Historically, if a tax-exempt organization were generating a loss from one activity (such as advertising), it would be able to offset it with a gain from a separate activity, such as unrelated business taxable income (UBTI) reported on a Schedule K-1.
In 2017, the Tax Cuts and Jobs Act (TCJA) added a new IRC section 512(a)(6) and introduced a new UBTI silo concept. These changes require all exempt organizations with more than one unrelated trade or business to calculate UBTI separately for each trade or business.
The IRS recently released final regulations that provide insight as to how separate business activities should be determined. There are several key considerations to keep in mind when evaluating each activity.
IDENTIFYING A TRADE OR BUSINESS
The final regulations provide different methodologies in determining separate trades or businesses:
- Prior to the implementation of IRC section 512(a)(6), organizations were able to group activities based on a six-digit NAICS code. The new regulation allows tax-exempt organizations to use a two-digit NAICS code to classify each separate unrelated trade or business. This allows organizations to group activities at a broader level.
- Organizations should review the NAICS manual to determine which code is appropriate for each activity and revisit prior classification and reporting to determine if there is a more applicable category.
- Once a two-digit NAICS code is used for an unrelated trade or business, the organization must continue to use the same code in subsequent years.
TYPES OF INCOME
Qualifying partnership interests (QPI), or partnership income considered UBTI from partnership investments, may be aggregated by meeting one of the following criteria:
- The de minimis test, in which an exempt organization holds no more than a 2-percent capital interest and no more than a 2-percent profit interest in the partnership.
- The participation test, which focuses on determining whether an exempt organization significantly participates in a partnership. This test looks at whether the exempt organization (i) directly holds no more than 20 percent of the capital interest in the partnership and (ii) does not significantly participate in the partnership. The QPI rule does not apply to organizations that are general partners in a partnership.
- The participation test is also governed by a look-through rule: Interest owned by a related organization should be included in determining the 20-percent capital interest limit.
Another type of income to keep in mind under these regulations is unrelated debt financed income. Organizations can treat any debt-financed income from investments, regardless of a tax-exempt investor's percentage of ownership in the investment, as part of the investor's qualifying investment activities.
ALLOCATION OF EXPENSES
Once income is analyzed, related expenses for each activity should be determined.
- An exempt organization can directly deduct connected business expenses against income from each activity.
- A reasonable allocation method will need to be determined in order to allocate indirect expenses among separate unrelated business activities.
- A charitable contribution deduction is allowed, regardless of whether it is directly connected to the conduct of a trade or business.
NET OPERATING LOSSES
The final regulations cover how net operating losses (NOLs) from the prior year should be used to offset future gains.
- Organizations with NOLs both pre-2018 and post-2017 (NOLs created in tax years after Dec. 31, 2017) should deduct the pre-2018 NOLs from total UBTI first.
- Post-2017 NOLs can only be used against income of the same type of activity that created the NOL.
- Pre-2018 NOLs must be used in a manner that results in maximum utilization of the pre-2018 NOLs in a tax year.
To learn more about unrelated business income and other topics related to nonprofit taxes, contact GHJ’s Nonprofit Practice.