On April 24, 2020 the Internal Revenue Service (IRS) announced the issuance of proposed regulations regarding tax-exempt organizations and their reporting of unrelated business taxable income (UBTI). The guidance intends to provide direction on how a tax-exempt organization subject to UBTI determines if it has more than one unrelated trade or business, and if so, how the organization then calculates UBTI under section 512(a)(6). More plainly, the proposed regulations significantly clarify and simplify the application of the new “siloing” rules for unrelated business taxable income.
The proposed regulations are not effective until final. However, taxpayers may rely on previously issued Notice 2018-67 or the proposed regulations for taxable years beginning before the publishing date of the final regulations, so long as they do so reasonably and in good faith.
The latest guidance provides welcome relief with respect to unrelated business income reporting. Organizations should assess how the latest guidance interacts with other aspects of their tax strategies such as net operating losses (NOLs), investment activities, and more.
Which organizations are subject to unrelated business income tax?
If a not-for-profit organization generates certain types of income from business activities unrelated to its tax-exempt purpose, it may be liable for federal income taxes – known as unrelated business income tax (UBIT). The IRS would like to understand how the organization earned the unrelated income, not necessarily how it was spent. Thus, income from unrelated business activities may be taxable even if the organization uses the income derived from such activities to further its tax-exempt purpose.
Nearly all tax-exempt organizations are subject to UBIT requirements. These include charitable entities such as religious and educational organizations and scientific and research institutions. The requirements also apply to social welfare organizations, advocacy groups, veterans’ organizations, trade and professional associations, labor organizations, employee benefit funds and fraternal organizations.
Organizations not subject to UBIT requirements include corporations organized under the Acts of Congress and are instrumental for the United States, and certain charitable trusts not subject to tax on private foundations.
What is the foundation for the proposed regulations?
The Tax Cuts and Jobs Act (TCJA) of 2017 modified the method in which tax-exempt organizations compute their unrelated business income. Under new section 512(a)(6), a tax-exempt organization with more than one unrelated trade or business can no longer aggregate those activities to calculate its unrelated business income tax. Rather, they must consider UBTI separately with respect to each trade or business. However, section 512(a)(6) provides no definitional guidance on what is considered a “separate trade or business” or how taxpayers should classify certain investment activities.
Notice 2018-67, released in August 2018, offered initial guidance and requested comments on possible methods for the siloing of unrelated trades or businesses. The notice allowed tax-exempt organizations to make a “reasonable, good faith” interpretation of what constituted a separate trade or business and offered the North American Industry Classification System (NAICS) six-digit codes as an acceptable manner of determining the appropriate silos.
How do I identify each unrelated trade or business?
For purposes of the Internal Revenue Code (IRC), there is no general statute or regulatory definition of activities constituting a “trade or business.” However, the recently proposed regulations clarify that an exempt organization should continue to separate trades or businesses using the NAICS code system. However, the recommendation is that organizations only apply the first two digits of the code, rather than the previously-used six digit code.
Seeing as the NAICS six-digit coding system encompasses many different business activities that do not conform to the traditional business activities of a tax-exempt organization, the simpler, two-digit coding system provides general categories of economic activity and reduces the hundreds of potential “silos” for unrelated business activities down to 20 broader sectors (e.g., retail, real estate and rental, educational services, etc.).
Reducing the number of silos from hundreds down to 20 by implementing use of the broader two-digit NAICS code also reduces compliance costs of affected organizations. Now, for instance, two different types of food services that may have been separated under the six-digit code methodology may fall under the same two-digit code. Similarly, if an organization had two different types of recreational activities, like a fitness center and golf course, those can now be grouped under the same NAICS two-digit code rather than separate six-digit codes.
However, please be aware of certain nuances:
- A college or university described in section 501(c)(3) cannot use the NAICS two-digit code for educational services to identify all of its separate unrelated trades or businesses.
- A qualified retirement plan described in section 401(a) cannot use the NAICS two-digit code for finance and insurance to identify all of its unrelated trades or businesses.
What does this mean for affected tax-exempt organizations?
The proposed regulations provide much-needed clarity and simplification for organizations looking to silo their unrelated business income trades or businesses. Utilization of the two-digit NAICS code system reduces the potential subsets of UBTI to 20 classifications, thereby enabling organizations to categorize activities into practical silos. Most organizations should experience a reduction in their tax compliance burden as fewer silos means less segregating and tracking separate NOLs. Effectively, the proposed regulations promote uniformity across not-for-profit sectors and ensure that all organizations implement similar approaches.
Organizations should review their current UBTI classification methodology to adapt their reporting to the broad classifications required by the two-digit methodology. You may find an opportunity to amend previously filed Forms 990-T to aggregate activities that may have been siloed separately on the 2018 return. This may not only increase available NOLs, it could also potentially recover taxes on a profitable business line that would have generated a loss under the current siloing guidance.
What other areas do the proposed regulations cover?
In efforts to provide additional clarification for tax-exempt organizations and UBTI reporting, the proposed regulations address a number of items of interest including:
- Investment activities and the treatment of revenue items identified in sections 511 through 514
- Definition of QPIs
- De minimis test as it relates to partnership profits
- Control test regarding capital interest of a partnership
- Public support test
- Charitable contributions
- Net operating losses
- Definition of a trade or business as it relates to Individual Retirement Accounts (IRAs)
- Treatment of Subpart F and GILTI income
- Specific guidance for social clubs, Voluntary Employee Benefit Associations, and Supplemental Unemployment Benefit Trusts
Please refer to the proposed regulations for detailed information on these specific topics.
How can Squar Milner help?
Squar Milner bolsters a skilled and diligent team of tax professionals with deep expertise working with tax-exempt organizations.
We can work with you to determine how these proposed regulations may affect your organization’s tax strategies going forward. For more information on the topic or to learn more about how our experts can help, contact us today.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.
Our Not-For-Profit Services
We have a team of professionals with extensive experience serving not-for-profit organizations. Our professionals understand that each not-for-profit organization is unique. Our goal is to provide you with timely and cost-efficient services tailored to your needs.