October 02, 2018
One of the provisions of the Tax Cuts and Jobs Act (Act) that has raised significant questions and concerns for exempt organizations is the calculation of unrelated business taxable income (UBTI). The Act added Section 512(a)(6) to the Internal Revenue Code requiring that UBTI from each unrelated trade or businesses be calculated separately. This “siloing” means an exempt organization may no longer use the losses of one unrelated trade or business to offset the UBTI of another unrelated trade or business. This may result in many organizations being subject to tax on UBTI for the first time. The lack of guidance on how to categorize different activities into separate trades or businesses, how to treat income from investing and the use of net operating losses has left many UBTI taxpayers confused.
On August 21, 2018, the Internal Revenue Service issued Notice 2018-67, providing interim guidance and clarity on how to identify separate trades or businesses in connection with UBTI. This interim guidance provides taxpayers with transition rules they may rely upon in calculating unrelated business income pending the release of proposed regulations. The IRS has not delayed the implementation of new Section 512(a)(6), which is generally effective for tax years beginning after December 31, 2017. However, the notice makes it clear the IRS will not penalize organizations if they use a reasonable, good-faith interpretation in calculating their UBTI relying on Sections 511 through 514 and consider all facts and circumstances. In addition, the guidance provided in the notice may be relied on by exempt organizations for taxable years beginning after December 31, 2017, with certain restrictions.
Identifying Trades or Businesses
According to the notice, the Treasury Department and the IRS are considering the use of the North American Industry Classification System (NAICS) to classify activities for defining a trade or business activity. The NAICS groups together similar economic activities into defined industries that are identified using a 6-digit coding system. These codes are already used on Form 990 and Form 990-T to classify activities. However, many organizations default to using an “other miscellaneous” code, so the use of the codes may still prove challenging. In addition, the notice states that the "fragmentation principle" in Section 513(c) and Reg. Section 1.513-1(b) and related guidance may also be helpful.
Investment Income and Partnership Activities
A question of particular interest that was raised with the passage of the act is how UBTI from investment activities, particularly partnerships, would be treated. Partnership interests can generate UBTI, even if the investment is passive, if the underlying activities would be unrelated business income if conducted by the partner itself. The IRS indicates it plans to propose regulations to permit exempt organizations to aggregate gross income and directly connected deductions from such investment activities where they do not significantly participate in the partnership trade or business. Until those regulations are released, the notice provides the following interim rule and transition rule.
Interim Rule for Qualifying Partnership Interest
An exempt organization may aggregate its UBTI from its interest in a single partnership with multiple trades or businesses, including trades or businesses conducted by lower-tier partnerships, as long as, the directly-held interest in the partnership meets either the "de minimis test" or the "control test." In addition, an exempt organization may aggregate all qualifying partnership interests and treat the aggregate group as a single trade or business for purposes of Section 512(a)(6)(A).
To acknowledge that it may be difficult to modify previously-acquired partnership interest to meet the de minimis or control test, a transition rule is provided for a partnership interest acquired prior to August 21, 2018. In such a case, the exempt organization may choose to treat all income earned from such partnership as a single trade or business, regardless of whether there is more than one trade or business directly or indirectly conducted by the partnership. However, the rule does not explicitly authorize aggregating these grandfathered partnerships.
Treatment of Fringe Benefits
The notice clarified that the amount included in UBTI for certain employee fringe benefits under 512(a)(7) will not be treated as a separate trade or business under 512(a)(6). This seems to imply that losses from other activities may be able to offset this income. Unfortunately, the notice did not address how this rule is implemented and calculated, leaving many open questions.
Net Operating Losses
In addition to the changes under 512(b)(6), the act also impacted the treatment of net operating losses under Section 172. The use of net operating losses allowed in the context of UBTI incurred in years beginning after December 31, 2017, is now limited to the lesser of:
The notice states that Section 512(a)(6) may have changed the order in which an organization would take NOLs, because Section 512(a)(6)(A) requires organizations to calculate UBTI separately before calculating total UBTI under Section 512(a)(6)(B). As such, Section 512(a)(6) could be viewed as an ordering rule requiring post-2017 NOLs to be taken before pre-2018 NOLs. The notice states that the IRS intends to issue guidance regarding how Section 172 generally applies to exempt organization with more than one activity.
Income treated as unrelated business income
The notice indicated that certain types of statutorily defined income (debt-financed income, income from controlled entities and insurance income from controlled foreign corporations) are calculated separately. However, the notice recognizes that such separate reporting may be administratively burdensome and aggregating such income may be appropriate in certain circumstances.
Global Intangible Low-Taxed Income
The notice also clarified that global intangible low-taxed income(GILTI) under Section 951A (added as part of the act) is to be treated as a dividend which is generally excluded form UBTI under 512(b)(1). Therefore, U.S. funds that have GILTI inclusions will not trigger UBTI for the funds’ tax exempt-investors.
Throughout the notice, the IRS requests interested parties to provide comments and guidance regarding the implementation of Section 512(a)(6). Exempt organizations are encouraged to take advantage of the offer to submit comments to the IRS regarding the application of this provision–the IRS really is interested in understanding the implication, particularly the administrative burdens and costs anticipated by exempt organization UBTI taxpayers, as they proceed to implement the notice changes. Comments may be submitted to the IRS on or before December 3, 2018 at the address provided in the notice.
Taxpayers who have unrelated business activities should use the information provided in Notice 2018-67 to make a good faith effort at classifying their activities either together or separately for purposes of estimating their projected tax liability for the coming year. In addition, they should ensure reasonable approaches are used in allocating expenses to the identified trades or businesses.
For more information contact your Eide Bailly tax professional, or a member of the Eide Bailly National Tax Office Exempt Organization service team.