Tax-Reform Issues for Exempt Organizations: IRS Provides New Guidance on UBI Calculations
Association TRENDS
The tax reform signed into law in December 2017 will have a significant impact on tax-exempt organizations nationwide, substantially increasing the amount of income that may be subject to tax. It is important that organizations are acutely aware of the changes in the law and, more importantly, the changes in the amount of income that may be subject to tax. Planning for these changes now can help organizations mitigate the potential impact of the new law and help management prepare for the impact of increased tax liability, or even the impact of having to pay taxes for the first time. The Internal Revenue Service (“IRS” or “Service”) recently published the first significant guidance relating to exempt organizations impacted by the new tax law which can be used by organizations to prepare for, and possibly limit, the adverse impact of the new law.
Notice 2018-67 (“Notice”), issued by the Service on August 21, 2018, interprets and provides administrative guidance about new Internal Revenue Code (“Code”) § 512(a)(6). Below is a brief summary of the interpretations and guidance provided in the Notice that may be applicable to, and useful for, most exempt organizations impacted by section 512(a)(6).
Background
New Code § 512(a)(6) drastically changes the calculation of unrelated business taxable income (“UBTI”). Previously, exempt organizations with more than one line of unrelated trade or businesses were required to pay tax on the net unrelated business income (“UBI”) determined by deducting the aggregated amounts of income and expenses from all unrelated business activities. However, under section 512(a)(6), for each tax year beginning on or after January 1, 2018, exempt organizations with more than one trade or business are required to calculate the net UBI separately with respect to each trade or business.
Under new Code § 512(a)(6), for purposes of calculating an exempt organization’s UBTI:
- the amount of UBTI, including the calculation of any net operating loss (“NOL”) deductions, shall be computed separately for each trade or business;
- the organization’s UBTI shall be the sum of the UBTI for each respective trade or business, less the specific deduction provided by the Code (currently $1,000); and
- the amount of UBTI for any single trade or business shall not be less than zero.
As a result of this change, exempt organizations will no longer be allowed to net the losses of a single loss activity against the gains from other profitable business activities. Additionally, organization’s will no longer be allowed to use NOLs accumulated from significant loss activities to reduce the future income derived from other unrelated trades or businesses.
Notice 2018-67 General Guidance for Identifying each Unrelated Trade or Business
Throughout the Notice, the Service repeatedly acknowledged the lack of appropriate guidance defining a single unrelated trade or business and the substantial burdens, on both exempt organizations and the Service, that would result from certain interpretations of Code § 512(a)(6). The Notice indicates that, pending the issuance of regulations interpreting section 512(a)(6), exempt organizations may rely on any “reasonable, good-faith interpretation of §§ 511 through 514, considering all of the facts and circumstances, when determining whether an exempt organization has more than one unrelated trade or business for purposes of § 512(a)(6).”
It is significant that the Notice specifically provides that organization’s “may rely” on any reasonable interpretation made in good faith. By repeatedly focusing on the ability of exempt organizations to rely upon their own reasonable interpretations, the Notice is essentially providing a safe harbor from any adverse decision regarding Code § 512(a)(6) to every exempt organization that merely undertakes the effort to determine whether they are engaged in multiple unrelated trades or businesses and, as such, are subject to the provisions of section 512(a)(6).
The “reasonable, good faith interpretation” standard is quite broad, and the Notice provides some specific guidance as to what the IRS will consider a basis for a “reasonable, good-faith interpretation,” including:
- An analysis taking into account all facts and circumstances;
- Classification of business activities through use of the North American Industry Classification System (“NAICS”), which can be found at https://www.census.gov/eos/www/naics/2017NAICS/2017_NAICS_Manual.pdf;
- An analysis using the fragmentation principle as provided in Code § 513(c) and Treasury Regulations (“Treas. Reg.”) § 1.513-1(b); and
- An analysis of other sections of the Code that provide various factors for determining whether an organization is engaged in a trade or business, including: sections 132, 162, 183, 414, and 469.
Until the Service publishes proposed regulations interpreting Code § 512(a)(6), an exempt organization may rely on any of the methods described above to aggregate or identify separate trades or businesses.
Specific Guidance
In addition to the general guidance pertaining to whether an exempt organization is engaged in more than one unrelated trade or business, the Notice provides guidance for specific situations that present unique factors or are potentially overburdensome, including: (a) the use of NOLs; (b) partnership income; and (c) fringe benefits characterized as UBI pursuant to section 512(a)(7).
- NOLs
Prior to the creation of Code § 512(a)(6), organizations were allowed to carry over their aggregate NOLs and deduct such losses from future or prior year gains as the law permitted. While the new provision continues to allow organizations to use NOLs, section 512(a)(6)(A) only allows an NOL deduction “with respect to a trade or business from which the loss arose.” As such, for tax years beginning on or after January 1, 2018, organizations will need to track their NOLs for each unrelated trade or business, only deducting NOLs from future gains within the same unrelated trade or business activity.
While tracking and using future NOLs may be a difficult process, the Notice clarifies that the NOL limitation does not apply to NOLs accumulated before 2018. As such, exempt organizations that accumulated NOLs before 2018 may continue to deduct such NOLs from the aggregate amount of their UBTI until such NOLs expire. It is unclear how the pre-2018 NOLs may be used in conjunction with the post-2018 NOLs in future tax years. However, the transitional rule permitting the use of aggregate NOLs as a deduction against the total amount of an organization’s UBI should be helpful to many organizations with prior year tax losses.
- Partnership income
Under Code § 512(a)(6), calculating the UBTI of exempt organization income derived from partnership activities, especially investment partnerships, may be nearly impossible. Generally, when an exempt organization participates in a partnership, the organization is treated as though it is directly engaged in each of the activities of the partnership. As such, a determination as to whether the organization is engaged in an unrelated trade or business through its partnership interests will be based on an analysis of the activities of the partnership itself.
By itself, analyzing the activities of a separate entity to determine whether income derived from that entity is UBTI seems like a difficult and burdensome process for determining an organization’s tax liability. However, the process becomes exponentially more difficult in situations where the partnership is itself invested in one or more partnerships which may have invested in one or more partnerships. Under the plain text of Code § 512(a)(6), it is possible that exempt organizations would be required to analyze the activities of each partnership in an ownership chain to determine whether each entity engaged in an unrelated trade or business and, if so, the amount of UBTI that the organization derived from the entity’s activities. Fortunately, the Notice saves exempt organizations from this nightmare by creating transition rules which permit the aggregation of gross income and deductions from certain investment activities.
The Notice provides that any proposed regulations will likely treat activities in the nature of an investment (“investment activities”) as one trade or business which will permit organizations to aggregate gross income and deductions from all such investment activities. Under the transitional rules, an organization will be permitted to aggregate a partnership investment with its other investment activities if it meets either a de minimis test or the control test.
An exempt organization’s partnership interest will satisfy the de minimis test if the organization holds no more than a 2 percent profits interest and no more than a 2 percent capital interest. An exempt organization’s partnership interest will satisfy the control test if the organization does not hold more than 20 percent of the capital interest in the partnership and the exempt organization does not have control or influence over the partnership’s operations. Where an organization satisfies either the de minimis or the control test, the organization may treat all such partnerships interests as a single trade or business for purpose of Code § 512(a)(6).
- Fringe benefits characterized as UBI under Code § 512(a)(7)
Code § 512(a)(7) increases an organization’s UBTI by the amount of certain fringe benefit expenses for which a deduction is not allowed under section 274. However, the Notice provides that such additions to UBTI are not subject to section 512(a)(6) because the increase in taxable income under section 512(a)(7) is not the result of an item of gross income derived from an unrelated trade or business.
Next Steps
Notice 2018-67 is very important to exempt organizations preparing themselves for the impact of the recent tax reform. The greatest significance of the Notice is that it essentially provides a safe harbor to all organization’s that undertake the effort to make a “reasonable, good-faith” determination as to whether they are engaged in more than one unrelated trade or business, allowing organizations to rely on such internal determinations until the Service publishes proposed regulations. The protection that this affords organizations in light of the uncertainty of Code § 512(a)(6) is significant, and the benefit of such protections definitely will outweigh the time and resources required to develop such a reasonable, good faith basis for an organization’s positions. It is strongly advised that exempt organizations impacted by section 512(a)(6) take the steps necessary to avail themselves of the safe harbor that the Service has created.