We’ve blogged quite a bit about changes affecting the exempt sector under the Tax Cuts and Jobs Act. One change in the realm of unrelated business income taxation has caused concern among practitioners, with the American Bar Association recommending a delay of the new rule until clarifying regulations are issued by the IRS.
To recap, longstanding law allowed exempt organizations to offset all gains and losses from all their unrelated trade or businesses in order to come up with an aggregate gain or loss from nonexempt activities. Under new Section 512(a)(6), only losses from the same unrelated trade or business can be used to offset gains. Thus, for exempt organizations that have more than one unrelated trade or business, each separate unrelated trade or business is considered a “silo” and must track its gains and losses separately from all other unrelated trades or businesses.
The American Bar Association Section of Taxation has weighed in on the implementation of the change in a comment letter to the Acting Commissioner of the IRS, noting several areas that it has asked for guidance in implementing the rule, some recommendations as to rules, and a request to delay implementation until guidance has been issued. The comments state that as a practical matter absent regulations, exempt organizations do not have enough guidance to know how to track income and expenses in order to comply with the new law. Below is a summary of areas highlighted as unclear:
- Definition of “each such trade or business.” Does an exempt theater organization that operates three parking lots used by theater goers have a single unrelated trade or business or does it have three? The boundaries for what constitutes each trade or business need to be clarified with respect to substantially similar activities.
- Application of the silo rule to items of income that are “deemed” UBTI such as debt-financed income or fringe benefits. Passive investment income also does not easily lend itself to categorization as a distinct line of business. Should an organization consider all deemed UBTI in a single silo or separate ones? What about passive investment income from partnerships—can that be aggregated or must it also be siloed? Or worse yet, will the exempt organization be asked to look through the K-1 issued by these partnerships to determine each line of business within the partnership?
- Establishment of a system of allocation of overhead expenses, and the software necessary to accommodate the rules in order to make quarterly tax payments. The absence of this guidance effectively penalizes small exempt organizations for failure to estimate their taxes accurately when they have nothing they can rely on is unfair and serves no legitimate purpose.
The ABA Section of Taxation not only recommends that regulations be issued as soon as possible in response to defining “each such trade or business” and delaying implementation of the new law until those regulations are issued, but also makes some specific recommendations with respect to what should be contained in the regulations including:
- Deemed UBTI (taxable fringe benefits, unrelated debt-financed income, payments from controlled entities, S corporation stock) should not be subject to the silo rule and should continue to be available to offset UBTI from any active unrelated trades or businesses of exempt organizations.
- Passive investment income should not be subject to the silo rule if the organization is not engaged in an active trade or business and has no control (defined as being a general partner or manager, or having more than 50% profits or capital interest) over the business.
- Similar or identical activities (e.g. operating three parking lots) should constitute a single unrelated trade or business silo and the regulations should allow use of the North American Industry Classification System (NAICS) codes currently used on Form 990 and 990-T to provide categories for grouping of various trades and businesses.
- Net operating loss ordering should follow the usual rules of Section 172, with the oldest NOLs being applied to income first.