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KSM Blog | Katz, Sapper & Miller CPA

IRS Releases Proposed Regulations on UBTI Calculation for Not-for-Profit Organizations

Posted 1:00 PM by

The IRS published proposed regulations on April 23, providing guidance on the changes made to calculating unrelated business taxable income (UBTI) when Internal Revenue Code Sec. 512(a)(6) was enacted as part of the Tax Cuts and Jobs Act of 2017. Under this new guidance, exempt organizations would be required to determine how many unrelated trade or business activities they have and then to separately calculate the income or loss of each activity. This raised many questions about how to determine if an exempt organization had more than one unrelated trade or business and, if so, how to calculate its taxable income and tax due.

While most entities organized under Internal Revenue Code Sec. 501(c) are generally exempt from federal income tax, income from certain trade or business activities that are not mission-related and income from certain debt-financed assets are considered unrelated business income. Organizations must report their unrelated business income (and related expenses) on Form 990-T and calculate tax due. Before Sec. 512(a)(6), all the unrelated business income from all activities could be aggregated, and sometimes net operating losses (NOLs) were created that could be used to offset prior or future UBTI. Under 512(a)(6), the unrelated business income from each activity must be separately calculated. Many organizations have struggled with how to identify separate activities. Here is how the Department of the Treasury and the IRS have proposed to separate and classify unrelated trades or business activities.

  1. Use broader North American Industry Classification System (NAICS) codes to classify and separate activities on Form 990-T, with the exception of investment activities. The NAICS system uses six-digit codes to identify trade or business activities. Exempt organizations already use a NAICS code to classify their mission activity on Form 990. The proposed regulations recommend using only the first two digits to classify the unrelated trades or businesses reported on Form 990-T. This means there are only about 20 categories or “silos” for reporting activities. Limiting the number of categories available to classify unrelated activities might allow for more aggregation than previously thought.

Additionally, the category used for the exempt organization’s mission on Form 990 (i.e., healthcare) cannot be repeated as a category on the 990-T. The proposed regulations also stipulate that once an exempt organization has assigned an unrelated trade or business a particular NAICS two-digit code, it cannot change that code unless the organization can show that the first choice was due to “an unintentional error.” This rule becomes effective with the first 990-T filed after final regulations under 512(a)(6) are published.

  1. Exempt organizations’ investment activities can be aggregated; investment activities include qualified partnership interests, qualifying S corporation interests, and debt-financed properties. The proposed regulations permit, but don’t require, exempt organizations to combine all investment activities that qualify. In general, to determine if a partnership or S corporation interest is “qualified,” an exempt organization’s interest in that entity must pass one of two tests: the de minimis test (directly holds no more than a 2% profit or capital interest); or the control test (directly holds no more than a 20% capital interest and not have control or influence over the entity). Additionally, the proposed regulations modify some of the two tests’ requirements. For the de minimis test, an exempt organization no longer has to combine certain related interests, and the look-through rule is changed. For the control test, the proposed regulations list certain specific circumstances that show control. Note: The qualifying partnership rules outlined here do not apply to 501(c)(7) social clubs.

For many exempt organizations, the most anticipated part of the proposed regulations deals with identifying separate unrelated trades or businesses, but there were some other notable items covered:

  • Charitable deductions: Sec. 1.512(b)-1(g)(4) of the proposed regulations clarifies that the charitable deduction is taken against total UBTI, not allocated to each separate activity.
  • How to use pre-2018 and post-2017 NOLs: Exempt organizations with both pre-2018 and post-2017 NOLs are instructed to deduct pre-2018 NOLs from their total UBTI before using post-2017 NOLs against the income of a separate unrelated trade or business. The preamble to the proposed regulations states that pre-2018 NOLs should be used in the manner that results in maximum utilization of the pre-2018 NOLs in a taxable year. Note: These proposed regulations were written before the Coronavirus, Aid, Relief, and Economic Security (CARES) Act was enacted. Since this new law temporarily repeals some of TCJA’s changes to NOLs, the authors of the proposed regulations’ preamble say the IRS and Department of the Treasury may issue further guidance on this topic.
  • Public support test: Sec. 512(a)(6) states that the income and loss of separate unrelated business activities cannot be aggregated. Commentators questioned whether increases to UBTI amounts reported on the 990-T meant that the amounts reported as part of total support or part of a “not-more-than-one-third” test should be increased, too. If so, some entities might fail their public support test. The Department of the Treasury and the IRS said this was not the intent of 512(a)(6). The proposed regulations clarify that, for the preparation of Schedule A, its net income and net losses from all of its unrelated business activities can be aggregated.
  • Individual Retirement Accounts (IRAs): Sec. 1.513-1(f) of the proposed regulations clarifies how all types of IRAs should define “unrelated trade or business” when considering if they have more than one unrelated activity. “Any trade or business regularly carried on by such [plan] or by a partnership of which it is a member” should be given the NAICS two-digit code that most accurately describes it, or be labeled as an investment activity.” The preamble notes, however, that most IRAs “derive most, if not all, of their UBTI from investment activities.”
  • Subpart F income and Global Intangible Low-Taxed Income (GILTI): The proposed regulations clarify that subpart F income and GILTI should be treated as dividend income and, for most exempt organizations, not be included in the calculation of UBTI. Social clubs and other exempt organizations that are required to treat their investment income as UBTI are an exception.

The applicability date for the proposed regulations is tax years beginning on or after the date the regulations are published as final regulations. Organizations may choose, however, to apply the subpart F and GILTI exclusion rules immediately. 

For tax years beginning before the proposed regulations are finalized, the IRS says exempt organizations can use one of the following to identify separate unrelated trades or businesses for the purposes of Sec. 512(a)(6)(A): reasonable, good-faith interpretation of Sections 511-514, methods provided in Notice 2018-67, or these proposed regulations.

About the Author
Casse Tate is a partner in KSM’s Business Advisory and Not-for-Profit Services Groups. Casse guides clients through tax planning and compliance issues as well as provides general consulting services to ensure they are fully equipped to make advantageous financial decisions. Connect with her on LinkedIn.

 

About the Author
Victoria Snyder is a manager in KSM’s Tax Services Group. Victoria works with a variety of clients and entity types, including tax-exempt entities, to help them minimize tax liabilities and ensure tax compliance. Connect with her on LinkedIn.

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