Sikich Series on Tax Reform: IRS Releases Guidance for Tax-Exempt Organizations on New UBIT Rules for Separate Trades or Businesses

The focus on last year’s “Tax Cut and Jobs Act” (“TCJA”) was on business tax matters. There were, however, also several significant changes impacting Exempt Organizations (“EO”). One such change involved the tax treatment for an exempt organization involving the calculation of its “Unrelated Business Income Tax” (“UBIT”). The TCJA brought about new rules that changed how UBIT was calculated for an EO that had several trades or businesses, each of which generated unrelated business taxable income or loss. These changes resulted in many comments and questions by exempt organizations, as well as tax advisors in how to apply these new provisions. The IRS issued guidance on August 21, 2018 in Notice 2018-67 to help address some of these uncertainties and to provide clarification on certain items (please click here for a copy of Notice 2018-67).

Background

An EO generally may have revenue from four sources: (1) contributions, gifts, and grants; (2) investment income; (3) trade or business income that is related to exempt activities (e.g., program service revenue); and (4) trade or business income that is not related to exempt activities. This fourth category is subject to federal income tax; while the other three categories generally are exempt from federal income tax. The UBIT generally applies to income derived from a trade or business regularly carried on by the EO that is not substantially related to the performance of the organization’s tax-exempt functions.

An EO determines its unrelated business taxable income by subtracting from its gross unrelated business income deductions directly connected with the unrelated trade or business. In determining unrelated business taxable income, an organization that operates several unrelated trades or businesses aggregates income from all such activities and subtracts from the aggregate gross income the aggregate of deductions. Therefore, as a result, an EO may use a deduction or loss from one unrelated trade or business to offset income from another, thus reducing its total UBIT income.

UBIT Changes Made by TCJA

The TCJA, however, changed how UBIT is calculated for those exempt organizations that have multiple trades or businesses. For an EO with more than one unrelated trade or business, the new provision requires that unrelated business taxable income first be computed separately with respect to each trade or business. The EO’s unrelated business taxable income for a taxable year is the sum of the amounts (not less than zero) computed for each separate unrelated trade or business. A net operating loss deduction is allowed only with respect to a trade or business from which the loss arose. The net result of this new provision for an EO is 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.

While this new UBIT change may seem straightforward, its possible application for an EO was unclear. Therefore, many exempt organizations and tax advisors were waiting for direction from the IRS on how to interpret these new rules and put them into practice.

Takeaway

This Notice 2018-67 should assist EO and advisors in applying the new UBIT rules. But this notice is intended to offer some direction for exempt organizations and tax advisors, but it still plans on issuing late proposed regulations. A few items included in Notice 2018-67 were:

• One issue addressed in the notice was that an EO can rely on a “reasonable, good faith interpretation” to ascertain whether it has multiple unrelated trades or businesses when calculating its unrelated business taxable income. The IRS also stated that instead of a facts-and-circumstances test, it will consider use of the “North American Industry Classification System” (“NAICS”) code to be a reasonable and good-faith interpretation before it issues regulations.
• Also, the notice covers rules involving income of partnerships held by exempt organizations. An interim rule in the notice permits aggregation of qualifying partnership interests that satisfy either the de minimis test or control test into one trade or business. Also, there is a transition rule that permits aggregating income within each direct partnership interest acquired prior to August 21, 2018.
• Further, there was some speculation that the effective date for these new UBIT rules would be delayed a year, however, the notice did not offer such relief.

The guidance in Notice 2018-67 is a step forward in these new UBIT provisions. There are still some questions and unanswered items. We will analyze and review this IRS guidance, and provide a more detailed Sikich Insights article in the coming weeks addressing the impact of Notice 2018-67. Please contact your Sikich tax advisor with any questions you may have.