IRS Proposes Rules to Help Nonprofits Calculate Their Taxes
With the passing of the Tax Cuts and Jobs Act in 2017, nonprofit (NFP) organizations are now required to calculate unrelated business taxable income (UBTI) separately for each trade or business under Internal Revenue Code (IRC) Section 512(a)(6). This separate calculation is important, as organizations with more than one unrelated trade or business can’t use a loss from one trade or business to offset income from another. NFPs were in need of additional guidance on what constituted a trade or business for reporting purposes.
On August 21, 2018, the IRS and U.S. Department of the Treasury (Treasury) issued Notice 2018-67 (Notice), which laid the framework for calculating UBTI under IRC §512(a)(6). Even though the Notice only provided interim guidance, it stated the IRS and Treasury wanted feedback from the general public on the calculation that could be used to issue guidelines. On April 24, 2020, the IRS and Treasury issued 85 FR 23172 (proposed regulations) responding to the feedback given to them and updating the interim guidance on the UBTI calculation.
Separate Trades or Business
The original Notice stated that it was difficult to determine what constituted a separate trade or business. It suggested the North American Industry Classification System (NAICS) six-digit codes could be used but noted that in some instances, using five or four digits may be better, as it allows a wider assortment of businesses to be aggregated. Due to this, the IRS and Treasury asked for feedback from the general public. In response to the feedback received, the IRS and Treasury stated in the proposed regulations that an exempt organization can identify its separate unrelated trades or businesses using just the first two digits of the NAICS code. This greatly reduces the number of possible UBTI activities from hundreds to 20 and will make it much easier for NFPs to file their Form 990-T. The proposed regulations note that once an NFP has chosen a two-digit code, they won’t be able to change this code unless the code chosen was an unintentional error and the activity is better described by another code.
Income from Partnership & S Corporation Interests
In response to the difficulty of understanding a partnership interest’s NAICS code, the proposed regulations state the organization can choose to combine qualified partnership interests (QPI) if it meets either the de minimis test (the organization holds no more than 2 percent of the profits interest and no more than 2 percent of the capital interest) or the control test (the organization directly holds less than a 20 percent partnership interest and doesn’t have control or influence over the partnership). When applying these two tests, the Notice states the organization also would have to include ownership from disqualified persons to determine if the tests were met. The proposed regulations specify the organization only needs to look at the interests held by its supporting organizations or controlled entities to determine if it meets the tests.
The proposed regulations state that an organization can choose to not aggregate the partnership interests and use the two-digit NAICS code. This can be beneficial, as some organizations might perform activities and invest in partnerships that have the same two-digit NAICS code. If the NFP chooses to aggregate them, losses from one can offset income from another. The proposed regulations specifically state that once an organization designates a partnership interest as QPI, it can’t identify the partnership interest using NAICS two-digit codes unless the partnership interest no longer qualifies as a QPI. Luckily, organizations won’t have to make this determination immediately, as organizations can aggregate income and losses from pass-through partnerships until the proposed regulations are published as finalized.
The proposed regulations also address ownership in S corp interests, which was left out completely of the original notice. If an organization owns stock in an S corp, it will be treated as a separate unrelated trade or business unless the ownership interest meets the QPI rules described above for partnerships. If it’s unable to meet those rules, an organization with ownership in two S corps would report two separate unrelated activities.
Income Generated by Social Clubs, Voluntary Employee Beneficiary Plans & Unemployment Compensation Benefits Trusts
In the Notice, the IRS and Treasury originally stated that they anticipate the rules for identifying separate trades or businesses for social clubs described in §501(c)(7), voluntary employees’ beneficiary associations described in §501(c)(9) and supplemental unemployment compensation benefits trusts described in §501(c)(7) to be the same as other organizations but would welcome comments regarding this. The proposed regulations confirmed income generated by social clubs, voluntary employee beneficiary plans and unemployment compensation benefits trusts will be calculated the same way as other NFPs. For example, a social club will need to report as separate activities the nonmember revenue from golf, meals, equipment rental and event income.
Public Support Test
If an organization is required to meet the public support test on Schedule A, the proposed regulations clarify the organization may aggregate net income and net losses from all unrelated activities to calculate the public support.
Net Operating Loss
The last major issue in question was the calculation of the net operating loss (NOL) deduction for each separate trade or business as well as use of NOLs for taxable years beginning before December 31, 2017. The proposed regulations confirmed that if an exempt organization has more than one trade or business, the NOL must be calculated on each separate trade or business activity. It further states that a NOL from one trade or business can’t be used to offset income from another trade or business. The notice also clarifies that NOLs generated pre-2018 will be used before post-2017 NOLs.
Even though most items in the proposed regulations have been solidified, some items are still open for additional comments. These items include the ordering rules for NOLs and charitable deductions, how to apply the NOL carrybacks under the CARES Act and allocation of deductions. The proposed regulations can be relied on until the final regulations are issued.
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