On August 21, 2018, the IRS released Notice 2018-67 which both provides preliminary guidance and seeks comments on the calculation of unrelated business taxable income (UBTI) under the Tax Cuts and Jobs Act (TCJA). Tax-exempt organization that may be earning unrelated business income should be aware of the changes under the TCJA that impact this calculation and consequently the organization’s unrelated business income tax (UBIT) liability.
We have previously written on UBIT and some of the changes caused by the TCJA. See Unrelated Business Income Tax Explained; The New Tax Law and Its Impact on Nonprofits – Part 2; Whaaat?! Nonprofits need to pay taxes for providing employee parking! But there have been several open issues about how to interpret and incorporate the changes in practice. This post (Part I) focuses specifically on new Section 512(a)(6) of the Internal Revenue Code (IRC) and the limited guidance Notice 2018-67 provides on how to separate different lines of unrelated business activities, which is now required to calculate UBIT. A follow-up post (Part II) will focus on special issues arising from an exempt organization’s partnership investments.
Internal Revenue Code Section 512(a)(6)
Section 512(a)(6) created a new rule in calculating unrelated business taxable income (UBTI). Organizations with multiple unrelated 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.
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 or business for the same taxable year.”
Here’s the full statute:
(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.
UBIT Silos – What’s the Same and What’s Different?
In order to calculate UBTI, an organization must be able to determine whether it has more than one unrelated trade or business. And in order to do that, it must know what trades or businesses would be considered the same or different for purposes of this rule. Notice 2018-67 provides that regulations are forthcoming but pending their issuance, organizations may rely on a reasonable, good-faith interpretation of IRC Sections 511 through 514, considering all the facts and circumstances, when determining whether an exempt organization has more than one unrelated trade or business for purposes of Section 512(a)(6). However, the Treasury Department and the IRS do not want to develop or implement a facts and circumstances test, which would be administratively burdensome and difficult to enforce. The Notice further provides that a reasonable, good-faith interpretation includes using the North American Industry Classification System (NAICS) codes.
According to its FAQ page, NAICS “was developed as the standard for use by Federal statistical agencies in classifying business establishments for the collection, analysis, and publication of statistical data related to the business economy of the U.S.” The system relies on business establishments to self-identify their proper code numbers. Exempt organizations that file Form 990-T are already required to use the 6-digit NAICS codes so should be familiar with NAICS. For others, here’s a good starting point for determining appropriate NAICS codes – NAICS Lookup Help.
The IRS appears to be suggesting that if multiple unrelated trades or businesses are described by the same NAICS code, they could be treated as one trade or business for purposes of Section 512(a)(6). In support of such premise, Notice 2018-67 provides:
For example, under a NAICS 6-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.
However, the Notice also notes that the fragmentation principle may provide guidance in determining whether an organization has more than one unrelated trade or business. The fragmentation principle generally refers to how an exempt organization can separate unrelated trades or businesses from exempt activities. It is partly described in Section 513(c), which provides in pertinent part:
[A]n activity does not lose identity as a trade or business merely because it is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purposes of the organization.
So, fragmentation principles might encourage exempt organizations to identify multiple unrelated trades or businesses as separate even if they are carried on within a larger aggregate of similar activities. It would appear more guidance is necessary to harmonize how to interpret use of the NAICS codes and fragmentation principles.
How are Deductions Attributable to More Than One Trade or Business Treated?
IRC Section 512(a)(1) permits an exempt organization with an unrelated trade or business to reduce the income from that trade or business by the allowable deductions that are directly connected with the carrying on of such trade or business. But if a particular deduction is attributable to more than one unrelated trade or business, Section 512(a)(6) now requires that the deduction is properly allocated. For example, if a charity had two regularly carried on unrelated businesses, advertising that generated $100,000 in income and souvenir sales that generated a loss, and accounting fees of $10,000 attributable to both businesses, the charity must now figure out what portion of the accounting fees could be used to offset the 100,000 in advertising income. The portion of the accounting fees attributable to the souvenir sales can no longer be used to offset the advertising income as it could prior to the TCJA.
There exists some minimal guidance on how an organization should allocate expenses connected with both an exempt activity and an unrelated trade or business. Treasury Regulations 1.512(a)-1(c) provides:
Where facilities are used both to carry on exempt activities and to conduct unrelated trade or business activities, expenses, depreciation and similar items attributable to such facilities (as, for example, items of overhead), shall be allocated between the two uses on a reasonable basis. Similarly, where personnel are used both to carry on exempt activities and to conduct unrelated trade or business activities, expenses and similar items attributable to such personnel (as, for example, items of salary) shall be allocated between the two uses on a reasonable basis.
Additional guidance from Treasury and the IRS is expected soon on this section of the Regulations and may influence the similar allocation issue under 512(a)(6): how to allocate expenses connected with two separate unrelated trades or businesses.