Tax-exempt organizations with available resources increasingly are investing in the financial markets using partnership structures. Qualified organizations that invest in debt-financed real property through partnership structures need to understand the "fractions rule" in Sec. 514(c)(9)(E). Qualified organizations include educational organizations (and certain affiliates), pension trusts, tax-exempt title-holding corporations, and retirement income accounts described in Sec. 403(b)(9).
Although the fractions rule is complex in its application, a qualified organization can make better-informed investment decisions by understanding the rule's impact on a partnership structure, as the fractions rule is satisfied at the partnership level rather than at the partner level. To provide additional guidance on the fractions rule, the IRS published proposed regulations under Sec. 514(c)(9)(E) in November 2016 (REG-136978-12). These proposed regulations could present tax-saving opportunities for qualified organizations that invest in partnerships that comply with the fractions rule.
Sec. 512 defines "unrelated business taxable income" (UBTI) as the gross income derived by an exempt organization from any unrelated trade or business it regularly carries on, less allowable deductions that are directly connected with carrying on the trade or business. UBTI is reported on Form 990-T, Exempt Organization Business Income Tax Return, and is subject to tax at the organization's applicable corporate or trust tax rate.
There are various exceptions to UBTI, especially for passive income. Sec. 512(b) excludes the following from UBTI: dividends; interest; royalties; rents from real property; and gains and losses from the sale, exchange, or other disposition of property. However, income from property subject to acquisition indebtedness can be taxed as unrelated debt-financed income under Sec. 514, and the normal exclusions in Sec. 512(b) do not apply.
There is an exception to unrelated debt-financed income found in Sec. 514(c)(9) for qualified organizations that own real property. However, the exception from UBTI in Sec. 514(c)(9) does not apply if a qualified organization owns an interest in a partnership that holds debt-financed real property, unless the partnership meets one of the following requirements: (1) all of the partnership's partners are qualified organizations, (2) each allocation to a qualified organization is a qualified allocation (within the meaning of Sec. 168(h)(6)), or (3) each partnership allocation has substantial economic effect under Sec. 704(b)(2) and satisfies Sec. 514(c)(9)(E)(i)(I) (the fractions rule). Typically, most partnerships with qualified organization partners seek to meet the third fractions rule requirement to avoid the application of the unrelated-debt-financed-income rules to their qualified organizationpartners.
What is the fractions rule?
The fractions rule is intended to prevent the improper allocation of gains to a tax-exempt organization and losses to a taxable organization. Sec. 514(c)(9)(E)(i) defines the fractions rule in two parts: (1) allocation of items to a partner (the fractions part) and (2) substantial economic effect, which must be met both actually and prospectively. Under the fractions part:
[T]he allocation of items to any partner which is a qualified organization cannot result in such partner having a share of the overall partnership income for any taxable year greater than such partner's share of the overall partnership loss for the taxable year for which such partner's loss share will be the smallest. [Sec. 514(c)(9)(E)(i)(II)]
Regs. Sec. 1.704-1(b)(2) provides guidance with respect to the substantial-economic-effect test. It requires the partnership allocations to maintain consistency with the "underlying economic arrangement of the partners" (Regs. Sec. 1.704-1(b)(2)(ii)(a)).
If a partnership does not satisfy the fractions rule in Sec. 514(c)(9)(E)(i), the benefit of Sec. 514(c)(9) will not apply to the qualified organization partners. Overall, the determination of whether debt-financed income from real property will be classified as UBTI could depend on whether the partnership meets the fractions rule.
Qualified investor Schedule K-1 reporting
An exempt organization partner's Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., often will indicate that some amount of dividends, interest, royalties, rents, or capital gains derived from debt-financed property is UBTI. In certain instances, Schedules K-1 may provide different UBTI amounts generated by qualified organizations than those generated by nonqualified organizations. These Schedules K-1 highlight additional detail regarding the Sec. 514(c)(9)(C) exception and may indicate compliance with the fractions rule. When a qualified organization knows that it is invested in a partnership holding real property, and the Schedule K-1 does not break out qualified versus nonqualified UBTI, or the Schedule K-1 does not provide information regarding Sec. 514(c)(9)(C) and the fractions rule, the qualified organization should inquire with the partnership to confirm the UBTI amount.
What changes are proposed?
The IRS on Nov. 23, 2016, issued the proposed regulations on the application of the fractions rule. The proposed regulations reflect comments that the government received regarding "normal market practice" and modern changes in the structuring of real estate partnerships. As a result, the provisions generally are taxpayer-friendly.
The proposed regulations cover eight aspects of the fractions rule: (1) preferred returns; (2) partner-specific expenditures and management fees; (3) unlikely losses; (4) chargebacks of partner-specific expenditures and unlikely losses; (5) acquisition of partnership interests after initial formation of a partnership; (6) capital commitment defaults or reductions; (7) applying the fractions rule to tiered partnerships; and (8) de minimis exceptions from application of the fractions rule.
The proposed changes could alter partnerships' fractions rule calculation. For example, management fees that "do not, in the aggregate, exceed two percent of the partner's aggregate committed capital" would be excluded. Other proposed changes affect certain preferred return income and loss allocation items that are excluded from the fractions rule calculation.
Treasury and the IRS also received requests for clarification regarding the "independent chain approach" for tiered partnerships. The proposed change would "remove the requirement that a partnership allocate items from lower-tier partnerships separately from one another" and would allow the analysis of the fractions rule all at once, rather than having to review each partnership specifically. This does not alter the fact that UBTI generated by a lower-tier partnership that does not comply with the fractions rule still will be treated as UBTI.
The proposed regulations might provide qualified organizations an enhanced investment opportunity in real estate partnerships that use debt without the income generated being considered UBTI.
The regulations are proposed to apply to tax years ending on or after the date the regulations are published as final regulations. However, the preamble states that a partnership and all its partners may apply all the rules in the proposed regulations for tax years ending on or after Nov. 23, 2016.
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.
For additional information about these items, contact Ms. Smith at 202-414-1048 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.