[Federal Register Volume 85, Number 80 (Friday, April 24, 2020)]
[Proposed Rules]
[Pages 23172-23199]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-06604]



[[Page 23171]]

Vol. 85

Friday,

No. 80

April 24, 2020

Part III





Department of the Treasury





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Internal Revenue Service





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26 CFR Parts 1, 602





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

  Federal Register / Vol. 85 , No. 80 / Friday, April 24, 2020 / 
Proposed Rules  

[[Page 23172]]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[REG-106864-18]
RIN 1545-BO79


Unrelated Business Taxable Income Separately Computed for Each 
Trade or Business

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations that provide 
guidance on how an exempt organization subject to the unrelated 
business income tax described in section 511 of the Internal Revenue 
Code (Code) determines if it has more than one unrelated trade or 
business, and, if so, how the exempt organization calculates unrelated 
business taxable income. The proposed regulations also clarify that the 
definition of ``unrelated trade or business'' applies to individual 
retirement accounts. Additionally, the proposed 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 
section 512. The proposed regulations affect exempt organizations.

DATES: Written or electronic comments and requests for a public hearing 
must be submitted by June 23, 2020.

ADDRESSES: Submit electronic submissions via the Federal eRulemaking 
Portal at www.regulations.gov (indicate IRS and REG-106864-18) by 
following the online instructions for submitting comments. Once 
submitted to the Federal eRulemaking Portal, comments cannot be edited 
or withdrawn. The Department of the Treasury (Treasury Department) and 
the Internal Revenue Service (IRS) will publish for public availability 
any comment received to its public docket, whether submitted 
electronically or in hard copy. Send hard copy submissions to: 
CC:PA:LPD:PR (REG-106864-18), Room 5203, Internal Revenue Service, P.O. 
Box 7604, Ben Franklin Station, Washington, DC 20044.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed rules, 
Jonathan A. Carter at (202) 317-5800; concerning submissions of 
comments and requests for a public hearing, Regina Johnson at (202) 
317-5177 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

    Under section 501(a) of the Code, organizations described in 
sections 401(a) and 501(c) generally are exempt from federal income 
taxation. However, section 511(a)(1) imposes a tax (computed as 
provided in section 11) on the unrelated business taxable income (UBTI) 
of organizations described in section 511(a)(2), which includes 
organizations described in sections 401(a) and 501(c) (other than a 
trust described in section 511(b) or an instrumentality of the United 
States described in section 501(c)(1)), as well as state colleges and 
universities. Additionally, section 511(b)(1) imposes a tax (computed 
as provided in section 1(e)) on the UBTI of trusts described in section 
511(b)(2), which describes trusts that are exempt from federal income 
taxation under section 501(a) and which, if it were not for such 
exemption, would be subject to subchapter J of chapter 1 of the Code 
(relating to estates, trusts, beneficiaries, and decedents). 
Organizations described in section 511(a)(2) and trusts described in 
section 511(b)(2) are collectively called ``exempt organizations'' or 
``organizations'' throughout this preamble, unless otherwise stated.\1\
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    \1\ Section 408(e) states that an individual retirement account 
(IRA) is subject to the taxes imposed by section 511. Accordingly, 
any reference to an exempt organization in this preamble includes an 
IRA, without regard to whether it is a traditional IRA, Roth IRA, 
simplified employee pension (SEP-IRA), or savings incentive match 
plan for employees (SIMPLE IRA). See section 9 of this preamble for 
more information.
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Definitions of UBTI

    Section 512 provides two different definitions of UBTI--one in 
section 512(a)(1), which applies to most exempt organizations, and one 
in section 512(a)(3), which applies only to social clubs described in 
section 501(c)(7), voluntary employees' beneficiary associations 
(VEBAs) described in section 501(c)(9), and supplemental unemployment 
compensation benefits trusts (SUBs) described in section 501(c)(17).
    Section 512(a)(1) defines UBTI as the gross income derived by any 
exempt organization from an unrelated trade or business regularly 
carried on by it, less the deductions allowed by chapter 1 of the Code 
(chapter 1) that are directly connected with the carrying on of such 
trade or business, both computed with the modifications described in 
section 512(b). Section 513(a) generally defines ``unrelated trade or 
business'' as any trade or business the conduct of which is not 
substantially related (aside from the need of such exempt organization 
for income or funds or the use it makes of the profits derived) to the 
exercise or performance by such exempt organization of its charitable, 
educational, or other purpose or function constituting the basis for 
its exemption under section 501 (or, in the case of a state college or 
university, to the exercise or performance of any purpose or function 
described in section 501(c)(3)). However, in the case of a trust that 
is exempt from tax under section 501(a) and described in section 401(a) 
(qualified retirement plans) or section 501(c)(17) (SUBs), section 
513(b) defines ``unrelated trade or business,'' as any trade or 
business regularly carried on by such trust or by a partnership of 
which it is a member. Section 1.513-1(b) generally provides that, for 
purposes of section 513, the term ``trade or business'' has the same 
meaning as in section 162.
    By contrast, section 512(a)(3)(A) defines UBTI as the gross income 
(excluding exempt function income), less the deductions allowed by 
chapter 1 that are directly connected with the production of the gross 
income (excluding exempt function income), both computed with the 
modifications described in section 512(b)(6) (net operating loss (NOL) 
deduction), (b)(10) (charitable contribution deduction by exempt 
organizations), (b)(11) (charitable contribution deduction by certain 
trusts), and (b)(12) (specific deduction). Accordingly, UBTI under 
section 512(a)(3) is not limited to the gross income derived by an 
exempt organization from any unrelated trade or business regularly 
conducted by it. Thus, any gross income that is not exempt function 
income (nonexempt function income) is UBTI under section 512(a)(3).

Unrelated Trades or Businesses Conducted Indirectly Through Another 
Entity

    An exempt organization may conduct an unrelated trade or business 
directly or indirectly through another entity, such as a partnership 
(including any entity treated as a partnership for federal tax 
purposes). Section 512(c) provides that, if a trade or business 
regularly carried on by a partnership of which an exempt organization 
is a partner is an unrelated trade or business with respect to such 
exempt organization, the exempt organization includes in UBTI--subject 
to the exceptions, additions, and limitations of section 512(b)--its 
distributive share of partnership gross income (whether or not 
distributed) and partnership deductions directly connected with

[[Page 23173]]

such gross income. See Sec.  1.512(c)-1 (describing how UBTI is 
calculated in a situation in which an exempt organization's 
distributive share of partnership income consists of both UBTI and 
income that is excluded from the calculation of UBTI). In determining 
whether a partnership conducts a trade or business that is an unrelated 
trade or business with respect to an exempt organization partner, the 
exempt organization would use the applicable definition of ``unrelated 
trade or business'' in section 513(a) or (b). Section 512(c) applies 
regardless of whether an exempt organization is a general or limited 
partner. See Rev. Rul. 79-222, 1979-2 C.B. 236.

Calculation of UBTI

    An exempt organization may engage in more than one unrelated trade 
or business. Prior to the enactment of section 512(a)(6), an exempt 
organization deriving gross income from the regular conduct of two or 
more unrelated trades or businesses calculated UBTI by determining its 
aggregate gross income from all such unrelated trades or businesses and 
reducing that amount by the aggregate deductions allowed with respect 
to all such unrelated trades or businesses. See Sec.  1.512(a)-1(a). 
However, section 512(a)(6), which 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), enacted December 22, 2017, changed 
this calculation for exempt organizations with more than one unrelated 
trade or business so that, in the case of any exempt organization with 
more than one unrelated trade or business:
    (A) UBTI, including for purposes of determining any NOL deduction, 
shall be computed separately with respect to each trade or business and 
without regard to section 512(b)(12) (allowing a specific deduction of 
$1,000),
    (B) The UBTI of such exempt organization shall be the sum of the 
UBTI so computed with respect to each trade or business, less a 
specific deduction under section 512(b)(12), and
    (C) For purposes of section 512(a)(6)(B), UBTI with respect to any 
such trade or business shall not be less than zero.
    Thus, under section 512(a)(6), an exempt organization is no longer 
permitted to aggregate income and deductions from all unrelated trades 
or businesses when calculating UBTI. Section 512(a)(6) applies to 
taxable years beginning after December 31, 2017, but not to NOLs 
arising before January 1, 2018, that are carried over to taxable years 
beginning on or after such date. See section 13702(b) of the TCJA.
    In August 2018, the Treasury Department and the IRS issued 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 and considered these comments in 
drafting these proposed regulations. Some of these comments discussed 
the interaction between section 512(a)(6) and (7), which was also 
enacted by the TCJA and provided that an exempt organization's UBTI is 
increased by any amount for which a deduction is not allowable under 
chapter 1 by reason of section 274 and which is paid or incurred by 
such exempt organization for certain disallowed fringes. These comments 
are not discussed because section 512(a)(7) was repealed on December 
20, 2019. See Further Consolidated Appropriations Act, 2020, Division 
Q, Public Law 116-94, 133 Stat. 2534 (2019) (retroactively effective to 
date of enactment of the TCJA). The remaining comments are discussed in 
the Explanation of Provisions and Comment Summary. The comments are 
available for public inspection upon request.

Explanation of Provisions and Summary of Comments

    Section 512(a)(6) requires an exempt organization with more than 
one unrelated trade or business to first calculate UBTI separately with 
respect to each such trade or business, without regard to the specific 
deduction generally allowed under section 512(b)(12). The Conference 
Report explains that ``[t]he organization's [UBTI] for the taxable year 
is the sum of the amounts (not less than zero) computed for each 
separate trade or business, less the specific deduction allowed under 
section 512(b)(12).'' H.R. Rep. No. 115-466 (2017), at 548. Section 
512(a)(6) continues to allow an NOL deduction, but ``only with respect 
to a trade or business from which the loss arose.'' Id. Thus, the 
legislative history states that ``a deduction from one trade or 
business for a taxable year may not be used to offset income from a 
different unrelated trade or business for the same taxable year.'' Id. 
at 548. Because section 512(a)(6) disallows the aggregation of income 
and deductions from all unrelated trades or businesses, these proposed 
regulations revise Sec.  1.512(a)-1(a) to state that, in the case of an 
organization with more than one unrelated trade or business, UBTI is 
calculated separately with respect to each such trade or business as 
provided in new proposed Sec.  1.512(a)-6.
    Congress did not provide explicit criteria for determining whether 
an exempt organization has ``more than one unrelated trade or 
business'' or how to identify ``separate'' unrelated trades or 
businesses for purposes of calculating UBTI in accordance with section 
512(a)(6).\2\ Accordingly, these proposed regulations establish the 
method for determining whether an exempt organization has more than one 
unrelated trade or business for purposes of section 512(a)(6) and 
identifying separate unrelated trades or businesses for purposes of 
calculating UBTI under this section. These proposed regulations also 
clarify that, for purposes of the unrelated business income tax 
generally and the application of section 512(a)(6) specifically, an 
individual retirement plan (IRA) described in section 408(e) uses the 
definition of ``unrelated trade or business'' in section 513(b) 
applicable to trusts. Additionally, these proposed regulations clarify 
that inclusions of subpart F income under section 951(a)(1)(A) and 
global intangible low-taxed income (GILTI) under section 951A(a) are 
treated in the same manner as dividends for purposes of section 
512(b)(1).
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    \2\ The Joint Committee on Taxation's General Explanation of 
Public Law 115-97 states 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.
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1. Separate Unrelated Trade or Business

    There is no general statutory or regulatory definition of what 
activities constitute a ``trade or business'' for purposes of the Code. 
Whether an activity constitutes a trade or business may vary depending 
on which Code section is involved. See generally Commissioner v. 
Groetzinger, 480 U.S. 23, 27 (1987). Section 1.513-1(b) of the current 
Treasury regulations (promulgated in 1967) states 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 from the sale of goods or performance of 
services.''
    Notice 2018-67 permitted a reasonable, good-faith interpretation of 
sections 511 through 514, considering all the facts and circumstances, 
when determining whether an exempt organization has more than one 
unrelated trade or business for purposes

[[Page 23174]]

of section 512(a)(6). At the same time, Notice 2018-67 stated that the 
Treasury Department and the IRS were considering the use of the North 
American Industry Classification System (NAICS) codes as a method for 
determining whether an exempt organization has more than one unrelated 
trade or business for purposes of section 512(a)(6) and for purposes of 
calculating UBTI under section 512(a)(6)(A). NAICS is an industry 
classification system for purposes of collecting, analyzing, and 
publishing statistical data related to the United States business 
economy that results from a cooperative effort between Canada, Mexico, 
and the United States. See Executive Office of the President, Office of 
Management and Budget, North American Industry Classification System 
(2017) (2017 NAICS Manual), available at https://www.census.gov/eos/www/naics/2017NAICS/2017_NAICS_Manual.pdf. The structure of NAICS is 
hierarchical, using a six-digit coding system. Id. at 16, 18, & 20. 
NAICS divides the economy into 20 sectors. Id. at 3. The first two 
digits of the code designate the sector, each of which represents a 
general category of economic activity, including retail trade (44-45); 
real estate and rental and leasing (53); health care and social 
assistance (62); and accommodation and food services (72). Id. at 16 & 
20. The third digit designates the subsector; the fourth digit 
designates the industry group; and the fifth digit designates the NAICS 
industry. Any establishment is usually classified down to the NAICS 
five-digit industry level classification, using the classification of 
the industry that best matches its primary activity. When applicable, 
the sixth digit is used to designate the national industry, to reflect 
differences between the countries. A zero as the sixth digit generally 
indicates that the NAICS industry and the U.S. industry are the same. 
Id. at 18. Accordingly, each digit of the NAICS 6-digit codes describes 
an industry with increasing specificity.
    In Notice 2018-67, the Treasury Department and the IRS provided 
that a reasonable, good-faith interpretation included using the most 
specific level--six-digit codes (NAICS 6-digit codes). The Treasury 
Department and the IRS also requested comments regarding rules to 
identify separate trades or businesses that achieve the intent of 
Congress in enacting section 512(a)(6) and that are administrable for 
exempt organizations and the IRS. As discussed further in section 1.a 
of this preamble, methods commenters suggested included devising a 
facts and circumstances test along with a clearly defined safe harbor, 
adopting principles described in various Code sections (including 
sections 183 and 469), using the groupings described in Form 14018, 
``Compliance Questionnaire Colleges and Universities,'' and using less 
than six digits of the NAICS codes.
    After considering the comments, the Treasury Department and the IRS 
continue to view an identification method based on NAICS codes as 
administrable for exempt organizations and the IRS. Moreover, in 
response to comments regarding the burden related to the specificity of 
NAICS 6-digit codes, the proposed regulations provide that an exempt 
organization generally will identify its separate unrelated trades or 
businesses using the first two digits of the NAICS codes (NAICS 2-digit 
codes).
a. The North American Industry Classification System (NAICS)
    Most commenters that discussed NAICS supported using the NAICS 
codes to identify separate unrelated trades or businesses for purposes 
of section 512(a)(6). Nonetheless, several commenters generally opposed 
this proposed method. These commenters argued that the NAICS codes were 
not created to define ``trade or business'' for UBTI purposes and 
therefore fail to sufficiently describe the full range of possible 
unrelated trades or businesses engaged in by exempt organizations. 
While the Treasury Department and the IRS recognize that the NAICS 
codes were not specifically designed for use under section 512(a)(6), 
the Treasury Department and the IRS continue to believe that using the 
NAICS codes is appropriate because NAICS ``is a comprehensive 
[classification] system covering all economic activities.'' 2017 NAICS 
Manual, at 14. Additionally, the broad scope of activities covered by 
the NAICS 2-digit codes should cover all the unrelated trade or 
business activities conducted by exempt organizations.
    The NAICS codes were developed, in coordination with Canada and 
Mexico, by the Office of Management and Budget (OMB) and are managed by 
the United States Census Bureau. The OMB reviews and updates the NAICS 
codes as appropriate every five years and, at times, may remove codes. 
Id. at 78. In responding to the NAICS 6-digit codes discussed in Notice 
2018-67, some commenters expressed concern that the Treasury Department 
and the IRS do not control NAICS and that this could adversely impact 
organizations using the codes for tax purposes. The Treasury Department 
and the IRS view the proposal to use NAICS 2-digit codes as addressing 
this concern because the codes are revised through notice and comment 
rulemaking, and OMB has never revised the codes at the 2-digit level.
    A few commenters noted that a recent report by the Treasury 
Inspector General for Tax Administration (TIGTA) determined that the 
NAICS codes are ``unreliable for use to identify businesses that may be 
subject to excise tax reporting and payment.'' Treasury Inspector 
General for Tax Administration, The Affordable Care Act: An Improved 
Strategy is Needed to Ensure Accurate Reporting and Payment of the 
Medical Device Excise Tax 5 (Jul. 17, 2014). The Treasury Department 
and the IRS consider the situation addressed by the TIGTA report to be 
distinguishable from the use of the NAICS 2-digit codes to identify 
separate unrelated trades or businesses for purposes of section 
512(a)(6). The TIGTA report addressed the IRS's efforts to determine 
the population of taxpayers subject to the new medical device excise 
tax based on the NAICS 6-digit code a taxpayer had reported on Schedule 
K, ``Other Information,'' of Form 1120, ``U.S. Corporation Income Tax 
Return'' to identify the activity from which it derives the largest 
percentage of total receipts. TIGTA found that not every medical device 
manufacturer used the same NAICS 6-digit code to report the activity, 
such that reliance on one NAICS 6-digit code would not identify all 
businesses that may be subject to the tax. TIGTA also noted that the 
NAICS 6-digit code did not always signify a business that is engaged in 
taxable sales of medical devices. Here, an exempt organization will be 
reporting each of its separate unrelated trades or businesses using the 
more general NAICS 2-digit codes on Form 990-T, ``Exempt Organization 
Business Income Tax Return,'' for the purpose of ensuring compliance 
with section 512(a)(6). As previously discussed, the NAICS 2-digit code 
describes a broader sector of the economy, making it more likely that 
taxpayers engaged in similar activities that could be described in more 
than one NAICS 6-digit code will nonetheless report those activities as 
part of the same overall sector.
i. NAICS 2-Digit Codes
    As discussed in section 1 of this preamble, Notice 2018-67 
permitted reliance on NAICS 6-digit codes as a method of identifying 
separate trades or businesses and requested comments regarding whether 
use of less than six digits of the NAICS codes, either alone or in 
combination with one or more other methods, would appropriately

[[Page 23175]]

identify separate trades or businesses for purposes of achieving the 
objectives of section 512(a)(6). Nearly all the commenters making 
recommendations on the NAICS codes rejected the use of NAICS 6-digit 
codes. These commenters noted that using NAICS 6-digit codes would 
result in significant administrative burden because an exempt 
organization would have to determine which of over 1,000 NAICS 6-digit 
codes most accurately describes its trades or businesses. Commenters 
noted that many NAICS 6-digit codes may apply to more than one trade or 
business activity or that no NAICS 6-digit code may exist to accurately 
describe a trade or business activity. Additionally, these commenters 
argued that 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 activity into multiple trades or 
businesses.
    Half of the commenters making recommendations on the NAICS codes 
suggested adoption of NAICS 2-digit codes, which would identify trades 
or businesses in 20 sectors. These commenters generally explained that 
use of NAICS 2-digit codes would result in broader, less subjective 
identification of trades or businesses that would naturally permit the 
aggregation of similar activities. Furthermore, one of these commenters 
stated that the use of fewer digits of the NAICS codes would minimize 
implementation costs and reduce the administrative burden on the IRS as 
well as exempt organizations. This commenter opined that the NAICS 2-
digit codes are less likely to change over time than the NAICS codes 
with more digits because the specificity of the NAICS codes increases 
as digits are added. NAICS 3-digit codes, which one commenter 
recommended adopting, identify 99 subsectors. By contrast, NAICS 4-
digit codes, which two commenters recommended adopting, identify 311 
industry groups.
    The Treasury Department and the IRS recognize that limitations 
exist in using NAICS as a method of identifying an exempt 
organization's separate unrelated trades or businesses. However, the 
Treasury Department and the IRS conclude that adopting the NAICS 2-
digit codes will minimize those limitations and that NAICS 2-digit 
codes are less likely to change over time than NAICS codes with more 
digits. At the same time, adoption of NAICS 2-digit codes will not 
allow the offsetting of losses between the 20 sectors of unrelated 
trades or businesses. Additionally, under existing precedent, an 
organization must determine whether an activity is an ``unrelated trade 
or business'' within the meaning of section 513 before it determines 
what NAICS 2-digit code describes that ``separate'' unrelated trade or 
business. An organization cannot use losses from an activity that 
consistently generates losses to offset income from a profitable trade 
or business unless the organization can show that the loss-producing 
activity is conducted with the requisite profit motive. See Portland 
Golf Club v. Commissioner, 497 U.S. 154, 164 (1990) (confirming that, 
``[a]lthough [section 162] does not expressly require that a `trade or 
business' must be carried on with an intent to profit, this Court has 
ruled that a taxpayer's activities fall within the scope of [section] 
162 only if an intent to profit has been shown'' and citing 
Groetzinger, 480 U.S. at 35); Losantiville Country Club v. 
Commissioner, 906 F.3d 468, 473-75 (6th Cir. 2018) (demonstrating 
profit motive without reference to profitability by applying section 
183 factors).
    Furthermore, the Treasury Department and the IRS conclude that use 
of NAICS 2-digit codes results in broader identification of trades or 
businesses that will minimize implementation costs and will mitigate 
the administrative burden on exempt organizations and the IRS that 
would be imposed by more detailed NAICS codes. The use of NAICS 2-digit 
codes should also reduce any inequity that might result from a code 
system that was not specifically designed to describe the business 
activities of exempt organizations.
    For these reasons, the proposed regulations generally provide that 
an exempt organization will identify each of its separate unrelated 
trades or businesses using the first two digits of the NAICS code that 
most accurately describes a trade or business. The Treasury Department 
and the IRS request comments on whether another method, or additional 
methods, of identifying an exempt organization's separate unrelated 
trades or businesses better achieves the intent of Congress in enacting 
section 512(a)(6) while still being administrable for exempt 
organizations and the IRS.
    A few commenters requested confirmation that the Treasury 
Department and the IRS will permit an exempt organization to rely on 
the NAICS code that describes all the activities of the organization. 
For example, NAICS describes educational services, which includes 
colleges, universities, and professional schools, under one NAICS 2-
digit code (61).
    An unrelated trade or business generally is any trade or business 
the conduct of which is not substantially related to the exercise or 
performance by such exempt organization of its charitable, educational, 
or other purpose or function constituting the basis for its exemption 
under section 501. See section 513(a). A NAICS code that describes all 
of an exempt organization's activities, even those activities that are 
substantially related to the exercise or performance of the exempt 
organization's exempt function, fails to identify the exempt 
organization's unrelated trades or businesses and undermines the 
Congressional intent in enacting section 512(a)(6). Accordingly, the 
proposed regulations clarify that the NAICS code chosen must identify 
the unrelated trade or business in which the exempt organization 
engages (directly or indirectly) and not the activities the conduct of 
which are substantially related to the exercise or performance by such 
exempt 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 exempt organization described in section 
511(a)(2)(B), to the exercise or performance of any purpose or function 
described in section 501(c)(3)). Thus, returning to the previous 
example, a college or university cannot choose NAICS code 61 for all 
its unrelated trade or business activities.
    Similarly, one commenter requested that the Treasury Department and 
the IRS confirm that a qualified retirement plan can use the NAICS code 
describing employee benefit funds, which is included under the NAICS 2-
digit code for finance and insurance (52), to describe all the plan's 
unrelated trades or businesses. As discussed in the Background section, 
qualified retirement funds are subject to the general definition of 
UBTI in section 512(a)(1) but the term ``unrelated trade or business'' 
is defined in a special rule for trusts under section 513(b) as ``any 
trade or business regularly carried on by such [plan] or by a 
partnership of which it is a member.'' Accordingly, it must use the 
NAICS 2-digit code that most accurately describes the underlying trade 
or business regularly carried on by the plan or by a partnership of 
which it is a member. However, it appears that qualified retirement 
plans generally derive most, if not all, of their UBTI from investment 
activities, the identification of which is discussed in section 2 of 
this preamble, and which includes UBTI from any qualifying partnership 
interests (see section 2.d of

[[Page 23176]]

this preamble) or qualifying S corporation interests (see section 4.a 
of this preamble). Accordingly, unless a qualified retirement plan 
engages directly in one or more unrelated trades or businesses or has 
non-qualifying partnership interests or non-qualifying S corporation 
interests, a qualified retirement plan will not be subject to section 
512(a)(6) because it will only have one unrelated trade or business for 
purposes of section 512(a)(6)--its investment activities.
    A social club described in section 501(c)(7) would not be able to 
use the NAICS 2-digit code for arts, entertainment, and recreation 
(71), which includes golf courses and country clubs, to identify all 
its unrelated trades or businesses. As explained in the Background 
section, social clubs are subject to the definition of UBTI in section 
512(a)(3), which defines UBTI, in part, as ``gross income (excluding 
exempt function income)'' and does not refer directly to ``any 
unrelated trade or business.'' However, as further explained in section 
5 of this preamble, these proposed regulations apply regardless of 
whether an organization is subject to the definition of UBTI in section 
512(a)(1) or section 512(a)(3). Accordingly, a social club must use the 
NAICS code that most accurately describes its unrelated trade or 
business activities. The social club may use the NAICS 2-digit code for 
arts, entertainment, and recreation (71) only to the extent such code 
describes its unrelated trades or businesses, such as rounds of golf 
played by nonmembers, the greens fees for which would result in UBTI.
    At least one commenter recommended that the proposed regulations 
permit an exempt organization to aggregate trades or businesses that 
may be described by multiple NAICS codes as a single trade or business 
when those activities are closely related, similar in nature, and 
essentially conducted as a single trade or business. Although the 
Treasury Department and the IRS recognize that the use of more digits 
of the NAICS codes could result in the division of business activities 
traditionally conducted as one unit into more than one trade or 
business, the use of NAICS codes at the 2-digit level, as noted by 
other commenters, results in the aggregation of trades or businesses in 
the same economic sector. Accordingly, the Treasury Department and the 
IRS address this comment by adopting the use of NAICS 2-digit codes.
ii. Codes Reported Only Once
    The Treasury Department and the IRS recognize that an exempt 
organization can have a trade or business that it operates in 
different, geographic areas. For example, a hospital organization may 
operate several hospital facilities in a geographic area (or multiple 
geographic areas), all of which include pharmacies that sell goods to 
the general public. See Rev. Rul. 68-375, 1968-2 C.B. 245. Pharmacies 
are described under the NAICS 2-digit code for retail trade (44). 
Although each pharmacy potentially could be considered a ``separate'' 
trade or business under section 512(a)(6), particularly if separate 
books and records exist for each pharmacy, the Treasury Department and 
the IRS recognize that devising rules to distinguish between each 
pharmacy trade or business would introduce additional complexity and 
increase the administrative burden on the hospital organization. 
Accordingly, the proposed regulations provide that an exempt 
organization will report each NAICS 2-digit code only once. Thus, even 
though the hospital organization in the previous example operates more 
than one pharmacy, the hospital organization would report all the 
pharmacies using the NAICS 2-digit code for retail trade (44), along 
with any other retail trades or businesses described by this NAICS 2-
digit code, on Form 990-T as one unrelated trade or business.
iii. Erroneous Codes
    The proposed regulations provide that, once an exempt organization 
has identified a separate unrelated trade or business using a 
particular NAICS 2-digit code, the organization may not change the 
NAICS 2-digit code describing that trade or business unless the 
organization can show that the NAICS 2-digit code chosen was due to an 
unintentional error and that another NAICS 2-digit code more accurately 
describes the trade or business. This limitation will apply to codes 
reported on the first Form 990-T filed after final regulations under 
section 512(a)(6) are published in the Federal Register. The Treasury 
Department and the IRS anticipate that the instructions to the Form 
990-T will be revised to describe how an exempt organization provides 
notification of such an error. Additionally, the Treasury Department 
and the IRS request comments regarding whether there are other 
circumstances in which an exempt organization should be permitted to 
change NAICS 2-digit codes.
b. New Identification Methods
    At least two commenters suggested that the proposed regulations 
permit the Treasury Department and the IRS the flexibility to add new 
methods of identifying separate unrelated trades or businesses through 
guidance published in the Internal Revenue Bulletin. The Treasury 
Department and the IRS recognize that other code systems may exist (and 
have not yet been identified) or may be devised in the future that 
better reflect the unrelated trade or business activities engaged in by 
exempt organizations. However, the Treasury Department and the IRS also 
expect that the proposed regulations provide a method of identifying 
separate unrelated trades or businesses that is administrable for 
exempt organizations and the IRS and therefore do not anticipate the 
need to routinely modify that method. As more experience is gained over 
time with the administration of section 512(a)(6), the Treasury 
Department and the IRS may consider additional identification methods, 
including the use of code systems or indices other than NAICS, and will 
publish guidance as needed.
c. De Minimis Exceptions
    One commenter recommended that the Treasury Department and the IRS 
adopt a de minimis exception for exempt organizations reporting less 
than $100,000 of gross UBTI. Relying on statistical data published by 
the IRS, the commenter states that such organizations were responsible 
for only five percent of the total unrelated business income tax paid 
in 2013. This commenter argued that small exempt organizations likely 
lack the internal staff and the resources to implement the changes 
required by the enactment of section 512(a)(6) and to engage outside 
professionals to assist with ongoing compliance with that section.
    As a result of the commenter's proposed threshold, section 
512(a)(6) would not apply to more than 80 percent of the exempt 
organizations filing Form 990-Ts (based on the statistical data cited 
by the commenter). See Table 4. Unrelated Business Income Tax Returns: 
Returns with Positive Unrelated Business Taxable Income: Number of 
Returns, Gross Unrelated Business Income (UBI), Total Deductions, 
Unrelated Business Taxable Income, and Total Tax, by Type of Entity and 
Size of Gross UBI Tax Year 2013, available at https://www.irs.gov/statistics/soi-tax-stats-exempt-organizations-unrelated-business-income-ubi-tax-statistics#2. Accordingly, a supposed ``de minimis''

[[Page 23177]]

rule with a $100,000 gross UBTI threshold would effectively render 
section 512(a)(6) a nullity for most exempt organizations.
    More importantly, as noted by the commenter, section 512(a)(6) does 
not provide a de minimis rule and does not provide discretionary 
authority for the Treasury Department and the IRS to establish one. 
Accordingly, 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. However, the 
Treasury Department and the IRS note that the use of NAICS 2-digit 
codes, along with the treatment of an exempt organization's investment 
activities as one unrelated trade or business (as described in section 
2.a of this preamble), is expected to address many of the concerns 
prompting the request for a de minimis rule because smaller entities 
are not as likely to have more than one unrelated trade or business. 
The Treasury Department and the IRS therefore do not adopt this 
comment.
d. Allocation of Directly Connected Deductions
i. In General
    Section 512(a)(1) permits an exempt organization with an unrelated 
trade or business to reduce the income from that trade or business by 
the deductions allowed by chapter 1 that are directly connected with 
the carrying on of such trade or business. To be ``directly connected'' 
with a trade or business, an item of deduction must have a proximate 
and primary relationship to the carrying on of the unrelated trade or 
business generating the gross income. See Sec.  1.512(a)-1(a). 
Expenses, depreciation, and similar items attributable solely to the 
conduct of an unrelated trade or business are proximately and primarily 
related to that trade or business and qualify to reduce income from 
such trade or business under section 512(a)(1) to the extent such items 
meet the requirements of sections 162 (trade or business expenses), 167 
(depreciation), and other relevant provisions. 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. See Sec.  
1.512(a)-1(c).\3\
---------------------------------------------------------------------------

    \3\ The same method used for allocating expenses in determining 
taxable income must also be used when determining whether an 
activity is conducted with the intent to profit, and thus (as 
discussed further in section 5.b.iv of this preamble) whether such 
activity is a trade or business. Portland Golf Club v. Commissioner, 
497 U.S. 154, 171 (1990) (stating that ``in demonstrating the 
requisite profit motive, Portland Golf must employ the same method 
of allocating fixed expenses as it uses in calculating its actual 
loss'').
---------------------------------------------------------------------------

    The allocation issues under section 512(a)(1) are also relevant 
under section 512(a)(6) because an exempt organization with more than 
one unrelated trade or business must not only allocate indirect 
expenses among exempt and taxable activities as described in Sec.  
1.512(a)-1(c) but also among separate unrelated trades or businesses. 
Accordingly, Notice 2018-67 stated the Treasury Department and the IRS 
are considering modifying the underlying reasonable allocation method 
in Sec.  1.512(a)-1(c) and providing specific standards for allocating 
expenses relating to dual use facilities and the rules under section 
512(a)(6). Notice 2018-67 requested comments regarding possible rules 
or defined standards for the allocation of indirect expenses between 
separate unrelated trades or businesses for purposes of calculating 
UBTI under section 512(a)(6)(A), and regarding what allocation methods 
should be considered ``reasonable.''
    The three commenters addressing allocation methods generally 
recommended retaining the current ``any reasonable method'' approach. 
Nonetheless, one of these commenters recommended that the Treasury 
Department and the IRS adopt existing cost allocation rules set forth 
by the OMB, referred to as the Uniform Administrative Requirements, 
Cost Principles, and Audit Requirements for Federal Awards (2 CFR 200), 
and by the Financial Accounting Standards Board in the Accounting 
Standard Update 2016-14, both of which require allocations to be made 
``on a rational, reasonable, and objective basis across functional 
expense categories.'' Another commenter recommended adopting accounting 
methods specific to social club activities, such as a golf.
    The Treasury Department and the IRS are concerned that permitting 
allocation methods based solely on reasonableness is difficult for the 
IRS to administer and may not provide certainty for taxpayers. Whether 
an allocation method is ``reasonable'' depends on all the facts and 
circumstances. See Rensselaer Polytechnic Institute v. Commissioner, 79 
T.C. 967 (1982), aff'd 732 F.2d 1058 (2d Cir. 1984) (finding an 
allocation method based on actual use to be ``reasonable'' within the 
meaning of Sec.  1.512(a)-1(c)). The Treasury Department and the IRS 
continue to consider the allocation issue and intend to publish a 
separate notice of proposed rulemaking providing further guidance on 
this issue. Until publication of a separate notice of proposed 
rulemaking, these proposed regulations incorporate the existing 
allocation standard in Sec.  1.512(a)-1(c), which provides that an 
exempt organization must allocate deductions on a reasonable basis 
between separate unrelated trades or businesses. The proposed 
regulations also provide that the use of the unadjusted gross-to-gross 
method is not a reasonable allocation method under the general 
allocation rule and as incorporated for section 512(a)(6) purposes (see 
section 1.d.iii of this preamble).
ii. State and Local Taxes and Tax Preparation Fees
    At least one commenter requested guidance on the deduction of 
certain general expenses. This commenter recommended that tax return 
preparation fees be permitted as a deduction after calculation of total 
UBTI under section 512(a)(6)(B). The commenter argued that such 
expenses should not be allocated between separate unrelated trades or 
businesses because such expenses pertain to all the exempt 
organization's activities--related and unrelated.
    As previously discussed, deductions are permitted under section 
512(a)(1) and (3) only if two conditions are met: (1) The deduction is 
allowed under chapter 1; and (2) in the case of section 512(a)(1), the 
deduction is directly connected with the carrying on of such separate 
unrelated trade or business, or, in the case of section 512(a)(3), the 
deduction is directly connected with the production of the gross income 
(excluding exempt function income). Accordingly, an exempt organization 
may deduct only tax return preparation fees that are directly connected 
with a separate unrelated trade or business, in the case of an 
organization subject to section 512(a)(1), or that are directly 
connected with the production of the gross income (excluding exempt 
function income), in the case of an organization subject to section 
512(a)(3). If such fees are directly connected with more than one 
separate unrelated trade or business or are also attributable to the 
exempt organization's related activities (or exempt function income in 
the case of an organization subject to section

[[Page 23178]]

512(a)(3)), the exempt organization must allocate such expenses as 
discussed in section 4.d.i of this preamble. See Sec.  1.512(a)-1(c). 
Nothing in section 512(a)(6)(B) permits either the deduction of 
expenses that are not otherwise deductible in calculating UBTI or the 
deduction of expenses after calculation of total UBTI. Thus, the 
Treasury Department and the IRS do not adopt this comment.
    One commenter also suggested that state income taxes not directly 
connected with any separate unrelated trade or business resulting from 
the increase in UBTI under section 512(a)(7) be permitted as a 
deduction after calculation of total UBTI under section 512(a)(6)(B). 
With the repeal of section 512(a)(7), the Treasury Department and the 
IRS expect that exempt organizations are no longer subject to state 
income taxes that are not directly connected with the carrying on of a 
separate unrelated trade or business. If this is not the case, the 
Treasury Department and the IRS request examples of such state income 
taxes.
iii. The Unadjusted Gross-to-Gross Method Is Unreasonable
    The IRS has previously indicated that it will not litigate the 
reasonableness of the allocation method in Rensselaer pending revision 
of the Treasury regulations. 732 F.2d 1058, action on dec., 1987-014 
(Jun. 18, 1987). However, regarding facilities or personnel that are 
used both to carry on exempt activities and to conduct unrelated trade 
or business activities or more than one separate unrelated trade or 
business, the Treasury Department and the IRS have concluded 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).
    In some circumstances, the provision of a good or service can be 
both related and unrelated depending on to whom the good or service is 
offered. For example, with respect to social clubs, the provision of 
goods and services to members is an exempt function whereas the 
provision of the same goods and services to nonmembers is a nonexempt 
function. Another example is a school that operates a ski facility for 
use in its physical education program and for recreational use by its 
students and the general public. Rev. Rul. 78-98, 1978-1 C.B. 167. If 
the social club charges nonmembers a higher price than it charges 
members for the same good or service or if the school charges the 
general public more for slope and ski lift fees than it charges its 
students, the gross-to-gross ratio will increase, resulting in more 
indirect expenses being allocated to the unrelated activity. However, 
no difference likely exists in the cost of providing the good or 
service to members versus nonmembers or in the cost of providing the 
ski slopes and lifts to students versus the public. Accordingly, the 
failure to adjust the price of the good or service offered to 
nonmembers or the general public for purposes of determining the 
allocation of indirect expenses (that is, using an unadjusted gross-to-
gross method) overstates the percentage of the indirect expenses that 
should be allocated to the unrelated activities. See Portland Golf, 497 
U.S. at 157 fn. 4 (indicating that a system where the taxpayer 
``charges nonmembers higher prices for food and drink than members are 
charged, even though nonmembers' meals presumably cost no more to 
prepare and serve'' seems likely to ``[overstate] the percentage of 
fixed costs properly attributable to nonmember sales'').
    When an organization charges different prices for the same good or 
service depending on whether the offering of the good or service is a 
related or unrelated activity, then such organization should adjust the 
per ``unit'' price of the good or service of the related activity to 
that of the unrelated activity (or activities) for the ratio created by 
the gross-to-gross method to appropriately account for the percentage 
of indirect expenses attributable to the unrelated activity. Failing to 
make this adjustment does not appropriately account for the portion of 
indirect expenses attributable to an unrelated activity and is 
therefore an unreasonable method for allocating expenditures under 
Sec.  1.512(a)-1(c). Accordingly, the proposed regulations provide that 
the unadjusted gross-to-gross method is not reasonable, whether under 
the general allocation rule or as incorporated for section 512(a)(6) 
purposes.
    The Treasury Department and the IRS request comments regarding 
whether any other allocation methods should be considered unreasonable 
and the methods or rules that could be adopted instead of a 
reasonableness standard for allocations both between related and 
unrelated activities and between two or more separate unrelated trades 
or businesses.

2. Activities in the Nature of Investments

    Several commenters expressed concern regarding the use of the NAICS 
codes to identify investment activities as one or more separate 
unrelated trades or businesses. One commenter noted that a partnership 
is not required to report the NAICS codes for all the trades or 
businesses in which it engages on the Schedule K-1 (Form 1065), 
``Partner's Share of Income, Deductions, Credits, etc.,'' provided to 
its partners. Another commenter expressed concern that the NAICS codes 
lacked specificity for purposes of sufficiently identifying an exempt 
organization's investment activities. Therefore, two commenters 
suggested that an exempt organization's investment activities be 
identified separately from other activities identified using the NAICS 
codes.
    Consistent with Notice 2018-67, the proposed regulations generally 
permit the aggregation of the investment activities specifically listed 
in the proposed regulations for purposes of section 512(a)(6) to 
mitigate the burden on exempt organizations, particularly those with 
interests in multi-tier partnerships. However, under the proposed 
regulations, investment activities are not identified using NAICS 2-
digit codes. Specifically, the proposed regulations provide that NAICS 
2-digit codes are used to identify separate unrelated trades or 
businesses except to the extent provided in other paragraphs of the 
proposed regulations. Under the proposed regulations, an exempt 
organization's investment activities, as well as the separate unrelated 
trades or businesses discussed in sections 3 and 4 of this preamble, 
are identified as described in the proposed regulations and reported as 
described in the forms and instructions (see section 8 of this 
preamble).
a. Investment Activities Are Treated as a Separate Unrelated Trade or 
Business for Purposes of Section 512(a)(6)
    As a general matter, a number of commenters suggested 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 Treasury 
Department and the IRS have concluded that the structure and purposes 
of sections 511 through 514 indicate that an exempt organization's 
investment activities should be treated as a separate unrelated trade 
or business for purposes of section 512(a)(6). Section 512(a)(1)

[[Page 23179]]

provides that UBTI means the gross income derived by an exempt 
organization from any unrelated trade or business regularly carried on 
by it. Further, section 512(a)(1) provides that an exempt organization 
excludes from the calculation of UBTI the amounts described in section 
512(b)(1), (2), (3), and (5)--that is, dividends, interest, annuities, 
etc.; royalties; rents; and capital gains. If an exempt organization's 
investment activities were not an unrelated trade or business, 
exclusion of certain amounts under section 512(b), such as capital 
gains (and losses) under section 512(b)(5), would appear to be 
unnecessary. Furthermore, other income that an exempt organization may 
consider ``investment income''--such as unrelated debt-financed 
income--is treated as ``derived from an unrelated trade or business'' 
under other paragraphs of section 512(b)--including section 512(b)(4). 
The application of section 512(a)(6) to income included in UBTI under 
section 512(b)(4), (13), or (17) is discussed in more detail in section 
3 of this preamble.
    Some commenters cited Higgins v. Commissioner, 312 U.S. 212 (1941), 
to support the position that an exempt organization's investment of its 
own assets is not a trade or business. However, Higgins is not relevant 
under sections 511 through 514 because it applies to individuals, not 
corporations or trusts. For the taxable years involved in Higgins, a 
deduction was allowed for all ordinary and necessary expenses of 
carrying on a trade or business, but a deduction was not allowed for 
personal, living, or family expenses. Congress responded to Higgins by 
enacting what is now section 212(1) to allow individuals to deduct all 
ordinary and necessary expenses incurred in the production or 
collection of income. Estate of Rockefeller v. Commissioner, 762 F.2d 
264, 266 n.3 (2d Cir. 1985). Section 212 applies only to individuals. 
Corporations or trusts may deduct only ``ordinary and necessary 
expenses paid or incurred during the taxable year in carrying on any 
trade or business'' under section 162. Thus, no deduction for expenses 
directly connected with investment activities would be permitted to a 
corporation or trust unless its investment activities are a part of a 
trade or business within the meaning of section 162.
    However, the Treasury Department and the IRS recognize that exempt 
organizations have UBTI under sections 511 through 514 from activities 
engaged in with an intent to make an investment rather than with the 
intent to actively participate in any of the unrelated trade or 
business activities generating the UBTI. Accordingly, Notice 2018-67 
stated that, as a matter of administrative convenience, the proposed 
regulations would treat an exempt organization's investment activities 
as one trade or business for purposes of section 512(a)(6)(A) in order 
to permit the exempt organization to aggregate gross income and 
directly connected deductions from possibly multiple separate unrelated 
trades or businesses. After publication of Notice 2018-67, the Joint 
Committee on Taxation (JCT) confirmed that ``it is intended that the 
Secretary consider whether it would be appropriate in certain cases to 
permit an organization that maintains an investment portfolio to treat 
multiple investment activities as one unrelated trade or business.'' 
Staff of the Joint Committee on Taxation, General Explanation of Public 
Law 115-97 (December 2018), at 293 (General Explanation). Consistent 
with Notice 2018-67 and the General Explanation, the proposed 
regulations provide that an exempt organization's various investment 
activities, as exclusively listed therein, are treated as a separate 
unrelated trade or business for purposes of section 512(a)(6)(A) and 
the proposed regulations.
b. Exclusive List of ``Investment Activities''
    Notice 2018-67 did not define the term ``investment activities'' 
but rather requested comments regarding the scope of the activities, 
both investment partnership interests or other investment activities, 
that should be included in the category of ``investment activities'' 
for purposes of section 512(a)(6). Some commenters suggested that the 
term ``investment activities'' include all passive income. Some of 
these commenters specifically suggested using the definition of 
``material participation'' in section 469 as a method to identify 
``investment activities.'' However, most commenters addressing this 
issue suggested that the term ``investment activities'' should include 
activities that give rise to amounts included as: An item of gross 
income derived from an unrelated trade or business under section 
512(b)(4) (debt-financed property), (13) (certain amounts received from 
controlled entities), and (17) (certain amounts derived from foreign 
corporations); gross income (or loss) from a partnership that is not 
directly or indirectly controlled by the exempt organization; and, with 
respect to controlled partnerships, an item of gross income derived 
from an unrelated trade or business under section 512(b)(4), (13), and 
(17).
    In drafting these proposed regulations, the Treasury Department and 
the IRS considered whether to provide a general definition of the term 
``investment activities.'' However, even though other areas of the Code 
make a distinction between ``active'' and ``passive'' activities, those 
distinctions are not applicable for purposes of sections 511 through 
514. Section 512(c) applies regardless of whether the exempt 
organization is an active or passive participant in the unrelated trade 
or business of the partnership or whether it is a general or limited 
partner. Rev. Rul. 79-222; Service Bolt & Nut Co. v. Commissioner, 724 
F.2d 519, 523-24 (6th Cir., 1983), affg, 78 T.C. 812 (1982); see also 
Leila G. Newhall Unitrust v. Commissioner, 105 F.3d 482 (9th Cir. 
1997), affg, 104 T.C. 236 (1995) (following Service Bolt & Nut, 724 
F.2d 519). Thus, the Treasury Department and the IRS do not believe 
that use of the criteria for finding ``material participation'' under 
section 469 is appropriate in applying section 512(a)(6).
    Rather, the proposed regulations provide an exclusive list of an 
exempt organization's investment activities that can be treated as one 
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 section 2.d of this preamble); (ii) debt-financed 
properties (see section 3.a of this preamble); and (iii) qualifying S 
corporation interests (see section 4.a of this preamble). As discussed 
in section 5.b.i of this preamble, the qualifying partnership rules do 
not apply to social clubs described in section 501(c)(7). However, for 
exempt organizations subject to section 512(a)(3) (including social 
clubs), the proposed regulations clarify that UBTI from the investment 
activities of such organizations includes certain additional amounts 
(see section 5.a of this preamble).
    The Treasury Department and the IRS will continue to consider 
whether the term ``investment activities'' can be defined more 
generally in a manner that is administrable and consistent with the 
legislative intent of section 512(a)(6). The Treasury Department and 
the IRS request comments regarding the specific factors that should be 
considered when determining whether an activity is an investment 
activity for purposes of section 512(a)(6).

[[Page 23180]]

c. Partnership Interests
    With respect to partnership interests, the Treasury Department and 
the IRS stated in Notice 2018-67 that the category of ``investment 
activities'' for purposes of section 512(a)(6) should include only 
partnership interests in which the exempt organization does not 
significantly participate in any partnership trade or business. Some 
commenters suggested including in this category partnerships over which 
the exempt organization has no control, which is discussed in more 
detail in section 2.d of this preamble.
    Other commenters suggested that this category include all limited 
partnerships or limited liability companies (LLCs) in which the exempt 
organization is a non-managing member (regardless of the exempt 
organization's percentage interest or other participation in the 
partnership). The Treasury Department and the IRS decline to adopt this 
comment 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. Nonetheless, as discussed in 
section 2.d.iii.B of this preamble, the Treasury Department and the IRS 
recognize that there may be rights or actions permitted by state law 
that are normal and routine and that do not indicate any measurable 
influence or control over a partnership. Accordingly, the Treasury 
Department and the IRS request comments on whether certain permitted 
rights or actions should be disregarded in determining whether a 
partnership interest is a qualifying partnership interest. In addition, 
the proposed regulations clarify that any partnership in which an 
exempt organization is a general partner for any federal tax purpose is 
not a qualifying partnership interest within the meaning of the 
proposed regulations, regardless of the exempt organization's 
percentage interest.
d. Qualifying Partnership Interests
    Pending publication of proposed regulations, the interim rule 
described in Notice 2018-67 permitted an exempt organization to 
aggregate its UBTI from certain partnership interests with multiple 
trades or businesses, including trades or businesses conducted by 
lower-tier partnerships (qualifying partnership interest). See section 
6.01(2) of Notice 2018-67. Additionally, the interim rule permitted the 
aggregation of any qualifying partnership interest (QPI) with all other 
QPIs, resulting in the treatment of the aggregate group of QPIs as a 
single trade or business for purposes of section 512(a)(6)(A). Id.
    Although some commenters suggested retaining the interim rule as 
described in Notice 2018-67, the majority of commenters appeared to 
support retention of the interim rule but made suggestions regarding 
possible revisions that potentially could reduce any administrative 
burden associated with the rule. Consistent with these comments, the 
proposed regulations retain the interim rule with the modifications 
described in the following sections of this preamble.
i. Designation of a QPI
    Like Notice 2018-67, the proposed regulations permit, but do not 
require, an organization to aggregate its UBTI from QPIs. See section 
6.01(2) of Notice 2018-67. However, the proposed regulations add 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 organization using 
NAICS 2-digit codes unless and until the partnership interest is no 
longer a QPI. For example, if an organization has a partnership 
interest that is a QPI and the organization designates that partnership 
interest as a QPI on its Form 990-T, the 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 
organization using NAICS 2-digit codes. However, if in a future taxable 
year, the organization's partnership interest is no longer a QPI, then 
the organization would be required to identify the trades or business 
of the partnership that are unrelated trades or businesses with respect 
to the organization using NAICS 2-digit codes.
    A partnership interest is a QPI if it meets the requirements of 
either the de minimis test (discussed in section 2.d.ii of this 
preamble) or the control test (discussed in section 2.d.iii of this 
preamble).
ii. The De Minimis Test
    Both Notice 2018-67 and the proposed regulations provide that a 
partnership interest is a QPI that meets the requirements of the de 
minimis test if the exempt organization holds directly no more than 2 
percent of the profits interest and no more than 2 percent of the 
capital interest. See section 6.02(1) of Notice 2018-67. As noted by 
several commenters, the 2 percent threshold for the de minimis test is 
consistent with the de minimis test under section 4943, which provides 
that a private foundation does not have excess business holdings in any 
corporation in which it (together with certain related private 
foundations described in section 4946(a)(1)(H)) owns not more than 2 
percent of the voting stock and not more than 2 percent in value of all 
outstanding shares of all classes of stock. The Treasury Department and 
the IRS chose not to cross-reference the section 4943 de minimis test 
because that section applies only to private foundations. Nonetheless, 
because Congress adopted a 2 percent de minimis test under section 
4943, the Treasury Department and the IRS consider a 2 percent 
threshold to be appropriate for purposes of the de minimis test in the 
proposed regulations.
    However, the proposed regulations make two changes to the de 
minimis test provided in Notice 2018-67 to improve administrability and 
to provide more appropriate relief. First, as discussed in section 
2.d.iv of this preamble, an exempt organization is no longer required 
to combine certain related interests when determining whether a 
partnership interest meets the requirements of the de minimis test. 
Second, in response to comments that the interim rule should apply to 
lower-tier partnerships, the proposed regulations provide that, if an 
exempt organization does not control a partnership in which the exempt 
organization holds a direct interest (directly-held partnership 
interest) but that 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 
permit (but do not require) an exempt organization to aggregate the 
UBTI from some indirectly-held QPIs with its directly-held QPIs. 
However, the look-through rule does not apply to indirectly-held QPIs 
that do not meet the requirements of the de minimis test but may meet 
the requirements of the control test.
    For example, if an exempt organization directly holds 50 percent of 
the capital interests of a partnership that it does not control and the 
directly-held partnership holds 4 percent of the capital and profits 
interests of lower-tier partnership A and 10 percent of the

[[Page 23181]]

capital and profits interests of lower-tier partnership B, the exempt 
organization can aggregate its interest in lower-tier partnership A 
with its other QPIs because the exempt organization indirectly holds 2 
percent of the capital and profits interests of lower-tier partnership 
A (4 percent x 50 percent = 2 percent). However, the exempt 
organization may not aggregate its interest in lower-tier partnership B 
with its QPIs because the exempt organization indirectly holds 5 
percent (10 percent x 50 percent) of the capital and profits interest 
of lower-tier partnership B, which does not meet the requirements of 
the de minimis test.
    If a directly-held partnership interest is not a QPI, the general 
principles of section 512(c) apply and the exempt organization is 
required to identify the trades or businesses conducted by the 
directly-held partnership, and any indirectly-held partnerships, that 
are unrelated trades or businesses with respect to the exempt 
organization. The Treasury Department and the IRS expect that 
permitting an exempt organization to aggregate any indirectly-held 
partnership interests that meet the requirements of the de minimis test 
with all other QPIs will reduce the administrative burden on exempt 
organizations because there will be no need to identify each trade or 
business conducted by such indirectly-held partnership. However, the 
Treasury Department and the IRS request comments regarding the 
administrability of permitting the aggregation of indirectly-held 
partnership interests that meet the requirements of the de minimis 
test.
iii. The Control Test
    Notice 2018-67 stated 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 or influence over the partnership. See 
section 6.03(1) of Notice 2018-67.

A. Percentage Interest

    Numerous commenters made recommendations regarding the first prong 
of the control test, most of which recommend increasing the percentage 
threshold to 50 percent to conform with the definition of control in 
section 512(b)(13). Multiple commenters suggested that the percentage 
control requirement be eliminated entirely.
    The proposed regulations retain the 20 percent threshold used in 
Notice 2018-67. The Treasury Department and the IRS intend the 
percentage threshold to be a proxy to identify partnership interests in 
which the exempt organization does not significantly participate in any 
partnership trade or business and therefore may appropriately be 
considered an investment activity for purposes of section 512(a)(6). 
The 20 percent threshold is consistent with at least one other 
administrative exception created for certain investment activities. See 
section 731(c)(3)(C)(i) & Sec.  1.731-2(e). Accordingly, the proposed 
regulations treat a 20 percent interest in a partnership over which the 
exempt organization partner has no control (see section 2.d.iii.B of 
this preamble) as a part of the exempt organization's investment 
activities. However, as with the de minimis test, an exempt 
organization is no longer required to combine certain related interests 
when determining whether a partnership interest meets the 20 percent 
threshold under the control test (see section 2.d.iv of this preamble).
    The Treasury Department and the IRS recognize that an exempt 
organization may have more than 20 percent of the capital interests of 
a partnership but the exempt organization may consider that partnership 
interest to be part of its investment activities raising funds for its 
exempt activities. However, as discussed in section 2.b of this 
preamble, the proposed regulations do not provide a general definition 
of the term ``investment activities'' such that a non-QPI could be 
aggregated with the exempt organization's other investment activities 
for purposes of section 512(a)(6). While the addition of the look-
through rule to the de minimis test in these proposed regulations may 
result in the aggregation of some of the lower-tier partnership 
interests of a directly-held non-QPI, an exempt organization's 
investment intent is not sufficient to treat the overall non-QPI as 
part of its investment activities.
    At least two commenters suggested that the capital interests in a 
partnership do not indicate control over a partnership. The Treasury 
Department and the IRS understand that a partner's percentage interest 
in the capital interests of a partnership does not necessarily 
correlate with the partner's ability to control the partnership. 
However, the Treasury Department and the IRS have concluded that a 
combination of an exempt organization's percentage capital interest in 
a partnership and the exempt organization's ability to control the 
partnership are an appropriate administrative proxy for determining 
whether a partnership interest is an investment activity. The use of a 
percentage interest, in addition to the definition of ``control'' 
discussed in section 2.d.iii.B of this preamble, provides a bright line 
for the evaluation of partnership interests that may be investment 
activities. Furthermore, because an exempt organization's percentage 
profits interest may change throughout the year, the proposed 
regulations continue to consider only an exempt organization's capital 
interest in a partnership for purposes of the control test.

B. Definition of ``Control''

    Notice 2018-67 provided that all facts and circumstances are 
relevant for determining whether an exempt organization has control or 
influence over a partnership. See section 6.03(3) of Notice 2018-67. 
Notice 2018-67 then provided three specific circumstances in which an 
exempt organization has control or influence. Id. Commenters generally 
appeared to support the inclusion of a facts and circumstances test. 
Nonetheless, numerous commenters suggested revisions to what it means 
for an exempt organization to have influence or control over a 
partnership.
    First, Notice 2018-67 provided that an exempt organization has 
control or influence if the exempt organization may require the 
partnership to perform, or may prevent the partnership from performing, 
any act that significantly affects the operations of the partnership. 
Several commenters recommended that the proposed regulations clarify 
that the right to vote for the appointment or removal of a general 
partner or managing member, the ability to appoint representatives to 
investor committees or advisory committees, and the right to approve 
the selection or removal of a general partner or managing member do not 
evidence influence or control. These commenters explained that these 
rights help ensure that the general partner cannot alter a partnership 
without the consent of the limited partners. Similarly, other 
commenters requested that the proposed regulations clarify that an 
exempt organization will not be deemed to have influence or control 
over a partnership if it exercises its rights or takes actions that it 
is permitted to take under state law while maintaining its limited 
liability status in a partnership.
    Second, Notice 2018-67 provided that an exempt organization has 
control or influence over a partnership if any of the exempt 
organization's officers, directors, trustees, or employees have rights 
to participate in the management of the partnership or conduct the 
partnership's business at any time, or if

[[Page 23182]]

the exempt organization has the power to appoint or remove any of the 
partnership's officers, directors, trustees, or employees. One 
commenter stated that the presence of these rights or powers does not 
necessarily illustrate control. Another commenter suggested that this 
rule is overly restrictive and will cause many partnership interests in 
which an exempt organization has no influence or control to fail to 
meet the requirements of the control test. This commenter stated that 
many exempt organizations have governing board members that also work 
in the investment management industry and may participate in conducting 
the business of a partnership in which the exempt organization invests. 
The commenter explained that these individuals' expertise in financial 
management is essential for the prudent management of an exempt 
organization's investments. The commenter argued that a general rule 
based on facts and circumstances is sufficient to address situations in 
which an exempt organization exercises ``excessive'' influence or 
control over a partnership such that it should not be considered a QPI.
    The proposed regulations retain the control rule described in 
Notice 2018-67 with minor modifications to address the comments 
described above. In particular, the proposed regulations remove the 
term ``influence'' so that the second prong of the control test 
provides that, if the exempt organization has 20 percent or less of the 
capital interests, a partnership interest is a QPI that meets the 
requirements of the control test if the exempt organization does not 
control the partnership. Consistent with Notice 2018-67, the proposed 
regulations provide that all the facts and circumstances are relevant 
for determining whether an exempt organization controls a partnership. 
The proposed regulations clarify that the partnership agreement is 
among the facts and circumstances that may be considered when making a 
determination of control.
    The proposed regulations also list certain specific circumstances 
that evidence control, focusing on four discrete rights or powers. Two 
circumstances focus on the exempt organization's ability to perform 
certain actions on its own. Specifically, the proposed regulations 
provide 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 
focus 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. No exception is provided for certain professionals that may 
serve on the boards of both the exempt organization and partnerships in 
which the exempt organization is a partner.
    The Treasury Department and the IRS recognize that, although these 
rights or powers indicate control in some situations, other facts and 
circumstances may tip the scale the other way. Accordingly, the 
Treasury Department and the IRS request comments regarding whether all 
these rights or powers should be weighted the same or whether there are 
certain circumstances in which such right or power would never indicate 
control.
iv. Combining Related Interests
    Both the de minimis test and the control test in Notice 2018-67 
required an exempt organization to own less than a certain percentage 
of the profits and capital interests in a partnership. See sections 
6.02(1) (de minimis test) and 6.03(1) (control test) of Notice 2018-67. 
In determining the exempt organization's ownership percentage, both the 
de minimis test and the control test required the exempt organization 
to combine certain related interests (aggregation rule). Id. The 
aggregation rule in section 6.02(2)(b)(i) of Notice 2018-67 provided 
that, when determining an exempt organization's percentage partnership 
interest, the interest of a disqualified person (as defined in section 
4958(f)), a supporting organization (as defined in section 509(a)(3)), 
or a controlled entity (as defined in section 512(b)(13)) in the same 
partnership would be taken into account. See section 6.02(2)(b)(ii) 
through (iv) of Notice 2018-67.
    Most commenters suggested that the aggregation rule is overly 
burdensome and requested that it be removed. Commenters noted that many 
public charity boards have numerous members and argued that verifying 
the board members' ownership percentages, after taking into account 
other related interests, for every partnership interest that generates 
UBTI would be unreasonable, if not impossible. Additionally, these 
commenters stated that the exempt organization cannot usually obtain 
information about other partners from the partnerships in which it 
holds interests because of confidentiality agreements.
    If the aggregation rule is retained, commenters recommended several 
revisions. First, two commenters suggested eliminating the aggregation 
rule for the de minimis test. Next, a commenter suggested only 
requiring aggregation of interests owned by controlled entities and 
persons with direct control over the exempt organization's investment 
decisions. Additionally, another commenter would limit aggregation with 
interests owned by controlled entities to those interests owned by Type 
I and II supporting organizations described in section 509(a)(3)(B)(i) 
and (ii) and exclude interests owned by Type III supporting 
organizations described in section 509(a)(3)(B)(iii). Finally, another 
commenter suggested requiring aggregation with interests owned by 
controlled entities but not interests owned by persons or organizations 
that are not controlled by the exempt organization.
    The proposed regulations retain a modified aggregation rule to 
address situations in which an exempt organization may control a 
partnership through the aggregation of interests. The aggregation rule 
in the proposed regulations differs from the aggregation rule in Notice 
2018-67 in two ways. First, the aggregation rule in the proposed 
regulations applies only for purposes of the control test and not for 
purposes of the de minimis test. Second, the proposed regulations do 
not require an exempt organization to take into account the interests 
of disqualified persons when determining the exempt organization's 
percentage interest in a partnership for purposes of the control test.
    The proposed regulations adopt other aspects of the aggregation 
rule from Notice 2018-67 without change. In particular, the proposed 
regulations include the definitions of ``supporting organization'' and 
``controlled entity'' used in Notice 2018-67, which cross-referenced 
sections 509(a)(3) and 512(b)(13)(D), respectively. Additionally, the 
proposed regulations provide that, when determining an exempt 
organization's percentage interest in a partnership for purposes of the 
control test, the interests of a supporting organization or a 
controlled entity in the same partnership will be taken into account. 
However, the Treasury Department and the IRS will continue to consider 
whether the aggregation of the interests of supporting organizations is 
appropriate in the circumstance in which the exempt organization is a 
supported

[[Page 23183]]

organization that has little to no control over its supporting 
organizations.
v. Reliance on Schedule K-1 (Form 1065)
    Notice 2018-67 provided that, in determining the exempt 
organization's percentage interest in a partnership, the exempt 
organization may rely on the Schedule K-1 (Form 1065) (or its 
successor) it receives from the partnership. Commenters requested 
various revisions to the Schedule K-1 (Form 1065) to assist in the 
reporting process. The Treasury Department and the IRS will consider 
revisions to the Schedule K-1 (Form 1065). Otherwise, the proposed 
regulations continue to permit reliance on Schedule K-1 (Form 1065) 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 clarify that the exempt 
organization may not rely on the form to the extent that any 
information about the exempt 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 exempt 
organization's percentage capital interest at the beginning and end of 
the year but lists its profits interest as ``variable,'' the exempt 
organization may rely on the form only with respect to its percentage 
capital interest.
vi. Additional Recommended Changes
    Commenters suggested additional modifications to the de minimis and 
control tests, including phase-in and grace periods to address changes 
in an exempt organization's percentage interest that are beyond the 
exempt organization's control. Two commenters requested that an exempt 
organization be permitted up to 90 days to reduce its interest in a 
partnership in order to satisfy the requirements of the de minimis test 
if the increase in interest was because of another partner's withdrawal 
or percentage reduction. Another commenter suggested that, if a 
partnership interest met the requirements of either the de minimis test 
or the control test in a taxable year, the partnership interest should 
continue to meet those requirements in the following taxable years if 
the exempt organization's percentage interest changed through no action 
of the exempt organization partner.
    The proposed regulations do not adopt any of these recommended 
changes because the de minimis and control tests are rules of 
administrative convenience. Allowing greater interests due to other 
actions would require other safeguards and limitations that would 
complicate the rule and place additional administrative burdens on 
exempt organizations and the IRS. Nevertheless, 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. Accordingly, the Treasury 
Department and the IRS request comments regarding whether permitting a 
higher percentage interest in taxable years in which the increase 
occurs as the result of the actions of other partners would address 
these commenters' concerns.
e. Transition Rule
    Pending publication of proposed regulations, the transition rule in 
Notice 2018-67 permitted an exempt organization to treat each 
partnership interest acquired prior to August 21, 2018, that failed to 
meet the requirements of either the de minimis test or 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. See 
section 6.04 of Notice 2018-67.
    Many commenters asserted that the transition rule should apply to 
any partnership interest held by an exempt organization regardless of 
the date acquired. However, in the case of a partnership that conducts 
more than one trade or business that is a separate unrelated trade or 
business with respect to the exempt organization, applying the 
transition rule to all partnership interests and treating each non-QPI 
as one trade or business would undermine the purpose of section 
512(a)(6) by allowing the gains from one unrelated trade or business to 
offset the losses from another unrelated trade or business. 
Accordingly, the Treasury Department and the IRS do not accept this 
comment.
    Other commenters suggested that the proposed regulations should 
clarify that, if an exempt organization acquired a partnership interest 
before August 21, 2018, changes in the exempt organization's percentage 
interest would not affect the availability of the transition rule. 
Accordingly, the proposed regulations clarify 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.
    The proposed regulations also include two additions to the 
transition rule. First, the proposed regulations permit an exempt 
organization to rely on the transition rule only until the first day of 
the organization's first taxable year beginning after the date these 
proposed regulations are published as final regulations (transition 
period). Second, the proposed regulations provide 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. During the transition period, the exempt 
organization must determine how a partnership interest to which it 
chose to apply the transition rule will be treated under the final 
regulations. The Treasury Department and the IRS request comments 
regarding whether any additional transitional relief is necessary.

3. Inclusions of Income Derived From an Unrelated Trade or Business 
Under Section 512(b)(4), (13), and (17)

    Section 512(b)(4), (13), and (17) require the inclusion of certain 
income as items of gross income derived from an unrelated trade or 
business if such income is unrelated debt-financed income, a specified 
payment from controlled entities, or certain insurance income derived 
from a controlled foreign corporation, respectively. In Notice 2018-67, 
the Treasury Department and the IRS explained that, in the absence of 
section 512(b)(1), (2), (3), and (5), the income described in these 
sections would be included in the calculation of UBTI to the extent 
that such amounts are ``gross income derived by any organization from 
any unrelated trade or business . . . regularly carried on by it'' 
under section 512(a)(1). Accordingly, the Treasury Department and the 
IRS stated that no distinction existed between ``gross income derived 
by any organization from any unrelated trade or business . . . 
regularly carried on by it'' within the meaning of section 512(a)(1) 
and amounts included ``as an item of gross income derived from an 
unrelated trade or business'' under section 512(b)(4), (13), and (17).
    However, the Treasury Department and the IRS recognized that some 
interpretations of section 512(a)(6) might impose a significant burden 
on exempt organizations required to include certain income in UBTI 
under section 512(b)(4), (13), or (17), and,

[[Page 23184]]

consequently, that aggregating income included in UBTI under these 
sections may be appropriate in certain circumstances. In Notice 2018-
67, the Treasury Department and the IRS requested comments regarding 
the treatment under section 512(a)(6) of income that is not from a 
partnership, but that is included in UBTI under section 512(b)(4), 
(13), and (17).
    A few commenters disagreed with the statement that there is ``no 
distinction between `gross income derived by any organization from any 
unrelated trade or business . . . regularly carried on by it' under 
section 512(a)(1) and amounts included in UBTI `as an item of gross 
income derived from an unrelated trade or business' under section 
512(b)(4), (13), and (17).'' These commenters argued that amounts 
included as items of gross income from an unrelated trade or business 
under section 512(b)(4), (13), and (17) should not be subject to 
section 512(a)(6) because such amounts are treated as income from 
investment activities and not as gross income from a trade or business.
    As discussed in section 2.a of this preamble, investment activities 
are treated as a separate unrelated trade or business for purposes of 
section 512(a)(6). Furthermore, section 512(b)(4), (13), and (17) each 
provide that income described in the provision is income derived from 
an unrelated trade or business. Accordingly, amounts included in UBTI 
under section 512(b)(4), (13), and (17) contribute to the determination 
of whether an organization has more than one unrelated trade or 
business and thus is subject to section 512(a)(6). After considering 
the comments received and the legislative history of each section, the 
Treasury Department and the IRS propose the following treatment of 
amounts included in UBTI under section 512(b)(4), (13), and (17) for 
purposes of section 512(a)(6).
a. Unrelated Debt-Financed Income
    In the case of debt-financed property (as defined in section 514), 
section 512(b)(4) requires an exempt organization to include, as an 
item of gross income from an unrelated trade or business, any unrelated 
debt-financed income, determined under section 514, with respect to 
such debt-financed property, even if an amount received with respect to 
the debt-financed property would ordinarily be excluded from the 
calculation of UBTI under section 512(b)(1), (2), (3), or (5). Section 
514(b)(1) defines the term ``debt-financed property'' as any property 
that is held to produce income and with respect to which there is 
acquisition indebtedness. Section 1.514(b)-1(a) clarifies that property 
held to produce income includes rental real estate, tangible personal 
property, and corporate stock. Section 1.514(a)-1(a) provides that the 
calculation of debt-financed taxable income is made on a property-by-
property basis. Thus, as stated in Notice 2018-67, one interpretation 
of sections 512(b)(4) and 514 and the regulations thereunder could 
require each debt-financed property to be treated as a separate 
unrelated trade or business under section 512(a)(6).
    However, the amounts excluded from the calculation of UBTI under 
section 512(b)(1), (2), (3), and (5) that are included in UBTI if 
subject to acquisition indebtedness include dividends, interest, 
annuities, royalties, rents, and capital gains. As acknowledged in 
section 2.a of this preamble, dividends, interest, annuities, 
royalties, rents, and capital gains generally are income from 
investment activities. Additionally, section 514 generally does not 
apply to any property to the extent that the income from such property 
is taken into account in computing the gross income of any unrelated 
trade or business (except in the case of capital gains from such 
property that would be excluded under section 512(b)(5)). See section 
514(b)(1)(B). Accordingly, the Treasury Department and the IRS agree 
with commenters that debt-financed properties (as defined in section 
514) generally are held for investment purposes. Therefore, to reduce 
the reporting burden on exempt organizations, the proposed regulations 
include all the UBTI under section 512(b)(4) from an exempt 
organization's debt-financed property or properties (and not just its 
unrelated debt-financed income arising in connection with a QPI as 
provided in Notice 2018-67) in the list of ``investment activities'' 
treated as a separate unrelated trade or business for purposes of 
section 512(a)(6).
    The Treasury Department and the IRS note that rental of certain 
property is a trade or business that must be identified using NAICS 2-
digit codes. For example, section 512(b)(3)(B) provides that rents from 
real and personal property are included in UBTI if more than 50 percent 
of the total rent received or accrued under a lease is attributable to 
personal property. Also, Sec.  1.512(b)-1(c)(5) indicates that payments 
for the use or occupancy of rooms or other space where services are 
also rendered to the occupant do not constitute rent from real 
property. Sections 512(b)(4) and 514 do not apply where such real or 
personal property is purchased with debt financing because the rents 
from these properties will have already been included in UBTI. See 
section 514(b)(1)(B) (providing that, except in the case of income 
excluded under section 512(b)(5), the term ``debt-financed property'' 
does not include any property to the extent that the income from such 
property is taken into account in computing the gross income of any 
unrelated trade or business); Sec.  1.514(b)-1(b)(2)(i). Accordingly, 
because rent from such real and personal property is included in UBTI, 
the exempt organization must identify such unrelated trade or business 
using the NAICS 2-digit code for real estate rental and leasing (53).
b. Specified Payments Received From Controlled Entities
    Notwithstanding section 512(b)(1), (2), and (3), 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 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.
    Commenters argued that amounts included in UBTI under section 
512(b)(13) should be included with an exempt organization's other 
investment activities. Presumably, this argument rests on the premise 
that the types of payments described in section 512(b)(13)(C)--that is, 
any interest, annuity, royalty, or rent--might be characterized 
generally as ``investment income.'' However, treating specified 
payments included in UBTI as income from an exempt organization's 
investment activities 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

[[Page 23185]]

``enable[ ] the taxable [subsidiary] to escape nearly all of its income 
taxes''). Consistent with that purpose, section 512(b)(13)(A) treats a 
specified payment 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).'' Section 512(b)(13) thus views such payments as 
stemming from the trade or business activity of the controlled entity 
rather than from the ``investment activity'' of the controlling 
organization.
    Further, 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. In general, section 
512(b)(13)(D) defines the term ``control'' as ownership of more than 50 
percent of the stock in a corporation, of the profits interests or 
capital interests in a partnership, or, in any other case, of the 
beneficial interests in an entity. The section 318 constructive 
ownership rules apply when determining the ownership of stock in a 
corporation, and similar principles apply in determining the ownership 
of interests in other types of entities. As generally discussed in 
section 2.d.iii.B of this preamble, control over an organization 
suggests that such interest is not part of the exempt organization's 
investment activities. Accordingly, even though the controlled entity's 
trades or businesses might not be attributed to the controlling 
organization (such as in the case of a controlled corporation), the 
control itself indicates that the controlled entity is held as part of 
a trade or business other than the controlling organization's 
investment activities.
    The plain language of section 512(b)(13) could require each 
specified payment to be treated as a separate unrelated trade or 
business under section 512(a)(6) because section 512(b)(13) requires an 
exempt organization to include such payment as an item of gross income 
derived from ``an'' unrelated trade or business. However, this 
treatment may impose a considerable administrative burden on 
controlling organizations that receive numerous specified payments from 
controlled entities, such as may be the case with a university or 
hospital system. Therefore, these proposed regulations permit an exempt 
organization to aggregate all the specified payments received from a 
controlled entity and to treat the payments as received from a single 
separate unrelated trade or business for purposes of section 512(a)(6).
    In particular, the proposed regulations provide 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 
payments from each controlled entity are treated as separate unrelated 
trades or businesses. For example, a controlling organization that 
receives rental payments from two controlled entities will have two 
separate unrelated trades or businesses, one for each controlled 
entity. The specified payments from a controlled entity will be treated 
as gross income from one unrelated 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.
c. Certain Amounts Derived From 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 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.
    Commenters have argued that insurance income included in UBTI under 
section 512(b)(17) belongs in the category of investment activities. 
However, like section 512(b)(13), 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 probably is not a part of the exempt organization's 
otherwise appropriately characterized investment activities. In 
particular, section 951(a)(1)(A) applies only if a foreign corporation 
is a controlled foreign corporation, which section 957 defines as any 
foreign corporation if more than 50 percent of the total combined 
voting power of all classes of stock of such corporation entitled to 
vote or the total value of the stock of such corporation is owned, 
directly, indirectly, or constructively by United States shareholders. 
Section 951(b) defines ``United States shareholder,'' with respect to 
any foreign corporation, as a United States person (within the meaning 
of section 7701(a)(30), which includes domestic corporations and 
certain trusts) who owns, directly, indirectly, or constructively, 10 
percent or more of the total combined voting power of all classes of 
stock entitled to vote of such foreign corporation or 10 percent or 
more of the total value of shares of all classes of stock of such 
foreign corporation.
    Furthermore, 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. Section 501(m) provides 
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). However, rather than treating insurance 
income from each controlled foreign corporation as income from a 
separate unrelated trade or business, these proposed regulations treat 
the provision of insurance by all controlled foreign corporations as 
one trade or business, regardless of whether such insurance income is 
received from more than one controlled foreign corporation. This 
approach is consistent with how NAICS would categorize the provision of 
insurance (52--Finance and Insurance).
    However, the proposed regulations do 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 
controlled foreign corporation, 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 is not attributed to 
the exempt organization

[[Page 23186]]

and thus is distinguishable from any commercial-type insurance activity 
engaged in directly by the exempt organization.

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

    An S corporation is a ``small corporation'' that may elect to be 
treated under a simplified tax regime that acts as a hybrid between the 
rules for corporations and the rules for pass-through entities. In 
general, the items of income and loss of an S corporation are taxed 
directly to the shareholders of that corporation. See section 1366(a). 
The types of exempt organizations that are permitted to be shareholders 
of an S corporation are described in section 1361(c)(2)(A)(vi) and (6). 
Exempt organizations permitted to be S corporation shareholders include 
qualified retirement plans, exempt organizations described in section 
501(c)(3), and certain IRAs (including, subject to the limitation 
described more specifically in 1361(c)(2)(A)(vi), an IRA designated as 
a Roth IRA under section 408A).
    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 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.
    Notice 2018-67 did not address, or request comments on, the 
treatment of amounts taken into account in computing UBTI under section 
512(e). Nonetheless, one commenter recommended that UBTI from an S 
corporation should be treated as income from a single trade or business 
regardless of the manner in which such income is earned by the S 
corporation. The commenter stated that having to separate all the 
income producing activities of an S corporation would be extremely 
burdensome. Accordingly, the commenter recommended that all income from 
an S corporation should be aggregated with the income from QPIs to 
ensure similar treatment of all pass-through entities. In the 
alternative, the commenter suggested combining all income from S 
corporations in which the exempt organization shareholder owns less 
than 50 percent of the shares with the income from QPIs.
    The proposed regulations generally provide that each S corporation 
interest will be treated as an interest in a separate unrelated trade 
or business, which is consistent with the language of section 
512(e)(1)(A). Accordingly, if an exempt organization has two S 
corporation interests (that are not qualifying S corporation interests 
described in section 4.a of this preamble), the exempt organization 
will report two trades or businesses, one for each S corporation 
interest. The treatment of each S corporation interest as one trade or 
business for purposes of section 512(a)(6) is similar to the treatment 
of specified payments from a controlled entity under section 
512(b)(13). Furthermore, the Treasury Department and the IRS view this 
treatment as best serving the purposes of section 512(a)(6).
    Section 512(e) provides two different rules: One for items of 
income, loss, or deduction taken into account under section 1366(a) and 
one for any gain or loss on the disposition of S corporation stock. 
Although these amounts could be treated as separate unrelated trades or 
businesses for purposes of section 512(a)(6) due to the disparate 
methods of inclusion in the language of section 512(e), such treatment 
would artificially divide each S corporation interest into two trades 
or businesses. The separate enumeration of the gain or loss on the 
disposition of S corporation stock serves to override section 
512(b)(5), which would otherwise exclude such gain or loss from the 
calculation of UBTI, and not to indicate the existence of a separate 
unrelated trade or business. Accordingly, the proposed regulations 
provide 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 and loss on the disposition of S corporation stock.
a. Qualifying S Corporation Interests
    Notwithstanding the general rule that each S corporation interest 
is treated as a separate unrelated trade or business, the Treasury 
Department and the IRS recognize that an exempt organization may hold S 
corporation stock for different purposes, including investment 
purposes. Additionally, the look-through treatment of an S corporation 
is similar to the look-through treatment of a partnership. As discussed 
in section 2.d of this preamble, these proposed regulations permit the 
aggregation of QPIs to mitigate the burden on exempt organizations with 
interests in multi-tier partnerships. Similarly, the proposed 
regulations permit an exempt organization to aggregate its UBTI from an 
S corporation interest with its UBTI from other investment activities 
if the exempt organization's stock ownership (by percentage of stock 
ownership) in the S corporation meets the requirements provided in the 
de minimis test or the control test for ``qualifying partnership 
interests.'' As such, if an exempt organization owns (by percentage of 
stock ownership) 2 percent or less of the stock in an S Corporation, 
or, if it owns 20 percent or less of the stock in such S corporation 
and meets the facts and circumstances requirements under the second 
prong of the control test, then such S corporation interest will be a 
``qualifying S corporation interest'' and can be aggregated with other 
investment activities. When determining an exempt organization's 
percentage ownership of stock in an S corporation, the exempt 
organization must apply the same rules for combining related interests 
that are used to determine whether a partnership interest is a QPI. An 
exempt organization may rely on the Schedule K-1 (Form 1120-S) that the 
exempt organization receives from the S corporation when determining 
its percentage ownership of the stock in such S corporation.
b. Employee Stock Ownership Plans
    Section 512(e)(3) provides that section 512(e) does not apply to 
employer securities (within the meaning of section 409(l)) held by an 
employee stock ownership plan (ESOP) described in section 4975(e)(7). 
ESOPs holding S corporation stock (``S corporation ESOPs'') are subject 
to the limits imposed by section 409(p) on the concentration of S 
corporation ownership. Ownership includes shares allocated to the 
accounts of ESOP participants. Failing to meet the requirements of 
section 409(p) will result in the imposition of an excise tax on the S 
corporation and other adverse consequences to the ESOP and certain 
individuals. Although section 512(e) generally does not apply to S 
corporation ESOPs, the application of section 409(p) to an S 
corporation ESOP might give rise to UBTI. The primary means of avoiding 
a section 409(p) failure is for the S corporation ESOP to transfer some 
of its S corporation shares

[[Page 23187]]

to a non-ESOP portion of the plan or to another qualified retirement 
plan of the employer. See Sec.  1.409(p)-1(b)(2)(v)(A)-(B). Such a 
transfer may result in a significant number of S corporation shares 
being held by the non-ESOP portion of an S corporation ESOP or by 
another section 401(a) plan (``transferee plan''). The transferred 
shares, no longer held in an ESOP, are not described in section 
512(e)(3). Accordingly, the transferee plan treats the S corporation 
interest resulting from the transfer of the S corporation shares as an 
interest in an unrelated trade or business under the general rule of 
section 512(e)(1) and takes the amounts described in section 
512(e)(1)(B) into account in computing UBTI. The Treasury Department 
and IRS anticipate that a transferee plan is not likely to have more 
than one S corporation interest. However, whether such S corporation 
interest may be aggregated with the investment activities of the 
transferee plan will depend on whether the S corporation interest is a 
qualifying S corporation interest. The Treasury Department and the IRS 
request comments on this issue.

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

    As noted in the Background section, section 512(a)(3) provides a 
special definition of UBTI for social clubs, VEBAs, and SUBs. Section 
512(a)(3)(A) defines UBTI, in part, as ``gross income (excluding exempt 
function income).'' ``Gross income'' under section 61(a) includes 
``gains derived from dealings in property,'' ``interest,'' ``rents,'' 
``royalties,'' ``dividends,'' and ``annuities.'' See section 61(a)(3) 
through (8). Consistent with section 61(a), the gross income subject to 
the unrelated business income tax under section 512(a)(3) generally 
includes interest, annuities, dividends, royalties, rents, and capital 
gains because the modifications in section 512(b)(1), (2), (3), and (5) 
that exclude such amounts from UBTI for organizations subject to 
section 512(a)(1) are not available under section 512(a)(3). 
Accordingly, social clubs, VEBAs, and SUBs generally must include 
interest, dividends, royalties, rents, and capital gains in UBTI unless 
such amounts may be set aside for a purpose described in section 
512(a)(3)(B)(i) or (ii) and therefore would be exempt function income 
excluded from UBTI under section 512(a)(3)(A).
    Section 512(a)(3)(B) defines ``exempt function income'' as (1) 
``the gross income from dues, fees, charges, or similar amounts paid by 
members of the organization as consideration for providing such members 
or their dependents or guests goods, facilities, or services in 
furtherance of the purposes constituting the basis for the exemption of 
the organization;'' and (2) ``all income (other than an amount equal to 
the gross income derived from any unrelated trade or business regularly 
carried on by such organization computed as if the organization were 
subject to [section 512(a)(1)]) which is set aside'' for one of the 
purposes described in section 512(a)(3)(B)(i) or (ii). Such amounts set 
aside include reasonable costs of administration directly connected 
with a purpose described in section 512(a)(3)(B)(i) or (ii).
    Section 512(a)(3)(B)(i) includes in exempt function income amounts 
set aside for a purpose specified in section 170(c)(4), that is, 
exclusively for religious, charitable, scientific, literary, or 
educational purposes. In the case of a VEBA or SUB, section 
512(a)(3)(B)(ii) includes in exempt function income amounts set aside 
to provide for the payment of life, sick, accident, or other benefits. 
Section 512(a)(3)(E) limits the amounts that may be set aside under 
section 512(a)(3)(B)(ii). In general, section 512(a)(3)(E)(i) provides 
that a set aside for any purpose described in section 512(a)(3)(B)(ii) 
may be taken into account as exempt function income only to the extent 
that such set aside does not result in an amount of assets set aside 
for such purpose in excess of the account limit determined under 
section 419A (without regard to section 419A(f)(6)) for the taxable 
year (not taking into account any reserve described in section 
419A(c)(2)(A) for post-retirement medical benefits).
    In determining what income may be set aside under 512(a)(3)(B)(i) 
or (ii), the income available is ``all income (other than an amount 
equal to the gross income derived from any unrelated trade or business 
regularly carried on by such organization computed as if the 
organization were subject to [section 512(a)(1)]).'' This parenthetical 
language, by referencing ``the gross income from any unrelated trade or 
business computed as if the organization was subject to [section 
512(a)(1)],'' pulls in the modifications of section 512(b) applicable 
to that computation. Accordingly, amounts excluded from UBTI under 
section 512(a) via the modifications in section 512(b) (such as 
interest, dividends royalties, rents, and capital gains) are available 
to be set aside for the purposes of section 512(a)(3)(B)(i) and (ii) 
and may constitute exempt function income, subject to the other 
applicable limitations.
    For example, if a social club has interest and dividends, and does 
not set aside any amount of such interest or dividends for a purpose 
specified in section 170(c)(4), then the full amount of the interest 
and dividends would constitute UBTI under section 512(a)(3). However, 
if the social club sets aside any amount of the interest or dividends 
for a purpose specified in section 170(c)(4), the amount of the 
interest and dividends set aside would be excluded from the calculation 
of UBTI under section 512(a)(3)(B)(i) as exempt function income 
(provided that such amount set aside actually is used for a purpose 
specified in section 170(c)(4)). Similarly, a VEBA with interest and 
dividends may set aside amounts to provide for the payment of life, 
sick, accident, or other benefits, subject to the limitations of 
section 512(a)(3)(E).\4\ Such amount set aside will be excluded from 
UBTI as exempt function income (provided that such amount actually is 
used to provide for the payment of benefits).
---------------------------------------------------------------------------

    \4\ See Treas. Reg. Sec.  1.512(a)-5(c).
---------------------------------------------------------------------------

    Notice 2018-67 anticipated that the rules issued regarding how an 
exempt organization identifies separate trades or businesses for 
purposes of section 512(a)(6)(A) generally would apply under both 
section 512(a)(1) and (3). Nonetheless, because social clubs, VEBAs, 
and SUBs are taxed differently than other exempt organizations under 
section 511, Notice 2018-67 requested comments regarding any additional 
considerations that should be given to how section 512(a)(6) applies 
within the context of section 512(a)(3), and, in particular, how the 
income from investment activities of these organizations should be 
treated for purposes of section 512(a)(6).
    Commenters generally agreed that social clubs should be subject to 
the same rules as exempt organizations subject to section 512(a)(1) 
when determining whether the social club is subject to section 
512(a)(6). A social club therefore would identify its unrelated trades 
or businesses using NAICS codes and treat the income derived from 
investment activities as a separate unrelated trade or business. Only 
one commenter addressed how section 512(a)(6) should apply to VEBAs. 
This commenter suggested that VEBAs would not be subject to section 
512(a)(6) because the unrelated trade or business activities of the 
VEBA could be identified under one NAICS 6-digit code--the code for 
health and welfare funds (525120). However, as explained in section 
1.a.i of this preamble, an exempt organization cannot use a

[[Page 23188]]

NAICS 2-digit code describing the activities the conduct of which is 
substantially related to the exercise or performance by such exempt 
organization of the purpose or function constituting the basis for its 
exemption under section 501. No commenter addressed how section 
512(a)(6) should apply to a SUB.
    Consistent with the statement made in Notice 2018-67, the Treasury 
Department and the IRS have determined that a social club, VEBA, or SUB 
will 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) except as discussed in sections 5.a and b of this preamble.
a. Investment Activities
    As discussed in section 2 of this preamble, the proposed 
regulations treat certain ``investment activities'' (that is, QPIs, 
qualifying S corporation interests, and debt-financed property or 
properties) as a separate unrelated trade or business for purposes of 
section 512(a)(6) and the proposed regulations. Thus, a social club, 
VEBA, or SUB generally will treat the investment activities 
specifically listed in the proposed regulations as a separate unrelated 
trade or business for purposes of section 512(a)(6). Nonetheless, 
because UBTI is defined differently for social clubs, VEBAs, and SUBs, 
the proposed regulations clarify 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 specific 
amounts discussed in sections 5.a.i. and ii of this preamble. The 
Treasury Department and the IRS request comments regarding any 
unintended consequences, in areas other than the unrelated business 
income tax, resulting from the treatment of investment activity as an 
unrelated trade or business for purposes of section 512(a)(6) for VEBAs 
and SUBs.
i. Amounts Described in Section 512(b)(1), (2), (3), and (5)
    Because the modifications in section 512(b)(1), (2), (3), and (5) 
are not available under section 512(a)(3), social clubs, VEBAs, and 
SUBs generally must include interest, dividends, royalties, rents, and 
capital gains in UBTI under section 512(a)(3)(A) unless such amounts 
are set aside for a purpose described in section 512(a)(3)(B)(i) or 
(ii).\5\ As stated in section 2.a of this preamble, interest, 
dividends, royalties, rents, and capital gains generally are considered 
income from investment activities. Accordingly, the proposed 
regulations provide 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).
---------------------------------------------------------------------------

    \5\ As explained in the introduction to section 5 of this 
preamble, 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).
---------------------------------------------------------------------------

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, 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 be in excess of the set aside limit under section 
512(a)(3)(E) and any amount in excess of this limit is nonexempt 
function income included in UBTI under section 512(a)(3)(A).
    As discussed in section 5.a.i of this preamble, the amounts that 
may be set aside under section 512(a)(3)(B)(i) or (ii) are part of the 
social club, VEBA, or SUB's investment activities. Therefore, the 
proposed regulations also provide 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 any amount in excess 
of the set aside limit described in section 512(a)(3)(E).
b. Social Club Activities
i. Limitation on Investment Activities
    Notice 2018-67 provided that the interim and transition rules for 
certain partnership interests did not apply to social clubs described 
in section 501(c)(7), pending receipt of comments and additional 
consideration of the issues specific to social clubs. 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. Accordingly, consistent 
with Notice 2018-67, the proposed regulations provide 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. Thus, the Treasury Department and the 
IRS do not consider the administrative convenience rationale supporting 
the QPI rule as relevant for social clubs.
ii. Nonmember Activities
    Two commenters 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). One of these commenters argued that a 
social club could not easily separate its nonmember activities into 
separate unrelated trades or businesses because social clubs do not 
generally maintain separate books and records for the various locations 
in which sales to nonmembers may occur, such as in dining facilities or 
retail stores. The other commenter added 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.
    As generally discussed in section 5 of this preamble, 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 section 1.a.i of this preamble, a social club cannot use

[[Page 23189]]

the NAICS 2-digit code generally describing social clubs (71) to 
describe all its non-member 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 non-member income, such as greens fees, other NAICS codes are 
more appropriate to describe other non-member 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 section 1 of 
this preamble like an exempt organization subject to section 512(a)(1).
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).'' For example, one commenter 
requested guidance on how to treat income from social club events that 
are not anticipated to reoccur. The commenter provides as an example 
the hosting of a professional golf tournament when similar tournaments 
are not held in the same location on an annual basis. The commenter 
suggested that events such that occur once, or seldom, in the life of a 
social club, should be classified as a single trade or business under 
section 512(a)(6).
    As explained in section 1.a of this preamble, these proposed 
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). The Treasury Department and the IRS request 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).
iv. Activities Without a Profit Motive
    One commenter requested that the Treasury Department and the IRS 
clarify that nonmember activities conducted without intent to profit 
are not unrelated trades or businesses. The Treasury Department and the 
IRS do not address this comment in the proposed regulations because it 
is adequately addressed by existing precedent. See, e.g., Portland Golf 
Club, 497 U.S. at 164 (1990); Rev. Rul. 81-69, 1981-1 C.B. 351.

6. Total UBTI and the Charitable Contribution Deduction

    Consistent with section 512(a)(6)(B), the proposed regulations 
provide that the total UBTI of an exempt 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 the proposed regulations), less the specific deduction under 
section 512(b)(12). The proposed regulations also state that, for 
purposes of calculating an exempt organization's total UBTI, the UBTI 
with respect to any separate unrelated trade or business identified 
under the proposed regulations shall not be less than zero. See section 
512(a)(6)(C).
    Additionally, section 512(b)(10) and (11) permits exempt 
organizations to take the deduction under section 170 for charitable 
contributions whether or not the deduction is directly connected with 
the carrying on of an unrelated trade or business. The deduction is 
computed under section 170 except as otherwise provided in section 
512(b)(10) and (11) and the Treasury regulations thereunder. For an 
exempt organization described in section 511(a), the deduction allowed 
by section 170 is limited to 10 percent of the exempt organization's 
UBTI computed without the benefit of section 512(b)(10). For a trust 
described in section 511(b), the deduction allowed by section 170 is 
limited as prescribed by section 170(b)(1)(A) and (B) determined with 
reference to UBTI computed without the benefit of section 512(b)(11).
    At least one commenter recommended that the charitable contribution 
deductions permitted under section 512(b)(10) and (11) be taken against 
total UBTI calculated under section 512(a)(6)(B) rather than being 
allocated among unrelated trades or businesses. Additionally, the JCT 
stated that ``[i]t is not intended that an exempt organization that has 
more than one unrelated trade or business be required to allocate its 
deductible charitable contributions among its various unrelated trades 
or businesses.'' General Explanation, at 293 n.1377. The Treasury 
Department and the IRS agree. Thus, these proposed regulations clarify 
in new Sec.  1.512(b)-1(g)(4) 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).
    Under section 170(d)(1)(A), exempt organizations generally are 
permitted to carry over charitable contributions that exceed the 
organization's contribution base in a taxable year. Section 
170(d)(1)(B) provides a special rule when an exempt organization has 
both NOL carryovers and excess contributions. In the case of an exempt 
organization with more than one unrelated trade or business, the 
function of this special rule is complicated by the requirement in 
section 512(a)(6)(A) to calculate NOLs separately with respect to each 
trade or business (see section 7 of this preamble). The Treasury 
Department and the IRS recognize that an ordering rule may be necessary 
to clarify how the special rule in section 170(d)(1)(B) operates when 
an exempt organization has NOL carry overs in more than one unrelated 
trade or business. Accordingly, the Treasury Department and the IRS 
request comments on this issue.

7. NOLs and UBTI

a. NOL Deduction Calculated Separately With Respect to Each Trade or 
Business
    Section 512(b)(6), which was not changed by the TCJA, generally 
allows an exempt organization subject to the unrelated business income 
tax under section 511, including an exempt organization with more than 
one unrelated trade or business, to take the NOL deduction provided in 
section 172. Section 512(b)(6)(A) states that the NOL for any taxable 
year, the amount of the NOL carryback or carryover to any taxable year, 
and the NOL deduction for any taxable year shall be determined under 
section 172 without taking into account any amount of income or 
deduction that is excluded under section 512(b) in computing UBTI. For 
example, a loss attributable to an unrelated trade or business is not 
to be reduced by reason of the receipt of dividend income. See Sec.  
1.512(b)-1(e)(1). An NOL carryover is allowed only from

[[Page 23190]]

a taxable year for which the taxpayer is subject to the provisions of 
section 511, or a corresponding provision of prior law. See section 
512(b)(6)(B); Sec.  1.512(b)-1(e)(3).
    Notice 2018-67 explained that section 512(a)(6) changes how an 
exempt organization with more than one unrelated trade or business 
calculates and takes NOLs into account with respect to a trade or 
business. Specifically, section 512(a)(6)(A) requires such an exempt 
organization to calculate UBTI, ``including for purposes of determining 
any NOL deduction,'' separately with respect to each trade or business 
for taxable years beginning after December 31, 2017. The legislative 
intent behind this change is to allow an NOL deduction ``only with 
respect to a trade or business from which the loss arose.'' H.R. Rep. 
No. 115-466, at 547. Accordingly, consistent with the language of 
section 512(a)(6)(A) and legislative intent, the proposed regulations 
provide that 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. The proposed regulations clarify that, if an exempt 
organization has more than one unrelated trade or business, Sec.  
1.512(b)-1(e), which explains the application of section 172 within the 
context of the unrelated business income tax, applies separately with 
respect to each such unrelated trade or business. Additionally, the 
proposed regulations add a new paragraph to Sec.  1.512(b)-1(e) that 
refers an exempt organization with more than one unrelated trade or 
business to new proposed Sec.  1.512(a)-6(h) regarding the computation 
of the NOL deduction.
b. Coordination of NOLs
    To preserve NOLs from tax years prior to the effective date of the 
TCJA, Congress created a special transition rule for NOLs arising in a 
taxable year beginning before January 1, 2018 (``pre-2018 NOLs''). 
Section 13702(b)(2) of the TCJA provides that section 512(a)(6)(A) does 
not apply to pre-2018 NOLs; rather, pre-2018 NOLs are taken against the 
total UBTI calculated under section 512(a)(6)(B). However, when an 
exempt organization has pre-2018 NOLs, which are subject to a carry-
forward limitation, and NOLs arising in a taxable year beginning after 
December 31, 2017 (``post-2017 NOLs''), which are not, a question 
arises regarding the order in which such losses should be taken.
    In Notice 2018-67, the Treasury Department and the IRS noted that 
section 512(a)(6) may have changed the order in which an organization 
would ordinarily take losses. For example, if section 512(a)(6) is read 
as a more specific ordering rule for purposes of calculating and taking 
the NOL deduction than the one found in section 172, post-2017 NOLs 
would be calculated and taken before pre-2018 NOLs because the UBTI 
with respect to each separate unrelated trade or business is calculated 
under section 512(a)(6)(A) before calculating total UBTI under section 
512(a)(6)(B). Accordingly, Notice 2018-67 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. Notice 2018-67 also requested comments on the ordering of pre-
2018 and post-2017 NOLs and the potential treatment of pre-2018 NOLs 
that may expire in a given tax year if not taken before post-2017 NOLs.
    In response to Notice 2018-67, several commenters addressed 
possible ordering rules for organizations subject to section 512(a)(6). 
These commenters noted that the language should not alter the ordering 
rules under section 172 such 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 language of section 512(a)(6) and section 13702(b) of the TCJA 
do not alter the ordering rules under section 172. Accordingly, the 
proposed regulations provide that an exempt organization with both pre-
2018 and post-2017 NOLs will deduct its pre-2018 NOLs from its total 
UBTI under section 512(a)(6)(B) before deducting any post-2017 NOLs 
with regard to a separate unrelated trade or business from the UBTI 
from such unrelated trade or business. The proposed regulations clarify 
that pre-2018 NOLs are deducted from total UBTI in the manner that 
results in maximum utilization of the pre-2018 NOLs in a taxable year.
c. Legislative Changes to Section 172
    At the same time Congress added section 512(a)(6), it also made 
extensive changes to section 172. These changes included limiting the 
NOL deduction to 80 percent of taxable income, prohibiting the 
carryback of NOLs (except for certain farming losses and in the case of 
certain insurance companies), and allowing the indefinite carryover of 
NOLs. Id. However, shortly before publication of these proposed 
regulations, Congress enacted the Coronavirus Aid, Relief, and Economic 
Security Act, Public Law 116-136, 134 Stat. 281 (2020) (CARES Act). 
Section 2303 of the CARES Act temporarily repeals the 80 percent income 
limitation and permits the carryback of NOLs arising in taxable years 
beginning after December 31, 2017, and before January 1, 2021, to each 
of the five taxable years preceding the taxable year of such loss. The 
Treasury Department and the IRS will further consider how the changes 
to section 172 made by the CARES Act affect the calculation of UBTI 
under section 512(a)(6) and may issue additional guidance on the issue.

8. Form 990-T

    One commenter suggested updating the Form 990-T to provide space 
for an exempt organization to disclose and describe the method chosen 
for identifying the separate unrelated trades or businesses being 
reported on Form 990-T. This commenter recommended either the addition 
of a ``miscellaneous schedule'' similar to Schedule O, ``Supplemental 
Information to Form 990 or 990-EZ,'' of the Form 990, ``Return of 
Organization Exempt from Income Tax,'' or the inclusion of space on the 
schedules to the Form 990-T to make such disclosure. This commenter 
also recommended that the IRS update the instructions to the Form 990-T 
either to include a more complete list of applicable NAICS codes or to 
state clearly where additional codes may be found. The Treasury 
Department and the IRS recognize that changes to the Form 990-T and 
related schedules may be necessary. In particular, the Treasury 
Department and the IRS recognize that additional instructions are 
required regarding how separate unrelated trades or businesses 
identified under the special rules (rather than NAICS)--such as for 
investment activities (see section 2 of this preamble), inclusions of 
income derived from certain controlled entities (see section 3 of this 
preamble), and non-qualifying S corporation interests (see section 4 of 
this preamble)--are identified on Form 990-T and related schedules. 
Accordingly, the IRS intends to update the Form 990-T and related 
schedules, and the instructions thereto, as appropriate.

9. Individual Retirement Accounts

    As previously discussed in the Background section of this preamble, 
section 513(b) provides a special definition of ``unrelated trade or 
business'' for a qualified retirement plan or for a trust that is 
exempt from tax under section 501(c)(17) (SUB). Section 513(b) defines 
``unrelated trade or business,'' as any trade or business

[[Page 23191]]

regularly carried on by such trust or by a partnership of which it is a 
member.
    Notice 2018-67 stated in a footnote that, because IRAs described in 
section 408 are, under section 408(e), subject to the tax imposed by 
section 511, and IRAs are most similar to qualified retirement plans, 
it is reasonable to apply the definition of ``unrelated trade or 
business'' described in section 513(b) to IRAs. The footnote stated 
that the Treasury Department and the IRS intended to provide that the 
section 513(b) definition of unrelated trade or business should be used 
for IRAs subject to the unrelated business income tax in section 511 
pursuant to section 408(e). Consistent with this statement, the 
proposed regulations add a new paragraph to Sec.  1.513-1 clarifying 
that the section 513(b) definition of ``unrelated trade or business'' 
applies to IRAs. Accordingly, Sec.  1.513-1(f) provides that an IRA 
will apply the definition of ``unrelated trade or business'' in section 
513(b) when determining whether it has more than one unrelated trade or 
business within the meaning of section 512(a)(6). The proposed 
regulations make corresponding changes to Sec.  1.513(b)-1(a) to 
account for the new paragraph added at Sec.  1.513(b)-1(f).

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

    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). Accordingly, an inclusion of subpart F income generally is 
excluded from the calculation of UBTI under section 512(b)(1). Notice 
2018-67 explained that Congress approved the IRS's long-standing 
position when Congress enacted section 512(b)(17). Furthermore, Notice 
2018-67 provided that an inclusion of GILTI under section 951A(a) 
should be 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) and 
therefore would be treated as a dividend that generally is excluded 
from UBTI. Two commenters explicitly agreed with these conclusions and 
one commenter requested that the Treasury Department and the IRS revise 
the Treasury Regulations consistent with these conclusions. 
Accordingly, the proposed regulations revise 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 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).

11. Public Support

    A question has arisen regarding whether the enactment of section 
512(a)(6) impacts the calculation of public support under sections 
509(a)(1) and 170(b)(1)(A)(vi) and under section 509(a)(2). Exempt 
organizations described in section 501(c)(3) that are classified as 
publicly supported charities under these sections must calculate public 
support annually on Form 990, Schedule A, ``Public Charity Status and 
Public Support.'' In general, public support is expressed as a 
percentage of support from certain public sources over total support. 
See Sec.  1.170A-9(f) (definition of section 170(b)(1)(A)(vi) 
organization); Sec.  1.509(a)-3 (publicly supported organizations).
    Section 512(a)(6) potentially impacts two aspects of the public 
support test. First, section 512(a)(6) potentially impacts the 
calculation of total support under section 509(d), a number which is 
used for purposes of both section 509(a)(1) and (2). Specifically, 
section 509(d)(3) includes, in the calculation of total support, the 
organization's net income from unrelated business activities, whether 
or not such activities are carried on regularly as a trade or business. 
Although section 509(d)(3) does not specifically cross-reference 
section 512, the term ``unrelated business activities'' can be read 
broadly to include, but not be limited to, UBTI within the meaning of 
section 512. If this is the case, then an organization with more than 
one unrelated trade or business could be required to apply section 
512(a)(6) in determining its total support, which may increase its 
amount of total support because the losses from one unrelated trade or 
business cannot offset the gains from another unrelated trade or 
business.
    Second, section 512(a)(6) potentially impacts the not-more-than-
one-third support test under section 509(a)(2)(B), which requires 
calculation of the excess (if any) of the amount of UBTI (as defined in 
section 512) over the amount of the tax imposed by section 511. Unlike 
section 509(d)(3), which does not cross-reference section 512, the not-
more-than-one-third support test specifically cross-references section 
512. Accordingly, an organization with more than one unrelated trade or 
business could be required to apply section 512(a)(6) when determining 
whether it receives more than one-third of its support from non-public 
sources. If this is the case, application of section 512(a)(6) in this 
context may result in an increase in support received from non-public 
sources, again, because of the inability to use losses from one 
unrelated trade or business to offset income from another unrelated 
trade or business.
    If section 512(a)(6) applies in either context, organizations with 
more than one unrelated trade or business may have difficulty 
qualifying as publicly supported because of the potential increase in 
the calculated support from non-public sources as well as the potential 
increase in the calculated amount of total support. The Treasury 
Department and the IRS are not aware of any intent of Congress to 
change the public support test when enacting section 512(a)(6). 
Accordingly, the proposed regulations include revisions to 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 its unrelated 
trades or businesses within the meaning of section 512, for purposes of 
determining whether the organization is publicly supported. The 
Treasury Department and the IRS recognize that requiring different 
calculations for purposes of calculating public support and UBTI may 
impose a significant administrative burden on organizations with more 
than one unrelated trade or business. Accordingly, the Treasury 
Department and the IRS request comments regarding the application of 
section 512(a)(6) to the public support test.

12. Technical Correction of Inadvertently Omitted Regulatory Language

    These proposed regulations make a technical correction to Sec.  
1.512(a)-1(b). In 1967, the Treasury Department and the IRS published 
Sec.  1.512(a)-1 in the Federal Register (TD 6939, 32 FR 17660). 
Section 1.512(a)-1(b) explained that ``[e]xpenses, depreciation and 
similar items attributable solely to the conduct of an unrelated 
business are proximately and primarily related to that business and 
therefore qualify for deduction to the extent that they meet the 
requirements of section 162, section 167, or other relevant provisions 
of the Internal Revenue Code.'' An example followed this statement 
providing that, ``[t]hus, for example, salaries of personnel employed 
full-time in carrying on an unrelated business are directly connected 
with the conduct of the unrelated business and are deductible in 
computing unrelated business taxable income if they otherwise qualify 
for deduction under the requirements of section 162.''

[[Page 23192]]

    In 1975, the Treasury Department and the IRS revised Sec.  
1.512(a)-1(b) in regulations published in the Federal Register (TD 
7392, 40 FR 58639). The final regulations omitted from the example the 
following language: ``[t]hus, for example, salaries of personnel 
employed full-time in carrying on an unrelated business are directly.'' 
However, the final regulations as published in the Cumulative Bulletin 
(1976-1 CB 162) contained this language. Accordingly, the Treasury 
Department and the IRS have concluded that this language was 
inadvertently omitted from the final regulations in 1975 and are making 
a technical correction to the regulations. Therefore, the proposed 
regulations include the omitted language in Sec.  1.512(a)-1(b).

Proposed Applicability Dates

    These regulations are proposed to apply to taxable years beginning 
on or after the date these regulations are published in the Federal 
Register as final regulations. For taxable years beginning before the 
date these 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)(A). In addition, for these 
same taxable years, an exempt organization may rely on these proposed 
regulations in their entirety. Alternatively, for these same taxable 
years, an exempt organization may rely on the methods of aggregating or 
identifying separate trades or businesses provided in the Notice 2018-
67.

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.
    The proposed regulations have been designated as significant under 
Executive Order 12866 pursuant to the Memorandum of Agreement (April 
11, 2018) between the Treasury Department and the Office of Management 
and Budget (OMB) regarding review of tax regulations. The Office of 
Information and Regulatory Affairs (OIRA) has designated the proposed 
rulemaking as significant under section 1(b) of the Memorandum of 
Agreement. Accordingly, the proposed regulations have been reviewed by 
OMB. For purposes of Executive Order 13771, the proposed regulations 
are regulatory.
A. 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 
activity could be used to offset profits from another 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.
    Previously, on September 4, 2018, the Treasury Department and the 
IRS published Notice 2018-67, 2018-36 I.R.B. 409 (the Notice), 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 the Notice. The proposed regulations 
consider and respond to these comments.
    The proposed 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 proposed 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.
B. Baseline
    The Treasury Department has assessed the benefits and costs of the 
proposed regulations relative to a no-action baseline reflecting 
anticipated Federal income tax-related behavior in the absence of these 
regulations.
C. Affected Entities
    Prior tax law did not require reporting unrelated business income 
by separate activity so taxpayer counts are not available. However, the 
IRS estimates that less than 2 percent of exempt organizations would be 
affected. Potentially affected organizations are only those with more 
than one unrelated trade or business, a group likely to include 
colleges and universities, certain cultural organizations such as 
museums, and some tax-exempt hospitals.
    Presently it is not possible to obtain accurate counts of the 
number of exempt organizations potentially affected by the proposed 
regulations, because prior law did not require disaggregation of the 
separate sources of UBTI and therefore the IRS does not have access to 
this level of detail on UBTI. Approximately 1.4 million exempt 
organizations filed some type of information or tax return with the IRS 
for fiscal year 2018.\6\ 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

[[Page 23193]]

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.
---------------------------------------------------------------------------

    \6\ 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.\7\ 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 would be affected by 
the proposed regulations and that these would tend to be large 
educational or arts and cultural organizations.
---------------------------------------------------------------------------

    \7\ See Elizabeth Boris and Joseph Cordes, ``How the TCJA's New 
UBIT Provisions Will Affect Nonprofits,'' Urban Institute Research 
Report, January 2019.
---------------------------------------------------------------------------

D. Economic Analysis of NPRM
    The proposed regulations provide greater certainty to exempt 
organizations regarding how to compute UBTI and tax in response to the 
changes made by TCJA and adopt standards that balance the statutory 
intent of those changes and excessive burden that might result from 
some interpretations of such standards. 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 provisions of the NPRM for which 
economic analysis is helpful and provides a qualitative economic 
analysis of each one.
i. Identifying Separate Trades or Businesses
    As discussed above, 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 only used to 
offset income from the same unrelated trade or business. The Notice 
stated that the Treasury Department and the IRS were considering the 
use of NAICS codes to identify separate unrelated trades or businesses 
and, in the meantime, would consider the use of NAICS 6-digit codes to 
be reasonable for identifying 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.
    In the Notice, the Treasury Department and the IRS requested 
comments regarding methods to identify separate unrelated trades or 
businesses in general and the use of NAICS codes in particular. As 
discussed further below, several commenters pointed out potential 
difficulties in using NAICS 6-digit codes and suggested using NAICS 2- 
or 3-digit codes; that is, a higher level of aggregation of business 
activity. The proposed regulations allow the use of NAICS 2-digit 
codes, thereby addressing the concerns raised in comments received and 
reducing compliance burdens for exempt organizations with multiple 
similar types of business activity.
    Several commenters stated that the NAICS codes represented a 
workable system for identifying a separate unrelated trade or business. 
Not all commenters agreed as to what level of these codes should be 
used to group the various activities. Most of the commenters making 
recommendations on the NAICS codes rejected the use of NAICS 6-digit 
codes. These commenters noted that using NAICS 6-digit codes would 
result in significant compliance burden because an exempt organization 
would have to determine which of over 1,000 NAICS 6-digit codes most 
accurately describes its trades or businesses. Commenters noted that 
many NAICS 6-digit codes may apply to more than one trade or business 
activity or that no NAICS 6-digit code may exist to accurately describe 
a trade or business activity. Additionally, these commenters argued 
that 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. Some commenters noted they would have to incur the costs of 
changing their accounting systems so as to collect the information 
needed for separate NAICS 6-digit codes. These commenters suggested a 
range of code levels representing various levels of specificity from 2-
digits up to 4-digits.
    Reflecting comments on the Notice from potentially affected 
organizations, the Treasury Department and the IRS chose NAICS 2-digit 
codes for identifying unrelated trades or businesses. Allowing the use 
of NAICS 2-digit codes to identify separate unrelated trades or 
businesses reduces the compliance costs of affected organizations 
relative to the use of NAICS 6-digit codes. For example, different 
types of food services would be 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 guidance provided in the proposed regulations also 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 interpretation of the 
statute. In the absence of these proposed regulations, an exempt 
organization might be uncertain about whether an activity is one or 
more than one business activity. As a result, in the absence of the 
proposed regulations, similar institutions might take different 
positions and pay different amounts of tax, introducing economic 
inefficiency and inequity.
    Since exempt organizations could use a reasonable and good-faith 
effort to interpret whether some trade and business activities would 
have to be reported separately, behavioral responses were likely muted. 
These regulations do provide greater certainty and flexibility such 
that compliance costs may be slightly lower for affected organizations.
    The Treasury Department and the IRS solicit comments on the use of 
the NAICS 2-digit codes and comments that provide data, other evidence, 
or models that would enhance the rigor by which the final regulations 
might be developed.
ii. Aggregation of Investment Activities
    The proposed regulation's treatment of investment activities will 
also provide clarity and reduce burdens for

[[Page 23194]]

exempt organizations. By providing more explicit rules for the 
treatment of investment activities, the proposed regulations reduce the 
uncertainty about what would be acceptable under the ``reasonable, 
good-faith interpretation'' provided in the Notice. Although investment 
income, such as interest and dividend income, is not generally 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. 
Consistent with the guidance included in the Notice, the proposed 
regulations allow certain of this ``investment'' income to be 
aggregated and treated as a single trade or business. The proposed 
regulations further expand on the notice by providing a more developed 
rule for partnership income and explicitly list the other types of UBTI 
that can be aggregated as ``investment'' income in response to comments 
requesting additional clarification. As a result, the proposed 
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.
    Given these proposed regulations follow and slightly expand the 
guidance in the Notice, investment responses are likely to be minimal. 
While some exempt organizations may have perceived a need to reorganize 
certain investments, such as in partnerships that qualify for aggregate 
treatment and thereby seek offset any losses, few would have been 
expected to do this reorganization prior to regulations being 
published.
iii. Summary
    The proposed 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 
proposed 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 proposed 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 
proposed regulations will be modest.

II. Paperwork Reduction Act

    The collection of information in these proposed 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.
    The paperwork burden estimate for tax-exempt organizations is 
reported under OMB control number 1545-0047, which represents a total 
estimated burden time, including all other related forms and schedules 
for corporations, of 52 billion hours and total estimated monetized 
costs of $4.17 billion ($2017). The burden estimates provided in the 
OMB control number are aggregate amounts that relate to the entire 
package of forms associated with the OMB control number and will in the 
future include, but not isolate, the estimated burden of these proposed 
regulations. These numbers are therefore unrelated to the future 
calculations needed to assess the burden imposed by adoption of these 
proposed regulations. The Treasury Department and IRS urge readers to 
recognize that these numbers are duplicates and to guard against 
overcounting the burden. No burden estimates specific to the proposed 
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 proposed 
regulations. Those estimates would capture both changes made by the Act 
and those that arise out of discretionary authority exercised in the 
proposed regulations. The current status of the Paperwork Reduction Act 
submissions related to these proposed regulations is provided in the 
following table.

------------------------------------------------------------------------
             Form                OMB control 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.
------------------------------------------------------------------------

    The Treasury Department and the IRS request comments on all aspects 
of information collection burdens related to the proposed 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. Proposed revisions (if any) 
to the Form 990-T and related schedules that reflect the information 
collections contained in these proposed regulations will be made 
available for public comment at http://apps.irs.gov/app/picklist/list/draftTaxForms.html. The revised Form 990-T and related schedules 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.
    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

[[Page 23195]]

become material in the administration of any internal revenue laws. 
Generally, tax returns and return information are confidential, as 
required by 26 U.S.C. 6103.

III. Regulatory Flexibility Act

    Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6) 
(RFA), it is hereby certified that these proposed regulations would not 
have a significant economic impact on a substantial number of small 
entities. As discussed elsewhere in this preamble, these proposed 
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 proposed 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). The IRS expects 
that less than 10 percent of the exempt organizations population will 
be affected by these proposed regulations because the exempt 
organizations filing Form 990-T include entities not included in the 
definition of ``small entities,'' such as large hospital systems and 
universities. Therefore, this proposed regulation is 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 this proposed rule is 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 the previous two tax years. As 
discussed elsewhere in this preamble, these regulations would 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 and understanding these regulations, the 
Treasury Department and the IRS project that the proposed regulations 
provide certainty and guidance that will reduce taxpayer compliance 
burden for large and small entity taxpayers.
    Notwithstanding this certification, the Treasury Department and the 
IRS invite comments on the impact this rule may have on small entities.
    Pursuant to section 7805(f), this proposed rule has been submitted 
to the Chief Counsel for Advocacy of the Small Business Administration 
for comment on its impact on small entities.

Comments and Requests for Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any comments that are timely submitted 
to the IRS as prescribed in the preamble under the ADDRESSES section. 
All comments submitted will be made available at https://www.regulations.gov or upon request.
    A public hearing on these proposed regulations will be scheduled if 
requested in writing by any person who timely submits written comments. 
If a public hearing is scheduled, notice of the date, time, and place 
for the public hearing will be published in the Federal Register.

Drafting Information

    The principal author of this notice of proposed rulemaking is 
Stephanie N. Robbins, 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.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be 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 proposed to be amended by:
0
1. Adding new paragraph (f)(7)(v).
0
2. Adding new 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 paragraph 
(f)(7)(i) of this section), 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.
* * * * *
    (k) * * *
    (3) Applicability date. Paragraph (f)(7)(v) of this section applies 
to taxable years beginning on or after [DATE OF PUBLICATION OF THE 
FINAL RULES IN THE FEDERAL REGISTER].
0
Par. 3. Section 1.509(a)-3 is proposed to be 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)) 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.
* * * * *

[[Page 23196]]

    (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.
* * * * *
    (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 
[DATE OF PUBLICATION OF THE FINAL RULES IN THE FEDERAL REGISTER]. For 
taxable years beginning before [DATE OF PUBLICATION OF THE FINAL RULES 
IN THE FEDERAL REGISTER], see these paragraphs as in effect and 
contained in 26 CFR part 1 revised as of April 1, 2019.
0
Par. 4. Section 1.512(a)-1 is proposed to be 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 using an unadjusted gross-to-gross method is not 
reasonable. For example, if a social club charges nonmembers a higher 
price than it charges members for the same good or service, it must 
adjust the price of the good or service provided to members for 
purposes of determining the allocation of indirect expenses to avoid 
overstating the deductions allocable to the unrelated business activity 
of providing goods and services to nonmembers.
* * * * *
    (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 
[DATE OF PUBLICATION OF THE FINAL RULES IN THE FEDERAL REGISTER]. For 
taxable years beginning before [DATE OF PUBLICATION OF THE FINAL RULES 
IN THE FEDERAL REGISTER], see these paragraphs as in effect and 
contained in 26 CFR part 1 revised as of April 1, 2019.
0
Par. 5. Section 1.512(a)-6 is proposed to be 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), including for 
purposes of determining any net operating loss (NOL) deduction, 
separately with respect to each such trade or business, without regard 
to the specific deduction in section 512(b)(12). 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. For purposes of section 
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.
    (b) North American Industry Classification System--(1) In general. 
Except as provided in paragraphs (c) through (e) of this section, an 
organization will 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 trade or business. The NAICS 2-digit code chosen must 
identify the unrelated trade or business in which the organization 
engages (directly or indirectly) and not the 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.
    (2) 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.
    (3) Erroneous codes. Once an organization has identified a separate 
unrelated trade or business using a particular NAICS 2-digit code, the 
organization may not change the NAICS 2-digit code describing that 
unrelated trade or business unless the organization can show that the 
NAICS 2-digit code chosen was due to an unintentional error and that 
another NAICS 2-digit code more accurately describes the trade or 
business.

[[Page 23197]]

    (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)(A) and paragraph (a) of this 
section. Except as provided in paragraphs (c)(6) 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 a 
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 control test (described in paragraph 
(c)(4) of this section).
    (ii) Indirectly-held partnership interests. If an organization does 
not control (within the meaning of paragraph (c)(4)(iii) of this 
section) a partnership in which the organization holds a direct 
interest but that directly-held partnership interest is not a QPI 
because the organization holds more than 20 percent of the capital 
interest, 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 the de minimis test 
(described in paragraph (c)(3) of this section) (look-through rule). 
For example, if an organization directly holds 50 percent of the 
capital interests of a partnership that it does not control and the 
directly-held partnership holds 4 percent of the capital and profits 
interests of lower-tier partnership A, and 10 percent of the capital 
and profits interests of lower-tier partnership B, 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). 
However, the organization may not aggregate its interest in lower-tier 
partnership B with its QPIs because the organization indirectly holds 5 
percent of the capital and profits interests of lower-tier partnership 
B (10 percent x 50 percent), which does not meet the requirements of 
the de minimis test.
    (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 control test.
    (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.
    (4) Control test--(i) In general. A partnership interest is a QPI 
that meets the requirements of the control test if the organization 
holds no more than 20 percent of the capital interest and does not 
control 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) or 
a controlled entity (as defined in section 512(b)(13)(D) and Sec.  
1.512(a)-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 supporting organization owns an additional 15 
percent capital interest in that partnership, the organization would 
not meet the requirements of the control test because its aggregate 
percentage interest exceeds 20 percent (10 percent + 15 percent = 25 
percent).
    (iii) Control. All facts and circumstances, including the 
partnership agreement, are relevant for determining whether an 
organization controls a partnership. In any case, however, an 
organization controls a partnership if--
    (A) The 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;
    (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) Reliance on Schedule K-1 (Form 1065)--(i) In general. When 
determining the organization's percentage interest (described in 
paragraph (c)(5)(ii) of this section) in a partnership for purposes of 
the de minimis test (described in paragraph (c)(3) of this section) and 
the control 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 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.
    (ii) Determining percentage interest. For purposes of paragraph 
(c)(5)(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

[[Page 23198]]

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).
    (6) 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).
    (7) 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)(7)(iii) of this section).
    (ii) Exclusivity. An organization may apply either the transition 
rule in paragraph (c)(7)(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)(7)(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 [DATE OF PUBLICATION OF THE FINAL RULES IN THE 
FEDERAL REGISTER].
    (8) Limitations--(i) Social clubs. Paragraphs (c)(2) (regarding 
QPIs) and (c)(7) (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 is a general partner is not a QPI within the meaning of 
paragraph (c)(2) of this section, regardless of the organization's 
percentage interest.
    (iii) Application of other sections. This paragraph (c) will not 
otherwise impact application of section 512(c) and the fragmentation 
principle under section 513(c).
    (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 will be 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 will have two separate unrelated trades or 
businesses, one for each controlled entity. The specified payments from 
a controlled entity will be 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) will be 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 will 
be 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 will report 
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--(i) 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 (by percentage of 
stock ownership) in the S corporation meets the criteria for a QPI as 
described in paragraph (c)(2)(i) of this section (qualifying S 
corporation interest).
    (ii) Reliance on Schedule K-1 (Form 1120-S). When determining how 
much S corporation stock an organization owns for purposes of paragraph 
(e)(2)(i) of this section, the organization may rely on the Schedule K-
1 (Form 1120-S) (or its successor) it receives from the S corporation 
if the form lists the organization's percentage of stock ownership for 
the year.
    (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 
specific deduction under section 512(b)(12).
    (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 losses arising in a taxable year beginning before January 1, 2018 
(pre-2018 NOLs),

[[Page 23199]]

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 the manner that results in maximum utilization of the 
pre-2018 NOLs in a taxable year.
    (i) Applicability dates. This section is applicable to taxable 
years beginning on or after [DATE OF PUBLICATION OF THE FINAL RULES IN 
THE FEDERAL REGISTER].
0
Par. 6. Section 1.512(b)-1 is proposed to be amended by:
0
1. Revising paragraph (a)(1).
0
2. Adding a new sentence to the end of paragraph (a)(3).
0
3. Adding a new paragraph (e)(5).
0
4. Adding new 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 [DATE OF PUBLICATION OF THE FINAL RULES IN 
THE FEDERAL REGISTER]. However, an organization may choose to apply 
this exclusion to taxable years beginning before [DATE OF PUBLICATION 
OF THE FINAL RULES IN THE FEDERAL REGISTER].
* * * * *
    (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 [DATE OF PUBLICATION OF THE FINAL RULES IN THE 
FEDERAL REGISTER].
* * * * *
0
Par. 7. Section 1.513-1 is proposed to be 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 new sentence to the end of new 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 [DATE OF PUBLICATION OF THE FINAL RULES IN THE 
FEDERAL REGISTER].
* * * * *

Sunita Lough,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2020-06604 Filed 4-23-20; 8:45 am]
 BILLING CODE 4830-01-P