In Part I of this two-part article on IRS Notice 2018-67 regarding the calculation of unrelated business taxable income (UBTI) under the Tax Cuts and Jobs Act (TCJA), we discussed the need to separate different lines of unrelated business activities, which is now required to calculate an organization’s unrelated business income tax (UBIT). In Part II, we focus on special issues arising from an exempt organization’s partnership investments and fringe benefits and how they are impacted by the UBIT silos described in the new law.
Internal Revenue Code Section 512(a)(6)
Section 512(a)(6) requires an organization subject to the unrelated business income tax under Section 511, with more than one unrelated trade or business, to calculate unrelated business taxable income (UBTI) separately with respect to each trade or business. This is required because organizations with multiple unrelated trade or business activities can no longer offset income from one line of activity with losses from another line of activity. Prior to the TCJA, organizations could aggregate the income and deductions from all their unrelated businesses.
Section 512(a)(6) reads as follows:
(6) Special rule for organization with more than 1 unrelated trade or business In the case of any organization with more than 1 unrelated trade or business—
(A) unrelated business taxable income, including for purposes of determining any net operating loss deduction, shall be computed separately with respect to each such trade or business and without regard to subsection (b)(12),
(B) the unrelated business taxable income of such organization shall be the sum of the unrelated business taxable income so computed with respect to each such trade or business, less a specific deduction under subsection (b)(12), and
(C) for purposes of subparagraph (B), unrelated business taxable income with respect to any such trade or business shall not be less than zero.
Accordingly, if a charity had two regularly carried on unrelated businesses: Business A, which involved the sale of souvenirs, and Business B, which involved the sale of management consulting services, its UBTI would be calculated like this –
Business A – Income ($100,000) – Deductible Expenses ($75,000) = UBTI for Business A ($25,000)
Business B – Income ($100,000) – Deductible Expenses ($125,000) = Net Operating Loss (NOL) for Business B <25,000>
After TCJA – Total UBTI ($25,000) resulting in total UBIT of 21% x $25,000 or $5,250; Carryover NOL for Business B to be applied only against Business B Income
Before TCJA – Total UBTI (0) resulting in no UBIT owed
Under the TCJA, the charity has to pay a tax of $5,250 for the UBTI for Business A. It can no longer apply the losses of Business B to offset the UBTI of Business A like it could have in previous years.
The Congressional intent behind this change is to allow an NOL deduction “only with respect to a trade or business from which the loss arose.”
Note, however, that pre-2018 NOLs are not subject to this new rule and can continue to be taken against total UBTI calculated under Section 512(a)(6)(B), which provides in pertinent part: “the unrelated business taxable income of such organization shall be the sum of the unrelated business taxable income so computed with respect to each such trade or business, less a specific deduction under subsection (b)(12)”.
Partnership Investments and UBIT Silos
Generally, an exempt organization that is a partner in a partnership that conducts an unrelated trade or business (with respect to the exempt organization) must include as UBTI its distributive share of gross partnership income (and directly connected partnership deductions) from such unrelated trade or business. Through its partnership interest, an exempt organization might easily receive income originating from a large number of different unrelated businesses. Treasury and the IRS appear to have recognized that the reporting and administrative requirements of tracking each of these unrelated businesses separately could be unduly burdensome. Accordingly, Notice 2018-67 provides an interim rule (pending the publication of proposed regulations) that permits an exempt organization to aggregate its UBTI (including any unrelated debt-financed income that arises in connection with the qualifying partnership interest) from its interest in a single partnership with multiple trades or businesses if it meets either the de minimis test or control test.
- De minimis test: This test is generally met if the exempt organization holds directly no more than 2 percent of the profits interest and no more than 2 percent of the capital interest.
- Control test: This test is generally met if the exempt organization (i) directly holds no more than 20 percent of the capital interest; and (ii) does not have control or influence over the partnership.
Additionally, under the interim rule, an exempt organization may aggregate all qualifying partnership interests and treat the aggregate group of qualifying partnership interests as comprising a single trade or business for purposes of the UBIT silos rule described in Section 512(a)(6)(A).
Recognizing the difficulty and costs of modifying a previously acquired partnership interest to meet either the de minimis test or control test, Notice 2018-67 provides a transition rule.
[A]n organization may choose to apply the following transition rule, if applicable, for a partnership interest acquired prior to August 21, 2018: an exempt organization may treat each such partnership interest as comprising a single trade or business for purposes of § 512(a)(6) whether or not there is more than one trade or business directly or indirectly conducted by the partnership or lower-tier partnerships. … [A]ny unrelated debt-financed income that arises in connection with a partnership interest that meets the requirements of the transition rule may be aggregated with the other UBTI that arises in connection with that partnership interest.
Under the TCJA, UBTI of an exempt organization shall be increased by any amount for which a deduction is not allowable by reason of Section 274 and which is paid or incurred by such organization for certain fringe benefits described in Section 512(a)(7).
Unrelated business taxable income of an organization shall be increased by any amount for which a deduction is not allowable under this chapter by reason of section 274 and which is paid or incurred by such organization for any qualified transportation fringe (as defined in section 132(f)), any parking facility used in connection with qualified parking (as defined in section 132(f)(5)(C)), or any on-premises athletic facility (as defined in section 132(j)(4)(B)). The preceding sentence shall not apply to the extent the amount paid or incurred is directly connected with an unrelated trade or business which is regularly carried on by the organization. The Secretary shall issue such regulations or other guidance as may be necessary or appropriate to carry out the purposes of this paragraph, including regulations or other guidance providing for the appropriate allocation of depreciation and other costs with respect to facilities used for parking or for on-premises athletic facilities.
Notice 2018-67 makes clear that Treasury and the IRS do not believe that the provision of the fringe benefits described in Section 512(a)(7) is an unrelated trade or business. Accordingly, UBTI attributable to these fringe benefits are not subject to the UBIT silos provisions described above. However, there are many questions left open regarding Section 512(a)(7) for which we need much additional guidance. See, e.g., Nonprofit Radio: Unrelated Business Income Tax and Fringe Benefits; Whaaat?! Nonprofits need to pay taxes for providing employee parking!