apply for purposes of determining
whether an S corporation interest is a QSI. Rather, the average
percentage stock ownership is determinative.
Third, because of differences in the Schedule K-1 (Form 1065) and
the Schedule K-1 (Form 1120-S), the final regulations clarify that an
exempt organization can rely on the Schedule K-1 (Form 1120S) received
from the S corporation if the form lists information sufficient to
determine the exempt organization's percentage of stock ownership for
the year. A Schedule K-1 (Form 1120-S) that reports ``zero'' as the
organization's number of shares of stock in either the beginning or end
of the S corporation's taxable year does not list information
sufficient to determine the organization's percentage of stock
ownership for the year. The Treasury Department and the IRS are
considering whether revision of Schedule K-1 (Form 1120S) is needed to
provide the information needed to determine whether an S corporation
interest is a QSI.
Finally, the final regulations also clarify that a grace period may
apply for changes in an exempt organization's percentage of stock
ownership in an S corporation.
b. Nonqualifying S Corporation Interests
With the exception of QSIs, the proposed regulations applied the
language of section 512(e)(1)(A) to provide that if an exempt
organization owns stock in an S corporation, such S corporation
interest will be treated as an interest in a separate unrelated trade
or business for purposes of the proposed regulations. Similarly, the
proposed regulations clarified that if an exempt organization owns two
S corporation interests, neither of which is a QSI, the exempt
organization will report two separate unrelated trades or businesses,
one for each S corporation interest. The proposed regulations also
provided that the UBTI from an S corporation interest is the amount
described in section 512(e)(1)(B), which includes both the items of
income, loss, or deduction taken into account under section 1366(a) and
the gain or loss on the disposition of S corporation stock.
Two commenters recommended that an exempt organization with an S
corporation interest should be permitted to look through that S
corporation to the underlying trades or businesses and to classify
those S corporation trades or business using NAICS 2-digit codes. One
of these commenters suggested that this should be the general rule for
all non-qualifying S corporation interests. The other commenter
provided that such a rule should be an alternative to the rule
requiring each S corporation interest to be treated as an interest in a
separate unrelated trade or business. One of these commenters further
recommended that income that would ordinarily be excluded under section
512(b)(1), (2), (3) or (5), but that is taxable because it is earned
through an S corporation, should be included as part of the exempt
organization's investment activities.
The final regulations adopt the proposed regulations regarding non-

[[Page 77969]]

qualifying S corporation interests without change. As discussed in the
preamble to the proposed regulations, this treatment is consistent with
the language of section 512(e)(1)(A), which treats an interest in an S
corporation as an unrelated trade or business. Although the Treasury
Department and the IRS considered whether to permit exempt
organizations to look through the S-corporation and identify the
separate unrelated trades or businesses conducted by the S-corporation
using NAICS 2-digit codes as a matter of administrative convenience,
the commenters to Notice 2018-67 noted that obtaining that information
from the S corporation would be difficult. Accordingly, the Treasury
Department and the IRS decline to adopt a rule that modifies the
straightforward application of the language of section 512(e)(1)(A) and
is not otherwise justified as a matter of administrative convenience to
taxpayers or the IRS.

4. Social Clubs, Voluntary Employees' Beneficiary Associations, and
Supplemental Unemployment Benefits Trusts

As discussed in the preamble to the proposed regulations, section
512(a)(3) provides a special definition of UBTI for social clubs,
VEBAs, and SUBs.\5\ Unlike an exempt organization subject to section
512(a)(1) which is taxed only on income derived from an unrelated trade
or business, a social club, VEBA, or SUB is taxed on ``gross income
(excluding exempt function income),'' which includes amounts excluded
from the calculation of UBTI under section 512(a)(1), such as interest,
annuities, dividends, royalties, rents, and capital gains. The preamble
to the proposed regulations provided that, despite the differences
between section 512(a)(1) and (3), a social club, VEBA, or SUB would
determine whether it has more than one unrelated trade or business in
the same manner as an exempt organization subject to section 512(a)(1).
The final regulations adopt the same approach, as discussed in parts
4.a and b of this Summary of Comments and Explanation of Revisions.
---------------------------------------------------------------------------

\5\ See Sec. 1.512(a)-5, 84 FR 67370 (Dec. 10, 2019), for a
discussion of the UBTI rules as they specifically apply to VEBAs and
SUBs.
---------------------------------------------------------------------------

a. Investment Activities
As discussed in part 2 of this Summary of Comments and Explanation
of Revisions, the proposed regulations treated certain investment
activities (that is, QPIs, QSIs, and debt-financed property or
properties) as a separate unrelated trade or business for purposes of
section 512(a)(6). Thus, because a social club, VEBA, or SUB determines
whether it has more than one unrelated trade or business in the same
manner as an exempt organization subject to section 512(a)(1), such an
exempt organization would include the investment activities
specifically listed in the proposed regulations as a separate unrelated
trade or business for purposes of section 512(a)(6). However, because
UBTI is defined differently for social clubs, VEBAs, and SUBs, the
proposed regulations clarified that, in addition to other investment
activities treated as a separate unrelated trade or business for
purposes of section 512(a)(6), gross income from the investment
activities of a social club, VEBA, or SUB also includes any amount that
(i) would be excluded from the calculation of UBTI under section
512(b)(1), (2), (3), or (5) (that is, interest, annuities, dividends,
royalties, rents, and capital gains) if the organization were subject
to section 512(a)(1); (ii) is attributable to income set aside (and not
in excess of the set aside limit described in section 512(a)(3)(E)),
but not used, for a purpose described in section 512(a)(3)(B)(i) or
(ii); or (iii) is in excess of the set aside limit described in section
512(a)(3)(E). The final regulations adopt the proposed investment
activity rules specific to social clubs, VEBAs, and SUBs, without
change as discussed in part 4.a.i and ii of this Summary of Comments
and Explanation of Revisions.
In the preamble to the proposed regulations, the Treasury
Department and the IRS requested comments on any unintended
consequences, in areas other than UBIT, resulting from the treatment of
investment activity of VEBAs and SUBs as an unrelated trade or business
for purposes of section 512(a)(6). One commenter expressed a concern
that these proposed rules could encourage VEBAs and SUBs to create more
complicated investment structures (for example, increased use of
blocker corporations) or that these rules could encourage VEBAs and
SUBs to consider more conservative investment strategies than otherwise
merited based on their asset values.
The commenter did not include any further elaboration on these
general nontax concerns regarding the investment behavior of VEBAs and
SUBs. Furthermore, the commenter did not offer a specific
recommendation to address these general concerns other than its overall
recommendation to not treat investment activities as an unrelated trade
or business for purposes of section 512(a)(6). As discussed earlier in
part 2 of this Summary of Comments and Explanation of Revisions, the
Treasury Department and the IRS have concluded that the structure and
purposes of sections 511 through 514 treat an exempt organization's
investment activities as unrelated trade or business activities for
purposes of section 512(a)(6). Accordingly, the final regulations adopt
these provisions of the proposed regulations without change.
i. Amounts Described in Section 512(b)(1), (2), (3), and (5)
Social clubs, VEBAs, and SUBs generally must include interest,
dividends, royalties, rents, and capital gains in UBTI under section
512(a)(3)(A) because the modifications in section 512(b)(1), (2), (3),
and (5) are not available under section 512(a)(3). Nonetheless, such
amounts may be excluded from UBTI if set aside (and not in excess of
the set aside limit described in section 512(a)(3)(E)) for a purpose
described in section 512(a)(3)(B)(i) or (ii).\6\ Interest, dividends,
royalties, rents, and capital gains generally are considered income
from investment activities and, as stated in part 4 of this Summary of
Comments and Explanation of Revisions, treated as one unrelated trade
or business for purposes of section 512(a)(6). Accordingly, the
proposed regulations provided that, for purposes of section 512(a)(6),
UBTI from the investment activities of a social club, VEBA, or SUB
includes any amount that would be excluded from the calculation of UBTI
under section 512(b)(1), (2), (3), or (5) if the social club, VEBA, or
SUB were subject to section 512(a)(1).
---------------------------------------------------------------------------

\6\ As explained in the introduction to part 4 of this Summary
of Comments and Explanation of Revisions, treating the investment
activities of a social club, VEBA, or SUB as an unrelated trade or
business for purposes of section 512(a)(6) does not affect the
amounts that may be set aside under section 512(a)(3)(B)(i) or (ii).
---------------------------------------------------------------------------

Commenters generally were in favor of this approach. Accordingly,
the final regulations adopt this portion of the proposed regulations
without change.
ii. Amounts Set Aside But Used for Another Purpose and Amounts in
Excess of Account Limits
Section 512(a)(3)(B) provides that, if an amount which is
attributable to income set aside for a purpose described in section
512(a)(3)(B)(i) or (ii) is used for a purpose other than one described
therein, then such amount shall be included in UBTI under section
512(a)(3)(A). Furthermore, with respect to a VEBA or SUB, the amount
set aside may not exceed the set aside limit under section 512(a)(3)(E)
and any amount that exceeds this limit is UBTI under section
512(a)(3)(A).

[[Page 77970]]

As discussed in part 4.a.i of this Summary of Comments and
Explanation of Revisions, the amounts that may be set aside under
section 512(a)(3)(B)(i) or (ii) are income from the social club, VEBA,
or SUB's investment activities. Therefore, the proposed regulations
also provided that UBTI from the investment activities of a social
club, VEBA, or SUB includes any amount that is attributable to income
set aside (and not in excess of the set aside limit described in
section 512(a)(3)(E)), but not used, for a purpose described in section
512(a)(3)(B)(i) or (ii) and also includes any amount in excess of the
set aside limit described in section 512(a)(3)(E).
No comments were received on this section of the proposed
regulations and it is therefore adopted as final.
b. Social Club Activities
i. Limitation on Investment Activities
Section 501(c)(7) requires that ``substantially all of the
activities'' of an organization described therein be ``for pleasure,
recreation, and other nonprofitable purposes.'' Accordingly, a social
club has specific limits on the amount of nonexempt function income
that may be earned without endangering its tax-exempt status. While the
Code does not provide more detail, intended limits are described in
legislative history. See S. Rep. No. 94-1318 (1976), at 4-5.
Additionally, Congress did not intend social clubs to receive, within
these limits, non-traditional unrelated business income. Id. at 4 (``It
is not intended that these organizations should be permitted to receive
. . . income from the active conduct of businesses not traditionally
carried on by these organizations.''). Accordingly, consistent with
Notice 2018-67, the proposed regulations provided that the QPI rule and
the transition rule do not apply to social clubs because social clubs
should not be invested in partnerships that would generally be
conducting non-traditional, unrelated trades or businesses that
generate more than a de minimis amount of UBTI. In this regard, a
partnership interest meeting the requirements of the de minimis rule in
these proposed regulations is not the same as a partnership interest
generating only de minimis amounts of UBTI from non-traditional,
unrelated trades or businesses.
One commenter recommended that social clubs should have access to
the de minimis test for investments in partnerships. The commenter
states that partnership holdings may include exclusively items that are
described in section 512(b)(1), (2), (3), and (5) and that social clubs
would have equal difficulty determining the underlying trade or
business as other exempt organization investors.
The Treasury Department and the IRS do not adopt the commenter's
recommendation for the following reasons. To the extent that a social
club is invested in a partnership all of the holdings of which would be
excluded under section 512(b)(1), (2), (3), and (5) if the social club
were subject to section 512(a)(1), then all such income is part of the
social club's investment activities trade or business without
application of the de minimis test. To the extent that a social club
holds, directly or indirectly, an interest in a partnership that is
performing a non-traditional, unrelated trade or business, then under
section 512(c) the social club itself is engaged in a non-traditional,
unrelated trade or business. Because a social club's nontraditional
activities could jeopardize a social club's exemption, it is incumbent
upon the social club to know the type and amount of such activities
without regard to section 512(a)(6). Thus, the Treasury Department and
the IRS do not consider the administrative convenience rationale
supporting the QPI rule as relevant for social clubs and do not adopt
the commenter's recommendation.
ii. Nonmember Activities
Under the proposed regulations, a social club with nonmember income
is subject to the same rules for identifying its unrelated trades or
businesses as an organization subject to the rules of section
512(a)(1). Further, as discussed in the preamble to the proposed
regulations, a social club cannot use the NAICS 2-digit code generally
describing golf courses and country clubs (71) to describe all its
nonmember income because the NAICS code used must describe its separate
unrelated trade or business and not the purpose for which it is exempt.
While this code may describe some of a social club's nonmember income,
such as greens fees, other NAICS codes may be more appropriate to
describe other nonmember income, such as merchandise sales (45) and
food and beverage services (72). Accordingly, a social club must
identify its separate unrelated trades or businesses in accordance with
the rule described in part 1 of this Summary of Comments and
Explanation of Revisions, like an exempt organization subject to
section 512(a)(1). See part 1.c of this Summary of Comments and
Explanation of Revisions for a discussion of how to identify the
appropriate NAICS 2-digit code.
Commenters again requested that a social club be permitted to treat
all nonmember activities as one unrelated trade or business for
purposes of section 512(a)(6). The commenters stated that separating a
social club's nonmember activities into more than one unrelated trade
or business would result in substantial administrative burden. The
commenters describe the variety of activities in which social clubs
engage, including food and beverage sales in club dining facilities and
on club grounds (such as at pools or on golf courses and tennis
courts); retail sales; greens fees; and space rental fees, whether or
not they include substantial services. One commenter also stated that,
because the treatment of UBTI for social clubs under section 512(a)(3)
is different from that of other exempt organizations' treatment of UBTI
under section 512(a)(1), using different rules to identify the separate
unrelated trades or businesses for social clubs was reasonable.
Finally, a commenter provided that, because social clubs are already
capped at 15 percent of their revenue from nonmember activities,
aggregating all nonmember income under that cap has a de minimis effect
on taxable income while greatly decreasing the administrative burden of
such organizations.
Section 512(a)(3) taxes all income, other than exempt function
income, of the exempt organizations subject to that section, while
section 512(a)(1) taxes only the income from the unrelated trades or
businesses of all other exempt organizations. As a result, section
512(a)(3) captures a broader group of sources of income than under
section 512(a)(1). Further, Congress has previously expressed a desire
to limit the nonmember income of a social club to 15 percent of all
income and to constrain further the non-traditional trades or
businesses of a social club. See S. Rep. No. 94-1318, at 4. Social
clubs would be in a more favorable tax position if social clubs were
permitted to aggregate income that organizations subject to section
512(a)(1) would not be able to aggregate if they performed the same
activities. The Treasury Department and the IRS are not persuaded that
social clubs should have a more favorable position under section
512(a)(6) than other exempt organizations. Additionally, section
512(a)(6) does not specifically except social clubs, nor does it except
a social club's nonmember income. Accordingly, the Treasury Department
and the IRS do not adopt the recommendation to treat

[[Page 77971]]

all of a social club's nonmember income as a single unrelated trade or
business.
One commenter recommended that social clubs be permitted to use the
Uniform System of Financial Reporting for Clubs that is produced
jointly by Hospitality Financial and Technology Professionals and Club
Managers Association of America. This commenter stated that this system
would better represent separate unrelated trades or businesses
historically identified by social clubs.
The accounting system recommended by the commenter is a proprietary
system that is not available for public use. Adopting this system as
the required method of identifying a separate unrelated trade or
business for social clubs would require all such clubs to purchase the
materials of a third-party provider. Accordingly, the Treasury
Department and the IRS do not adopt the Uniform System of Financial
Reporting for Clubs as a method of identifying a separate unrelated
trade or business for social clubs.
The final regulations adopt the proposed regulations' treatment of
a social club's nonmember activities without change.
iii. Nonrecurring Events
The Treasury Department and the IRS recognize that UBTI within the
meaning of section 512(a)(3) includes gross income without regard to a
specific determination regarding the associated activities'
qualification as an unrelated trade or business (within the meaning of
section 513) because UBTI under section 512(a)(3) includes ``all gross
income (excluding exempt function income).''
These final regulations generally require an exempt organization to
identify its separate unrelated trades or businesses using the NAICS 2-
digit code that most accurately describes each trade or business.
Whether an infrequent or possibly nonrecurring event constitutes a
separate unrelated trade or business or whether such event is part of
another trade or business (including, in some cases, part of the social
club's investment activities) depends on the facts and circumstances of
each social club and the event at issue, including the scope of
activities as part of the event. While such determination is not
necessary for including such income in UBTI under section 512(a)(3),
identification of separate unrelated trades or businesses is necessary
for applying section 512(a)(6). In the preamble to the proposed
regulations, the Treasury Department and the IRS requested comments
regarding the particular facts and circumstances that should be
considered by a social club when determining whether a non-recurring
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 section 512(a)(6).
Multiple commenters provided several facts and circumstances that
might assist a social club in identifying the separate unrelated trade
or business associated with the non-recurring activity. However, the
Treasury Department and the IRS have determined that, due to the
limited nature of these activities and the great variety of such
circumstances, the inclusion of such a list of factors within the final
regulations is not warranted at this time. Accordingly, the Treasury
Department and the IRS do not adopt any additional factors for social
clubs to consider when identifying the separate trade or business of
the non-recurring activity. Social clubs can rely on the general rules
in the final regulations for identifying a separate trade or business
to identify the separate trade or business associated with non-
recurring events.
iv. Activities Without a Profit Motive
As discussed in part 1 of this Summary of Comments and Explanation
of Revisions, Sec. 1.513-1(b) provides that ``for purposes of section
513 the term trade or business has the same meaning it has in section
162, and generally includes any activity carried on for the production
of income.'' The requirement for a trade or business to have an intent
to profit is further supported by case law. See, e.g., Commissioner v.
Groetzinger, 480 U.S. 23, 35 (1987) (stating that, ``to be engaged in a
trade or business, . . . the taxpayer's primary purpose for engaging in
the activity must be for income or profit''). This profit motive
requirement was applied to the unrelated trades or businesses of a
social club in Portland Golf Club v. Commissioner, 497 U.S. 154 (1990)
(finding that, under section 512(a)(3) prior to the enactment of
section 512(a)(6), the golf club could use nonmember sales losses for
food and drink to offset investment income only if the sales were
motivated by an intent to profit, and in demonstrating the requisite
profit motive, the golf club had to employ the same method of
allocating fixed expenses as it used in calculating its actual loss).
One commenter on the proposed regulations requested that the
Treasury Department and the IRS clarify that nonmember activities
conducted without intent to profit are not unrelated trades or
businesses. In the preamble to the proposed regulations, the Treasury
Department and the IRS declined to address this comment in the proposed
regulations because it is adequately addressed by existing precedent
and cited to Portland Golf.
In response to the preamble of the proposed regulations, one
commenter stated that a specific trade or business activity must be
identified prior to determining whether it creates losses on a
consistent basis. Given that the trade or business activity must first
be identified, and that the proposed regulations prescribed the use of
NAICS 2-digit codes for identifying a separate unrelated trade or
business, the commenter noted that a social club must first identify
the appropriate NAICS 2-digit code for a trade or business activity and
determine whether the trade or business activity represented by that
NAICS 2-digit code generates losses on a consistent basis (and thus may
lack the requisite profit motive to be a trade or business at all for
UBIT purposes). Under this analysis, the commenter recommended allowing
exempt organizations to include, or exclude, certain activities from a
trade or business based on the social club's internal determination
that the activity lacks a profit motive.
The Treasury Department and the IRS agree that profit motive is
relevant to determining whether an activity is a trade or business and
that an exempt organization has a separate unrelated trade or business
for purposes of section 512(a)(6) only if the activity being analyzed
as separate is a trade or business. The Treasury Department and the IRS
also agree that, for UBIT purposes, the appropriate level for
determining whether a profit motive exists (based on the generation of
consistent losses) with regard to an activity as a trade or business is
the NAICS 2-digit level since the Treasury Department and the IRS have
determined that the NAICS 2-digit codes appropriately identify separate
unrelated trades or businesses.
However, the Treasury Department and the IRS do not adopt the
commenter's recommendation to allow exempt organizations to exclude
certain activities from the UBTI calculation based on the
organization's assertion of a lack of intention to make a profit. In
determining the lack of a profit motive, greater weight is given to
objective facts than to a taxpayer's intent. See, e.g., Sec. 1.183-
2(a). Thus, an exempt organization would need to demonstrate a factual
lack of profit motive rather than claiming a lack of intent without any
demonstrated losses. Furthermore, in light of the purpose and effect of

[[Page 77972]]

section 512(a)(6) to not permit losses from one trade or business to
offset income from another trade or business, the commenter's
recommendation would only benefit exempt organizations if the exempt
organization could exclude income from a trade or business activity
(first separated on the basis of the NAICS 2-digit code levels) from
UBTI on an assertion that the exempt organization has no profit motive
with regard to such activity notwithstanding the income from that
activity. The Treasury Department and the IRS do not see any basis for
providing such a rule.

5. Total UBTI and the Charitable Contribution Deduction

Consistent with section 512(a)(6), the proposed regulations
provided that the total UBTI of an exempt organization with more than
one unrelated trade or business is the sum of the UBTI with respect to
each separate unrelated trade or business, less the specific deduction
under section 512(b)(12), and that the UBTI with respect to any
separate unrelated trade or business cannot be less than zero.
Section 512(b)(10) and (11) permit exempt organizations to take a
charitable contribution deduction. The amount of this deduction, in the
case of section 512(b)(10), which applies to most exempt organizations,
is limited to 10 percent of UBTI computed without application of the
charitable contribution deduction and, in the case of section
512(b)(11), which applies to certain trusts, is limited to the amounts
described in section 170(b)(1)(A) and (B) determined with reference to
UBTI, again, computed without application of the charitable
contribution deduction. The proposed regulations clarified that the
term ``unrelated business taxable income'' as used in section
512(b)(10) and (11) refers to UBTI after application of section
512(a)(6). As a result, the limitations on the charitable contribution
deduction would be computed using total UBTI under section
512(a)(6)(B).
Although the proposed regulations clarified how to calculate the
limitation on the charitable contribution deduction (that is, using
total UBTI), the proposed regulations did not explicitly state, other
than in the preamble, that the charitable contribution deduction was to
be taken against total UBTI. Accordingly, the final regulations have
been revised to clarify that the total UBTI of an exempt organization
with more than one unrelated trade or business is the sum of the UBTI
with respect to each separate unrelated trade or business, less a
charitable contribution deduction, an NOL deduction for losses arising
in taxable years beginning before January 1, 2018 (discussed in part 6
of this Summary of Comments and Explanation of Revisions), and a
specific deduction under section 512(b)(12), as applicable.
One commenter asserted that certain expenses, such as tax return
preparation fees and state taxes, are difficult to allocate between two
or more unrelated trades or businesses and recommended that exempt
organizations be permitted to deduct such expenses against total UBTI.
Similarly, this commenter recommended that investment management fees
be deducted against total investment related UBTI (instead of total
UBTI). In support of this suggestion, this commenter noted that the
proposed regulations permitted the charitable contribution deduction in
section 512(b)(10) and (11) to be taken against total UBTI.
The final regulations do not adopt this commenter's
recommendations. First, the charitable contribution deduction in
section 512(b)(10) and (11) is distinguishable from other deductions
under section 512(a)(1) or (3) or section 512(b) because the Code
specifically provides that this deduction is permitted ``whether or not
directly connected with the carrying on of an unrelated trade or
business.'' Accordingly, the Treasury Department and the IRS determined
that the charitable contribution deduction could be taken against total
UBTI calculated under section 512(a)(6)(B).
Second, the structure of section 512(a)(6) itself confirms that
Congress did not intend for any deductions to be taken against total
UBTI calculated under section 512(a)(6)(B) other than the ones
specifically permitted. Section 512(a)(6)(A) provides that, when
calculating the UBTI of a separate unrelated trade or business, such
calculation is made ``without regard to'' the specific deduction in
section 512(b)(12). Section 512(a)(6)(B) clarifies that total UBTI is
the sum of UBTI computed with respect to each separate unrelated trade
or business ``less a specific deduction under [section] 512(b)(12).''
Thus, the only deductions permitted against total UBTI are a charitable
contribution deduction under section 512(b)(10) and (11), an NOL
deduction for losses arising in taxable years beginning before January
1, 2018 (permitted by section 13702(b)(2) of the TCJA), and a specific
deduction under section 512(b)(12). All other deductions are taken
against the UBTI of each separate unrelated trade or business, provided
that each such deduction meets the requirements of section 512(a)(1) or
(3), as applicable. Any deduction attributable to more than one
unrelated trade or business must be allocated in accordance with Sec.
1.512(a)-1(c) of the current regulations.

6. NOLs and UBTI

a. NOL Deduction Calculated Separately With Respect to Each Trade or
Business
Consistent with the statute and the proposed regulations, the final
regulations provide that, for taxable years beginning after December
31, 2017, an exempt organization with more than one unrelated trade or
business determines the NOL deduction allowed by sections 172(a) and
512(b)(6) separately with respect to each of its unrelated trades or
businesses. Also consistent with the proposed regulations, the final
regulations provide that Sec. 1.512(b)-1(e), which addresses the
application of section 172 in the context of UBIT, applies separately
with respect to each such unrelated trade or business.
b. Coordination of NOLs
The proposed regulations provided that an organization with losses
arising in a taxable year beginning before January 1, 2018 (pre-2018
NOLs), and losses arising in a taxable 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 such trade or business. One
commenter recommended that an exempt organization be permitted to
choose the order in which it uses pre-2018 and post-2017 NOLs based on
its own facts and circumstances.
The Treasury Department and the IRS do not accept this
recommendation. Section 1.172-4(a)(3) of the current regulations
provides that the amount which is carried back or carried over to any
taxable year is an NOL ``to the extent it was not absorbed in the
computation of the taxable (or net) income for other taxable years,
preceding such taxable year, to which it may be carried back or carried
over.'' This section further provides that, for the purpose of
determining the taxable (or net) income for any such preceding taxable
year, the various NOL carryovers and carrybacks to such taxable year
are considered to be applied in reduction of the taxable (or net)
income in the order of the taxable years from which such losses are
carried over or carried back, beginning with the loss for the earliest
taxable year. Furthermore, in Notice 2018-67, the Treasury Department
and

[[Page 77973]]

the IRS noted that section 512(a)(6) may have changed the order in
which NOLs are taken and requested comments regarding how the NOL
deduction should be taken under section 512(a)(6) by exempt
organizations with more than one unrelated trade or business and, in
particular, by such organizations with both pre-2018 and post-2017
NOLs. Comments received in response to Notice 2018-67 noted that
section 512(a)(6) does not alter the ordering rules under section 172
and that pre-2018 NOLs should be allowed prior to post-2017 NOLs,
especially because pre-2018 NOLs remain subject to a carry-forward
limitation. The commenter on the proposed regulations provided no new
information that would support changing the NOL ordering rule for
purposes of section 512(a)(6). Accordingly, the final regulations adopt
the proposed regulations without change.
The proposed regulations further provided that pre-2018 NOLs are
taken against total UBTI in the manner that results in maximum
utilization of the pre-2018 NOLs in a taxable year. One commenter
requested that the final regulations clarify the methodology or
principle that should be used to allocate pre-2018 NOLs among separate
unrelated trades or businesses. The methods suggested by this commenter
would result in the pro-rata distribution of pre-2018 NOLs based on
various factors, such as the ratio of UBTI of a separate unrelated
trade or business to total UBTI. In the alternative, two commenters
proposed that an exempt organization be permitted to use any reasonable
method to allocate its pre-2018 NOLs.
Although pre-2018 NOLs are taken against total UBTI, pre-2018 NOLs
must be allocated in some manner between separate unrelated trades or
businesses to determine the amount of pre-2018 NOLs actually taken in a
taxable year because the UBTI with respect to each separate unrelated
trade or business is calculated before total UBTI and post-2017 NOLs
are taken against the UBTI of the separate unrelated trade or business
in which they arose. Pre-2018 NOLs could be allocated any number of
ways, including ratably between separate unrelated trades or businesses
or only to those separate unrelated trades or businesses with no post-
2017 NOLs. In permitting the ``maximum utilization of the pre-2018 NOLs
in a taxable year'' in the proposed regulations, the Treasury
Department and the IRS intended to provide exempt organizations with
the flexibility to choose how to allocate pre-2018 NOLs among separate
unrelated trades or businesses. However, the actual effect of this rule
is to permit an exempt organization to maximize post-2017 NOLs taken
against the UBTI from the separate unrelated trades or businesses after
taking the pre-2018 NOLs. Accordingly, the final regulations clarify
that pre-2018 NOLs are taken against the total UBTI in a manner that
allows for maximum utilization of post-2017 NOLs, rather than pre-2018
NOLs, in a taxable year. For example, the final regulations further
clarify that an exempt 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.
Additionally, several commenters requested guidance regarding how
changes made to section 172 by the Coronavirus Aid, Relief, and
Economic Security Act, Public Law 116-136, 134 Stat. 281 (2020) (CARES
Act) would affect section 512(a)(6). The Treasury Department and the
IRS are considering how these changes affect the calculation of UBTI
under section 512(a)(6) and expect to publish additional guidance on
the issue. It is anticipated that this additional guidance will include
examples that illustrate both how the changes to the CARES Act affect
the calculation of UBTI as well as how an exempt organization
calculates UBTI when it has pre-2018 NOLs, either with or without post-
2017 NOLs.
c. Treatment of NOLs Upon Sale, Transfer, Termination, or Other
Disposition of a Separate Unrelated Trade or Business
Several commenters requested guidance on the treatment of
accumulated NOLs upon the sale, transfer, termination, or other
disposition of a separate unrelated trade or business. At least one
commenter recommended that, in such an event, the use of all such prior
losses be applied first to any gain realized on the disposition of the
trade or business and that any remaining losses be permitted to offset
UBTI from other, separate unrelated trades or businesses. Another
commenter recommended that any accumulated NOLs be suspended and taken
if the exempt organization later resumes the separate unrelated trade
or business.
Section 512(a)(6) permits only pre-2018 NOLs to be taken against
total UBTI. Consistent with the legislative intent of section
512(a)(6), losses attributable to a separate unrelated trade or
business may be taken only against income from that separate unrelated
trade or business. However, the Treasury Department and the IRS
recognize that an exempt organization later may recommence that
separate unrelated trade or business or acquire a separate unrelated
trade or business identified in the same manner. Accordingly, the final
regulations provide that, after offsetting any gain from the
termination, sale, exchange, or other disposition of a separate
unrelated trade or business, any NOL remaining is suspended. However,
the suspended NOLs may be used if that previous separate unrelated
trade or business is later resumed or if a new unrelated trade or
business that is accurately identified using the same NAICS 2-digit
code as the previous separate unrelated trade or business is commenced
or acquired in a future taxable year.
d. Treatment of NOLs Upon Changing Identification of a Separate
Unrelated Trade or Business
Six commenters requested that the final regulations clarify what
happens to NOLs when a partnership interest moves in and out of QPI
status. The Treasury Department and the IRS expect that the grace
period described in part 2.b.vi of this Summary of Comments and
Explanation of Revisions will reduce the incidence of partnership
interests moving in and out of QPI status. Nonetheless, instances will
exist where a partnership interest that was a QPI becomes a non-QPI.
Additionally, as discussed in part 1.d of this Summary of Comments and
Explanation of Revisions, an exempt organization may change the NAICS
2-digit code identifying a separate unrelated trade or business. Thus,
the same question exists regarding what happens to NOLs when the NAICS
2-digit code identifying a separate unrelated trade or business
changes.
In response to the commenters, the final regulations generally
provide that, for purposes of 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.
As a result, none of the NOLs from the previously identified separate
unrelated trade or business will be carried over to the newly
identified separate unrelated trade or business. For example, if the
nature of a separate unrelated trade or business changes such that it
is more accurately described by another NAICS 2-digit code, the
separate unrelated trade or business is treated as a new

[[Page 77974]]

separate unrelated trade or business with no NOLs.
The final regulations further clarify that the change in
identification may apply to all or a part of the originally identified
separate unrelated trade or business. If the change in identification
applies to the originally identified separate trade or business in its
entirety, any NOLs attributable to that separate unrelated trade or
business are suspended. If the change in identification applies to the
originally identified separate unrelated trade or business in part, to
aid in tax administration and to avoid a need for allocation of NOLs
within an originally identified separate trade or business, the
originally identified separate unrelated trade or business that is not
changing retains the full NOLs attributable to it, including the
portion for which the identification is changing. Additionally, the
final regulations provide that this general rule also applies to the
separate unrelated trades or businesses that are identified when a QPI
becomes a non-QPI. In this case, any NOLs attributable to the QPI that
became a non-QPI are retained with the organization's investment
activities.
Under the final regulations, a change in identification is
effective as of the first day of the taxable year in which the change
is made. Accordingly, the final regulations treat the newly identified
separate unrelated trade or business as commencing on this date.
Nonetheless, the final regulations provide an exception for when an
organization has determined that an unrelated trade or business is more
accurately identified by another NAICS 2-digit code, provided that
there has been no material change in the unrelated trade or business.
In these cases, the final regulations provide that the NOLs
attributable to the previously identified separate unrelated trade or
business are NOLs of the newly identified separate unrelated trade or
business. This approach is consistent with the legislative intent that
losses from one unrelated trade or business not be used to offset the
gains from another unrelated trade or business but recognizes that
mistakes may be made and that NOLs should not be suspended (as
discussed in part 6.c of this Summary of Comments and Explanation of
Revisions) in such a case. The final regulations provide examples
illustrating the application of these rules regarding NOLs.
e. Coordination of NOL and Excess Charitable Contribution Carryovers
The proposed regulations requested comments on the coordination of
NOL and excess contribution carryovers. The proposed regulations noted
that an ordering rule may be necessary. Although a few comments were
received, these final regulations do not address this issue. The
Treasury Department and the IRS continue to consider this issue and
will issue additional guidance, if needed.

7. Form 990-T

At least one commenter requested clarification regarding the
reporting of separate unrelated trades or businesses that do not have
corresponding NAICS codes, such as investment activities, income from
certain controlled entities, and non-qualifying S corporation
interests. The IRS is in the process of revising the 2020 Form 990-T
and related instructions. It is anticipated that separate unrelated
trades or businesses that are not identified using NAICS 2-digit
codes--that is, separate unrelated trades or businesses identified
under Sec. 1.512(a)-6(c) (investment activities), (d)(1) (specified
payments from controlled entities), (d)(2) (certain amounts derived
from controlled foreign corporations), and (e) (non-qualifying S
corporation interests)--will be identified using numeric codes
distinguishable from NAICS codes. The instructions to the Form 990-T
will explain how an exempt organization determines the appropriate code
to use, as well as how to report code changes.

8. Waiver of Penalties Not Provided

One commenter requested that the Treasury Department and the IRS
waive any penalties arising from the underpayment of tax for tax years
prior to the applicability date of the final regulations. As discussed
in the Applicability Dates section of this preamble, an exempt
organization may rely on a reasonable, good-faith interpretation of
section 512(a)(6) prior to the applicability date of the final
regulations. Accordingly, the Treasury Department and the IRS decline
to waive any underpayment penalties with respect to the calculation of
UBTI under section 512(a)(6).

9. Individual Retirement Accounts

The proposed regulations added a new paragraph to Sec. 1.513-1
clarifying that the section 513(b) definition of ``unrelated trade or
business'' applies to individual retirement accounts (IRAs) described
in section 408. No comments were received with respect to this
provision. Accordingly, the final regulations adopt these proposed
regulations without change.

10. Inclusions of Subpart F Income and Global Intangible Low-Taxed
Income

The proposed regulations revised Sec. 1.512(b)-1(a) to clarify
that an inclusion of subpart F income under section 951(a)(1)(A) is
treated in the same manner as a dividend for purposes of section
512(b)(1) and that an inclusion of global intangible low-taxed income
(GILTI) under section 951A(a) is treated in the same manner as an
inclusion of subpart F income under section 951(a)(1)(A) for purposes
of section 512(b)(1). At least one commenter explicitly supported this
treatment of an inclusion of subpart F income or GILTI and no other
comments were received. Therefore, the final regulations adopt these
proposed regulations without change.

11. Public Support

The preamble to the proposed regulations confirmed that section
512(a)(6) potentially impacted the calculation of public support under
sections 509(a)(1) and 170(b)(1)(A)(vi) and under section 509(a)(2)
(the public support tests) because of the inability of an exempt
organization with more than one unrelated trade or business to use
losses from one unrelated trade or business to offset gains from
another unrelated trade or business. Furthermore, the preamble to the
proposed regulations noted that the Treasury Department and the IRS
were not aware of any congressional intent to change the public support
tests in enacting section 512(a)(6). Accordingly, the proposed
regulations revised Sec. Sec. 1.170A-9(f) and 1.509(a)-3 to permit an
organization with more than one unrelated trade or business to
aggregate its net income and net losses from all of its unrelated
business activities, including unrelated trades or businesses within
the meaning of section 512, for purposes of determining whether an
organization is publicly supported.
Commenters agreed that Congress likely did not intend to change the
public support tests when enacting section 512(a)(6) and generally
supported the proposed clarifications to the public support test.
However, two commenters noted that an exempt organization that
satisfies the public support tests using its UBTI calculated for
purposes of section 512(a)(6) also will satisfy the public support
tests if it calculates its UBTI in the aggregate. These commenters
therefore recommended that an exempt organization be permitted to use
either its UBTI calculated under section 512(a)(6) or its UBTI
calculated in the aggregate to determine public support.

[[Page 77975]]

These commenters noted that this approach would reduce the
administrative burden on exempt organizations because organizations
that satisfy the requirements of the public support test using their
UBTI calculated under section 512(a)(6) would not be required to
recalculate UBTI in the aggregate. At the same time, this approach
would also address any unintended consequence of the enactment of
section 512(a)(6) for exempt organizations that have historically
satisfied the requirements of the public support test but would no
longer because of the effect of section 512(a)(6). The final
regulations adopt these commenters' suggestions and permit an exempt
organization with more than one unrelated trade or business to
determine public support using either its UBTI calculated under section
512(a)(6) or its UBTI calculated in the aggregate.

12. Technical Correction of Inadvertently Omitted Regulatory Language

The proposed regulations made a technical correction to Sec.
1.512(a)-1(b) by including language that was omitted from the Federal
Register when the final regulation was published in 1975. No comments
were received with respect to this technical correction. Accordingly,
the final regulations adopt the technical correction in the proposed
regulations without change.

Applicability Dates

The proposed regulations were proposed to apply to taxable years
beginning on or after the date the regulations were published in the
Federal Register as final regulations. Two commenters recommended that
the applicability date of the final regulations be delayed. Another
commenter suggested that the applicability date be extended such that
all exempt organizations be provided with at least one year before the
final regulations are applicable. This commenter explained that time
will be required to implement the final regulations, including making
changes to accounting systems. Accordingly, this commenter proposed
that the applicability date of the final regulations be extended to the
first day of the second taxable year beginning after the date the final
regulations are published in the Federal Register.
The Treasury Department and the IRS recognize that implementation
of the requirements of section 512(a)(6) by some exempt organizations
requires changes to the way these organizations track income and
expenses. However, the Treasury Department and the IRS have provided
guidance regarding how exempt organizations would be expected to comply
with section 512(a)(6) starting with Notice 2018-67 in September of
2018 and continuing with the proposed regulations in April of 2020. The
final regulations adopt the proposed regulations with minor changes
requested by commenters. Accordingly, consistent with the proposed
regulations, the final regulations are applicable to taxable years
beginning on or after December 2, 2020. In addition, an exempt
organization may choose to apply the final regulations under section
512(a)(6), as well as the final regulations relating to the calculation
of public support, to taxable years beginning on or after January 1,
2018, and before December 2, 2020. Alternatively, an exempt
organization may rely on a reasonable, good-faith interpretation of
section 512(a)(6) for such taxable years. For this purpose, a
reasonable good faith interpretation includes the methods of
aggregating or identifying separate trades or businesses provided in
Notice 2018-67 or the proposed regulations.
With respect to the inclusions of subpart F income or GILTI
discussed in part 10 of the Summary of Comments and Explanation of
Revisions, a taxpayer may choose to apply the final regulations under
Sec. 1.512(b)-1(a) to taxable years beginning before December 2, 2020
consistent with the longstanding position of the Treasury Department
and the IRS on the inclusion of subpart F income under section
951(a)(1)(A).

Statement of Availability of IRS Documents

For copies of recently issued Revenue Procedures, Revenue Rulings,
Notices, and other guidance published in the Internal Revenue Bulletin,
please visit the IRS website at http://www.irs.gov or the
Superintendent of Documents, U.S. Government Printing Office,
Washington, DC 20402.

Special Analyses

I. Regulatory Planning and Review--Economic Analysis

Executive Orders 12866, 13563, and 13771 direct agencies to assess
costs and benefits of available regulatory alternatives and, if
regulation is necessary, to select regulatory approaches that maximize
net benefits (including potential economic, environmental, public
health, and safety effects; distributive impacts; and equity).
Executive Order 13563 emphasizes the importance of quantifying both
costs and benefits, of reducing costs, of harmonizing rules, and of
promoting flexibility.
These final regulations have been designated as significant and
subject to review under Executive Order 12866 and section 1(b) of the
Memorandum of Agreement (April 11, 2018) between the Treasury
Department and the Office of Management and Budget regarding review of
tax regulations. For purposes of Executive Order 13771, the final
regulations are regulatory. The Administrator of the Office of
Information and Regulatory Affairs (OIRA), Office of Management and
Budget, has waived review of this rule in accordance with section
6(a)(3)(A) of Executive Order 12866.

1. Background

Certain corporations, trusts, and other entities are exempt from
Federal income taxation because of the specific functions they perform
(exempt organizations). Examples include religious and charitable
organizations. However, exempt organizations that engage in business
activities that are not substantially related to their exempt purposes
may have taxable income under section 511(a)(1) of the Internal Revenue
Code (Code). For example, the income that a tax-exempt organization
generates from the sale of advertising in its quarterly magazine is
unrelated business taxable income (UBTI).
Prior to the Tax Cuts and Jobs Act (TCJA), UBTI was calculated by
aggregating the net incomes from all the unrelated business activities
conducted by an exempt organization. As a result, losses from one
unrelated trade or business activity could be used to offset profits
from another unrelated trade or business activity. New section
512(a)(6), enacted in the TCJA, provides that organizations with more
than one unrelated trade or business calculate the taxable amounts
separately for each trade or business so that losses only offset income
from the same unrelated trade or business. The statutory language,
however, does not specify standards for determining what activities
would be considered the same or a different trade or business.
On April 21, 2020, the Department of the Treasury (Treasury
Department) and the IRS published a notice of proposed rulemaking (REG-
106864-18) in the Federal Register (85 FR 23172) containing proposed
regulations under section 512 (proposed regulations). The final
regulations retain the basic approach and structure of the proposed
regulations with certain minor modifications. As part of these
modifications, the final regulations

[[Page 77976]]

modify the participation test (called the ``control test'' in the
proposed regulations) to permit indirectly held partnerships interests
to be eligible for inclusion in an exempt organization's single
``investment activities'' trade or business. The final regulations
address the need for guidance by providing rules for determining when
an exempt organization has more than one unrelated trade or business
and how such an exempt organization computes UBTI under new section
512(a)(6). Specifically discussed below, the final regulations
establish guidelines for (1) identifying separate unrelated trades or
businesses; and (2) in certain cases, permitting an exempt organization
to treat investment activities as one unrelated trade or business for
purposes of computing UBTI.

2. Baseline

In this analysis, the Treasury Department and the IRS assess the
benefits and costs of these proposed regulations relative to a no-
action baseline reflecting anticipated Federal income tax-related
behavior in the absence of these proposed regulations.

3. Affected Entities

Prior tax law did not require tax-exempt organizations to report
unrelated business income by separate activity, so it is not possible
to obtain accurate counts of the number of exempt organizations
potentially affected by the final regulations. However, the IRS
estimates that less than 2 percent of exempt organizations would be
affected, as calculated below.
Approximately 1.4 million exempt organizations filed some type of
information or tax return with the IRS for fiscal year 2018.\7\ Only
188,000 exempt organizations filed Form 990-T, which is used to report
UBTI. While not all Form 990-T filers also file an information return
with the IRS, as an upper bound estimate, 14 percent of exempt
organizations could be affected by the regulations. Within Form 990-T
filers, only a smaller subset, primarily the largest organizations in
certain categories, are expected to have more than one unrelated trade
or business. Among the types of organizations expected to have more
than one unrelated trade or business are colleges and universities,
certain cultural organizations such as museums, and some tax-exempt
hospitals.
---------------------------------------------------------------------------

\7\ See Internal Revenue Service Research, Applied Analytics,
and Statistics, Statistics of Income Division Fiscal Year Return
Projections for the United States Publication 6292 (Rev. 9-2019),
Projected Returns 2019-2026. Exempt organizations generally must
file an annual information return with IRS. See generally section
6033. However, churches and small organizations are exempt from this
filing requirement. See section 6033(a)(3). Organizations that have
more than $1,000 in gross UBTI must also file Form 990-T to
calculate their UBTI and tax. See section 512(b)(12) (providing a
$1,000 specific deduction).
---------------------------------------------------------------------------

Additional information on organizations that may be affected is
provided by a 2018 Center on Nonprofits and Philanthropy (CNP) survey
of 723 primarily large exempt organizations.\8\ Three-hundred and
thirty of these organizations reported that they had filed a Form 990-
T. Of these, 70 percent had revenues over $10 million and most were
educational or arts and cultural organizations. Only 46 organizations
(14 percent of the surveyed organizations filing Form 990-T) reported
having more than one source of UBTI and almost half of these had only
two sources. Thus, the Treasury Department and the IRS project that if
the CNP survey results applied to the population of Form 990-T filers,
then less than 2 percent of exempt organizations or approximately 4,000
filers would be affected by the final regulations and that these would
tend to be large educational or arts and cultural organizations.
---------------------------------------------------------------------------

\8\ See Elizabeth Boris and Joseph Cordes, ``How the TCJA's New
UBIT Provisions Will Affect Nonprofits,'' Urban Institute Research
Report, January 2019.
---------------------------------------------------------------------------

4. Economic Analysis of Final Regulations

The final regulations provide greater certainty to exempt
organizations regarding how to compute UBTI and tax in response to the
changes made by TCJA. They also improve economic efficiency by helping
to ensure that similar exempt organizations are taxed similarly. In the
absence of this guidance taxpayers might make different assumptions
regarding how to calculate UBTI and tax.
This section describes the two major provisions of the final rule
and provides a qualitative economic analysis of each one.
a. Identifying Separate Trades or Businesses
Section 512(a)(6) requires exempt organizations with more than one
unrelated trade or business to calculate UBTI separately for each trade
or business so that losses are used to offset only income from the same
unrelated trade or business. The final regulations generally require
the use of NAICS codes to identify separate unrelated trades or
businesses. NAICS is an industry classification system for purposes of
collecting, analyzing, and publishing statistical data related to the
United States business economy. Each digit of the NAICS 6-digit codes
describes an industry with increasing specificity. The final
regulations allow the use of NAICS 2-digit codes, which encompass
broader categories of trades or businesses than NAICS 6-digit codes, to
reduce the compliance burdens for exempt organizations with multiple
similar types of business activity. For example, different types of
food services would be included in the same NAICS 2-digit code as
opposed to separate NAICS 6-digit codes. Similarly, different types of
recreational activities, such as fitness centers and golf courses,
would be in the same NAICS 2-digit code as opposed to separate NAICS 6-
digit codes. A single facility might have elements fitting several of
these categories, which could change over time when NAICS codes are
revised. The use of NAICS 6-digit codes could potentially require an
exempt organization to split what has traditionally been considered one
unrelated trade or business into multiple unrelated trades or
businesses. In addition, exempt organizations may need to incur the
costs of changing their accounting systems so as to collect the
information needed for separate NAICS 6-digit codes.
Some commenters to the proposed regulations advocated using the
NAICS 2-digit codes as a safe-harbor when identifying separate
unrelated trades or businesses and that a facts and circumstances test
be applied as the primary method of identifying separate unrelated
businesses. Adoption of a facts and circumstances test would increase
the administrative burden of tax-exempt organizations in complying with
section 512(a)(6) because fact-intensive analysis would be required to
determine each unrelated trade or business. Additionally, adoption of a
facts and circumstances test would offer exempt organizations less
certainty and increase the IRS administrative burden.
The guidance provided in the final regulations ensures that the tax
liability is calculated similarly across taxpayers, avoiding situations
where one taxpayer receives differential treatment compared to another
taxpayer for fundamentally similar economic activity based on their
differing reasonable, good-faith interpretations of the statute. In the
absence of these final regulations, an exempt organization might be
uncertain about whether an activity is one or more than one trade or
business. As a result, in the absence of the final regulations, similar
institutions might take different positions and pay different amounts
of tax, introducing economic inefficiency and inequity. These
regulations provide

[[Page 77977]]

greater certainty and flexibility such that compliance costs may be
slightly lower for affected organizations relative to a no-action
baseline.
b. Aggregation of Investment Activities
The final regulation's treatment of investment activities will also
provide clarity and reduce burdens for exempt organizations. By
providing explicit rules for the treatment of investment activities,
the final regulations reduce the uncertainty about what would be
acceptable under a reasonable, good-faith interpretation. Although
investment income, such as interest and dividend income, is not
generally statutorily taxed as UBTI, exempt organizations may engage in
certain activities that the organization considers ``investments'' but
that generate UBTI, such as debt-financed investments or investments
through partnerships. The final regulations allow certain of this
investment income to be aggregated and treated as a single trade or
business. The final regulations provide rules for the treatment of
partnership income and explicitly list the other types of UBTI that can
be aggregated as ``investment'' income in response to comments
requesting additional clarification. The allowance of this type of
aggregation is responsive to situations where exempt organizations are
invested in partnerships in which they do not significantly
participate. The allowance of aggregation in the final regulations
recognizes that in these situations the exempt organizations are
unlikely to be able to access information from such partnerships for
purposes of separating the partnerships' investments according to NAICS
codes. As a result, the final regulations reduce the compliance burdens
of exempt organizations of obtaining information from partnerships and
simplify the calculation of UBTI when the income is generated from
``investment'' activities relative to the no-action baseline.
c. Summary
The final regulations provide rules for determining when an exempt
organization has more than one unrelated trade or business and how such
an exempt organization computes UBTI. In addition, the final
regulations provide guidelines for when an exempt organization treats
its investment activities as one unrelated trade or business for
purposes of computing UBTI. In the absence of guidance, affected
taxpayers may face more uncertainty when calculating their tax
liability, a situation generally that could lead to greater conflicts
with tax administrators. The Treasury Department and the IRS project
that the final regulations will reduce taxpayer compliance burden
relative to the no-action baseline. In addition, the Treasury
Department and the IRS project that these regulations will affect a
small number of exempt organizations. Based on this analysis, the
Treasury Department and the IRS anticipate any economic effects of the
final regulations will be modest relative to the no-action baseline.

II. Paperwork Reduction Act

The collections of information contained in the final regulations
will be submitted to the Office of Management and Budget for review in
accordance with the Paperwork Reduction Act of (1995) (44 U.S.C.
3507(d)). An agency may not conduct or sponsor, and a person is not
required to respond to, a collection of information unless it displays
a valid control number assigned by the Office of Management and Budget.
Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
return information are confidential, as required by 26 U.S.C. 6103.

1. Collections of Information Imposed by the Regulations

The collection of information in these final regulations is in
Sec. 1.512(b)-6(a). This information is required to determine whether
an exempt organization has more than one unrelated trade or business
and therefore must report those unrelated trades or businesses on Form
990-T and related schedules. In 2018, the IRS released and invited
comments on drafts of an earlier version of the Form 990-T and related
schedules to give members of the public opportunity to comment on
changes made to the Form 990-T, and the addition of a new schedule to
report additional unrelated trades or businesses, as required by the
enactment of section 512(a)(6). The IRS received no comments on the
Form 990-T and related schedules during that comment period.
Consequently, the IRS made Form 990-T available on January 8, 2019, and
the new schedule for reporting additional unrelated trades or
businesses available on January 25, 2019, for use by the public. The
IRS intends that the burden of collections of information will be
reflected in the burden associated with the Form 990 series under OMB
approval number 1545-0047.

2. Burden Estimates

The burden associated with Form 990-T is included in the aggregated
burden estimates for OMB control number 1545-0047. The burden estimates
in 1545-0047 relate to all filers associated with the Forms 990, and
will in the future include, but not isolate, the estimated burden of
the information collections associated with these final regulations.
No burden estimates specific to the final regulations are currently
available. The Treasury Department has not estimated the burden,
including that of any new information collections, related to the
requirements under the final regulations. Those estimates would capture
both changes made by the Act and those that arise out of discretionary
authority exercised in the final regulations. The current status of the
Paperwork Reduction Act submissions related to these final regulations
is provided in the following table.

------------------------------------------------------------------------
OMB control
Form No. Status
------------------------------------------------------------------------
990 and related forms........... 1545-0047 Sixty-day notice
published on 9/24/
2019. Thirty-day
notice published on
12/31/2019. Approved
by OIRA on 2/12/2020.
---------------------------------------
Link: https://www.irs.gov/forms-pubs/about-form-990.
------------------------------------------------------------------------

In the proposed regulations, the Treasury Department and the IRS
requested comments on all aspects of information collection burdens
related to the regulations, including estimates for how much time it
would take to comply with the paperwork burdens described above for
each relevant form and ways for the IRS to minimize the paperwork
burden. The Treasury Department and the IRS did not receive any
comments on these issues. Proposed

[[Page 77978]]

revisions (if any) to the forms that reflect the information
collections contained in these final regulations will be made available
for public comment at https://apps.irs.gov/app/picklist/list/draftTaxForms.html and will not be finalized until after these forms
have been approved by OMB under the PRA. Comments on these forms can be
submitted at https://www.irs.gov/forms-pubs/comment-on-tax-forms-and-publications.

III. Regulatory Flexibility Act

Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it
is hereby certified that these final regulations will not have a
significant economic impact on a substantial number of small entities.
In the proposed regulations, the Treasury Department and the IRS
invited comments on the impact this rule may have on small entities.
The Treasury Department and the IRS did not receive any comments on
this issue. As discussed elsewhere in this section, these final
regulations apply to all exempt organizations with UBTI, but only to
the extent required to determine if an exempt organization has more
than one unrelated trade or business. If an exempt organization only
has one unrelated trade or business, these regulations do not apply and
the exempt organization determines UBTI under section 512(a)(1) or
section 512(a)(3), as appropriate. If an exempt organization has more
than one unrelated trade or business, these proposed regulations
provide instructions for computing UBTI separately with respect to each
such unrelated trade or business.
These final regulations are not likely to affect a substantial
number of small entities. According to the IRS Data Book, 1,835,534
exempt organizations existed in 2018. Internal Revenue Service,
Publication 55B, Internal Revenue Service Data Book 2018, 57 (May
2019). However, only 188,334 Form 990-Ts were filed in 2018. Internal
Revenue Service, Publication 6292, Fiscal Year Return Projects for the
United States: 2019-2026, Fall 2019 4 (September 2019). Accordingly,
approximately 10 percent of the exempt organization population file
Form 990-T. This population includes large hospital systems and
universities not included in the SBA definition of ``small entities.''
Therefore, these final regulations are not likely to affect a
substantial number of small entities.
Even if the regulations affected a substantial number of small
entities, the economic impact of these final rules are not likely to be
significant. An organization affected by this rule, with more than one
unrelated trade or business, completes Part I and Part II on page 1 of
Form 990-T and completes and attaches a separate schedule for each
additional unrelated trade or business. Affected taxpayers have been
reporting UBTI on form 990-T for separate unrelated trades or
businesses for the previous two tax years. As discussed elsewhere in
this section, these regulations provide certainty and guidance for
these organizations. In the absence of this guidance, affected
taxpayers may face more uncertainty when calculating their tax
liability, a situation generally that could lead to greater conflicts
with tax administrators. Although affected taxpayers will have to spend
time reading these final regulations, the Treasury Department and the
IRS project that the final regulations provide certainty and guidance
that will reduce taxpayer compliance burden for large and small entity
taxpayers. Accordingly, the Secretary of the Treasury's delegate
certifies that these regulations will not have a significant economic
impact on a substantial number of small entities.
Pursuant to section 7805(f), the notice of proposed rulemaking was
submitted to the Chief Counsel for the Office of Advocacy of the Small
Business Administration for comment on its impact on small business (84
FR 31795). No comments on the notice were received from the Chief
Counsel for the Office of Advocacy of the Small Business
Administration.

IV. Congressional Review Act

The Office of Management and Budget has determined that the final
rule is not a ``major rule'' within the meaning of the Congressional
Review Act (5 U.S.C. 801, et seq.).

V. Unfunded Mandates Reform Act

Section 202 of the Unfunded Mandates Reform Act of 1995 requires
that agencies assess anticipated costs and benefits and take certain
other actions before issuing a final rule that includes any Federal
mandate that may result in expenditures in any one year by a state,
local, or tribal government, in the aggregate, or by the private
sector, of $100 million in 1995 dollars, updated annually for
inflation. The final regulations do not include any Federal mandate
that may result in expenditures by state, local, or tribal governments,
or by the private sector in excess of that threshold.

VII. Executive Order 13132: Federalism

Executive Order 13132 (entitled ``Federalism'') prohibits an agency
from publishing any rule that has federalism implications if the rule
either imposes substantial, direct compliance costs on state and local
governments, and is not required by statute, or preempts state law,
unless the agency meets the consultation and funding requirements of
section 6 of the Executive order. The final regulations do not have
federalism implications and do not impose substantial direct compliance
costs on state and local governments or preempt state law within the
meaning of the Executive order.

Drafting Information

The principal authors of these regulations are Stephanie N. Robbins
and Jonathan A. Carter, Office of the Chief Counsel (Employee Benefits,
Exempt Organizations, and Employment Taxes). However, other personnel
from the Treasury Department and the IRS participated in their
development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 are amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:

Authority: 26 U.S.C. 7805 * * *

0
Par. 2. Section 1.170A-9 is amended by:
0
1. Adding paragraph (f)(7)(v).
0
2. Adding paragraph (k)(3).
The additions read as follows:

Sec. 1.170A-9 Definition of section 170(b)(1)(A) organization.

* * * * *
(f) * * *
(7) * * *
(v) Unrelated business activities. The term net income from
unrelated business activities in section 509(d)(3) includes (but is not
limited to) an organization's unrelated business taxable income (UBTI)
within the meaning of section 512. However, when calculating UBTI for
purposes of determining support (within the meaning of this paragraph
(f)(7)), section 512(a)(6) does not apply. Accordingly, in the case of
an organization that derives gross income from the regular conduct of
two or more unrelated business activities, support includes the
aggregate of gross income from all such unrelated business activities
less the aggregate of the deductions allowed with respect to all such
unrelated business activities. Nonetheless, when

[[Page 77979]]

determining support, such organization can use either its UBTI
calculated under section 512(a)(6) or its UBTI calculated in the
aggregate.
* * * * *
(k) * * *
(3) Applicability date. Paragraph (f)(7)(v) of this section applies
to taxable years beginning on or after December 2, 2020. Taxpayers may
choose to apply this section to taxable years beginning on or after
January 1, 2018, and before December 2, 2020.

0
Par. 3. Section 1.509(a)-3 is amended by:
0
1. Revising the first sentence of paragraph (a)(3)(i).
0
2. Redesignating paragraph (a)(4) as paragraph (a)(5).
0
3. Adding new paragraph (a)(4).
0
4. Revising paragraph (o).
The revisions and additions read as follows:

Sec. 1.509(a)-3 Broadly, publicly supported organizations.

(a) * * *
(3) * * *
(i) * * * An organization will meet the not-more-than-one-third
support test under section 509(a)(2)(B) if it normally (within the
meaning of paragraph (c) or (d) of this section) receives not more than
one-third of its support in each taxable year from the sum of its gross
investment income (as defined in section 509(e)) and the excess (if
any) of the amount of its unrelated business taxable income (as defined
in section 512, without regard to section 512(a)(6), or with regard to
section 512(a)(6), if the organization so chooses) derived from trades
or businesses that were acquired by the organization after June 30,
1975, over the amount of tax imposed on such income by section 511.
* * * * *
(4) Unrelated business activities. The denominator of the one-third
support fraction and the denominator of the not-more-than-one-third
support fraction both include net income from unrelated business
activities, whether or not such activities are carried on regularly as
a trade or business. The term net income from unrelated business
activities includes (but is not limited to) an organization's unrelated
business taxable income (UBTI) within the meaning of section 512.
However, when calculating UBTI for purposes of determining the
denominator of both support fractions, section 512(a)(6) does not
apply. Accordingly, in the case of an organization that derives gross
income from the regular conduct of two or more unrelated business
activities, support includes the aggregate of gross income from all
such unrelated business activities less the aggregate of the deductions
allowed with respect to all such unrelated business activities.
Nonetheless, when determining support, such organization can use either
its UBTI calculated under section 512(a)(6) or its UBTI calculated in
the aggregate.
* * * * *
(o) Applicability date. This section generally applies to taxable
years beginning after December 31, 1969, except paragraphs (a)(3)(i)
and (a)(4) of this section apply to taxable years beginning on or after
December 2, 2020. Taxpayers may choose to apply this section to taxable
years beginning on or after January 1, 2018, and before December 2,
2020. Otherwise, for taxable years beginning before December 2, 2020,
see these paragraphs as in effect and contained in 26 CFR part 1
revised as of April 1, 2020.

0
Par. 4. Section 1.512(a)-1 is amended by:
0
1. Revising the first and fourth sentence of paragraph (a).
0
2. Revising the first and second sentence of paragraph (b).
0
3. Adding two sentences to the end of paragraph (c).
0
4. Revising paragraph (h).
The revisions and additions read as follows:

Sec. 1.512(a)-1 Definition.

(a) * * * Except as otherwise provided in Sec. 1.512(a)-3, Sec.
1.512(a)-4, or paragraph (f) of this section, section 512(a)(1) defines
unrelated business taxable income as the gross income derived from any
unrelated trade or business regularly carried on, less those deductions
allowed by chapter 1 of the Internal Revenue Code (Code) which are
directly connected with the carrying on of such trade or business,
subject to certain modifications referred to in Sec. 1.512(b)-1. * * *
In the case of an organization with more than one unrelated trade or
business, unrelated business taxable income is calculated separately
with respect to each such trade or business. See Sec. 1.512(a)-6. * *
*
(b) * * * Expenses, depreciation, and similar items attributable
solely to the conduct of unrelated business activities are proximately
and primarily related to that business activity, and therefore qualify
for deduction to the extent that they meet the requirements of section
162, section 167, or other relevant provisions of the Code. Thus, for
example, salaries of personnel employed full-time in carrying on
unrelated business activities are directly connected with the conduct
of that activity and are deductible in computing unrelated business
taxable income if they otherwise qualify for deduction under the
requirements of section 162. * * *
(c) * * * However, allocation of expenses, depreciation, and
similar items is not reasonable if the cost of providing a good or
service in a related and an unrelated activity is substantially the
same, but the price charged for that good or service in the unrelated
activity is greater than the price charged in the related activity and
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. For example, if a social club
described in section 501(c)(7) charges nonmembers a higher price than
it charges members for the same good or service but does not adjust the
price of the good or service provided to members for purposes of
allocating expenses, depreciation, and similar items attributable to
the provision of that good or service, the allocation method is not
reasonable.
* * * * *
(h) Applicability date. This section generally applies to taxable
years beginning after December 12, 1967, except as provided in
paragraph (g)(2) of this section, and except that paragraphs (a)
through (c) of this section apply to taxable years beginning on or
after December 2, 2020. For taxable years beginning before December 2,
2020, see these paragraphs as in effect and contained in 26 CFR part 1
revised as of April 1, 2020.

0
Par. 5. Section 1.512(a)-6 is added to read as follows:

Sec. 1.512(a)-6 Special rule for organizations with more than one
unrelated trade or business.

(a) More than one unrelated trade or business--(1) In general. An
organization with more than one unrelated trade or business must
compute unrelated business taxable income (UBTI) separately with
respect to each such trade or business, without regard to the specific
deduction in section 512(b)(12), including for purposes of determining
any net operating loss (NOL) deduction. An organization with more than
one unrelated trade or business computes its total UBTI under paragraph
(g) of this section.
(2) Separate trades or businesses. An organization determines
whether it regularly carries on unrelated trades or businesses by
applying sections 511 through 514. For purposes of section

[[Page 77980]]

512(a)(6)(A) and paragraph (a)(1) of this section, an organization
identifies its separate unrelated trades or businesses using the
methods described in paragraphs (b) through (e) of this section.
(3) Reporting changes in identification. An organization that
changes the identification of a separate unrelated trade or business
under paragraph (a)(2) of this section must report the change in the
taxable year of that change in accordance with forms and instructions.
For this purpose, a change in identification of a separate unrelated
trade or business includes the changed identification of the separate
unrelated trade or business with respect to a partnership interest that
was incorrectly designated as a qualifying partnership interest (QPI).
In the case of an incorrect designation of a QPI, paragraph (c)(2)(iii)
of this section (regarding designation of qualifying partnership
interests) does not apply. In all cases, to report the change in
identification, an organization must provide the following information
with respect to each separate change in identification--
(i) The identification of the separate unrelated trade or business
in the previous taxable year
(ii) The identification of the separate unrelated trade or business
in the current taxable year; and
(iii) The reason for the change.
(b) North American Industry Classification System--(1) In general.
Except as provided in paragraphs (c) through (e) of this section, an
organization identifies each of its separate unrelated trades or
businesses using the first two digits of the North American Industry
Classification System code (NAICS 2-digit code) that most accurately
describes the unrelated trade or business based on the more specific
NAICS code, such as at the 6-digit level, that describes the activity
it conducts and subject to the requirements of paragraph (b)(2) and (3)
of this section. The descriptions in the current NAICS manual
(available at www.census.gov) of trades or businesses using more than
two digits of the NAICS codes are relevant in this determination. In
the case of the sale of goods, both online and in stores, the separate
unrelated trade or business is identified by the goods sold in stores
if the same goods generally are sold both online and in stores.
(2) Codes must identify the unrelated trade or business. The NAICS
2-digit code must identify the unrelated trade or business in which the
organization engages (directly or indirectly) and not activities the
conduct of which are substantially related to the exercise or
performance by such organization of its charitable, educational, or
other purpose or function constituting the basis for its exemption
under section 501 (or, in the case of an organization described in
section 511(a)(2)(B), to the exercise or performance of any purpose or
function described in section 501(c)(3)). For example, a college or
university described in section 501(c)(3) cannot use the NAICS 2-digit
code for educational services to identify all its separate unrelated
trades or businesses, and a qualified retirement plan described in
section 401(a) cannot use the NAICS 2-digit code for finance and
insurance to identify all of its unrelated trades or businesses.
(3) Codes only reported once. An organization will report each
NAICS 2-digit code only once. For example, a hospital organization that
operates several hospital facilities in a geographic area (or multiple
geographic areas), all of which include pharmacies that sell goods to
the general public, would include all the pharmacies under the NAICS 2-
digit code for retail trade, regardless of whether the hospital
organization keeps separate books and records for each pharmacy.
(c) Activities in the nature of investments--(1) In general. An
organization's activities in the nature of investments (investment
activities) are treated collectively as a separate unrelated trade or
business for purposes of section 512(a)(6) and paragraph (a) of this
section. Except as provided in paragraphs (c)(7) and (c)(8) of this
section, an organization's investment activities are limited to its--
(i) Qualifying partnership interests (described in paragraph (c)(2)
of this section);
(ii) Qualifying S corporation interests (described in paragraph
(e)(2)(i) of this section); and
(iii) Debt-financed property or properties (within the meaning of
section 514).
(2) Qualifying partnership interests--(i) Directly-held partnership
interests. An interest in a partnership is a qualifying partnership
interest (QPI) if the exempt organization holds a direct interest in
the partnership (directly-held partnership interest) that meets the
requirements of either the de minimis test (described in paragraph
(c)(3) of this section) or the participation test (described in
paragraph (c)(4) of this section).
(ii) Indirectly-held partnership interests--(A) Look through rule.
If an organization holds a direct interest in a partnership but that
directly-held partnership interest is not a QPI because it does not
meet the requirements of the de minimis test (described in paragraph
(c)(3) of this section) or the participation test (described in
paragraph (c)(4) of this section), any partnership in which the
organization holds an indirect interest through the directly-held
partnership interest (indirectly-held partnership interest) may be a
QPI if the indirectly-held partnership interest meets the requirements
of paragraph (c)(2)(ii)(B) or (c)(2)(ii)(C) of this section.
(B) Indirectly-held partnership interests that meet the
requirements of the de minimis test. An indirectly-held partnership
interest meets the requirements of this paragraph (c)(2)(ii)(B) if the
indirectly-held partnership interest meets the requirements of the de
minimis test described in paragraph (c)(3) of this section with regard
to the organization. For example, if an organization directly holds 50
percent of the capital interests of a partnership and the directly-held
partnership holds 4 percent of the capital and profits interest of
lower-tier partnership A, the organization may aggregate its interest
in lower-tier partnership A with its other QPIs because the
organization indirectly holds 2 percent of the capital and profits
interests of lower-tier partnership A (4 percent x 50 percent).
(C) Indirectly-held partnership interests that meet the
requirements of the participation test. An indirectly-held partnership
interest meets the requirements of this paragraph (c)(2)(ii)(C) if the
indirectly-held partnership interest meets the requirements of the
participation test (described in paragraph (c)(4) of this section) with
respect to the partnership that directly owns the interest in the
indirectly-held partnership. For purposes of applying the participation
test to a partnership, the term organization in paragraph (c)(4) of
this section refers to the partnership that directly holds the
indirectly-held partnership interest being tested for QPI status.
Additionally, the list of officers, directors, trustees, or employees
of an organization found in paragraphs (c)(4)(iii)(B) and (C) includes
a general partner that directly owns an interest in the lower-tier
partnership.
(D) Example--(1) Organization D is described in section 501(c) and
is exempt from Federal income tax under section 501(a). Organization D
owns 50 percent of the capital interest in Partnership A. Partnership A
owns 30 percent of the capital interest in Partnership B, but
Partnership A does not significantly participate in Partnership B
within the meaning of paragraph (c)(4)(iii) of this section.

[[Page 77981]]

Further, Partnership B owns 15 percent of the capital interest in
Partnership C, in which Partnership B does not significantly
participate within the meaning of paragraph (c)(4)(iii) of this
section. No other organizations related (within the meaning of
paragraph (c)(4)(ii) of this section) to either Organization D or the
partnerships owns an interest in any of the lower-tier partnerships.
(2) Neither the interest in Partnership A nor B is a QPI.
Organization D's interest in Partnership A does not meet the
requirements of either the de minimis test or the participation test
because it owns 50 percent of the interest in the partnership.
Organization D's indirect interest in Partnership B (50 percent of 30
percent, or 15 percent) does not meet the de minimis test.
Additionally, because Partnership A owns greater than 20 percent
interest in Partnership B, Partnership A's interest in Partnership B
does not meet the participation test. However, Organization D's
interest in Partnership C is a QPI because Partnership C meets the
participation test. That is, Partnership B holds a 15 percent interest
in Partnership C and does not significantly participate in Partnership
C.
(iii) Designation. An organization that has a partnership interest
meeting the requirements of paragraph (c)(2)(i) or (ii) of this section
in a taxable year may designate that partnership interest as a QPI by
including its share of partnership gross income (and directly connected
deductions) with the gross income (and directly connected deductions)
from its other investment activities (see paragraph (c)(1) of this
section) in accordance with forms and instructions. Any partnership
interest that is designated as a QPI remains a QPI unless and until it
no longer meets the requirements of paragraph (c)(2)(i) or (ii) of this
section. For example, if an organization designates a directly-held
partnership interest that meets the requirements of the de minimis rule
as a QPI in one taxable year, the organization cannot, in the next
taxable year, use NAICS 2-digit codes to describe the partnership
trades or businesses that are unrelated trades or businesses with
respect to the organization unless the directly-held partnership
interest fails to meet the requirements of both the de minimis test and
the participation test (after application of the grace period described
in paragraph (c)(6) of this section, if appropriate).
(3) De minimis test. A partnership interest is a QPI that meets the
requirements of the de minimis test if the organization holds directly
(within the meaning of paragraph (c)(2)(i) of this section) or
indirectly (within the meaning of paragraph (c)(2)(ii) of this section)
no more than 2 percent of the profits interest and no more than 2
percent of the capital interest during the organization's taxable year
with which or in which the partnership's taxable year ends.
(4) Participation test--(i) In general. A partnership interest is a
QPI that meets the requirements of the participation test if the
organization holds directly (within the meaning of paragraph (c)(2)(i)
of this section) or indirectly (within the meaning of paragraph
(c)(2)(ii) of this section) no more than 20 percent of the capital
interest during the organization's taxable year with which or in which
the partnership's taxable year ends and the organization does not
significantly participate in the partnership within the meaning of
paragraph (c)(4)(iii) of this section.
(ii) Combining related interests. When determining an
organization's percentage interest in a partnership for purposes of
paragraph (c)(4)(i) of this section, the interests of a supporting
organization (as defined in section 509(a)(3) and Sec. 1.509(a)-4),
other than a Type III supporting organization (as defined in Sec.
1.509(a)-4(i)) that is not a parent of its supported organization, or
of a controlled entity (as defined in section 512(b)(13)(D) and Sec.
1.512(b)-1(l)) in the same partnership will be taken into account. For
example, if an organization owns 10 percent of the capital interests in
a partnership, and its Type I supporting organization owns an
additional 15 percent capital interest in that partnership, the
organization would not meet the requirements of the participation test
because its aggregate percentage interest exceeds 20 percent (10
percent + 15 percent = 25 percent).
(iii) Significant Participation. An organization significantly
participates in a partnership if--
(A) The organization, by itself, may require the partnership to
perform, or may prevent the partnership from performing (other than
through a unanimous voting requirement or through minority consent
rights), any act that significantly affects the operations of the
partnership;
(B) Any of the organization's officers, directors, trustees, or
employees have rights to participate in the management of the
partnership at any time;
(C) Any of the organization's officers, directors, trustees, or
employees have rights to conduct the partnership's business at any
time; or
(D) The organization, by itself, has the power to appoint or remove
any of the partnership's officers or employees or a majority of
directors.
(5) Determining percentage interest--(i) Profits interest. For
purposes of the de minimis test described in paragraph (c)(3) of this
section, an organization's profits interest in a partnership is
determined in the same manner as its distributive share of partnership
taxable income. See section 704(b) (relating to the determination of
the distributive share by the income or loss ratio) and Sec. Sec.
1.704-1 through 1.704-4.
(ii) Capital interest. For purposes of the de minimis test
(described in paragraph (c)(3) of this section) and the participation
test (described in paragraph (c)(4)(i) of this section), in the absence
of a provision in the partnership agreement, an organization's capital
interest in a partnership is determined on the basis of its interest in
the assets of the partnership which would be distributable to such
organization upon its withdrawal from the partnership, or upon
liquidation of the partnership, whichever is the greater.
(iii) Average percentage interest. For purposes of the de minimis
test (described in paragraph (c)(3) of this section) and the
participation test (described in paragraph (c)(4)(i) of this section),
an organization determines its percentage interest by taking the
average of the organization's percentage interest at the beginning and
the end of the partnership's taxable year, or, in the case of a
partnership interest held for less than a year, the percentage interest
held at the beginning and end of the period of ownership within the
partnership's taxable year. For example, if an organization acquires an
interest in a partnership that files on a calendar year basis in May
and the partnership reports on Schedule K-1 (Form 1065) that the
partner held a 3 percent profits interest at the date of acquisition
but held a 1 percent profits interest at the end of the calendar year,
the organization will be considered to have held 2 percent of the
profits interest in that partnership for that year ((3 percent + 1
percent)/2).
(iv) Reliance on Schedule K-1 (Form 1065). When determining the
organization's average percentage interest (described in paragraph
(c)(5)(iii) of this section) in a partnership for purposes of the de
minimis test (described in paragraph (c)(3) of this section) and the
participation test (described in paragraph (c)(4) of this section), an
organization may rely on the Schedule K-1 (Form 1065) (or its
successor) it receives from the partnership if the form lists the
organization's percentage

[[Page 77982]]

profits interest or its percentage capital interest, or both, at the
beginning and end of the year. However, the organization may not rely
on the form to the extent that any information about the organization's
percentage interest is not specifically provided. For example, if the
Schedule K-1 (Form 1065) an organization receives from a partnership
lists the organization's profits interest as ``variable'' but lists its
percentage capital interest at the beginning and end of the year, the
organization may rely on the form only with respect to its percentage
capital interest.
(6) Changes in percentage interest. A partnership interest that
fails to meet the requirements of the de minimis test (described in
paragraph (c)(3) of this section) or the participation test (described
in paragraph (c)(4) of this section) because of an increase in
percentage interest in the organization's current taxable year may be
treated for the taxable year of the change as meeting the requirements
of the test it met in the prior taxable year if--
(i) The partnership interest met the requirements of the de minimis
test or participation test, respectively, in the organization's prior
taxable year without application of this paragraph (c)(6);
(ii) The increase in percentage interest is solely due to the
actions of one or more partners other than the organization; and
(iii) In the case of a partnership interest that met the
requirements of the participation test in the prior taxable year, the
interest of the partner or partners that caused the increase in
paragraph (c)(6)(ii) of this section was not combined for the prior
taxable year and is not combined for the taxable year of the change
with the organization's partnership interest for purposes of paragraph
(c)(4)(ii) of this section.
(7) UBTI from the investment activities of organizations subject to
section 512(a)(3). For purposes of paragraph (c)(1) of this section,
UBTI from the investment activities of an organization subject to
section 512(a)(3) includes any amount that--
(i) Would be excluded from the calculation of UBTI under section
512(b)(1), (2), (3), or (5) if the organization were subject to section
512(a)(1);
(ii) Is attributable to income set aside (and not in excess of the
set aside limit described in section 512(a)(3)(E)), but not used, for a
purpose described in section 512(a)(3)(B)(i) or (ii); or
(iii) Is in excess of the set aside limit described in section
512(a)(3)(E).
(8) Limitations--(i) Social clubs. Paragraphs (c)(2) (regarding
QPIs) and (c)(9) (transition rule for certain partnership interests) of
this section do not apply to social clubs described in section
501(c)(7).
(ii) General partnership interests. Any partnership in which an
organization, or an organization whose interest is combined with that
organization's interest for purposes of paragraph (c)(4)(ii) of this
section, is a general partner under applicable state law is not a QPI
within the meaning of paragraph (c)(2) of this section, regardless of
the organization's percentage interest. Such partnership interest
cannot be a QPI for any organization or for any of the organizations
whose interest is combined with that organization's interest for
purposes of paragraph (c)(4)(ii) of this section.
(iii) Application of other sections. This paragraph (c) does not
otherwise impact application of section 512(c) and the fragmentation
rule under section 513(c).
(9) Transition rule for certain partnership interests--(i) In
general. If a directly-held partnership interest acquired prior to
August 21, 2018, is not a QPI, an organization may treat such
partnership interest as a separate unrelated trade or business for
purposes of section 512(a)(6) regardless of the number of unrelated
trades or businesses directly or indirectly conducted by the
partnership. For example, if an organization has a 35 percent capital
interest in a partnership acquired prior to August 21, 2018, it can
treat the partnership as a single trade or business even if the
partnership's investments generated UBTI from lower-tier partnerships
that were engaged in multiple trades or businesses. A partnership
interest acquired prior to August 21, 2018, will continue to meet the
requirement of this rule even if the organization's percentage interest
in such partnership changes before the end of the transition period
(see paragraph (c)(9)(iii) of this section).
(ii) Exclusivity. An organization may apply either the transition
rule in paragraph (c)(9)(i) of this section or the look-through rule in
paragraph (c)(2)(ii) of this section, but not both, to a partnership
interest described in paragraph (c)(9)(i) of this section that also
qualifies for application of the look-through rule described in
paragraph (c)(2)(ii).
(iii) Transition period. An organization may rely on this
transition rule until the first day of the organization's first taxable
year beginning after December 2, 2020.
(d) Income from certain controlled entities--(1) Specified payments
from controlled entities. If an organization (controlling organization)
controls another entity (within the meaning of section 512(b)(13)(D))
(controlled entity), all specified payments (as defined in section
512(b)(13)(C)) received by a controlling organization from that
controlled entity are treated as gross income from a separate unrelated
trade or business for purposes of paragraph (a) of this section. If a
controlling organization receives specified payments from two different
controlled entities, the payments from each controlled entity are
treated as a separate unrelated trade or business. For example, a
controlling organization that receives rental payments from two
controlled entities has two separate unrelated trades or businesses,
one for each controlled entity. The specified payments from a
controlled entity are treated as gross income from one trade or
business regardless of whether the controlled entity engages in more
than one unrelated trade or business or whether the controlling
organization receives more than one type of specified payment from that
controlled entity.
(2) Certain amounts derived from controlled foreign corporations.
All amounts included in UBTI under section 512(b)(17) are treated as
income derived from a separate unrelated trade or business for purposes
of paragraph (a) of this section.
(e) S corporation interests--(1) In general. Except as provided in
paragraph (e)(2) of this section, if an organization owns stock in an S
corporation (S corporation interest), such S corporation interest is
treated as an interest in a separate unrelated trade or business for
purposes of paragraph (a) of this section. Thus, if an organization
owns two S corporation interests, neither of which is described in
paragraph (e)(2) of this section, the exempt organization reports two
separate unrelated trades or businesses, one for each S corporation
interest. The UBTI from an S corporation interest is the amount
described in section 512(e)(1)(B).
(2) Exception for a qualifying S corporation interest.
Notwithstanding paragraph (e)(1) of this section, an organization may
aggregate its UBTI from an S corporation interest with its UBTI from
other investment activities (described in paragraph (c)(1) of this
section) if the organization's ownership interest in the S corporation
meets the criteria for a QPI as described in paragraph (c)(2)(i) of
this section (substituting ``S corporation'' for ``partnership'' and
``shareholder'' or ``shareholders'' for ``partner'' or ``partners,'' as
applicable, throughout paragraphs (c)(2)(i), (c)(3), (c)(4),
(c)(5)(iii), (c)(5)(iv), and (c)(6) of this

[[Page 77983]]

section; ``no more than 2 percent of stock ownership'' for ``no more
than 2 percent of the profits interest and no more than 2 percent of
the capital interest'' in paragraph (c)(3) of this section; ``no more
than 20 percent of stock ownership'' in place of ``no more than 20
percent of the capital interest'' in paragraph (c)(4)(i) of this
section; and ``Schedule K-1 (Form 1120-S)'' for ``Schedule K-1 (Form
1065)'' for purposes of paragraph (c)(5)(iv) of this section).
Paragraphs (c)(5)(i) and (c)(5)(ii) do not apply for purposes of
determining an organization's ownership interest in an S corporation;
rather, the average percentage stock ownership determined under
paragraph (c)(5)(iii) of this section applies for purposes of this
paragraph (e)(2). For purposes of paragraph (c)(5)(iv) of this section,
an organization can rely on the Schedule K-1 (Form 1120-S) (or its
successor) it receives from the S corporation only if the form lists
information sufficient to determine the organization's percentage of
stock ownership for the year. A Schedule K-1 (Form 1120-S) that reports
``zero'' as the organization's number of shares of stock in either the
beginning or end of the S corporation's taxable year does not list
information sufficient to determine the organization's percentage of
stock ownership for the year. The grace period described in paragraph
(c)(6) of this section applies to changes in an exempt organization's
percentage of stock ownership in an S corporation.
(f) Allocation of deductions. An organization must allocate
deductions between separate unrelated trades or businesses using the
method described in Sec. 1.512(a)-1(c).
(g) Total UBTI--(1) In general. The total UBTI of an organization
with more than one unrelated trade or business is the sum of the UBTI
computed with respect to each separate unrelated trade or business (as
identified under paragraph (a)(2) of this section and subject to the
limitation described in paragraph (g)(2) of this section), less a
charitable contribution deduction, an NOL deduction for losses arising
in taxable years beginning before January 1, 2018 (pre-2018 NOLs), and
a specific deduction under section 512(b)(12), as applicable.
(2) UBTI not less than zero. For purposes of paragraph (g)(1) of
this section, the UBTI with respect to any separate unrelated trade or
business identified under paragraph (a)(2) of this section cannot be
less than zero.
(h) Net operating losses--(1) In general. For taxable years
beginning after December 31, 2017, an exempt organization with more
than one unrelated trade or business determines the NOL deduction
allowed by sections 172(a) and 512(b)(6) separately with respect to
each of its unrelated trades or businesses. Accordingly, if an exempt
organization has more than one unrelated trade or business, Sec.
1.512(b)-1(e) applies separately with respect to each such unrelated
trade or business.
(2) Coordination of pre-2018 and post-2017 NOLs. An organization
with pre-2018 NOLs, and with losses arising in a taxable 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 such trade
or business. Pre-2018 NOLs are taken against the total UBTI as
determined under paragraph (g) of this section in a manner that allows
for maximum utilization of post-2017 NOLs in a taxable year. For
example, an organization could choose to allocate all of its pre-2018
NOLs to one of its separate unrelated trade or business or it could
allocate its pre-2018 NOLs ratably among its separate unrelated trades
or businesses, whichever results in the greatest utilization of the
post-2017 NOLs in that taxable year.
(3) Treatment of NOLs upon the termination, sale, exchange, or
other disposition of a separate unrelated trade or business. After
offsetting any gain resulting from the termination, sale, exchange, or
disposition of a separate unrelated trade or business, any NOL
remaining is suspended. However, the suspended NOLs may be used if that
previous separate unrelated trade or business is later resumed or if a
new unrelated trade or business that is accurately identified using the
same NAICS 2-digit code as the previous separate unrelated trade or
business is commenced or acquired in a future taxable year.
(4) Treatment of NOLs when the identification of a separate
unrelated trade or business changes--(i) In general. For purposes of
section 512(a)(6) and this section, a separate unrelated trade or
business for which the appropriate identification (within the meaning
of paragraph (a) of this section) changes 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 to the newly identified separate
unrelated trade or business. For example, if the nature of a separate
unrelated trade or business changes such that it is more accurately
described by another NAICS 2-digit code, the separate unrelated trade
or business is treated as a new separate unrelated trade or business
with no NOLs. The change in identification may apply to all or a part
of the originally identified separate unrelated trade or business. If
the change in identification applies to the originally identified
separate trade or business in its entirety, any NOLs attributable to
that separate unrelated trade or business are suspended in accordance
with paragraph (h)(3) of this section. If the change in identification
applies to the originally identified separate unrelated trade or
business in part, the originally identified separate unrelated trade or
business that is not changing retains the full NOLs attributable to the
originally identified separate unrelated trade or business, without
allocation to the portion that became a newly identified separate
unrelated trade or business. This paragraph (h)(4) also applies to each
QPI that becomes a non-QPI. In this case, any NOLs attributable to the
QPI that became a non-QPI are retained with the organization's
investment activities described in paragraph (c) of this section.
(ii) Exception for non-material changes. In the case of a separate
unrelated trade or business that is accidentally identified using the
wrong NAICS 2-digit code or if an organization has determined that a
separate unrelated trade or business that has not materially changed is
more accurately identified by another NAICS 2-digit code, any NOL
attributable to the originally identified separate unrelated trade or
business becomes an NOL of the newly identified separate unrelated
trade or business.
(iii) Effective date of change in identification. A change in
identification described in this paragraph (h)(4) is effective on the
first day of the taxable year in which the change in identification is
made. Accordingly, the newly identified separate unrelated trade or
business is treated as commencing on this date.
(iv) Examples--(A) In general. The following examples illustrate
the rules described in this paragraph (h)(4).
(B) Example 1. Erroneous code--(1) Organization G is described in
section 501(c) and is exempt from Federal income tax under section
501(a). In addition to its investment activities, Organization G has
two separate unrelated trades or businesses--Q and R--that are
identified with different NAICS 2-digit codes. Both Q and R have NOLs
carried over from post-2017 taxable years.
(2) In Year 2 (a post-2017 taxable year), Organization G realizes
that it

[[Page 77984]]

accidentally used the wrong NAICS 2-digit code to identify R. The NOLs
attributable to R under the old NAICS 2-digit code become the NOLs of R
under the new NAICS 2-digit code as of the first day of Year 2.
(C) Example 2. Material change--(1) Same facts as Example 1, except
assume that, in addition to its investment activities, Organization G
has three separate unrelated trades or businesses--Q, R, and S--that
are identified with different NAICS 2-digit codes. Q, R, and S all have
NOLs carried over from post-2017 taxable years.
(2) Organization G changes the NAICS 2-digit code identifying R to
the same NAICS 2-digit code identifying S because the nature of the
unrelated trade or business materially changed. Any post-2017 NOLs
attributable to R are suspended (see paragraph (h)(4)(i) of this
section). Organization G now has two separate unrelated trades or
businesses--Q and S--as of the first day of Year 2.
(D) Example 3. Partial material change. Same facts as Example 1,
except assume that Organization G determines that a part of R has
materially changed such that R should be identified as two separate
unrelated trades or businesses--R1 and R2. R1 retains the NAICS 2-digit
code originally identifying R, and R2 is identified with a new NAICS 2-
digit code that is not the same NAICS 2-digit code identifying Q. R2 is
treated as a new separate unrelated trade or business with no NOLs as
of the first day of Year 2. Any post-2017 NOLs attributable to R remain
with R1.
(E) Example 4. QPI to non-QPI--(1) Same facts as Example 1, but
assume that Organization G has a partnership interest in T that was,
for prior taxable years, a QPI included with Organization G's
investment activities. In Year 3 (a post-2017 taxable year),
Organization G acquires more than 20 percent of the capital interests
in T. The grace period described in paragraph (c)(6) of this section
does not apply because the increase in percentage interest was not due
to the actions of other partners.
(2) T conducts two trade or business activities that are unrelated
trade or business activities with respect to Organization G--T1 and T2.
Both T1 and T2 will be treated as new separate unrelated trades or
business as of the first day of Year 2. Organization G identifies T1
with the same NAICS 2-digit code used to identify Q and T2 with a NAICS
2-digit code that is different than the NAICS 2-digit codes used to
identify Q and R. In addition to its investment activities,
Organization G has three separate unrelated trades or businesses--Q, R,
and T2. Any post-2017 NOLs attributable to the QPI remain with
Organization G's other investment activities separate unrelated trade
or business.
(i) Applicability dates. This section is applicable to taxable
years beginning on or after December 2, 2020. Taxpayers may choose to
apply this section to taxable years beginning on or after January 1,
2018, and before December 2, 2020.

0
Par. 6. Section 1.512(b)-1 is amended by:
0
1. Revising paragraph (a)(1).
0
2. Adding a sentence to the end of paragraph (a)(3).
0
3. Adding paragraph (e)(5).
0
4. Adding paragraphs (g)(4) and (5).
The revisions and additions read as follows:

Sec. 1.512(b)-1 Modifications.

(a) * * *
(1) * * * Dividends (including an inclusion of subpart F income
under section 951(a)(1)(A) or an inclusion of global intangible low-
taxed income (GILTI) under section 951A(a), both of which are treated
in the same manner as a dividend for purposes of section 512(b)(1)),
interest, payments with respect to securities loans (as defined in
section 512(a)(5)), annuities, income from notional principal contracts
(as defined in Sec. 1.837-7 or regulations issued under section 446),
other substantially similar income from ordinary and routine
investments to the extent determined by the Commissioner, and all
deductions directly connected with any of the foregoing items of income
must be excluded in computing unrelated business taxable income.
* * * * *
(3) * * * The exclusion under paragraph (a)(1) of this section of
an inclusion of subpart F income under section 951(a)(1)(A) or an
inclusion of GILTI under section 951A(a) from income (both inclusions
being treated in the same manner as dividends) is applicable to taxable
years beginning on or after December 2, 2020. However, an organization
may choose to apply this exclusion to taxable years beginning before
December 2, 2020.
* * * * *
(e) * * *
(5) See Sec. 1.512(a)-6(h) regarding the computation of the net
operating loss deduction when an organization has more than one
unrelated trade or business.
* * * * *
(g) * * *
(4) The term unrelated business taxable income as used in section
512(b)(10) and (11) refers to unrelated business taxable income after
application of section 512(a)(6).
(5) Paragraph (g)(4) of this section is applicable to taxable years
beginning on or after December 2, 2020. Taxpayers may choose to apply
this section to taxable years beginning on or after January 1, 2018,
and before December 2, 2020.
* * * * *

0
Par. 7. Section 1.513-1 is amended by:
0
1. Revising the third and fourth sentence in paragraph (a).
0
2. Redesignating paragraphs (f) and (g) as paragraphs (g) and (h).
0
3. Adding new paragraph (f).
0
4. Adding a sentence to the end of newly redesignated paragraph (h).
The revisions and additions read as follows:

Sec. 1.513-1 Definition of unrelated trade or business.

(a) * * * For certain exceptions from this definition, see
paragraph (e) of this section. For a special definition of unrelated
trade or business applicable to certain trusts, see paragraph (f) of
this section. * * *
* * * * *
(f) Special definition of ``unrelated trade or business'' for
trusts. In the case of a trust computing its unrelated business taxable
income under section 512 for purposes of section 681, or a trust
described in section 401(a) or section 501(c)(17), which is exempt from
tax under section 501(a), section 513(b) provides that the term
unrelated trade or business means any trade or business regularly
carried on by such trust or by a partnership of which it is a member.
This definition also applies to an individual retirement account
described in section 408 that, under section 408(e), is subject to the
tax imposed by section 511.
* * * * *
(h) * * * Paragraph (f) of this section applies to taxable years
beginning on or after December 2, 2020.

Sunita Lough,
Deputy Commissioner for Services and Enforcement.
Approved: November 13, 2020.
David J. Kautter,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2020-25954 Filed 11-30-20; 4:15 pm]
BILLING CODE 4830-01-P