INSIGHT: Proposed Tax-Exempt Entity Rules Bring Welcome Relief for Retirement Plan Investments

On April 23, 2020, the Internal Revenue Service issued proposed rules clarifying how tax-exempt organizations, including tax-qualified retirement plans, are to report unrelated business taxable income (UBTI) under requirements put in place by the Tax Cuts and Jobs Act of 2017 (TCJA).

The proposed rules provide that, so long as a tax-exempt organization invests through “qualifying partnership interests,” UBTI gains and losses associated with such interests may be aggregated for purposes of the TCJA. As a practical matter, this means that tax-qualified retirement plans that are engaging in typical passive investment partnership activities, which constitute qualifying partnership interests, will not be subject to the separate calculation and reporting requirements put in place by the TCJA. This guidance should significantly ease the burden of the requirements of the TCJA on tax-qualified retirement plans, though plan sponsors should review plan investments to verify their treatment under the rules.

Background

On Dec. 22, 2017, the TCJA added a new Section 512(a)(6) to the tax code. Section 512(a)(6) required tax-exempt organizations to calculate and report UBTI separately for each trade or business, effective for years after Dec. 31, 2017. Prior to the TCJA, such organizations were permitted to aggregate all UBTI and reduce total UBTI by all allowable deductions (permitting UBTI gains and losses to offset each other on an aggregate basis, which had the effect of reducing such organizations’ taxable UBTI).

On Aug. 21, 2018, the IRS issued Notice 2018-67, which acknowledged no specific guidance existed as to what constituted a “separate trade or business” for purposes of the new reporting requirements of Section 512(a)(6). The notice provided that, until further guidance was issued, tax-exempt entities could use a reasonable, good-faith interpretation when identifying a separate trade or business, including by looking to the North American Industry Classification System (NAICS) and Section 513(c) as guides.

The notice took a look-through approach to partnership activities, by stating that “one interpretation of Section 512(a)(6) might require an exempt organization to calculate UBTI separately with respect to each unrelated trade or business regularly carried on by the partnership in which the exempt organization is a direct or indirect partner.” The notice also stated that if a partnership held multiple lower level partnerships, “the exempt organization may be engaged in multiple separate unrelated trades or businesses through its interest in the partnership.”

Finally, the notice provided transition rules for the treatment of such partnership investments under Section 512(a)(6), which included:

• a de minimis test, which permitted aggregation of partnership interests in which the tax-exempt organization held no more than 2% of the profits or capital interests in each such partnership;

• a control test, which permitted aggregation of partnership interests in which the tax-exempt organization held no more than 20% of the capital interest and did not have control or influence over the partnership; and

• permitting aggregation for investments acquired prior to Aug. 21, 2018, as a single trade or business.

New Guidance Under Proposed Rules

On April 23, 2020, the IRS issued proposed rules that clarify how tax-exempt organizations should group separate trades and businesses for purposes of Section 512(a)(6). Until the publication of final regulations, taxpayers can (1) rely on the proposed rules, (2) continue to rely on the notice, or (3) rely on a reasonable, good faith interpretation of Section 512(a)(6).

The proposed rules retain the de minimis and control tests (although modify them slightly) and provide that investments that meet such tests may be aggregated as a single trade or business for purposes of Section 512(a)(6). The proposed rules also retain the rule that each investment acquired prior to Aug. 21, 2018, may be aggregated as a single trade or business.

NAICS Codes

The proposed rules adopted one approach included in the notice regarding the identification of separate trades or businesses based on categories set forth in the NAICS. However, instead of categorizing each trade or business based on its six digit NAICS number (which would have resulted in over 1,000 categories of trades or businesses), each trade or business will be categorized based on its first two NAICS digits (resulting in 20 categories of trades or businesses). So long as UBTI is generated by trades or businesses that have the same first two NAICS digits, UBTI gains and losses may be aggregated for purposes of Section 512(a)(6).

Investments in Partnerships

Additionally, the proposed rules permit (but do not require) aggregation of certain investment activities under a single trade or business for purpose of Section 512(a)(6). These investment activities include “qualifying partnership interests” (QPIs), qualifying S corporation interests and debt-financed property or properties.

The proposed rules provide that a QPI is one that meets either the de minimis or the control tests provided for in the notice (e.g. the tax-exempt entity must either hold less than 2% of the capital or profits interest of the partnership or no more than 20% of the capital interest and not exercise control over the partnership). However, once designated as a QPI, such designation cannot be changed unless and until such investment no longer qualifies as a QPI.

The proposed rules also make certain changes to the de minimis and control tests. Namely, with respect to the de minimis test:

• A tax-exempt organization is no longer required to combine certain related interests for purposes of the de minimis test; and

• With respect to partnership interests that do not qualify as QPIs under the de minimis test that hold lower tiered partnership interests that do qualify as QPIs, such qualifying lower tiered partnerships may be aggregated with other QPI interests under Section 512(a)(6), notwithstanding the higher-tired partnership’s lack of qualification.

Additionally with respect to the control test:

• While the aggregation rules of the notice remain for purposes of the control test, a tax-exempt organization is no longer required to combine interests of disqualified persons for purposes of the test (but is required to combine interests of supporting organizations and controlled entities); and

• An interest no longer fails to be a QPI under the control test if the organization has the ability to “influence” the partnership. The test is now limited to whether an organization has the ability to control the partnership, as further defined in the proposed rules. The proposed rules clarify that whether an organization has the ability to control the partnership will be determined on all the facts and circumstances, including whether:
  • the organization can, by itself, require the partnership to perform or prevent it from performing any act that significantly affects the operations of the partnership;
  • any of the organizations officers, directors, trustees or employees have the right to participate in management of the partnership or conduct the partnership’s business at any time; and
  • the organization, by itself, has the power to appoint or remove any of the partnership’s officers or employees or a majority of directors.

The proposed rules also retain the transition rule that provides that directly held partnership interests acquired prior to Aug. 21, 2018, whether or not qualifying as a QPI, can be treated as a separate line of business for purposes of Section 512(a)(b), regardless of the number of unrelated trades or businesses directly or indirectly conducted by the partnership.

Guidance on Tax-Qualified Retirement Plan Investments

The proposed rules specifically provide that “…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.” However, the preamble to the proposed rules acknowledge that tax-qualified retirement plans “generally derive most, if not all, of their UBTI from investment activities… which includes UBTI from qualifying partnership interests.” As such, so long as all UBTI generated by the plan’s investments come from investments that qualify as QPIs, that plan will have only one unrelated trade or business—investment activities, covered by NAICS two digit code 52. As a practical matter, this means that “typical” tax-qualified retirement plan investments that constitute QPIs will not be subject to the implications of Section 512(a)(6), because the UBTI gains and losses associated with all such QPIs will be able to be aggregated, consistent with pre-TCJA practices.

Any tax-qualified retirement plan investment which does not constitute a QPI will need to be analyzed and potentially accounted for and reported separately under Section 512(a)(6). This would include investments such as direct investments, investments where the plan has control over the partnership or has significant ownership in the partnership such that it does not fall within the definition of a QPI. While these types of investments could increase costs for tax-qualified retirement plans that will need to comply with Section 512(a)(6)’s new requirements with respect to such investments, these situations are not typically the bulk of such investments made by such plans.

Conclusion

With this additional guidance from the IRS, tax-qualified retirement plans should review their investments that generate UBTI to determine correct treatment under Section 512(a)(6), especially to determine whether such investments constitute QPIs if acquired after Aug. 21, 2018. This may mean reducing and monitoring ownership in partnership interests, as well as an analysis to determine whether “control” over such entity exists under the proposed rules. For investments that do not qualify as QPIs and are acquired after Aug. 21, 2018, plans will need to ensure they are complying with the separate accounting and reporting requirements in Section 512(a). Plans will also need to consider these rules when entering into new investments that may generate UBTI.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Meredith O’Leary is a partner at Eversheds Sutherland in Washington and counsels both public and private companies on a diverse spectrum of employment, compensation and benefits law.