As we’ve blogged about previously, the Tax Cuts and Jobs Act brought about some major changes in the area of unrelated business income taxation—mainly its new prohibition on calculating unrelated business taxable income (“UBTI”) on an aggregated basis. The legislation itself left many unanswered questions, and the IRS has recently issued some interim guidance to fill in some gaps. In Notice 2018-67, the IRS addresses how to determine if an organization has separate unrelated trades or businesses, how to treat UBTI that doesn’t technically arise from an unrelated trade or business, and how to deal with UBTI from investment activities, among other issues.
Different unrelated trade or business. Section 512(a)(6) of the Tax Code now requires exempt organizations with more than one trade or business to calculate their UBTI separately with respect to each trade or business. This begs the question of what constitutes more than one trade or business. In some cases, it may be reasonably clear—for example, an exempt organization that operates a café that is an unrelated trade or business, as well as a gift shop that is an unrelated trade or business, almost certainly has two separate trades or businesses for purposes of this rule. But what about an exempt organization with more than one restaurant?
In the Notice, the IRS states that until regulations or other interim guidance is issued, exempt organizations may rely on a reasonable, good-faith interpretation of the statute. Moreover, the use of North American Industry Classification System 6-digit codes is specifically called out as a reasonable, good-faith interpretation. This system is already utilized in preparing the revenue section on Form 990, Part VIII, and on Form 990-T in Block E. As an example, a full service restaurant would be classified as 722511 under this system—and if an exempt organization operated multiple full-service restaurants that are unrelated businesses, it would be able to calculate UBTI for them as a group under this guidance.
The Notice also speaks to the potential need to allocate expenses between different unrelated businesses—similar to what exempt organizations need to do when expenses are shared between exempt activities and unrelated businesses. The IRS is planning to address allocation in upcoming regulations, and is requesting comments on this issue.
Income treated as UBTI. Under the Tax Code, certain items of revenue are taxed as UBTI even though they technically does result from an unrelated trade or business. Some examples are debt-financed income and income received from controlled entities. The Notice notes that requiring an organization to treat each debt-financed property as a separate unrelated trade or business would impose an administration burden on the organization and the IRS, and states that aggregating income in these circumstances (e.g., aggregating all debt-financed income), may be appropriate.
Investment UBTI. Exempt organizations may receive UBTI from investments they hold in partnerships, as they generally are taxed on their holdings in partnerships on a passthrough basis. Organizations that hold many different partnership investments, including partnerships that themselves have partnership investments, could face an extreme burden if forced to view each one separately. The Notice recognizes this, and notes that the IRS intends to propose regulations that treat certain activities in the nature of investments as one trade or business. Comments are requested as to what constitutes “investment activities.”
The Notice contains an interim rule allowing exempt organizations to aggregate UBTI from all qualifying partnership interests, which meet either the de minimis test or the control test.
- De minimis test: a partnership interest will meet this test if the exempt organization holds directly no more than 2 percent of the profits interest and 2 percent of the capital interest.
- Control test: A partnership interest will meet this test if the exempt organization directly holds no more than 20 percent of capital interest, and does not have control or influence over the partnership.
In addition, an exempt organization can aggregate its UBTI from its interest in a single partnership with multiple trades or businesses, including trades or businesses conducted by lower-tier partnerships, so long as the directly held interest is a qualifying partnership interest.
For purposes of both the de minimis test and the control test, when determining an
exempt organization’s percentage partnership interest, the interest of a disqualified
person, a supporting organization, or a controlled entity in the same partnership will be
taken into account.
Net Operating Losses. Changes to the UBTI rules also affect net operating losses. Going forward, a net operating loss deduction can be taken only with respect to a trade or business from which the loss arose. There is a transition rule for NOLs from tax years prior to 2018, which allows those NOLs to be taken against total UBTI.
Application to Other Exempts. Certain exempt organizations, such as 501(c)(7) social clubs, are subject to slightly different rules on unrelated business income taxation. In a nutshell, UBTI for these organziations includes essentially all income that is not exempt function income. So there is no exception for passive income like royalties, or for unrelaed income from a business that is not regularly carried on. The Notice makes clear that the new rules regarding different unrelated businesses will apply the same to these organizations as to others, like 501(c)(3)s.
Fringe Benefits. Section 512(a)(7) increases UBTI by the amount of fringe benefits qualified transportation fringe, any parking facility used in connection with qualified parking, or any on-premises athletic facility. The Notices states that the provision of the fringe benefits described in Section 512(a)(7) not an unrelated trade or business, and as such, any amount included in UBTI under this section is not subject to the Section 512(a)(6) aggregation rules..
Comments on the application of Section 512(a)(6) and the issues discussed in the Notice should be submitted to the IRS on or before December 3, 2018. The cover page or subject line should include a reference to Notice 2018-67. Comments can be sent to the following addresses:
Internal Revenue Service
CC:PA:LPD:PR (Notice 2018-67), Room 5203
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044
Internal Revenue Service
1111 Constitution Ave., N.W.
Washington, DC 20224
Attn: CC:PA:LPD:PR (Notice 2018-67)