The IRS recently issued much-needed guidance on how tax-exempt organizations should calculate unrelated business taxable income (UBTI) for each separate trade or business they operate. This requirement was part of the Tax Cuts and Jobs Act (TCJA), which was signed into law in December 2017. The new UBTI requirement generally applies to tax years beginning after 2017. Organizations can rely on Notice 2018-67 until proposed regulations are issued.
To Tax or Not to Tax?
As the name suggests, tax-exempt organizations aren't taxed on most income they receive, such as charitable contributions from donors. But if an organization carries on a trade or business that's unrelated to its tax-exempt function, it must pay the unrelated business income tax.
UBTI refers to the income received from these business activities, less any allowable deductions.
In addition, a tax-exempt organization can carry over a net operating loss (NOL) from such unrelated business activities.
When computing UBTI, a specific deduction of $1,000 is permitted, except for purposes of computing the NOL deduction and concerning certain local church units (for example, a diocese or association of churches) that file separate returns. For these units, the allowable deduction is the lesser of:
- $1,000, or
- The gross income from any unrelated trade or business carried on by the unit.
Tax Law Changes
Now the TCJA change requiring UBTI to be calculated separately has added another layer of complexity to an already-confusing set of rules.
Under the TCJA, nonprofits must calculate UBTI for each unrelated trade or business, with the total UBTI equaling the sum of those amounts. (None may be less than zero.) The determination for each business is made without regard to the $1,000 deduction generally allowed. That deduction is applied to the aggregate UBTI.
You can claim NOLs only against future income from the specific business that generated the loss. (You can still use NOL carryovers from years prior to 2018 to offset all UBTI.) Under prior law, you could apply NOLs from one business to reduce the taxable income of another, as well as to gains from alternative investments or pass-through entities also considered UBTI. The loss of this option could cause organizations with multiple unrelated businesses to have more UBTI than in the past.
The TCJA also changes the corporate tax rate to a flat 21% from a range of 15% to 35%. Because not-for-profits pay the corporate rate on UBTI, your tax liability potentially could fall, even if your overall UBTI grows.
Highlights of UBTI Guidance
IRS Notice 2018-67 provides some clarity on the details of the UBTI rule. Although it's 36 pages long and contains a dizzying array of code section references, there are some key elements that tax-exempt organizations should know:
Investments in partnerships. For tax-exempt organizations investing in partnerships, a special interim rule applies. An organization may combine its interest in a single partnership with multiple trades or businesses (including trades or businesses conducted by lower-tier partnerships) if it meets either one of the following two tests:
- De minimis test. The organization directly holds no more than 2% of the profits interest and no more than 2% of the capital interest of the partnership.
- Control test. The organization directly holds no more than 20% of the capital interest and doesn't have control or influence over the partnership.
If an organization satisfies either test, it may treat the aggregate group of partnership interests as a single trade or business for these purposes.
In addition, a tax-exempt organization that acquired a partnership interest prior to August 21, 2018, may treat each partnership interest as a single trade or business, regardless of whether it meets either test or there's more than one trade or business directly or indirectly conducted by the partnership (or lower-tier partnerships).
Nonpartnership activities. If a tax-exempt organization engages in an activity other than a partnership, it should use the six-digit North American Industry Classification System (NAICS) codes to determine if it has more than one unrelated trade or business. This is considered "a reasonable, good-faith interpretation" of the rules. Use of fewer than six digits would result in overly broad categories.
GILTI. For purposes of computing UBTI, global intangible low-taxed income (GILTI) is treated as a dividend, which is generally excluded from UBTI. This is consistent with other tax treatment of GILTI.
Employee fringe benefits. Under another provision in the TCJA, transportation fringe benefits (such as mass transit passes and parking fees) provided to employees of a tax-exempt organization must be included in UBTI. These amounts aren't subject to the rules requiring a separate calculation for each trade or business.
Special UBTI definitions apply to social clubs, voluntary employees' beneficiary associations and supplemental unemployment compensation benefits trusts. As a result, the IRS is requesting comments regarding additional considerations that should be given to these entities.
The IRS also acknowledges in Notice 2018-67 some of the difficulties arising under the new requirements. For instance, with respect to items relating to certain unrelated debt-financed income, income from controlled entities and insurance income, the IRS recognizes that aggregating income included in UBTI may be appropriate in certain situations.
Contact a Tax Pro
These highlights just scratch the surface of this complex topic. The recent IRS Notice also details various transitional rules, including those regarding NOLs from unrelated business activities of tax-exempt organizations. The key takeaway is that computing UBTI isn't a do-it-yourself proposition. It's important to rely on your PDR tax advisor to steer you in the right direction and help strategize ways to minimize the adverse effects of the new UBTI rule.