Tax-exempt organizations that have unrelated business taxable income (UBTI) may need to calculate their UBTI differently as a result of a change in the tax law made by the Tax Cuts and Jobs Act of 2017 (TCJA). The TCJA added new section 512(a)(6) of the Internal Revenue Code of 1986, as amended (the Code), which requires UBTI to be calculated separately for each trade or business. This section precludes a loss from one trade or business from being used against income from a different trade or business. In Notice 2018-67 (the Notice), released on August 21, 2018, the IRS issued interim guidance, described planned regulations, and solicited comments on section 512(a)(6). This section can be crucial for affected tax-exempt organizations that are filing Form 990 for 2018.
Organizations described in sections 401(a) and 501(a) of the Code are generally exempt from federal taxation. However, if these organizations regularly engage in a trade or business unrelated to the charitable, educational or other purposes constituting the basis for their tax exemption, they are subject to tax on their UBTI. Before the TCJA, tax-exempt organizations that derived gross income from the regular conduct of two or more unrelated trades or businesses were permitted to report combined net taxable income (gross income less aggregate deductions) from those activities. This method allowed these organizations to reduce total UBTI. Section 512(a)(6) created a new rule in calculating UBTI. Under this new section, tax-exempt organizations with multiple unrelated business activities can no longer offset income from one activity with losses from another activity.
The new section was added because Congress intended that a deduction from one trade or business for a taxable year may not be used to offset income from a different unrelated trade or business for the same taxable year. However, the statute left unclear the scope of the activities that could be grouped together as a single unrelated trade or business.
In order to calculate UBTI, an organization must be able to determine whether it has more than one unrelated trade or business. To make that determination, it must know what trades or businesses would be considered the same or different for purposes of
Reliance on a Reasonable, Good-Faith Interpretation for Separate Trade or Business Determination
The Notice permits tax-exempt organizations to rely on a "reasonable, good-faith interpretation" of sections 511 to 514 of the Code in determining whether they have more than one unrelated trade or business, pending issuance of proposed regulations. A good-faith interpretation must consider all the facts and circumstances. For this purpose, the Notice states that a reasonable, good-faith interpretation includes using the six-digit codes of the North American Industry Classification System (NAICS). The NAICS is the standard used by federal agencies to classify businesses for statistical purposes. Tax-exempt organizations that file Form 990-T are already required to use the six-digit NAICS codes and therefore should be familiar with NAICS.
The IRS is suggesting that, if multiple unrelated trades or businesses are described by the same NAICS code, they could be treated as one trade or business for purposes of section 512(a)(6). In support of this conclusion, the Notice provides:
For example, under a NAICS 6-digit code, all of a tax-exempt organization’s advertising activities and related services (NAICS code 541800) might be considered one unrelated trade or business activity, regardless of the source of the advertising income.
The IRS has requested comments on possible methods to identify separate trades or businesses. However, the Treasury Department and the IRS do not want to develop or implement a facts-and-circumstances test. The Notice states that such a test would be administratively burdensome and difficult to enforce, and likely would result in inconsistencies across the tax-exempt organization sector. Therefore, the Notice asks about the usefulness of other Code sections or approaches that define a trade or business.
The IRS also noted in the Notice that the fragmentation rule set forth in section 513(c) of the Code and Treasury Regulations section 1.513-1(b) may be a prudent guide in developing a tax-exempt organization’s good-faith interpretation. The fragmentation rule provides that a tax-exempt organization’s business activity will not lose its identity as an unrelated trade or business merely because it is carried on within a larger aggregate of similar activities that are related to the organization’s tax-exempt purposes. Before the TCJA, this principle was used to "fragment" the unrelated aspects of a trade or business from the related aspects. An example is the sale of toys in an art museum gift shop (unrelated) versus the sale of prints depicting the art in the museum (related). However, the Notice does not explain how to apply the fragmentation rule in determining separate or combined trades or businesses.
Allocation of Deductions Attributable to More Than One Trade or Business
Section 512(a)(1) of the Code permits a tax-exempt organization with an unrelated trade or business to reduce the income from that trade or business by the allowable deductions that are directly connected with the carrying on of the trade or business. If a particular deduction is attributable to more than one unrelated trade or business, section 512(a)(6) now requires that the deduction be properly allocated. For example, if a tax-exempt organization conducted merchandise sales that generated $60,000 in income and conducted a separate advertising business that generated a loss, and also had legal fees of $15,000 attributable to both businesses, the tax-exempt organization must now figure out what portion of the legal fees could be used to offset the $60,000 in merchandise sales income. Under the TCJA, the portion of the legal fees attributable to the advertising can no longer be used to offset the merchandise sale income as it could before the TCJA.
There exists some minimal guidance on how a tax-exempt organization should allocate expenses connected with both a tax-exempt activity and an unrelated trade or business. Treasury Regulations section 1.512(a)-1(c) provides:
Where facilities are used both to carry on tax-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 tax-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.
Additional guidance from Treasury and the IRS is expected soon on this section of the regulations. This could modify the existing approach for allocation expenses between a related and an unrelated activity. The Notice requests comments on the standards that should be used for such allocations. Changes to the existing regulations may influence a similar allocation issue under section 512(a)(6), which is how to allocate expenses connected with two separate unrelated trades or businesses.
Activities in the Nature of Investments
The Notice explains that one interpretation of section 512(a)(6) might require a tax-exempt organization to calculate UBTI separately for each unrelated trade or business regularly carried on by a partnership in which the tax-exempt organization is a direct or indirect partner. The Notice also states that the IRS has received comments that this interpretation could result in significant reporting and administrative burdens for tax-exempt organizations with various investment activities, including ownership interest in funds, which often involves multi-tier partnership structures that generate UBTI or have UBTI flowing through them.
As a matter of administrative convenience for both tax-exempt organizations and the IRS, the Notice states that the IRS plans to propose regulations treating certain investment activities of a tax-exempt organization as one trade or business for purposes of section 512(a)(6) to permit tax-exempt organizations to aggregate gross income and directly connected deductions from such investment activities. This should also alleviate the administrative burden on funds that need to provide relevant UBTI information to their tax-exempt investors along with Schedule K-1 disclosures. The IRS requests comments regarding the scope of the activities that should be included in this "investment activities" category for purposes of section 512(a)(6). For this purpose, the Notice specifies that the "investment activities" category should include only partnership interests in which a tax-exempt organization does not significantly participate in any partnership trade or business.
Interim Rule for Partnership Investments
In addition to the reasonable, good-faith standard, the Notice provides two rules specifically for aggregating partnership interests and activities for purposes of the UBTI grouping rule.
Tax-exempt organizations may aggregate UBTI from an organization’s interest in a single partnership that reports multiple trades or businesses, including trades or businesses conducted by lower-tier partnerships, as long as the directly held interest in the partnership meets the requirements of either the de minimis test or the control test (described below). Additionally, this interim rule permits the aggregation of all qualifying partnership interests as comprising a single trade or business.
De Minimis Test
The de minimis test is met if a tax-exempt organization directly holds no more than 2 percent of the profits interest and no more than 2 percent of the capital interest in a partnership. A tax-exempt organization may rely on the Schedule K-1 to determine the percentage interest in the partnership. When determining this percentage, the interest of certain related organizations with regard to the same partnership will be taken into account.
A partnership interest meets the control test if the tax-exempt organization (1) directly holds no more than 20 percent of the capital interest in a partnership and (2) does not have "control or influence" over the partnership. Whether a tax-exempt organization has "control or influence" over the partnership is determined by facts and circumstances.
Transition Rule for Pre-August 21, 2018 Partnership Investments
Pending publication of proposed regulations, a tax-exempt organization may treat a partnership interest acquired before August 21, 2018 as constituting a single trade or business, whether or not the partnership (or any lower-tier partnerships) directly or indirectly conducts more than one trade or business. A tax-exempt organization may follow the transition rule for partnership interests for which it is not applying the interim rule. However, a tax-exempt organization may not aggregate a direct partnership interest falling under the transition rule with other direct partnership interests as a single trade or business.
Income Treated as an Item of Gross Income From an Unrelated Trade or Business
Sections 512(b)(4), (13) and (17) treat unrelated debt-financed income, specified payments received from controlled entities, and certain insurance income as items of gross income derived from an unrelated trade or business includable in the calculation of UBTI.
The Notice states that the IRS recognizes that one interpretation of section 512(a)(6) might impose a significant burden on organizations required to include amounts in UBTI under section 512(b)(4), (13) or (17). This interpretation, for instance, could require treating each debt-financed property owned by a tax-exempt organization as a separate trade or business, or require reporting income from each controlled entity as income from a separate trade or business. This separate reporting would impose a significant burden on both the organization and the IRS. Accordingly, the Notice states that aggregating income included in UBTI under section 512(b)(4), (13) or (17) may be appropriate in certain circumstances. The Notice requests comments regarding the treatment under section 512(a)(6) of income that is not from a partnership, but is included in UBTI under sections 512(b)(4), (13) and (17).
Ordering of Net Operating Losses
Net operating losses (NOLs) generated in taxable years beginning before January 1, 2018 may be used in subsequent years with no siloing limitation. However, because UBTI must be calculated separately for each trade or business before calculating total UBTI for taxable years beginning on or after January 1, 2018, it appears that post-2017 NOLs should be calculated and taken before pre-2018 NOL carryovers are taken. If read as imposing such an ordering rule, section 512(a)(6) could lead to the expiration of unused pre-2018 NOLs that remain subject to the 20-year expiration under prior law. The Notice requests comments on this issue and any other issue relating to the interaction of section 512(a)(6) with section 172 of the Code.
Tax-exempt organizations must carefully consider what type of UBTI must be calculated separately under the new rules. The ability under the Notice to rely on a reasonable, good-faith interpretation of the rules in determining what constitutes a trade or business gives tax-exempt organizations substantial latitude in making a determination. With respect to partnership interests, tax-exempt organizations need to assess whether their ownership structure enables them to meet the Notice’s de minimis test or the control test of the interim rules. Whether a tax-exempt organization should make changes to its ownership structure depends on each organization’s particular facts, as well as an assessment of whether the interim rule is likely to be continued in proposed and final regulations.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.