The IRS has released final regulations dealing with the revisions made to the unrelated business income tax (UBIT) by the Tax Cuts and Jobs Act (TCJA) in 2017.[1] TCJA added IRC §512(a)(6) which provides:

(6) Special rule for organization with more than 1 unrelated trade or business

In the case of any organization with more than 1 unrelated trade or business—

(A) unrelated business taxable income, including for purposes of determining any net operating loss deduction, shall be computed separately with respect to each such trade or business and without regard to subsection (b)(12),

(B) the unrelated business taxable income of such organization shall be the sum of the unrelated business taxable income so computed with respect to each such trade or business, less a specific deduction under subsection (b)(12), and

(C) for purposes of subparagraph (B), unrelated business taxable income with respect to any such trade or business shall not be less than zero.

The IRS had initially released Notice 2018-67 dealing with these issues in August of 2018, followed up by proposed regulations (REG-106864-18) that were issued in April 2020. These regulations are now being finalized with some modifications.

The key provisions are found in new Reg. §1.512(a)-6, with some modifications made to Reg. §§1.170A-9, 1.509(a)-3, 1.512(a)-1, 1.512(b)-1 and 1.513-1.

Reserved Issues

The preamble to the final regulations remind readers that the IRS still has additional guidance it plans to release in this area, noting:

The proposed regulations reserved two issues for additional consideration. The first issue relates to the allocation of expenses, depreciation, and similar items shared between an exempt activity and an unrelated trade or business or between more than one unrelated trade or business. The second issue relates to changes made to the section 172 NOL deduction by the Coronavirus Aid, Relief, and Economic Security Act, Public Law 116-136, 134 Stat. 281 (2020) (CARES Act). The Treasury Department and the IRS anticipate publishing a separate notice of proposed rulemaking that will address these issues.[2]

General Rule for Identifying Separate Trades or Businesses – NAICS Codes

Except as otherwise provided in Reg. §1.512(a)-6(c), (d) and (e), “an organization identifies each of its separate unrelated trades or businesses using the first two digits of the North American Industry Classification System code (NAICS 2-digit code) that most accurately describes the unrelated trade or business based on the more specific NAICS code, such as at the 6-digit level, that describes the activity it conducts…”[3]

The regulation continues:

The descriptions in the current NAICS manual (available at www.census.gov) of trades or businesses using more than two digits of the NAICS codes are relevant in this determination. In the case of the sale of goods, both online and in stores, the separate unrelated trade or business is identified by the goods sold in stores if the same goods generally are sold both online and in stores.[4]

The regulation warns that the code has to be limited to the unrelated trade or business, not related to the conduct of the taxpayer’s exempt function:

The NAICS 2-digit code must identify the unrelated trade or business in which the organization engages (directly or indirectly) and not activities the conduct of which are substantially related to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under section 501 (or, in the case of an organization described in section 511(a)(2)(B), to the exercise or performance of any purpose or function described in section 501(c)(3)). For example, a college or university described in section 501(c)(3) cannot use the NAICS 2-digit code for educational services to identify all its separate unrelated trades or businesses, and 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.[5]

An entity reports each NAICS 2-digit code only once. As the regulation notes:

For example, a hospital organization that operates several hospital facilities in a geographic area (or multiple geographic areas), all of which include pharmacies that sell goods to the general public, would include all the pharmacies under the NAICS 2-digit code for retail trade, regardless of whether the hospital organization keeps separate books and records for each pharmacy.[6]

Activities in the Nature of Investments Treated as a Separate Unrelated Trade or Business

All of an organization’s activities in the nature of investments (investment activities) are treated as a separate unrelated trade or business for the purposes of these rules. Such activities are limited to:

Qualifying partnership interests;
Qualifying S corporation interests; and
Debt-financed property or properties within the meaning of IRC §514.[7]

The investment activity rules do not otherwise impact:

The application of IRC §512(c) and
The fragmentation rule under IRC §513(c).[8]

Qualifying Partnership Interests (QPI)

If an organization holds a direct interest in a partnership (directly-held partnership interest), it is treated as a qualifying partnership interest (QPI) if the holding meets either

the de minimis test (found in Reg. §1.512(a)-6(c)(3) or
the participation test (found in Reg. §1.512-6(c)(4).[9]

If the entity holds a direct interest in a partnership, but that particular holding is not a QPI because neither test is met, any partnership interest held by that partnership may still qualify under the look through rule if the indirectly-held interest meets either the de minimis test or the participation test.[10]

The organization designates a partnership as a QPI as follows:

An organization that has a partnership interest meeting the requirements of paragraph (c)(2)(i) or (ii) of this section in a taxable year may designate that partnership interest as a QPI by including its share of partnership gross income (and directly connected deductions) with the gross income (and directly connected deductions) from its other investment activities (see paragraph (c)(1) of this section) in accordance with forms and instructions.[11]

The QPI designation once made remains in force until and unless the interest no longer meets the requirements to be a QPI.[12]

Example – Reg. §1.512(a)-6(c)(2)(iii)

For example, if an organization designates a directly-held partnership interest that meets the requirements of the de minimis rule as a QPI in one taxable year, the organization cannot, in the next taxable year, use NAICS 2-digit codes to describe the partnership trades or businesses that are unrelated trades or businesses with respect to the organization unless the directly-held partnership interest fails to meet the requirements of both the de minimis test and the participation test (after application of the grace period described in paragraph (c)(6) of this section, if appropriate).

It’s not clear if an organization can treat a partnership the qualifies as a QPI as not being an investment activity by simply not designating it. While the designation rule states the organization may designate the activity as a QPI by reporting as noted (which suggests a choice can be made), the definition of a QPI indicated that a partnership interest is a QPI if it meets the various tests, and the investment related activity definition indicates that such activities are treated as a separate unrelated trade or business (which implies there is no choice to be made). The above example found in the regulation seems to imply that the designation is voluntary, but again this is never stated explicitly.

The QPI rules do not apply to social clubs described in IRC §501(c)(7).[13]

As well, if an interest is held as a general partnership interest, it may not be treated as a QPI by the organization holding the interest or any other organization in a combined group that contains such a general partner:

Any partnership in which an organization, or an organization whose interest is combined with that organization’s interest for purposes of paragraph (c)(4)(ii) of this section, is a general partner under applicable state law is not a QPI within the meaning of paragraph (c)(2) of this section, regardless of the organization’s percentage interest. Such partnership interest cannot be a QPI for any organization or for any of the organizations whose interest is combined with that organization’s interest for purposes of paragraph (c)(4)(ii) of this section.[14]

De Minimis Test

A partnership interest is a QPI under the de minimis test if the organization holds (directly or indirectly):

No more than 2% of the profits interests and
No more than 2% of the capital interests

during the organization’s taxable year with which or in which the partnership taxable year ends.[15]

The profits interest is determined in the same manner as its distributive share of partnership taxable income. The regulation directs the organization to IRC §704(b), relating to the determination of the distributive share by the income or loss ratio, and Reg. §§1.704-1 through 1.704-4.[16]

The organization’s capital interest is:

…in the absence of a provision in the partnership agreement, an organization’s capital interest in a partnership is determined on the basis of its interest in the assets of the partnership which would be distributable to such organization upon its withdrawal from the partnership, or upon liquidation of the partnership, whichever is the greater.[17]

The average percentage interest is computed as follows:

…[A]n organization determines its percentage interest by taking the average of the organization’s percentage interest at the beginning and the end of the partnership’s taxable year, or, in the case of a partnership interest held for less than a year, the percentage interest held at the beginning and end of the period of ownership within the partnership’s taxable year.[18]

The regulation also generally allows the organization to rely on the K-1 received from the partnership for this information:

…An organization may rely on the Schedule K-1 (Form 1065) (or its successor) it receives from the partnership if the form lists the organization’s percentage profits interest or its percentage capital interest, or both, at the beginning and end of the year. However, the organization may not rely on the form to the extent that any information about the organization’s percentage interest is not specifically provided.[19]

Example Reg. §1.512(a)-(c)(5)(iv) – When K-1 Fails to Show Specific Percentage

If the Schedule K-1 (Form 1065) an organization receives from a partnership lists the organization’s profits interest as “variable” but lists its percentage capital interest at the beginning and end of the year, the organization may rely on the form only with respect to its percentage capital interest.

Example Reg. §1.512(a)-6(c)(5)(iii) – Computing Interests Based On K-1 Numbers Provided

If an organization acquires an interest in a partnership that files on a calendar year basis in May and the partnership reports on Schedule K-1 (Form 1065) that the partner held a 3 percent profits interest at the date of acquisition but held a 1 percent profits interest at the end of the calendar year, the organization will be considered to have held 2 percent of the profits interest in that partnership for that year ((3 percent + 1 percent)/2).

For an indirectly-held interest, the regulation provides the following example of such an organization meeting the de minimis test:

Example indirectly-held interest and de minimis test (Reg. §1.512(a)-6(c)(2)(ii)(B)

For example, if an organization directly holds 50 percent of the capital interests of a partnership and the directly-held partnership holds 4 percent of the capital and profits interest of lower-tier partnership A, the organization may aggregate its interest in lower-tier partnership A with its other QPIs because the organization indirectly holds 2 percent of the capital and profits interests of lower-tier partnership A (4 percent x 50 percent).[20]

Participation Test

An organization’s interest in a partnership is treated as meeting the participation test if

The organization holds, directly or indirectly, no more than 20% of the capital interest during the taxable year with which or in which the partnership’s taxable year ends (computed in the same fashion as for the de minimis test) and
The organization does not significantly participate in the partnership.[21]

For purposes of this test, the interests of the organization must be combined with certain related supporting organizations and related entities:

When determining an organization’s percentage interest in a partnership for purposes of paragraph (c)(4)(i) of this section, the interests of a supporting organization (as defined in section 509(a)(3) and §1.509(a)-4), other than a Type III supporting organization (as defined in §1.509(a)-4(i)) that is not a parent of its supported organization, or of a controlled entity (as defined in section 512(b)(13)(D) and §1.512(b)-1(l)) in the same partnership will be taken into account. For example, if an organization owns 10 percent of the capital interests in a partnership, and its Type I supporting organization owns an additional 15 percent capital interest in that partnership, the organization would not meet the requirements of the participation test because its aggregate percentage interest exceeds 20 percent (10 percent + 15 percent = 25 percent).[22]

An organization will be treated as significantly participating in the partnership if:

The organization, by itself, 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 at any time;
Any of the organization’s officers, directors, trustees, or employees have rights to conduct the partnership’s business at any time; or
The organization, by itself, has the power to appoint or remove any of the partnership’s officers or employees or a majority of directors.[23]

The regulations contain the following clarification for applying the participation test to indirectly held partnerships:

For purposes of applying the participation test to a partnership, the term organization in paragraph (c)(4) of this section refers to the partnership that directly holds the indirectly held partnership interest being tested for QPI status. Additionally, the list of officers, directors, trustees, or employees of an organization found in paragraphs (c)(4)(iii)(B) and (C) includes a general partner that directly owns an interest in the lower-tier partnership.[24]

Example of Indirect Partnership Interest Failing Both Tests

The regulations contain the following example of an indirect interest failing both tests:

Example - Reg. §1.512(a)-6(c)(2)(ii)(D)

(I) Organization D is described in section 501(c) and is exempt from Federal income tax under section 501(a). Organization D owns 50 percent of the capital interest in Partnership A. Partnership A owns 30

Partnership B within the meaning of paragraph (c)(4)(iii) of this section. Further, Partnership B owns 15 percent of the capital interest in Partnership C, in which Partnership B does not significantly participate within the meaning of paragraph (c)(4)(iii) of this section. No other organizations related (within the meaning of paragraph (c)(4)(ii) of this section) to either Organization D or the partnerships owns an interest in any of the lower-tier partnerships.

(II) Neither the interest in Partnership A nor B is a QPI. Organization D’s interest in Partnership A does not meet the requirements of either the de minimis test or the participation test because it owns 50 percent of the interest in the partnership. Organization D’s indirect interest in Partnership B (50 percent of 30 percent, or 15 percent) does not meet the de minimis test. Additionally, because Partnership A owns greater than 20 percent interest in Partnership B, Partnership A’s interest in Partnership B does not meet the participation test. However, Organization D’s interest in Partnership C is a QPI because Partnership C meets the participation test. That is, Partnership B holds a 15 percent interest in Partnership C and does not significantly participate in Partnership C.[25]

One Year Relief for Increase in Organization’s Interest

If an organization fails to meet either test in the tax year due to an increase in interest in the organization’s current taxable year, it may be treated as meeting the requirement for the current year that it met in the prior taxable year if:

The partnership interest met the requirements of the de minimis test or participation test, respectively, in the organization’s prior taxable year without considering this relief provision;
The increase in percentage interest is solely due to the actions of one or more partners other than the organization; and
In the case of a partnership interest that met the requirements of the participation test in the prior taxable year, the interest of the partner or partners that caused the increase was not combined for the prior taxable year and is not combined for the taxable year of the change with the organization’s partnership interest for purposes of the participation test.[26]

Special Rule for §501(c)(7), (9) or (17) Organizations

IRC §501(c)(7), (9) or (17) organizations are subject to a special rule at IRC §512(a)(3) for computing their unrelated business taxable income (UBTI). For such organizations, the UBTI from the investment activities includes any amount that:

Would be excluded from the calculation of UBTI under section 512(b)(1), (2), (3), or (5) if the organization were subject to section 512(a)(1);
Is attributable to income set aside (and not in excess of the set aside limit described in section 512(a)(3)(E)), but not used, for a purpose described in section 512(a)(3)(B)(i) or (ii); or
Is in excess of the set aside limit described in section 512(a)(3)(E).[27]

Transition Rule for Certain Partnership Interests

A special rule applies for partnership interests that are not a QPI that were acquired prior to August 21, 2018:

If a directly-held partnership interest acquired prior to August 21, 2018, is not a QPI, an organization may treat such partnership interest as a separate unrelated trade or business for purposes of section 512(a)(6) regardless of the number of unrelated trades or businesses directly or indirectly conducted by the partnership.[28]

Example Reg. §1.512(a)-6(c)(9)(i) – Temporary Transition Rule

If an organization has a 35 percent capital interest in a partnership acquired prior to August 21, 2018, it can treat the partnership as a single trade or business even if the partnership’s investments generated UBTI from lower-tier partnerships that were engaged in multiple trades or businesses.

The transition rule will continue to apply even if the organization’s percentage interest in the partnership changes before the end of the transition period.[29]

The transition rule can be relied upon until the first day of the first taxable year after the regulations are published in the Federal Register.[30] Assuming the regulations are published in December, 2020, for calendar year organizations, calendar year 2020 would be the last year this rule could be used.

A partnership must choose between using the transition rule or the look-through rule if a partnership interest qualifies to use both rules.[31]

Qualifying S Corporation Interest

A similar provision applies to create a qualifying S corporation interest as applies to create a QPI. The regulations provide:

…[A]n organization may aggregate its UBTI from an S corporation interest with its UBTI from other investment activities (described in paragraph (c)(1) of this section) if the organization’s ownership interest in the S corporation meets the criteria for a QPI as described in paragraph (c)(2)(i) of this section (substituting “S corporation” for “partnership” and “shareholder” or “shareholders” for “partner” or “partners,” as applicable, throughout paragraphs (c)(2)(i), (c)(3), (c)(4), (c)(5)(iii), (c)(5)(iv), and (c)(6) of this section; “no more than 2 percent of stock ownership” for “no more than 2 percent of the profits interest and no more than 2 percent of the capital interest” in paragraph (c)(3) of this section; “no more than 20 percent of stock ownership” in place of “no more than 20 percent of the capital interest” in paragraph (c)(4)(i) of this section; and “Schedule K-1 (Form 1120-S)” for “Schedule K-1 (Form 1065)” for purposes of paragraph (c)(5)(iv) of this section).[32]

The regulations also make use of the newly added shares of stock information to be added to the 2020 Schedule K-1s for S corporations for determining the ownership interest:

Paragraphs (c)(5)(i) and (c)(5)(ii) do not apply for purposes of determining an organization’s ownership interest in an S corporation; rather, the average percentage stock ownership determined under paragraph (c)(5)(iii) of this section applies for purposes of this paragraph (e)(2). For purposes of paragraph (c)(5)(iv) of this section, an organization can rely on the Schedule K-1 (Form 1120-S) (or its successor) it receives from the S corporation only if the form lists information sufficient to determine the organization’s percentage of stock ownership for the year. A Schedule K-1 (Form 1120-S) that reports “zero” as the organization’s number of shares of stock in either the beginning or end of the S corporation’s taxable year does not list information sufficient to determine the organization’s percentage of stock ownership for the year.[33]

The one year relief for an increase in the organization’s interest also applies to an S corporation interest:

The grace period described in paragraph (c)(6) of this section applies to changes in an exempt organization’s percentage of stock ownership in an S corporation.[34]

Income from Controlled Entities

Reg. §1.512(a)-6(d) provides special rules for income from certain controlled entities.

For specified payments from controlled entities (within the meaning of IRC §512(b)(13)(D)), the following rules apply:

If an organization (controlling organization) controls another entity (within the meaning of section 512(b)(13)(D)) (controlled entity), all specified payments (as defined in section 512(b)(13)(C)) received by a controlling organization from that controlled entity are treated as gross income from a separate unrelated trade or business for purposes of paragraph (a) of this section. If a controlling organization receives specified payments from two different controlled entities, the payments from each controlled entity are treated as a separate unrelated trade or business. For example, a controlling organization that receives rental payments from two controlled entities has two separate unrelated trades or businesses, one for each controlled entity. The specified payments from a controlled entity are treated as gross income from one trade or business regardless of whether the controlled entity engages in more than one unrelated trade or business or whether the controlling organization receives more than one type of specified payment from that controlled entity.[35]

As well, the following rules apply for controlled foreign corporations:

All amounts included in UBTI under section 512(b)(17) are treated as income derived from a separate unrelated trade or business for purposes of paragraph (a) of this section.[36]

Income of an S Corporation

Unless an S corporation interest meets the requirements to be treated as a qualifying S corporation interest, discussed earlier, each S corporation interest is treated as an interest in a separate unrelated trade or business under IRC §512(a)(6).

Except as provided in paragraph (e)(2) of this section, if an organization owns stock in an S corporation (S corporation interest), such S corporation interest is treated as an interest in a separate unrelated trade or business for purposes of paragraph (a) of this section. Thus, if an organization owns two S corporation interests, neither of which is described in paragraph (e)(2) of this section, the exempt organization reports two separate unrelated trades or businesses, one for each S corporation interest. The UBTI from an S corporation interest is the amount described in section 512(e)(1)(B).[37]

Reporting Changes in Identification

If an organization changes the identification of separate trades or businesses it must report the changes as detailed in Reg. §1.512(a)-6(a)(3).

To report a change in identification, an organization must provide the following information for each separate change in identification:

The identification of the separate unrelated trade or business in the previous taxable year;
The identification of the separate unrelated trade or business in the current taxable year; and
The reason for the change.[38]

A change in identification of a separate unrelated trade or business includes the changed identification of the separate unrelated trade or business with respect to a partnership interest that was incorrectly designated as a qualifying partnership interest (QPI).[39]

Allocation of Deductions

An organization must allocate deductions between separate unrelated trades or businesses using the method described in Reg. §1.512(a)-1(c).[40]

Those rules at Reg. §1.512(a)-1(c), as revised by these regulations, read:

Where facilities are used both to carry on exempt activities and to conduct unrelated trade or business activities, expenses, depreciation and similar items attributable to such facilities (as, for example, items of overhead), shall be allocated between the two uses on a reasonable basis. Similarly, where personnel are used both to carry on exempt activities and to conduct unrelated trade or business activities, expenses and similar items attributable to such personnel (as, for example, items of salary) shall be allocated between the two uses on a reasonable basis. The portion of any such item so allocated to the unrelated trade or business activity is proximately and primarily related to that business activity, and shall be allowable as a deduction in computing unrelated business taxable income in the manner and to the extent permitted by section 162, section 167, or other relevant provisions of the Code. Thus, for example, assume that X, an exempt organization subject to the provisions of section 511, pays its president a salary of $20,000 a year. X derives gross income from the conduct of unrelated trade or business activities. The president devotes approximately 10 percent of his time during the year to the unrelated business activity. For purposes of computing X's unrelated business taxable income, a deduction of $2,000 (10 percent of $20,000), would be allowable for the salary paid to its president.

However, allocation of expenses, depreciation, and similar items is not reasonable if the cost of providing a good or service in a related and an unrelated activity is substantially the same, but the price charged for that good or service in the unrelated activity is greater than the price charged in the related activity and no adjustment is made to equalize the price difference for purposes of allocating expenses, depreciation, and similar items based on revenue between related and unrelated activities. For example, 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 does not 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 is not reasonable.[41]

The last two sentences were added by the new regulations, and were significantly revised in the final regulations as compared to the proposed regulations.

Total UBTI

Total unrelated business taxable income (UBTI) for an organization with more than one trade or business is equal to

The total of the UBTI computed with respect to each unrelated trade or business (treating any trade or business having a UBTI of less than zero as if it were zero)[42]
Less
- A charitable contribution deduction;
- An NOL deduction for losses arising in years beginning before January 1, 2018; and
- A specific deduction under IRC §512(b)(12) as applicable.[43]

Net Operating Losses

For taxable years beginning after December 31, 2017, an organization with more than one unrelated trade or business computes the NOL deduction separately for each unrelated trade or business.[44]

Pre-2018 Net Operating Losses

If an organization has net operating losses in years beginning prior to January 1, 2018, the organization first applies those losses against total UBTI before deducting any post-2017 NOLs with regard to a separate trade or business against that trade or business.[45] The regulation provides:

Pre-2018 NOLs are taken against the total UBTI as determined under paragraph (g) of this section in a manner that allows for maximum utilization of post-2017 NOLs in a taxable year. For example, an organization could choose to allocate all of its pre-2018 NOLs to one of its separate unrelated trade or business or it could allocate its pre-2018 NOLs ratably among its separate unrelated trades or businesses, whichever results in the greatest utilization of the post-2017 NOLs in that taxable year.[46]

Organization Ceases to Conduct the Trade or Business

NOLs not absorbed by a trade or business that the organization ceases to conduct generally remain suspended. As the regulation provides:

After offsetting any gain resulting from the termination, sale, exchange, or disposition of a separate unrelated trade or business, any NOL remaining is suspended. However, the suspended NOLs may be used if that previous separate unrelated trade or business is later resumed or if a new unrelated trade or business that is accurately identified using the same NAICS 2-digit code as the previous separate unrelated trade or business is commenced or acquired in a future taxable year.[47]

Treatment When the Identification of a Separate Unrelated Trade or Business Changes

The regulation provides generally the following rules when there is a change in the identification of a trade or business:

For purposes of section 512(a)(6) and this section, a separate unrelated trade or business for which the appropriate identification (within the meaning of paragraph (a) of this section) changes is treated as if the originally identified separate unrelated trade or business is terminated and a new separate unrelated trade or business is commenced. None of the NOLs from the previously identified separate unrelated trade or business will be carried over to the newly identified separate unrelated trade or business.[48]

Example Reg. §1.512(a)-6(h)(4)(i)

If the nature of a separate unrelated trade or business changes such that it is more accurately described by another NAICS 2-digit code, the separate unrelated trade or business is treated as a new separate unrelated trade or business with no NOLs.

The regulations discuss how to handle the issue if the change in identification applies to all, or just part, of the prior unrelated trade or business:

The change in identification may apply to all or a part of the originally identified separate unrelated trade or business. If the change in identification applies to the originally identified separate trade or business in its entirety, any NOLs attributable to that separate unrelated trade or business are suspended in accordance with paragraph (h)(3) of this section. If the change in identification applies to the originally identified separate unrelated trade or business in part, the originally identified separate unrelated trade or business that is not changing retains the full NOLs attributable to the originally identified separate unrelated trade or business, without allocation to the portion that became a newly identified separate unrelated trade or business.[49]

A similar treatment applies when a QPI becomes a non-QPI:

This paragraph (h)(4) also applies to each QPI that becomes a non-QPI. In this case, any NOLs attributable to the QPI that became a non-QPI are retained with the organization’s investment activities described in paragraph (c) of this section.[50]

However, if the change in identification is not related to a material change in the business (the organization had been using the wrong 2-digit NAICS code), the following rule applies:

In the case of a separate unrelated trade or business that is accidentally identified using the wrong NAICS 2-digit code or if an organization has determined that a separate unrelated trade or business that has not materially changed is more accurately identified by another NAICS 2-digit code, any NOL attributable to the originally identified separate unrelated trade or business becomes an NOL of the newly identified separate unrelated trade or business.[51]

When a Change in Identification Takes Effect

A change in identification is treated as taking effect on the first day of the taxable year in which the change in identification is made, with the new unrelated trade or business treated as beginning on that first day of the taxable year (regardless of when the actual event leading to the change in identification takes place).[52]

Examples – Reg. §1.512(a)-6(h)(4)(iv)

The IRS provides a series of examples related to the change in identification of an unrelated trade or business.

Example 1. Erroneous code

(I) Organization G is described in section 501(c) and is exempt from Federal income tax under section 501(a). In addition to its investment activities, Organization G has two separate unrelated trades or businesses – Q and R – that are identified with different NAICS 2-digit codes. Both Q and R have NOLs carried over from post-2017 taxable years.

(II) In Year 2 (a post-2017 taxable year), Organization G realizes that it accidentally used the wrong NAICS 2-digit code to identify R. The NOLs attributable to R under the old NAICS 2-digit code become the NOLs of R under the new NAICS 2- digit code as of the first day of Year 2.

Example 2. Material change

(I) Same facts as Example 1, except assume that, in addition to its investment activities, Organization G has three separate unrelated trades or businesses – Q, R, and S – that are identified with different NAICS 2-digit codes. Q, R, and S all have NOLs carried over from post-2017 taxable years.

(II) Organization G changes the NAICS 2-digit code identifying R to the same NAICS 2-digit code identifying S because the nature of the unrelated trade or business materially changed. Any post-2017 NOLs attributable to R are suspended (see paragraph (h)(4)(i) of this section). Organization G now has two separate unrelated trades or businesses – Q and S – as of the first day of Year 2.

Example 3. Partial material change

(I) Same facts as Example 1, except assume that Organization G determines that a part of R has materially changed such that R should be identified as two separate unrelated trades or businesses – R1 and R2. R1 retains the NAICS 2-digit code originally identifying R, and R2 is identified with a new NAICS 2-digit code that is not the same NAICS 2-digit code identifying Q. R2 is treated as a new separate unrelated trade or business with no NOLs as of the first day of Year 2. Any post-2017 NOLs attributable to R remain with R1.

Example 4. QPI to non-QPI

(I) Same facts as Example 1, but assume that Organization G has a partnership interest in T that was, for prior taxable years, a QPI included with Organization G’s investment activities. In Year 3 (a post-2017 taxable year), Organization G acquires more than 20 percent of the capital interests in T. The grace period described in paragraph (c)(6) of this section does not apply because the increase in percentage interest was not due to the actions of other partners.

(II) T conducts two trade or business activities that are unrelated trade or business activities with respect to Organization G – T1 and T2. Both T1 and T2 will be treated as new separate unrelated trades or business as of the first day of Year 2. Organization G identifies T1 with the same NAICS 2-digit code used to identify Q and T2 with a NAICS 2-digit code that is different than the NAICS 2-digit codes used to identify Q and R. In addition to its investment activities, Organization G has three separate unrelated trades or businesses – Q, R, and T2. Any post-2017 NOLs attributable to the QPI remain with Organization G’s other investment activities separate unrelated trade or business.

[1] TD 9933, November 20, 2020, https://www.irs.gov/pub/irs-drop/td-9933.pdf (retrieved November 25, 2020)

[2] TD 9933, Background

[3] Reg. §1.512(a)-6(b)(1)

[4] Reg. §1.512(a)-6(b)(1)

[5] Reg. §1.512(a)-6(b)(2)

[6] Reg. §1.512(a)-6(b)(3)

[7] Reg. §1.512(a)-6(c)(1)

[8] [8] Reg. §1.512(a)-6(c)(8)(iii)

[9] Reg. §1.512(a)-6(c)(2)(i)

[10] Reg. §1.512(a)-6(c)(2)(ii)(A)

[11] Reg. §1.512(a)-6(c)(2)(iii)

[12] Reg. §1.512(a)-6(c)(2)(iii)

[13] Reg. §1.512(a)-6(c)(8)(i)

[14] Reg. §1.512(a)-6(c)(8)(ii)

[15] Reg. §1.512(a)-6(c)(3)

[16] Reg. §1.512(a)-6(c)(5)(i)

[17] Reg. §1.512(a)-6(c)(5)(ii)

[18] Reg. §1.512(a)-6(c)(5)(iii)

[19] Reg. §1.512(a)-6(c)(5)(iv)

[20] Reg. §1.512(a)-6(c)(2)(ii)(B)

[21] Reg. §1.512(a)-6(c)(4)(i)

[22] Reg. §1.512(a)-6(c)(4)(ii)

[23] Reg. §1.512(a)-6(c)(4)(iii)

[24] Reg. §1.512(a)-6(c)(2)(ii)(C)

[25] Reg. §1.512(a)-6(c)(2)(ii)(D)

[26] Reg. §1.512(a)-6(c)(6)

[27] Reg. §1.512(a)-6(c)(7)

[28] Reg. §1.512(a)-6(c)(9)(i)

[29] Reg. §1.512(a)-6(c)(9)(ii)

[30] Reg. §1.512(a)-6(c)(9)(iii)

[31] Reg. §1.512(a)-6(c)(9)(ii)

[32] Reg. §1.512(a)-6(e)(2)

[33] Reg. §1.512(a)-6(e)(2)

[34] Reg. §1.512(a)-6(e)(2)

[35] Reg. §1.512(a)-6(d)(1)

[36] Reg. §1.512(a)-6(d)(2)

[37] Reg. §1.512(a)-6(e)(1)

[38] Reg. §1.512(a)-6(a)(3)

[39] Reg. §1.512(a)-6(a)(3)

[40] Reg. §1.512(a)-6(f)

[41] Reg. §1.512(a)-1(c)

[42] Reg. §1.512(a)-6(g)(2)

[43] Reg. §1.512(a)-6(g)(1)

[44] Reg. §1.512(a)-6(h)(1)

[45] Reg. §1.512(a)-6(h)(1)

[46] Reg. §1.512(a)-6(h)(2)

[47] Reg. §1.512(a)-6(h)(3)

[48] Reg. §1.512(a)-6(h)(4)(i)

[49] Reg. §1.512(a)-6(h)(4)(i)

[50] Reg. §1.512(a)-6(h)(4)(ii)

[51] Reg. §1.512(a)-6(h)(4)(ii)

[52] Reg. §1.512(a)-6(h)(4)(iii)