Under the Tax Cuts and Jobs Act (TCJA), multiple changes were made to the Internal Revenue Code (IRC), and the unrelated business income tax (UBIT) section was no exception. The most significant change occurred in IRC Section 512(a)(6), which requires unrelated business taxable income (UBTI) to be calculated separately for each trade or business. Also, under this provision, organizations with more than one trade or business can’t use a loss from one trade or business to offset the income from another. This prompts the question: What constitutes a trade or business? In response to organizations having trouble answering this and other questions the TCJA created, the IRS and U.S. Department of the Treasury (Treasury) issued Notice 2018-67 (the Notice) to provide initial clarification.
Separate Trade or Business
As stated in the Notice, “Congress intended that a deduction from one trade or business for a taxable year may not be used to offset income from a different unrelated trade business for the same taxable year.” When determining whether an organization has more than one unrelated trade or business, the Notice states organizations may rely on “a reasonable good-faith interpretation using the North American Industry Classification System (NAICS) 6-digit codes.” This means if an organization has two or more separate sources of UBTI that fall under the same NAICS code, losses from one can be used to offset gains from the other. This also means the taxable income or losses of businesses that fall under different NAICS codes must be calculated separately and the net cannot be aggregated, unless another reasonable, good-faith method is used.
The IRS and Treasury are currently requesting comments regarding whether the full six-digit NAICS code should be required for determining separate trades or businesses. Alternatively, using five or four digits would allow a wider assortment of businesses to be aggregated. They also are requesting “whether and how these and other Code sections may aid in determining how to identify an exempt organization’s separate trades or business,” as well as how to allocate expenses among different trades or businesses. Currently, an exempt organization must allocate expenses among exempt activities and unrelated business activities when those expenses are shared between the two. Regulations have previously provided guidance in this area (Reg. §§1.512(a)-1(c) and (d)), and according to the IRS’s 2017–2018 Priority Guidance Plan, further guidance is planned to provide a framework to allocate expenses between two uses on a reasonable basis. This determination is now expanded to include the allocation of expenses among separate unrelated business activities.
The IRS and Treasury are proposing that the fragmentation principle found in IRC §513(c) and Reg. §1.513-1(b) may provide guidance to help identify separate trades and businesses. The principle states a business activity of an exempt organization may be treated as an unrelated business even though the activity is carried on within a larger framework of similar related activities. The identity of a trade or business isn’t lost just because it’s part of a larger related activity. The same concepts may be applied to IRC §512(a)(6).
There are special UBTI rules for certain revenue streams generated by §501(c)(7) social clubs, §501(c)(9) voluntary employees beneficiary association (VEBA) plans, §501(c)(17) supplemental unemployment compensation benefits (SUB) trusts, controlled entities under §512(b)(13) and debt-financed income. The IRS and Treasury anticipate the rules for identifying separate trades or businesses from social clubs, VEBAs and SUBs will be the same as other organizations, but they also welcome comments since the UBIT treatment for these organizations is different. Likewise, the IRS and Treasury don’t see the distinction between UBTI from a regularly carried on unrelated trade or business and UBTI generated through debt-financed income or income from a controlled entity. Therefore, aggregating UBTI from these activities using the same methodology mentioned above may be appropriate, but comments are requested.
Income from Partnership Interests
Another issue that needed to be addressed was how to handle income from partnership interests held for investment purposes. This could be one of the most difficult areas to tackle, as an exempt organization can be a partner in a holding partnership that is, in turn, a partner in multiple other partnerships, many of which engage in one or more unrelated trade or business. The organization also can own interests in partnerships that have debt-financed income, which is taxable under §512(b)(4). Treating each partnership interest and occurrence of debt-financed income as a separate trade or business could make the UBTI calculation very difficult to track, and not all information may be passed through to each ownership level. As a matter of administrative convenience, however, the IRS and Treasury intend to provide further guidance on this issue; they’re currently considering allowing aggregation of all partnership investment activities as one trade or business.
Pending issuance of proposed regulations, an interim rule has been put in place stating income from a partnership with multiple activities can be aggregated as one trade or business as long as either the “de minimis” test (the exempt organization directly holds no more than 2 percent of the profits or the capital in the partnership) or the “control” test (the organization directly holds less than a 20 percent capital interest and doesn’t have control or influence over the partnership) is met. These percentages are calculated for each partnership interest by taking the sum of the organization’s direct ownership percentage and the ownership percentage of all disqualified persons, supporting organizations and controlled entities with respect to the exempt organization. The organization’s share of debt-financed income from a partnership may be aggregated with any other UBTI passed through to the organization. A transition rule is available for partnership interests acquired before August 21, 2018, where the exempt organization holds an ownership percentage greater than the thresholds provided in the de minimis and control tests. Unlike the interim rule, the transition rule doesn’t allow aggregation of separate partnership interests.
UBTI from Fringe Benefits
In relation to the guidance detailed above, UBTI generated from fringe benefits stands on its own. IRC §512(a)(7) increases UBTI by the amount of the nondeductible expense incurred by an organization for any transportation fringe, parking facility or on-premises athletic facility. The IRS and Treasury believe that UBTI from these fringe benefits isn’t considered a trade or business; therefore, the amounts aren’t subject to §512(a)(6) for separate reporting. This may create planning opportunities for organizations to reduce the UBTI from offering certain fringe benefits.
Net Operating Losses (NOL)
The last major issue covered by the Notice was the carryover of NOLs from year to year. IRC §512(a)(6) changed how NOLs are calculated. NOLs generated in the current year and any carryforward NOL must be calculated with respect to each individual trade or business for taxable years beginning after December 31, 2017, and, if used, can’t exceed 80 percent of taxable income. On the other hand, pre-2018 NOLs don’t need to be separated by activity and can offset 100 percent of taxable income. This difference in treatment could pose an ordering problem for pre- and post-2018 NOLs at the separate trade or business level versus at the organization level. The IRS and Treasury want guidance regarding how the NOL deduction should be taken under §512(a)(6) and, specifically, how the ordering of pre- and post-2018 NOLs should be handled.
Many of the above items are currently open for debate as the IRS and Treasury are requesting comments. While the foundation has been laid, certain items—such as the number of NAICS digits, NOLs and the treatment of debt-financed income—need to be worked out. In any case, we’ll still need to watch for additional guidance. Until then, the Notice can be relied on for identifying separate trades or businesses for aggregation purposes (which includes the use of the NAICS code system), aggregating UBTI from investment partnerships and determining whether to separate debt-financed income, income from a controlled entity and UBTI generated from fringe benefits.
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