Editor: Annette B. Smith, CPA
Pension trusts and exempt organizations formed as trusts need to evaluate the impact of the changes to the Code made by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. While much attention has been given to the TCJA's impact on exempt entities organized as corporations (e.g., universities and hospitals), it may treat exempt organizations that are structured as trusts differently.
More specifically, tax-exempt trusts with unrelated business income (UBI) from partnership investments are affected by new Secs. 512(a)(6) and 199A. These provisions must be analyzed in conjunction with existing rules that remain predominantly intact. For example, tax-exempt trusts, like taxable trusts, are subject to the passive activity loss (PAL) rules under Sec. 469, net operating loss (NOL) rules under Sec. 172, and alternative minimum tax (AMT) under Sec. 55. This item addresses key issues concerning this complex landscape of old and new tax rules as related to tax-exempt trusts, including most pension funds.
Tax-exempt trusts may be described in Sec. 401(a) (e.g., pension trusts) or 501(c) (e.g., private foundations organized as trusts). Other exempt organizations that are subject to trust tax rules include individual retirement accounts, simplified employee pensions, SIMPLEs, Coverdell education savings accounts, health savings accounts, 529 tuition programs, and Archer medical savings accounts. Tax-exempt trusts are exempt from federal income tax and are not required to file an income tax return unless they generate UBI. UBI is defined as income from a trade or business, regularly carried on, that is not substantially related to the basis of an organization's exemption. Generally, UBI excludes investment-type income (e.g., dividends, interest, royalties, rents, and gains and losses from the sale of property).
A tax-exempt trust may conduct an unrelated trade or business directly or indirectly through another entity, such as a partnership. Sec. 512(c) provides that a trade or business regularly carried on by a partnership retains its character in the hands of a tax-exempt investor subject to UBI. For example, a partnership engaged in the trade or business of oil and gas extraction or refinement generates income to a tax-exempt partner that is deemed to be from an unrelated trade or business.
Sec. 512(a)(6) UBI segmentation
Sec. 512(a)(6), as added by the TCJA, requires an exempt organization to calculate unrelated business taxable income (UBTI) separately for each trade or business, including any NOL deduction. An exempt organization's total UBTI for a tax year will be the sum of the positive UBTI as computed with respect to each trade or business, less a specific deduction; thus, a loss from one trade or business may not offset the income of another trade or business. This is a significant change: Prior to the TCJA, the law allowed an exempt organization with multiple unrelated trades or businesses to aggregate the gross income and deductions from all such activities as if derived from a single trade or business. This new provision raises questions as to how a "trade or business" will be defined, particularly with respect to UBTI from partnership investments.
Some questions were addressed by the release of interim guidance in Notice 2018-67 on Aug. 21, 2018. Pending the release of Treasury regulations, the notice provides that exempt organizations may rely on a reasonable, good-faith interpretation of Secs. 511 through 514 when identifying separate trades or business for purposes of Sec. 512(a)(6), such as use of the North American Industry Classification System (NAICS) six-digit business codes. The notice further states that Treasury intends to propose regulations treating certain "investment activities" as one trade or business for purposes of Sec. 512(a)(6)(A), permitting organizations to aggregate UBTI from partnerships in which it does not significantly participate.
The notice provides an interim rule permitting an exempt organization to aggregate (i.e., treat as a single trade or business) UBTI from certain partnership interests if the exempt organization meets the de minimis test or control test. An exempt organization satisfies the de minimis test if it (and certain related parties) directly holds no more than 2% of the profits interest and 2% of the capital interest in the partnership. The control test is satisfied if the exempt organization (and certain related parties) directly holds no more than 20% of the capital interest and does not have control or influence over the partnership. For exempt organizations that do not meet the interim rule, the notice provides a transition rule for partnerships acquired before Aug. 21, 2018, allowing an exempt organization to treat each partnership interest as a separate trade or business (without having to further segregate UBTI at lower-tier levels within one partnership).
Notice 2018-67 does not address how a tax-exempt trust might resolve conflicts between the interim and transition rules with the passive loss limitations under Sec. 469, which are an extensive regime of loss-limitation rules applicable to trust taxpayers. For example, if a tax-exempt trust has a greater-than-20% interest in a partnership, it is unclear how the passive loss rules under Sec. 469 and the UBI segregation rules under Sec. 512(a)(6) are applied if there is inconsistency in application. There is no guidance as to which rule takes priority over the other.
Several commenters on the notice have expressed the opinion that the definition of "control" in the interim rule is too restrictive and inconsistent with industry practices. For example, a tax-exempt trust with up to 50% capital ownership commonly will have no control or rights within the provisions of a partnership agreement (e.g., no general partnership rights). One might consider the definition of "control" to be contingent upon whether an exempt organization has limited liability protection as an investor. This would be in line with various uniform partnership acts and similar laws, including the Delaware Limited Partnership Act, which stipulates that a limited partner is not liable for the obligations of a limited partnership unless he or she is a general partner or participates in the control of the business. The reasoning is that investors with general liability have better access to the underlying trade or business activity of the partnership to comply with Sec. 512(a)(6) than an investor with limited liability would.
Treasury also has received comments that argue that control exists only when the investor holds more than 50% of the capital interest of the partnership, which would be consistent with other rules within the UBTI framework. For example, Sec. 512(b)(13)(D) defines "control" of a partnership to mean ownership of more than 50% of the profits or capital interests in the partnership.
Sec. 199A passthrough deduction
The Sec. 199A passthrough deduction seeks to reduce the differential between the new 21% corporate rate and the maximum individual and trust rate (37%) on business income. Sec. 199A provides tax relief to individuals and some trust taxpayers with a 20% deduction on qualified business income (QBI) from a qualified trade or business operated directly or through a passthrough entity (e.g., a partnership). Notably, the definition of QBI is similar to UBI. QBI is defined as income, gain, deduction, and loss from any qualified trade or business and must be effectively connected with a U.S. trade or business. Capital gains and losses, certain dividends, and interest income are excluded.
Final regulations under Sec. 199A, released in early February 2019 (T.D. 9847), include a number of qualifications, computations, and limitations. For example, taxpayers with multiple partnership investments must determine the amount of QBI separately (e.g., a Schedule K-1-by-K-1 basis) for each trade or business, unless aggregation is allowed under certain conditions. There are specific offsetting rules on negative and positive QBI across several trades or businesses, as well as guidance to incorporate suspended losses (e.g., Sec. 469) in calculating QBI. Importantly, the information to compute this deduction must be provided on the Schedule K-1 issued to partners.
Within the preamble of the regulations, Treasury declined to address whether tax-exempt trusts are entitled to a Sec. 199A deduction in computing their UBTI. Treasury further declined to comment on whether the method of determining or separating trades or businesses is the same for Secs. 199A and 512(a)(6). Treasury will continue to study this issue and may issue further guidance.
Net operating losses
The TCJA limits a taxpayer's ability to use an NOL deduction to 80% of taxable income but permits an NOL to be carried forward indefinitely (with no carryback). This applies to any NOL arising in tax years beginning after Dec. 31, 2017, including segregated NOLs under new Sec. 512(a)(6). An important distinction for all trust taxpayers — whether taxable or tax-exempt — is that the new NOL limitations under Sec. 172 do not apply to PALs, which are defined separately under Sec. 469. Tax-exempt trusts should continue to track NOLs separately from PALs to avoid any overlapping or misapplication of the new NOL rules.
Alternative minimum tax
The TCJA did not repeal AMT for trust taxpayers as it did for corporations. Tax-exempt trusts that are liable for tax on their UBTI may be subject to AMT. It is unclear how the UBI segregation rules under Sec. 512(a)(6) will apply to AMT adjustments and whether tax-exempt trusts are required to segregate AMT adjustments by trade or business. AMT NOLs also will continue to offset AMT income up to 90%. As a result, trust taxpayers now are subject to two NOL limitations — an 80% NOL limitation on regular taxable income and the historical 90% limitation on AMT income. Whether this outcome was intended by Congress is unclear. An 80% NOL limitation on regular taxable income often may yield a higher tax liability when compared to the tentative minimum tax under the AMT.
Tax-exempt trusts should plan for the additional time needed to track new information (e.g., partnership capital percentages and QBI). Furthermore, until further guidance under Sec. 512(a)(6) is issued, tax-exempt trusts should review their investment portfolio to address the impacts of applying Notice 2018-67 or taking an alternative reasonable interpretation of the statute.
Annette B. Smith, CPA, is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington, D.C.
For additional information about these items, contact Ms. Smith at 202-414-1048 or firstname.lastname@example.org.
Contributors are members of or associated with PricewaterhouseCoopers LLP.