IRS Regulations on Unrelated Business Taxable Income Siloing

Final regulations were issued in November 2020 to solidify how tax-exempt organizations should classify separate unrelated trades or businesses, and they adhere mostly to the proposed regulations issued earlier in 2020.

The final regulations retain the use of the two-digit North American Industry Classification System (NAICS) code to identify separate unrelated businesses, along with many of the rules on how tax-exempt organizations should treat investment activities.

The final regulations don’t fully address two issues:

  1. The allocation of expenses between an exempt activity and one or more unrelated trades or businesses
  2. Changes made to net operating losses (NOLs) under the Coronavirus Aid, Relief, and Economic Security (CARES) Act

The Treasury Department and the IRS expect to issue separate guidance on these issues.


Internal Revenue Code (IRC) Section 512(a)(6), which was enacted in December 2017 as part of 2017 tax reform, often referred to as the Tax Cuts and Jobs Act, requires exempt organizations that have more than one unrelated business activity to compute their unrelated business taxable income (UBTI) separately by activity. Previously, exempt organizations could aggregate unrelated trades or businesses on Form 990-T, allowing losses from one activity to offset income from another activity.

Beginning in 2018, exempt organizations had to report unrelated businesses separately on Schedule M of Form 990-T, and any losses from an activity couldn’t be netted against income from another activity.

The new law, however, didn’t specify how to identify a separate unrelated trade or business when calculating UBTI. Notice 2018-67, issued in August 2018, provided some initial guidance, and proposed regulations, issued in April 2020, offered further details. That guidance has evolved into the final regulations, which were issued on November 19, 2020, and went into effect on December 2, 2020, when they were published in the Federal Register.

Identifying Separate Unrelated Trades or Businesses

As in the proposed regulations, the final regulations allow exempt organizations to identify their separate, unrelated trades or businesses using the first two digits of the NAICS codes.

The first two digits of the NAICS codes represent a general category of activity, such as accommodation and food service, which is code 72. The two-digit codes, which can be found on the NAICS website, cover 20 business sectors. The final regulations don’t allow for a facts and circumstances determination of separate trades or businesses because the IRS believes this would be an administrative burden and would result in inconsistency across exempt organizations.

The final regulations clarify that exempt organizations identify their separate trades or businesses using the two-digit NAICS code based on the more specific NAICS code, such as the six-digit code, that describes the activity. Therefore, it’s possible that one activity could produce separate trades or businesses, such as when an organization conducts catering (code 72), parking (code 81), and personal property rental (code 53). The final regulations do clarify that when the same goods are sold both in stores and online, the entire activity is identified by the goods sold in stores. An organization reports each two-digit code only once on Form 990-T. 

Changing Activity Codes

One difference from the proposed regulations involves making a change to an activity’s two-digit code. Under the proposed regulations, a code couldn’t be changed unless the organization could show that the original code was selected because of an unintentional error or that another code more accurately describes the business.

The final regulations remove these restrictions and give organizations more leeway. Organizations will report a change of the two-digit code in the taxable year of the change on the Form 990-T in accordance with the instructions. The following information must be provided:

  • The identification of the separate unrelated trade or business in the previous year
  • The identification of the separate unrelated trade or business in the current year
  • The reason for the change

Transitioning from Six-Digit Codes

Exempt organizations, using the guidance provided in Notice 2018-67, may have been using the six-digit NAICS codes to identify separate activities. The preamble to the final regulations states that the transition from a six-digit code to a two-digit code doesn’t require the reporting of a code change.

The move to the two-digit code may result in the combination of NOLs, and exempt organizations may choose but are not required to amend any Forms 990-T filed prior to the issuance of the final regulations to report activities using the two-digit code.

Treatment of Investment Activity

The final regulations retain most of the provisions of the proposed regulations regarding an organization’s investment activities, which are treated collectively as one unrelated trade or business. As in the proposed regulations, investment activities that can be treated collectively are limited to:

  • Qualifying partnership interests (QPI)
  • Qualifying S corporation interests
  • Debt-financed properties (within the meaning of IRC Section 514)

Investment activities don’t include specified payments from controlled entities and amounts derived from controlled foreign corporations included in UBTI under Section 512(b)(17).

Qualifying Partnership Interests

A QPI occurs when an exempt organization holds a direct interest in a partnership that meets either the de minimis test or the participation test, previously known as the control test. Under the de minimis test, an organization can hold no more than 2% of the profit interest or 2% of the capital interest in a partnership.

De Minimis and Participation Tests

An organization determines its percentage interest for both the de minimis test and the participation test by taking the average of the interest held at the beginning of the year and the end of the year. For partnership interests held for less than a year, the average is of the interest held at the beginning and end of the period of ownership within the tax year.

Under the participation test, a partnership is a QPI if the organization—along with ownership by certain supporting organizations and all controlled organizations—holds no more than 20% of the capital interest and doesn’t significantly participate in the partnership.

Unlike the control test in the proposed regulations, the final regulations don’t include a facts and circumstances test to determine significant participation. Significant participation occurs when any one of the following takes place:

  • The organization may require the partnership to perform, or may prevent the partnership from performing—other than through a unanimous voting requirement or through minority consent rights—any act that significantly affects the operations of the partnership
  • Any of the organization’s officers, directors, trustees, or employees have rights to participate in the management of the partnership
  • Any of the organization’s officers, directors, trustees, or employees have rights to conduct the partnership’s business
  • The organization, by itself, has the power to appoint or remove any of the partnership’s officers, employees, or most of the directors
Determining Ownership Percentages

In determining the percentage ownership used in the participation test, exempt organizations must aggregate interests held by certain supporting organizations and all controlled organizations. The proposed regulations had included all supporting organizations in the aggregation rules.

Under the final regulations, however, all Type I and Type II supporting organizations—which have a parent-subordinate relationship and a brother-sister relationship, respectively—are still included in the aggregation. For Type III supporting organizations, only the partnership interests of a Type III supporting organization that’s a parent of its supported organization is aggregated with the exempt organization’s partnership interests.

The proposed regulations had stated that any partnership in which an exempt organization is a general partner isn’t a QPI. The final regulations also add that, for the participation test, a partnership isn’t a QPI if any supporting organization or other related organization used to determine total percentage ownership is a general partner in the partnership.

If an organization’s percentage interest in a partnership changes because of the actions of other partners, such as other partners selling their interest, the final regulations provide a grace period to allow a partnership interest to meet the requirements of the de minimis test or the participation test.

Under the final regulations, a partnership interest that fails to meet the requirements of either test because of an increase in percentage interest may be treated as meeting the tests in the current year if the following conditions are true:

  • The partnership interest met the requirements of either test in the organization’s prior tax year without use of the grace period
  • The increase in percentage interest is caused by the actions of one or more other partners
  • In the case of a partnership interest that met the participation test in the prior tax year, the interest of the partners that cause the increase wasn’t combined in the prior tax year or current tax year with the exempt organization’s partnership interest under the aggregation rules.

Indirectly Held Partnership Interests

An exempt organization may hold more than a 20% interest in a partnership but not significantly participate in it. Under the proposed regulations, if that directly owned partnership held interests in other partnerships, the exempt organization would be able to group these indirectly held partnerships as QPI if the indirectly held partnerships met the de minimis test.

The final regulations broaden this look-through rule. Now, indirectly held partnerships can be included as QPI if they meet the de minimis test or the participation test. The participation test must be met with respect to the partnership that directly owns the interest in the indirectly held partnership. For the purposes of the look-through rule, the participation test is applied tier by tier to the exempt organization’s indirectly held partnership interests.


The regulations provide an example to explain this tier-by-tier approach: Exempt Organization D owns a 50% capital interest in Partnership A. Partnership A owns a 30% capital interest in Partnership B but doesn’t significantly participate in Partnership B. Partnership B owns a 15% capital interest in Partnership C but doesn’t significantly participate in Partnership C.

Neither the interest in Partnership A nor B is a QPI for Organization D. D’s interest in Partnership A doesn’t meet the requirements of either the de minimis test or the participation test because it owns a 50% interest in the partnership. Organization D’s indirect interest in Partnership B (50% of 30%, or 15%) doesn’t meet the de minimis test. Also, because Partnership A owns more than a 20% interest in Partnership B, Partnership A’s interest in Partnership B doesn’t meet the participation test.

Organization D’s interest in Partnership C, however, is a QPI because Partnership C meets the participation test. This is because Partnership B holds only a 15% interest in Partnership C and doesn’t significantly participate in Partnership C.

Qualifying S Corporation Interests

An organization may aggregate its holdings in an S corporation with its UBTI from other investment activities if its ownership interest meets the same de minimis test or participation test as a QPI. Otherwise, each nonqualifying S corporation is treated as a separate unrelated activity; the filing organization isn’t required to look through the S corporation to determine if there’s more than one trade or business.

Debt-Financed Properties

All UBTI from an organization’s debt-financed properties is treated as a separate unrelated trade or business along with other investment activities. This is unchanged from the proposed regulations.

Transition Rule

The transition rule wasn’t changed from the proposed regulations to be a grandfather rule as requested in comments. If an organization acquired an interest in a partnership before August 21, 2018, that isn’t a QPI, the organization may treat the partnership as one unrelated trade or business, regardless of how many unrelated businesses the partnership directly or indirectly conducts.

This transition rule remains in effect only until the first day of the first taxable year after the publication of the final regulations in the Federal Register. Thereafter, the filing organization could have multiple separate trades or businesses from a single Schedule K-1, depending on application of the look-through rule, discussed above.

Expense Allocations

Exempt organizations with more than one unrelated business activity must allocate expenses not only between the exempt and taxable activities but now also among the separate taxable activities.

The Treasury Department didn’t fully address this issue in the final regulations, which state only that organizations must allocate deductions between separate unrelated businesses using the reasonable basis standard described in Treasury Regulation 1.512(a)-1(c).

Unadjusted Gross-to-Gross Method

The proposed regulations had declared that the unadjusted gross-to-gross method wasn’t a reasonable way to allocate expenses. The gross-to-gross method uses a ratio of gross income from an unrelated business activity over total gross income from all unrelated and related activities to allocate expenses.

The final regulations modify this stance by stating that the allocation of expenses isn’t reasonable if the cost of providing a good or service is essentially the same in a related and an unrelated activity but the price charged in the unrelated activity is greater and no adjustment was made to equalize the price differences in allocating indirect expenses.


If a social club described in section 501(c)(7) charges nonmembers a higher price than it charges members for the same good or service, but doesn’t adjust the price of the good or service provided to members for purposes of allocating expenses, depreciation, and similar items attributable to the provision of that good or service, the allocation method isn’t reasonable.

Using Net Operating Losses

For tax years beginning after December 31, 2017, Section 512(a)(6) requires organizations to determine any NOLs separately for each unrelated trade or business. These are called post-2017 NOLs in the regulations. NOLs generated before 2018 (referred to as pre-2018 NOLs), however, can be taken against total UBTI going forward.

As in the proposed regulations, the final regulations state that an organization deducts its pre-2018 NOLs from total UBTI before deducting any post-2017 NOLs against a separate trade or business. The final regulations do clarify that pre-2018 NOLs are taken in a way to allow for maximum use of the post-2017 NOLs—rather than the pre-2018 NOLs—in a taxable year.

For example, the final regulations state that an organization may allocate all of its pre-2018 NOLs to one of its separate unrelated business activities, or it may allocate its pre-2018 NOLs ratably among its separate activities. It can choose to do whichever results in greater utilization of the post-2017 NOLs in that year.

If a separate unrelated business activity is sold or otherwise disposed, the final regulations provide that any remaining post-2017 NOLs generated by that separate activity is suspended, after offsetting any gain from the disposal. If this unrelated business activity later resumes, or if a new activity begins using the same NAICS two-digit code, the suspended NOLs may be used.

If a separate unrelated business activity changes identification, that activity is treated as terminated under the final regulations. Therefore, none of the post-2017 NOLs from the original activity are carried over to the newly identified separate activity.

The final regulations do provide an exception when an organization has determined that the activity is more accurately described under another two-digit code, but there’s no material change in the activity. In this case, the post-2017 NOLs attributable to the previously identified activity are NOLs of the newly identified activity.

Additional Provisions

There are a few other provisions worth noting, which are detailed below.

Payments from Controlled Entities

The final regulations adopt the provision from the proposed regulations that all specified payments from a controlled entity are treated as one trade or business—for example, rent and interest received from a for-profit subsidiary. Additionally, the same type of payment from different controlled entities would be treated as separate trades or businesses, for instance, rent from two wholly owned for-profit subsidiaries.

Effect on Public Support Tests

The separation of activities under Section 512(a)(6) could have a negative effect on the public support tests of public charities because losses from one activity can’t offset income in another activity.

The proposed regulations allowed organizations with more than one unrelated business activity to aggregate the net income and net loss from those activities for public support test purposes only. The final regulations now allow organizations to determine public support using either UBTI calculated under Section 512(a)(6) or UBTI calculated in the aggregate.

Subpart F Income and Global Intangible Low-Taxed Income

As in the proposed regulations, the final regulations state that an inclusion of subpart F income under Section 951(a)(1)(A) or an inclusion of global intangible low-taxed income (GILTI) under Section 951(a) should be treated as dividends for the purposes of Section 512(b)(1). Under Section 512(b)(1), dividends are excluded as UBTI unless they are debt-financed income.

IRAs Described in Section 408(e)

The regulations added a new paragraph clarifying that the Section 513(b) definition of “unrelated trade or business” applies to IRAs.

Social Clubs

As in the proposed regulations, the final regulations clarified that social clubs described under Section 501(c)(7) aren’t able to use the NAICS two-digit code for arts, entertainment, and recreation (71) to identify all their unrelated trades or businesses.

While this code may be appropriate for rounds of golf played by nonmembers and greens fees, other NAICS codes are more appropriate to describe other nonmember income, such as merchandise sales (45) or food and beverage services (72). In addition, the QPI rules aren’t relevant for social clubs.

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