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IRS Provides Guidance on Unrelated Business Income Tax Provisions of the Tax Cuts and Jobs Act

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Background

Although there are certain modifications, exceptions and exclusions, organizations that are recognized as tax-exempt by the IRS under IRC §501(c)(3) may be subject to tax on unrelated trade or business activities.  An activity that is considered to be unrelated and subject to unrelated business income tax if it:

  1. Is a “trade or business”;
  2. Which is regularly carried on; and
  3. Not substantially related to the tax-exempt organization’s exempt purposes.

Prior to the enactment of the TCJA, tax-exempt organizations that carried on more than one unrelated trade or business activity were permitted to aggregate the income and expenses from these activities to calculate its tax liability.  As a result, a tax-exempt organization could offset income generated by one unrelated trade or business activity with losses from another.

The TCJA, and IRC §512(a)(6), requires, effective for tax years beginning after December 31, 2017, tax-exempt organizations to compute UBTI separately for each unrelated trade or business activity thus not allowing the use of net losses from one unrelated trade or business activity to offset income from another. The Notice provides interim guidance on various issues relating to IRC §512(a)(6) including:

  1. Determining what constitutes a separate trade or business;
  2. Aggregation of income from partnership investments;
  3. How to treat unrelated debt-financed income; and
  4. Net operating loss changes.

What is a Separate Trade or Business?

The IRC does not define what constitutes a separate trade or business nor does the TCJA include instructions on how to determine what activities constitute a separate trade or business. The Notice provides that a tax-exempt organization can rely on a reasonable, good-faith interpretation for determining which activity or activities constitute a separate trade or business by utilizing the North American Industry Classification System (“NAICS”).  By utilizing the NAICS codes, the IRS is attempting to reduce the administrative burden on tax-exempt organizations in complying with IRC §512(a)(6) in their determination of what constitutes a separate trade or business.

In addition, the IRS indicates that the “fragmentation principle” may also be used in determining what constitutes a separate trade or business.  The Notice states that the fragmentation principle “provides that an activity does not lose its identity as a trade or business merely because it is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purposes of an organization”.

Income from Investments in Partnerships

Various issues arise in determining whether a tax-exempt organization’s interest in a partnership constitutes a separate trade or business.  Examples include whether investments in different partnerships with similar activities could be aggregated as one separate trade or business; or whether multiple activities by carried on by one partnership in which the tax-exempt organization invests can be aggregated as one separate trade or business.

A tax-exempt hospital organization often maintains an interest in several types of partnerships including, but not limited to, alternative investments and ancillary healthcare joint ventures.  The question is how the tax-exempt organization identifies what constitutes a separate trade or business in these instances.  The Notice provides tax-exempt organizations maintaining interests in partnerships should use reasonable, good-faith interpretations of the IRC unrelated business income rules and regulations, considering all the facts and circumstances, when identifying separate trades or businesses for purposes of IRC §512(a)(6)(A). The Notice includes guidance with the introduction of the Interim Rule and Transition Rule that can be relied on by tax-exempt organizations in determining which partnership investments can be aggregated as one separate trade or business activity until proposed regulations are published.

Under the Interim Rule, tax-exempt organizations may aggregate UBTI from a single partnership with multiple trades or businesses, including trades or businesses conducted by lower-tier partnerships, as long as the directly-held interest in the partnership is deemed to be a “qualifying partnership interest”.  A qualifying partnership interest is one that meets the requirements of either the de minimis test or the control test.  In addition, the interim rules allow a tax-exempt organization to aggregate a group of qualifying partnership interests as a single trade or business under IRC §512(a)(6)(A).

In order to have a qualifying partnership interest that satisfies the de minimis test, a tax-exempt organization must hold, directly, including interests held by disqualified persons, supporting organizations, or controlled entities, no more than 2 percent of the profits interest and no more than 2 percent of the capital interest in a partnership.

In order to have a qualifying partnership interest that satisfies the control test, a tax-exempt organization must hold no more than 20 percent of the capital interest and does not have control or influence over the partnership.

Under the interim rule, tax-exempt organizations may aggregate all qualifying partnership interests as comprising a single trade or business for purposes of IRC §512(a)(6)(A).

For previously acquired partnership interests (those acquired prior to the release of the Notice on August 21, 2018), the Notice provides a Transition Rule stating that “a tax-exempt organization may treat each such partnership interest as comprising a single trade or business for purposes of IRC §512(a)(6) whether or not there is more than one trade or business directly or indirectly conducted by the partnership or lower-tier partnership.”

Unrelated Debt-Financed Income

The Notice provides that any income that is permitted to be aggregated in accordance with the Interim Rule outlined above also includes any unrelated debt-financed income that is generated by the qualifying partnership interest and meets either the de minimis test or control test.  The same holds true for qualifying partnership interests that generate unrelated debt-financed income and meets the requirements of the transition rule.

Net Operating Losses

The taxation of unrelated business income generally follows regular IRS corporate income tax rules and regulations.  Accordingly, any net operating loss (“NOL”) provisions introduced as part of the TCJA also apply to Form 990-T, Exempt Organization Business Income Tax Return, filers.

Prior to the TCJA, IRC §172 allowed taxpayers to carry back an NOL for two years and to carry forward 20 years. Tax-exempt organizations subject to UBTI with more than one unrelated trade or business activity were thus permitted to offset income generated by any unrelated trade or business activity with losses from another.

The Notice provides interim guidance with respect to how IRC §512(a)(6) changes how a tax-exempt organization with more than one unrelated trade or business activity is able to calculate and utilize NOLs.  Since tax-exempt organizations with more than one unrelated trade or business activity are now required to calculate UBTI separately for each activity, they can no longer offset income from one unrelated trade or business activity with losses from another.

The Notice provides a transition rule for any NOLs generated from unrelated trade or business income activities prior to 2018.   As outlined in the Notice, these pre-2018 NOLs may be utilized by tax-exempt organizations with more than one unrelated trade or business activity to offset income generated by any one of these activities in the first taxable year ending after December 31, 2017. Since a tax-exempt organization with more than one unrelated trade or business activity may have both pre-2018 and post-2017 NOLs, in the second taxable year ending after December 31, 2017, a tax-exempt organization can still utilize any pre-2018 NOLs to offset income from one of its unrelated trade or business activities; however, the tax-exempt organization would be required to first utilize post-2017 NOLs before using any pre-2018.

Lastly, the TCJA also now limits the amount of an NOL that can be utilized.  For any post-2017 NOL, the amount of NOL that can be utilized by a tax-exempt organization is limited to the lesser of (1) the aggregate NOLs that have been carried over to the year, plus any NOLs carried back to the year; or (2) 80 percent of the amount of taxable income calculated prior to any NOL utilization.

Conclusion

The interim guidance included in the Notice is extremely complex.  Clearly, further guidance will need to be included in proposed regulations to be published.

The IRS is requesting comments with respect to the Notice and IRC §512(a)(6).  The comment period is open until December 3, 2018.  There are several ways to submit comments as outlined in the notice either by mail, hand delivery and electronic mail.

Authors: John A. Smith, Jr.  | jsmith@withum.com and Eric Cooper | ecooper@withum.com

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