Charities and other exempt organizations face higher taxes, more complex returns and tough investment decisions under new unrelated business income tax rules effective for 2018. Despite recent guidance from the Internal Revenue Service, several key aspects of the rules remain unclear as tax return filing deadlines rapidly approach.
Rules Before 2017 Tax Act. Despite being called “exempt organizations” (EOs), groups such as charities, social welfare organizations and professional associations are not immune from all income tax. Rather, exempt status avoids tax on certain donations, receipts from charitable and other exempt activities, and many types of investment income. When an EO regularly conducts a trade or business not substantially related to its primary purposes, however, the resulting net “unrelated business taxable income” (UBTI) is taxed at regular corporate rates. The UBTI rules originally were enacted to put for-profits and EOs on level playing fields, from an income tax perspective, when EOs engage in activities in a manner similar to a for-profit business.
Through last year, an EO that carried on multiple, unrelated business activities could minimize its overall tax liability by using losses from one activity to reduce UBTI from another. Consequently, EOs were subject to tax only if, in the aggregate, their unrelated trades or business yielded a positive net income. The 2017 Tax Act effectively eliminated that opportunity.
2017 Tax Act Changes. Beginning with income earned in 2018, EOs must calculate their net UBTI from each unrelated business activity separately. Post-2017 losses from one activity can no longer be used to offset taxable income from another activity. The losses from a particular activity can be carried forward indefinitely, but only to offset income from that same activity in future years; and they may never offset more than 80 percent of otherwise taxable income from that activity in any year. Losses generated in prior years can still be carried forward and can be applied against UBTI from any activity for up to 20 years.
Identifying Separate Activities. These new rules apply separately to each unrelated trade or business that an EO conducts. The threshold question, therefore, is how to identify separate businesses. Prior law provides no guidance because the issue did not arise — EOs could bundle all of their business activities together for tax purposes. Despite abandoning that rule, the 2017 Tax Act offers no insights into when business activities must be reported separately. Should the decision be based on the location of the activity, its nature, its place in the EO’s corporate and financial structure, or other undetermined factors?
In an effort to provide some certainty, the IRS announced in its Notice 2018-67 that, until regulations are issued, EOs should simply make a “reasonable good-faith interpretation” of the existing rules on business activity. It suggested that EOs classify their unrelated business activities using the North American Industry Classification System codes that the IRS uses in other business contexts. Critics replied, however, that those six-digit codes are at once too specific and too general. For example, they might classify all advertising activities and related services as one business, whether derived from event fees, publications or other sources, while treating food service as several businesses, based on the type of food served and the location and degree of service.
Allocation of Deductions. In calculating their UBTI, EOs still may reduce the income from a business activity by expenses, depreciation and other deductions directly related to that activity. Prior law allowed an EO to use a “reasonable basis” to allocate expenses among related and unrelated business activities when, for example, facilities or personnel are used in both types of activities. Congress and the IRS provided no additional guidance, so similar methods should be acceptable to allocate expenses among several unrelated business activities under the 2017 Tax Act.
Questions also arise about whether deductions not allocable to a particular business activity, such as charitable contributions, can be allocated to UBTI items not linked to a particular business, such as unrelated debt-financed income or UBTI due to parking provided to employees.
Treatment of Investment Income. Several commentators suggested that investing should not be treated as a business activity at all, or if it is so treated, investment income should not be subject to fragmentation or expense allocation under the 2017 Tax Act even if it comes from multiple investments. Without further clarification, however, the legislative language could require separate UBTI calculations for income from debt-financed assets, controlled affiliates, foreign corporations and non-business activities such as providing transportation benefits for employees.
Treatment of Partnership Investments. Many EOs make investments through partnerships or limited liability companies, which in turn invest in businesses generating income that would be UBTI if the EO received it directly. A key question under the 2017 Tax Act is whether EOs must treat each of those indirect partnership or LLC investments as separate businesses for UBTI purposes. Tracking underlying investments would be costly and time-consuming for EOs, and some investment vehicles might choose to exclude EOs as investors rather than reveal that level of strategic information.
The IRS announced that EOs may aggregate UBTI (including unrelated debt-financed income) from a single partnership or LLC that invests in multiple businesses in two cases:
- De Minimis Test. The EO, its directors and other disqualified persons, its supporting organizations, and its close affiliates (EO group) hold no more than 2 percent of the profits interest or capital interest, as confirmed by Schedule K-1 for the partnership or LLC.
- Control Test. The EO and the EO group hold no more than 20 percent of the capital interests in the partnership or LLC and do not have control or influence over the entity.
Many EOs may not qualify under either test because they are unwilling or unable to monitor the investment holdings of their directors, substantial contributors and other group members. Others that can prevent certain significant acts of the partnership or LLC, appoint or remove personnel or otherwise participate in management may be deemed to have “control or influence” even though those rights give them no significant role in actually operating the entity. Several commentators suggested that the final regulations include tests that look only at an EO’s direct holdings and its ability to exert actual control over the investment entity.
Recognizing how difficult it may be to qualify an existing partnership or LLC interest to meet one of these tests in their current form, the IRS also proposed a transition rule that allows EOs to treat any interest acquired before Aug. 21, 2018, as a single business even if the partnership or LLC itself invests in several businesses. The rule does not apply to interests acquired after Aug. 20, nor does it state whether additional capital contributions made after that date will affect the status of a prior investment.
Application of Losses. With pre-2018 net operating losses (NOLs) that may be carried forward to apply against any future UBTI, and post-2017 NOLs that can offset only UBTI from the same business activity, EOs will need IRS guidance on several issues. These include the order in which the two types of losses should be applied, the status of losses from a discontinued business activity and the effect of NOL carryovers on the EO’s ability to deduct charitable contributions.
UBTI From Employer-Provided Parking. The 2017 Tax Act requires EOs that provide parking and qualified transportation fringe benefits for employees to treat the cost of those benefits as UBTI. The IRS confirmed, however, that the rule applies only to actual costs and not to items such as depreciation, and that the monthly taxable value of the benefit cannot exceed $260 in 2018. It also allows EOs to disregard parking that is not reserved for employees if more than 50 percent of the parking facility is used by the general public. EOs have until March 31, 2019, to reduce the number of reserved employee spaces to qualify for this safe harbor retroactively for 2018.
Tax Reporting. In late October and early November 2018, the IRS released drafts of Form 990-T and Schedule M for 2018 to reflect the 2017 Tax Act changes. These new forms and the accompanying instructions provide additional limited guidance. EOs with multiple separate unrelated trades or businesses may find their 2018 Form 990-T submissions rather burdensome, as a separate Schedule M will be required for each unrelated trade or business.
Relief From Potential Penalties. Despite the lack of congressional and IRS guidance on key issues, EOs conducting unrelated business activities in 2018 must calculate their UBTI under these new rules. Commentators urged the IRS not to penalize EOs that underpay their estimated income taxes for 2018 if they made good-faith attempts to comply with the rules. Thus far, the IRS has not offered any general penalty relief or other guidelines beyond those described in this article. It has, however, confirmed that an EO that must file returns only to reflect UBTI from employer-provided parking will be eligible for estimated tax penalty relief if it did not have to file an unrelated business tax return for the prior year.
Each EO that conducts unrelated business activities should closely examine those activities to determine whether there is a good-faith basis for combining their income and expenses when calculating its UBTI. If not, it should carefully record why it combined or separated particular activities and how it allocated the associated amounts. Without detailed information about the investments of its directors, officers and affiliated organizations, the EO may not be certain that it may combine its investment results from partnerships or LLCs. However, a transition rule will assure that treatment for investments made before Aug. 21, and a good-faith analysis may protect it from penalties with respect to investments acquired later.