IRS Addresses Post-TCJA Calculations of UBTI for VEBAs and SUBs

Practical Law Legal Update w-025-1580 (Approx. 6 pages)

IRS Addresses Post-TCJA Calculations of UBTI for VEBAs and SUBs

by Practical Law Employee Benefits & Executive Compensation

2017 Tax Reform Changed Rules for Determining UBTI

Under the Internal Revenue Code (Code), certain entities that are exempt from federal income taxation are nonetheless subject to tax on their UBTI. UBTI is generally defined as income from unrelated trade or business that is regularly carried on by the entity, less certain deductions (26 U.S.C. § 512(a)(1)). A trade or business is unrelated if conducting the business is not substantially related to an exempt entity's performance of the charitable, educational, or other purpose that is the basis for its tax-exempt status.

A separate definition of UBTI applies for:

VEBAs, which are plans established under Code Section 501(c)(9) to provide certain benefits, including health and accident benefits, life insurance, and similar benefits, to their members, dependents, or designated beneficiaries. A VEBA may include a trust, which is tax-exempt if it satisfies the requirements of Section 501(c)(9) (26 U.S.C. § 501(c)(9)).
SUB plans, which are established as separate trusts for providing unemployment compensation benefits and funded by employer payments. SUB trusts are tax-exempt under Section 501(c) if they satisfy the requirements of Code Section 501(c)(17) (see Article, Supplemental Unemployment Benefit (SUB) Plans and COVID-19).

(See Legal Updates, IRS Ruling Addresses Employer's Use of VEBA Assets and In Fiduciary Litigation, VEBA Trust Assets Were ERISA Plan Assets.)

For VEBAs and SUB trusts, UBTI is generally defined as income from unrelated trade or business that is regularly carried on by the entity, but excluding exempt function income. Exempt function income consists of:

Member income, which includes member-paid dues, fees, or similar amounts.
Passive income, which includes investment income if it is set aside for charitable gift purposes, paying benefits, or related administrative purposes.

(26 U.S.C. § 512(a)(3).)

The Code limits the amounts that VEBAs and SUB trusts may set aside under the exempt function income rules (26 U.S.C. § 512(a)(3)(E)).

Before 2018, entities with more than one unrelated trade or business could aggregate the incomes from those trades or businesses and deductions in calculating UBTI. In late 2017, however, the Tax Cuts and Jobs Act (TCJA) added a Code provision requiring that UBTI be calculated separately for each trade or business (known as "silos") (26 U.S.C. § 512(a)(6); see Tax Cuts and Jobs Act (TCJA) Compliance for Fringe Benefits and Health Plans Toolkit). As a result, a deduction from one trade or business for a year cannot be used to offset income from a different unrelated trade or business for the same year.

In Notice 2018-67, the IRS:

Provided interim guidance regarding Code Section 512(a)(6).
Indicated that UBTI attributable to certain benefits was not subject to the TCJA rule requiring entities with more than one unrelated trade or business to separately calculate UBTI for each trade or business.

The IRS also requested comments in Notice 2018-67 concerning, among other issues, how to identify separate trades or businesses in calculating UBTI.

Proposed Regulations Address Post-TCJA Calculations of UBTI

Consistent with the TCJA, the proposed regulations require entities with more than one unrelated trade or business to calculate UBTI for each trade or business separately, rather than aggregating income from all unrelated trades or businesses. Under the proposed regulations, certain investment activities of exempt entities are treated as unrelated trades or businesses for purposes of calculating UBTI. In addition, the proposed regulations permit separate trades or businesses to be identified using the North American Industry Classification System (NAICS) codes (an industry classification system).

The proposed regulations also address:

Identifying and reporting an entity's investment activities (which are treated as a separate unrelated trade or business).
Treatment of partnership interests.
Payments received from controlled entities.
S-corporation interests and employee stock ownership plans (ESOPs) (see Practice Note, Employee Stock Ownership Plans (ESOPs)).

Methods for VEBAs and SUBs

Under the proposed regulations, VEBAs and SUB trusts generally use the same methods as other types of entities to determine if they have more than one unrelated trade or business.

VEBAs and SUBs generally must include interest, dividends, royalties, rents, and capital gains in UBTI, unless these amounts are exempt function income (for example, income for paying life, sick, or accident insurance, or other benefits) (see Legal Update, IRS Proposed Rules Address UBTI Calculations for VEBAs and SUBs). The exempt function income amounts are subject to statutory limits. Amounts categorized as exempt function income are excluded from UBTI, if the amounts actually are used to pay benefits. If not used for such a purpose, the amounts are UBTI.

VEBAs and SUBs also treat certain investment activities listed under the proposed regulations (for example, qualifying S-corporation interests) as a separate unrelated trade or business for purposes of the TCJA requirements under Code Section 512(a)(6).

Classification of Unrelated Trades or Businesses

Under the proposed regulations, an exempt organization may identify its separate trades and businesses by using more general NAICS two-digit codes rather than the originally proposed six-digit codes. The two-digit codes identify trades or businesses in 20 sectors, rather than the more than 1,000 business activities classified by the six-digit codes. Adopting the two-digit code will:

Mitigate the administrative burden on exempt organizations (and the IRS) of using a system that was not designed for the purpose of identifying an exempt organization's activities.
Allow for a more natural aggregation of similar activities.
Minimize confusion and inconsistencies because the two-digit system is less likely to change over time.
Still meet the goal of limiting an organization's ability to offset its gains from one unrelated trade or business with the losses from another.

Comments on the proposed regulations are due by June 23, 2020.

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