IRS Issues Guidance on Calculating UBTI Under the New Tax Law
By Lisa W. Heller, Senior Tax Manager
The IRS has issued long-awaited guidance regarding the calculation of unrelated business taxable income (“UBTI”) for exempt organizations under the new tax law. Although it is considered interim guidance, taxpayers may rely on the guidance given here until proposed regulations are issued.
UBTI Silo Rule
Under the new Section 512(a)(6) of the Internal Revenue Code, created as part of the 2017 tax act (P.L. 115-97), exempt organizations carrying on more than one unrelated trade or business must calculate UBTI separately for each trade or business activity. In addition, UBTI with respect to any such trade or business shall not be less than zero. This new Code section applies to taxable years beginning after December 31, 2017, and it effectively prohibits an exempt organization from using losses from one unrelated trade or business to offset income from another unrelated trade or business. Notice 2018-67 (8/21/2018) provides interim guidance and transition rules with respect to the application of Section 512(a)(6), pending the issuance of proposed regulations.
“Reasonable, good-faith interpretation”
According to the Notice, exempt organizations may rely on a “reasonable, good-faith interpretation” of the tax law to determine whether the organization has more than one unrelated trade or business for purposes of applying Section 512(a)(6). Per the Notice, a reasonable, good-faith interpretation includes classifying separate trades or businesses according to the six-digit classification codes under the North American Industry Classification System (NAICS). IRS notes that exempt organizations are already required to use NAICS codes to describe their unrelated trades or businesses for revenue reporting on Form 990-T.
For example, using a NAICS six-digit code, all of an exempt organization’s advertising activities and related services (NAICS code 541800) might be considered one unrelated trade or business activity, regardless of the source of the advertising income. Thus, an organization that derives advertising income from its publications, its website, and its meetings may, under the interim guidance, reasonably combine the income streams from these activities as a single trade or business in calculating UBTI under the new tax law.
The NAICS code system has its limitations. Many unrelated trades or businesses that exempt organizations may undertake do not have their own specific NAICS codes. In addition, many organizations use the “catchall” NAICS code of 900099 on Form 990-T, as no other NAICS code accurately describes their specific unrelated business activities. Should IRS include NAICS codes as a way of separating unrelated trades or businesses in its forthcoming proposed regulations on Section 512(a)(6), IRS will need to update or clarify the NAICS coding for unrelated business activities so that the reporting is as accurate as possible.
IRS indicates in the Notice that it is not in favor of using a facts and circumstances test for determining the existence of separate trade or business activities. Reasons include an increased administrative burden in performing a fact-intensive analysis, and likely inconsistencies in reporting across the tax-exempt sector due to differing approaches in determining each set of facts and circumstances.
Interim and Transition Rules for Partnership Investments
The Notice also provides guidance regarding items of unrelated business income (UBI) passed through to exempt organizations from partnerships. Under an interim rule, an exempt organization may aggregate all partnership interests and may treat the aggregate group of qualifying partnership interests as comprising a single trade or business, as long as they satisfy either a de minimis test or a control test. A partnership interest meets the de minimis test if the exempt organization directly holds no more than 2% of the profits interest and no more than 2% of the capital interest. A partnership interest meets the control test if the exempt organization directly holds no more than 20% of the capital interest and does not have “control or influence” over the partnership. The exempt organization partner may rely on the Schedule K-1 it receives from the partnership in determining whether it meets these tests. Also, a transition rule permits treating each partnership interest as comprising a single trade or business, even if it does not meet either of these tests, for direct partnership interests acquired before August 21, 2018.
Calculating and Utilizing Net Operating Losses
The Notice also discusses calculating and utilizing net operating losses (NOLs) arising before and after tax years beginning after December 31, 2017, with respect to Section 512(a)(6). However, the Notice does not provide any guidance with respect to NOLs that taxpayers may rely upon at this time, especially with regard to the “ordering” rules for pre-2018 and post-2017 NOLs. IRS specifically has asked for comments regarding this ordering rule.
The Notice provides a good start to helping exempt organizations understand how to apply Section 512(a)(6), but many questions remain unanswered. For example, it is not at all clear whether losses from a single trade or business, if an exempt organization has only one, may offset UBI revenue from the transportation fringe benefits addback under Section 512(a)(7). Additionally, there has been some speculation in the tax-exempt sector that the effective date for implementing Section 512(a)(6) might be delayed for a year or more while IRS works to come up with additional guidance. The Notice makes no mention of a delay in implementing this new Code section. Absent further guidance on this matter, we must assume that there will not be a delay in implementation, and that Section 512(a)(6) will remain effective for tax years beginning after December 31, 2017.
Finally, IRS is asking for comments on specific aspects of the guidance provided in the Notice. Deadline for all comments is December 3, 2018. Because of this late-in-the-year deadline, it is clear that we cannot expect proposed regulations on Section 512(a)(6) until sometime in 2019 at the earliest.
Please contact us if you have any questions or need assistance in this area.