Final Regulations Issued for Unrelated Business Income Activities

February 10, 2021
Tax Exempt Organization

Final regulations were recently published in the Federal Register, providing guidance and clarity on the calculation of unrelated business income (UBI) for exempt taxpayers operating more than one unrelated trade or business.

The final regulations under 512(a)(6) apply to tax years beginning after December 2, 2020. For tax years before December 2, 2020, an organization may rely on the guidance published in Notice 2018-67, the Proposed Regulations or the Final Regulations. The most significant differences in the three pieces of guidance are discussed below.

Need help making sense of the final regulations for unrelated business income activities?

Background on Unrelated Business Income Activities
Section 512(a)(6) was added by the Tax Cuts and Jobs Act of 2017 and applies to tax years beginning after December 31, 2017. Section 512(a)(6) requires exempt organizations to separately calculate unrelated business income for each unrelated trade or business, commonly referred to as “silos.” Prior to the enactment of Section 512(a)(6), an exempt organization was able to aggregate income, expenses and deductions from all unrelated trade and business activities to calculate their taxable income. This allowed a loss from one unrelated trade or business activity to offset income from another unrelated trade or business, reducing total taxable income.

Interim guidance was released by the IRS in August of 2018 via Notice 2018-67. The interim guidance indicated that a taxpayer could use a “reasonable, good-faith interpretation” of the statute and also provided preliminary guidance and transitional rules for exempt organizations. The Notice allowed the use of 6-digit NAICS codes as an acceptable method of classifying business activities. In addition, the Notice introduced the concept of an “investment silo,” providing guidance for the treatment of investment partnership interests.

Proposed regulations published on April 24, 2020, built off the framework developed in Notice 2018-67, but provided several updates as well as further clarification of the rules. Major issues addressed included a change in the NAICS Code use from 6 digits to 2 digits, additional details on the investment silo, special rules for certain entity types and ordering rules for net operating losses.

What the Final Regulations Mean
The final regulations look very similar to the proposed regulations with a few minor modifications and clarifications. Below is an overview of the key components of the final regulations:

2-Digit NAICS Codes
The final regulations permit the use of 2-digit NAICS codes to identify separate unrelated trades or businesses. There are currently 20 NAICS 2-digit codes an organization can choose from. It is recommended they utilize the full NAICS 6-digit code to assist with identification of the trade or business before applying the 2-digit code.

Organizations should group activities based upon the underlying activity performed and cannot simply group all activities based upon the overall organization type (e.g. an educational institution cannot group all of its unrelated trades or businesses under NAICS Code 61 for educational services).

The final regulations removed the prior restriction prohibiting changing the NAICS code once established, but instead states that an organization that changes its code must indicate the change has occurred on its Form 990-T and include a statement on why the change was made.

Investment Siloing
The final regulations confirm that certain types of investments may be aggregated as one activity and grouped together as one trade or business. This investment silo includes investments in qualified partnership interests (QPIs), qualified S Corporation interests (QSCIs), as well as debt-financed property interests.

Qualified Partnership Interests and qualified S-Corporation Interests
A qualifying partnership interest (QPI), is a partnership interest in which neither the exempt organization nor its controlled or supporting organizations is a general partner. In addition, in order to be a QPI, the partnership investment must meet either the de minimis test or the participation test as detailed in the regulations. An S Corporation interest is considered a “qualifying” interest if it meets one of the same two tests.

De minimis Test
To meet the de minimis test, an organization may hold no more than 2% of the profits and no more than a 2% capital interest in the investment. When reviewing the percentage interests, the regulations specify that an organization may rely on the percentages reported on the Schedule K-1s received from the partnership or S corporation.

Participation Test
This test was renamed from the “control test,” and to meet this test, an organization must hold less than 20% of the capital interest in the activity and cannot significantly participate in the partnership. The regulations provide four specific factors that indicate significant participation:

  • The EO can require the partnership to perform or prevent from performing an action that affects operations of the partnership
  • The EO has the power to appoint or to remove the partnership’s officers, employees or a majority of the directors
  • The EO officers, directors, trustees or employees have the right to participate in the management of the partnership
  • The EO officers, directors, trustees or employees have rights to conduct partnership business

The final regulations require an exempt organization to include interests held by Type I and II supporting organizations and controlled entities for purposes of the participation test.

Look-Through Rule
In addition, the regulations modified the “look-through” rule, which permits an indirect interest in a lower-tiered partnership that meets the de minimis test to be treated as a QPI even if the exempt organization significantly participates in the directly held upper-tier partnership.

Transition Rule
A transition rule was introduced in Notice 2018-67 and was implemented in the proposed regulations. This rule allowed partnership interests acquired before August 21, 2018, that did not meet the de minimis or the control test to be treated as a single trade or business. This transition period will end on the first day of the first taxable year after December 2, 2020. As such, the organization needs to either reduce ownership to meet the QPI definition or treat the investment and any underlying investments as separate business activities after this date.

Grace Period
A grace period was added to the final regulations to allow a QPI to continue to meet either the de minimis or the participation test in any given tax year if the ownership percentage for that year increases above the applicable limits due to actions of other partners outside of the organization’s control.

Other Investment Rules
Partnership and S-Corporation investments that are not “qualifying” interests are treated as separate trade or business activities and UBTI is calculated for each investment based on the underlying activity. In addition, income from controlled entities under 512(b)(13) and foreign insurance payments under 512(b)(17) are both treated as separate silos.

Net Operating Losses (NOLs)
The final regulations confirm the earlier guidance on the ordering rules for NOLs. NOLs incurred before Section 512(a)(6) was enacted in 2018—, or pre-2018 NOLs—may be utilized to offset income from any activity and should be used before post-2017 NOLs are used.

Once an organization has utilized all pre-2018 NOLs, the post-2017 NOLs may only be used to offset income generated under the applicable silo. Another change in the Tax Cuts ad Jobs Act repealed NOL carrybacks while allowing indefinite carryforwards.

However, in 2020, the CARES Act modified this rule and allows NOLs arising in years between December 31, 2017 and January 1, 2021 to be carried back five years preceding the year of loss. This change technically allows NOLs subject to the siloing rules to be carried back to tax years before the enactment of 512(a)(6).

The final regulations do not address the changes to the NOL rules enacted by the CARES Act; however, the IRS has released additional FAQs that provide guidance for nonprofit organizations. It is anticipated that the IRS will issue regulations related to NOL guidance in the future.

Public Support Test Considerations
The final regulations address the fact the calculation of public support on Schedule A could be negatively impacted by the treatment of UBTI under the new silo rules. To address this issue, the final regulations allow exempt organizations to calculate public support tests using either UBTI calculation under Section 512(a)(6) or UBI calculated in the aggregate, whichever is least administratively burdensome or provides the highest ratio for the organization.

Expenditure Considerations
Lastly, the final regulations did not address the issue of proper expense allocation methodologies, but reserved this issue for future guidance. The concept that expenditures be allocated “reasonably” still prevails and organizations are left to choose an allocation method that best represents a fair allocation. The final regulations indicate that the use of the “unadjusted gross-to-gross” method is not reasonable and should not be used unless certain circumstances apply.

Understanding the Impact of Siloing on Your Organization
The 512(a)(6) rules are complex and will impact planning and reporting for UBTI for organizations with more than one unrelated trade or business activity. It’s important to stay on top of these updates and understand how the final regulations will affect your organization.


The unrelated business income ruling is complicated and exempt organizations must consider all facets when seeking compliance.

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