By Kari Jolly, Tax Senior Associate | Not-for-Profit Team
Proposed Changes for Exempt Organizations Reporting UBTI
Proposed Rules and Request for Comments from the Department of Treasury and IRS signal changes afoot for reporting UBTI pursuant to Section 512(a)(6) of the 2017 Tax Cuts and Jobs Act.
Prior to enactment of the Tax Cuts and Jobs Act (TCJA) in December 2017, exempt organizations (EOs) could aggregate and net revenue and expenses derived from all activities “not substantially related” to their exempt function for the purpose of calculating their Unrelated Business Taxable Income (UBTI) in compliance with section 511(a)(1). Among the many provisions affecting EOs, the TCJA introduced section 512(a)(6) which changed the UBTI calculation in that EOs would be required to report revenue and expenses for each separate trade or business generating UBTI.
Section 512(a)(6) requires that UBTI for a taxable year be the sum of gross revenue for each separate trade or business, less a deduction for expenses as provided in section 512(a)(1). Section 512(a)(1) permits an EO to deduct expenses that are “directly connected” to a revenue generating activity. To be directly connected and deductible, an expense must have a “proximate and primary relationship” to the trade or business activity generating the revenue. Congress did not, however, “provide explicit criteria for determining whether an exempt organization has more than one unrelated trade or business or how to identify separate unrelated trades or businesses” for the purpose of calculating UBTI under 512(a)(6); nor did it provide specific guidance for defining directly connected expenses in compliance with 512(a)(1). In 2018, the Department of Treasury and IRS released Notice 2018-67 which solicited comments and provided interim guidance on this topic. After consideration of the comments received and related legislation, the Department of Treasury and IRS published updated proposed rules for complying with 512(a)(6) on April 24, 2020.
85 FR 23172
Through 85 FR 23172, the IRS provides additional guidance regarding: 1) How an EO would identify a separate trade or business and report related activity; 2) How to allocate deductions for exempt purpose/UBTI crossover expenses (such as rent and depreciation); 3) How to apply the de minimus and control tests to identify a Qualifying Partnership Interest (QPI) for reporting a separate trade or business through an investment; and 4) How to prioritize the utilization of pre-2018 and post-2017 NOLs.
- There is no statutory or regulatory definition for what constitutes a separate trade or business activity. Notice 2018-67 allowed for a “reasonable, good-faith” interpretation considering all the facts and circumstances for determining a separate trade or business, while also positing the idea of using North American Industry Classification System (NAICS) six-digit codes as a method of classification. The updated proposed guidelines affirm the value of using NAICS codes for this purpose and also clarifies that only the first two digits of the codes, which “represent a general category of economic activity,” would suffice as an appropriate method of classification without demanding an overly burdensome implementation effort from the EO or administration effort from the IRS. The EO should select the two-digit code that most closely represents the relevant business unit and aggregate all revenue/expense activity to determine UBTI for that unit. It is important to note that once a two-digit NAICS code has been assigned to a trade or business, that code cannot be changed unless the EO can demonstrate that said two-digit code was “chosen due to unintentional error” and that another two-digit code is more appropriate.
- For expenses that are allocable to both exempt purpose and UBTI, the proposed guidelines affirm that the “reasonable basis” existing allocation standard set forth in §1.512(a)-1(c) is acceptable pending publication of a separate notice addressing this issue that the Department of Treasury and IRS intend to release at a future date. The publication also reaffirms that the “Unadjusted Gross-to-Gross Method” does not meet the reasonable basis standard.
- Investment activities are treated as a separate trade or business for the purpose of complying with 512(a)(6) and can be aggregated under a single two-digit NAICS code. All investments in QPIs are considered “investment activities” and as such can be included in that aggregation. However, in order to be designated as a QPI, either the de minimus or control test must be met. Ownership of less than a 2 percent interest in a partnership investment meets the de minimus test. The control test is met so long as the EO owns less than 20 percent of the total partnership interests and does not have effective control over the partnership’s operations and management.
- Just as expenses are to be deducted from unrelated business income only if they are directly connected to the same reportable trade or business, NOLs can only be used to offset revenue derived from the same trade or business in compliance with 512(a)(6)(B) of the TCJA. EOs that accrued NOLs based on UBTI generated through 12/31/2017 (“pre-2018 NOLs”), may use those NOLs as deduction against all UBTI generated after January 1, 2018 before applying 512(a)(6)(B) rules. In short, pre-2018 NOLs are preserved and may be utilized in the “manner that results in maximum utilization of the pre-2018 NOLs in a taxable year.”
The comment period for 85 FR 23172 is open through June 23, 2020. Until the rules have been finalized and published in the Federal Register, EOs “may rely on a reasonable, good-faith interpretation” of existing UBTI rules, the updated proposed rules set forth in 85 FR 23172 or the methods outlined in Notice 2018-67.
UBTI Reporting Takeaway for Exempt Organizations
Exempt Organizations have options for determining how best to calculate and silo UBTI in order to comply with section 512(a)(6), at least for now. It should be emphasized that this analysis is based on proposed rules – without a mythical crystal ball, no one can know what will be included when the final rules are published. What we can do is take cues from these proposals to develop a plan to address what we know is coming. The language in Notice 2018-67 and 85 FR 23172 make clear that EOs are well advised to evaluate their existing methodologies and develop an implementation plan that incorporates guidance received so far.
Keiter’s Not-for-Profit Opportunity advisors are ready to help your organization prepare for UBTI reporting changes and other regulation changes. Contact your Keiter representative or Email | Call: 804.747.0000.
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