For nonprofit organizations that report on a calendar-year basis, the May 17, 2021, deadline to file Form 990 and Form 990-T electronically is quickly approaching. Nonprofits should take time to review the recently released revised Form 990-T and its accompanying instructions before preparing and electronically filing their 2020 returns.
Additionally, nonprofits should consider the final regulations issued in November 2020 under Internal Revenue Code section 512(a)(6) regarding the unrelated business income tax imposed on exempt organizations with more than one unrelated trade or business. These final rules addressed many concerns raised about the 2017 Tax Act changes, IRS Notice 2018-67 and the proposed regulations. Because Form 990-T and its accompanying revised Schedule A include significant changes to reflect these new rules, nonprofit organizations may also need to make changes to their internal record-keeping procedures, among other things, to properly address their annual tax filing obligations for 2020 and going forward.
Background on Unrelated Trade or Business Taxable Income. Despite being called “exempt organizations” (EOs), groups such as charities, social welfare organizations and professional associations are not immune from all types of income tax. While these organizations do not have to pay tax on donations, receipts from charitable and other exempt activities, and many types of investment income, EOs that regularly conduct a trade or business that is not substantially related to their primary purposes pay a 21 percent tax on the resulting net unrelated business taxable income (UBTI) with the filing of IRS Form 990-T, Exempt Organization Business Income Tax Return. The 2017 Tax Act complicated this regime with a new subsection commonly referred to as the “SILO” rule, which requires each EO to calculate UBTI separately for each of its unrelated businesses and generally disallows using losses from one activity to offset gains from another.
Revised Form 990-T. The 2020 Form 990-T was completely overhauled. Importantly, there is a new Schedule A that replaces Schedule M for reporting separate trades or businesses in accordance with Code section 512(a)(6). For 2020, the core Form 990-T itself serves as a summary return consisting of only two pages. Similar to 2019 tax filings, the revised Form 990-T requires exempt organizations to complete a corresponding schedule for each separate trade or business (Schedule A instead of Schedule M).
Highlights of the new Schedule A, which replaces Schedule M, are as follows:
- Part VI relates to interest, annuities, royalties and rents from a controlled organization. It replaces Schedule F.
- Part IX relates to advertising income. It replaces Schedule J and includes formatting and layout changes. Additionally, there no longer are separate sections for periodicals reported on a consolidated basis versus a separate basis.
- Part X relates to compensation of officers, directors and trustees. It replaces Schedule K.
Electronic Filing Requirement. The Taxpayer First Act, which was enacted July 1, 2019, obligates tax exempt organizations to electronically file IRS Forms 990, 990-PF and 8872 for tax years beginning after July 1, 2019. For small exempt organizations, the Taxpayer First Act specifically allowed a postponement such that for tax years ending before July 31, 2021, the IRS will accept either paper or electronic filing of Form 990-EZ. But, for tax years ending July 31, 2021, and later, Forms 990-EZ must be filed electronically.
With regard to Form 990-T, the IRS accepted paper returns filed in 2020, but now requires that Form 990-T for tax year 2020 be filed electronically, with limited exceptions.
When preparing Form 990-T, nonprofit organizations must evaluate the final regulations issued in relation to the new SILO rule. Below is a brief summary of highlights from the final regulations.
NAICS Codes. One of the biggest areas of confusion in prior IRS guidance was how to identify separate unrelated businesses for purposes of applying the SILO rule. The final regulations confirm the use of the two-digit North American Industry Classification System (NAICS) codes for classifying unrelated businesses. In the final regulations, the Department of the Treasury agreed with commentators to the prior guidance that use of the two-digit codes instead of the six-digit codes was proper. However, Treasury did not agree to allow a facts and circumstance test to be used in addition to or in lieu of the two-digit codes. If multiple trades or businesses have the same two-digit code, the EO may aggregate those gains and losses when calculating UBTI. However, any UBTI from an activity with a different two-digit code must be segregated.
Sales of Goods. The final regulations add a new rule regarding an unrelated business involving the sale of goods. If an EO has an unrelated business that sells goods both online and in stores, the unrelated business is classified based on the goods sold in stores as long as it sells generally the same goods in both forums.
Changing NAICS Codes. The final regulations lift the restriction outlined in the proposed regulations on changing an NAICS code designation, and now require that an EO report any change in the same taxable year the change is made. The EO must indicate the code used in the previous tax year, the new code to be used in the current tax year and the reason for the change. Instructions to Form 990-T state that organizations must disclose the change on Part XI of Schedule A to Form 990-T.
Allocation of Deductions. The allocation rule of the proposed regulations is confirmed, requiring that EOs with multiple unrelated businesses allocate deductions among them using the reasonable basis standard. The final regulations specify that allocations of expenses, depreciation and similar items are not reasonable if the cost of providing a good or service in both the related and unrelated business is substantially the same, but the price charged in the unrelated business is higher and no adjustment is made during allocation to compensate for the price difference.
Investment Activities. The final regulations continue to treat an EO’s “investment activities” collectively as a single SILO for determining UBTI if such activities are: (1) qualifying partnership interests (QPIs), (2) qualifying S corporation interests (QSIs), or (3) debt-financed property. Despite the urging of commenters, specified payments from entities controlled by an EO are not considered investment activities, but instead are considered a separate unrelated business activity.
Qualifying Partnership Interests. Along with the clarification on NAICS codes, QPIs are another important topic addressed by the final regulations. A partnership interest can be a QPI if it satisfies either the de minimis test or the participation test. Any partnership interest designated as a QPI by the EO remains as such until it no longer satisfies one of these tests. The de minimis test remains the same from the proposed regulations and is satisfied if the EO holds, either directly or indirectly, no more than 2 percent of the profits and capital interest of the partnership.
Participation Test. The biggest change relating to QPIs includes renaming the control test as the participation test, which is satisfied if the EO: (1) directly holds no more than 20 percent of the capital interest, and (2) does not significantly participate in the partnership. Some commenters suggested that the capital interest threshold should be raised to 50 percent, but the final regulations declined to adopt this view. The facts and circumstances analysis for the second prong of the participation test was removed. Now, an EO is deemed to significantly participate in the partnership only if at least one of the following is true:
- The EO by itself may require the partnership to perform, or prevent the partnership from performing, any act that significantly affects the operations of the partnership.
- Any of the EO’s officers, directors, trustees or employees have rights to participate in the management of the partnership at any time.
- Any of the EO’s officers, directors, trustees or employees have rights to conduct the partnership’s business at any time.
- The EO by itself has the power to appoint or remove any of the partnership’s officers or employees, or a majority of directors.
Grace Period. The proposed regulations acknowledged that an EO could lose QPI status for a partnership interest it holds due to actions of other partners, and may not realize these changes until it receives a Schedule K-1. As a result, the final regulations now allow a grace period when a partnership interest would fail to qualify as a QPI in the current year because of an increase in percentage interest due to the actions of other partners. In this situation, the partnership interest may still be deemed a QPI in the current year if it meets all of the following criteria:
- The partnership interest met the requirements of the de minimis test or participation test in the prior taxable year without application of this new grace period.
- The increase in percentage interest is due to the actions of partners other than the EO.
- In the case of a partnership interest that met the requirements of the participation test in the prior taxable year, the interest of the partners that caused the increase in percentage interest was not combined for the prior taxable year or the taxable year of the change with the EO’s partnership interest.
Look-Through Rule. Previous guidance established a look-through rule, which said that if an EO directly holds a partnership interest that is not a QPI, any indirectly held partnership interests can be a QPI if they satisfy the de minimis test. The final regulations expand this rule to allow an indirectly held partnership interest to be a QPI if it satisfies either the de minimis or the participation test.
Limited Liability Companies. An EO’s interest in an LLC (treated as a partnership for federal tax purposes) can also be treated as a QPI. In the same way a partnership interest cannot be a QPI if the EO is the general partner, the final regulations hint, but do not explicitly say, that an interest in an LLC may fail as a QPI if the EO is the managing member. Thus, an EO serving as the managing member of an LLC should consult with their tax adviser to determine if it can be treated as a QPI.
Qualifying S Corporation Interests. As mentioned above, the final regulations confirm that a QSI is considered part of the investment activity SILO when determining UBTI. A QSI is determined with the same de minimis and participation tests used for partnerships, except any reference to “profit and capital interest in the partnership” should be replaced with “stock ownership of the corporation.”
Charitable Contribution Deduction. After an EO calculates its UBTI, it can offset this amount with a deduction for any charitable contributions made during the taxable year. The proposed regulations discussed how to calculate the statutory limit on this deduction, but were unclear whether the charitable contribution deduction was to be taken against total UBTI. This has now been clarified: An EO’s charitable contribution deduction should be taken against total UBTI (i.e., the aggregate amount of UBTI from all SILOs).
Net Operating Losses. The rule from prior guidance remains the same and says that an EO with more than one unrelated business must determine its net operating losses (NOLs) separately with respect to each unrelated business. Further, an EO with both pre-2018 and post-2017 NOLs must deduct any pre-2018 NOLs from its total UBTI before deducting any post-2017 NOLs for separate unrelated businesses. The final regulations clarify that pre-2018 NOLs should be taken against total UBTI in a way that maximizes the use of post-2017 NOLs in that taxable year.
As mentioned above, EOs can now change the NAICS codes of unrelated businesses, but doing so could result in the inability to claim such NOLs. When an unrelated business changes its NAICS two-digit code, it is treated as if the originally coded business is terminated and the newly coded business just commenced. Thus, any NOLs of the originally coded business cannot be carried over to the newly coded business. The NOLs are suspended until the EO commences an activity that is properly classified under the previous two-digit code.
Public Support. The proposed regulations allowed an EO with multiple unrelated businesses to aggregate its net UBTI when applying the public support test. The final regulations expand this slightly, allowing EOs with multiple unrelated businesses to calculate public support by using either the UBTI for each SILO or the EO’s aggregate UBTI.
Given all of the changes from the final regulations and the updates to Form 990-T, EOs should work with their tax return preparers to proactively plan for complying with the SILO rules.