September 26, 2018 | Tax Planning
More guidance has been issued by the IRS in regards to the Tax Cuts and Jobs Act (TCJA), signed into law in December 2017. This time the topic is the calculation of unrelated business taxable income (UBTI) for tax-exempt organizations and any separate trade or business they operate. This change will generally apply to tax years beginning after 2017 and until proposed regulations are issued, organizations can rely on Notice 2018-67.
To Tax or Not to Tax?
As you might guess from the description, tax-exempt organizations are not taxed on most of their income, such as charitable contributions from donors. However, if an organization carries on any trade or business that is unrelated to its tax-exempt function, the unrelated business income tax must be paid.
UBTI refers to the income that comes from these business activities, less any allowable deductions. A tax-exempt organization can also carry over a net operating loss (NOL) from such unrelated business activities.
To calculate UBTI, a specific deduction of $1,000 is allowed, except for when computing the NOL deduction and concerning certain local church units (for example, a diocese or association of churches) that file separate returns. For these units, the allowable deduction is the lesser of:
The gross income from any unrelated trade or business carried on by the unit.
Tax Law Changes
The TCJA change requiring UBTI to be calculated separately has added another layer of complexity to an already-confusing set of rules.
Under the new tax law, nonprofits must calculate UBTI for each unrelated trade or business, with the total UBTI equaling the sum of those amounts. (None may be less than zero.) The determination for each business is made without regard to the $1,000 deduction generally allowed. That deduction is applied to the aggregate UBTI.
NOLs can be claimed only against future income from the specific business that generated the loss. (NOL carryovers from years prior to 2018 can still be used to offset all UBTI.) Previously, NOLs from one business could be applied to reduce the taxable income of another, in addition to gains from alternative investments or pass-through entities also considered UBTI. The removal of this option could result in organizations with multiple unrelated businesses to have more UBTI than in the past.
The corporate tax rate also changes to a flat 21% from a range of 15% to 35% under the TCJA. Since not-for-profits pay the corporate rate on UBTI, your tax liability could potentially fall, even if your overall UBTI grows.
Highlights of UBTI Guidance
IRS Notice 2018-67 clears up some details of the UBTI rule. While it is 36 pages long and contains a dizzying array of code section references, tax-exempt organizations should know these key elements:
Investments in partnerships. A special interim rule applies for tax-exempt organizations investing in partnerships. An organization may combine its interest in a single partnership with multiple trades or businesses (including trades or businesses conducted by lower-tier partnerships) if it passes either one of the following two tests:
De minimis test. The organization directly holds no more than 2% of the profits interest and no more than 2% of the capital interest of the partnership.
Control test. The organization directly holds no more than 20% of the capital interest and does not have control or influence over the partnership.
If either test is satisfied by an organization, it may treat the aggregate group of partnership interests as a single trade or business for these purposes.
In addition, a tax-exempt organization that acquired a partnership interest prior to August 21, 2018, may treat each partnership interest as a single trade or business, regardless of whether it meets either test or there’s more than one trade or business directly or indirectly conducted by the partnership (or lower-tier partnerships).
Nonpartnership activities. If a tax-exempt organization engages in an activity other than a partnership, it should use the six-digit North American Industry Classification System (NAICS) codes to identify if it has more than one unrelated trade or business. This is considered “a reasonable, good-faith interpretation” of the rules. Use of fewer than six digits would result in overly broad categories.
GILTI. Global intangible low-taxed income (GILTI) is treated as a dividend for the purposes of computing UBTI and is generally excluded from UBTI. This is consistent with other tax treatment of GILTI.
Employee fringe benefits. Per another provision in the TCJA, transportation fringe benefits (such as mass transit passes and parking fees) provided to employees of a tax-exempt organization must be included in UBTI. These amounts are not subject to the rules requiring a separate calculation for each trade or business.
Special UBTI definitions apply to social clubs, voluntary employees’ beneficiary associations and supplemental unemployment compensation benefits trusts. The IRS is requesting comments regarding the additional considerations that should be given to these entities as a result.
Notice 2018-67 also finds the IRS acknowledging some of the difficulties arising under the new requirements. For instance, with regards to items relating to certain unrelated debt-financed income, income from controlled entities and insurance income, the IRS recognizes that aggregating income included in UBTI may be appropriate in certain situations.
Contact Filler & Associates
These highlights just scratch the surface of this complex topic. IRS Notice 2018-67 also specifies various transitional rules, including those regarding NOLs from unrelated business activities of tax-exempt organizations. The key learning is that determining UBTI isn’t a do-it-yourself proposition. You can rely on Filler & Associates to steer you in the right direction and help strategize ways to minimize the adverse effects of the new UBTI rule.