Proposed Unrelated Business Income Tax Regulations to Provide Relief for Nonprofit Organizations

On April 23, 2020, the Treasury Department and IRS released proposed regulations to provide guidance on how an exempt organization subject to the unrelated business income tax (“UBIT”) described in IRC Sec. 511 determines if it has more than one unrelated trade or business and, if so, how the exempt organization calculates unrelated business taxable income (“UBTI”) under IRC Sec. 512(a)(6).

Prior to the enactment of IRC Sec. 512(a)(6), an exempt organization that derived gross income from the regular conduct of two or more unrelated trades or businesses calculated UBTI by aggregating the income from all of its unrelated trades or businesses and reducing that amount by the aggregate deductions allowed with respect to all of its unrelated trades or businesses. However, IRC Sec. 512(a)(6), added by the Tax Cuts and Jobs Act (“TCJA”), changed this calculation so that exempt organizations could no longer aggregate income and deductions from all unrelated trades or businesses when calculating UBTI. Rather, a deduction from one trade or business for a taxable year may not be used to offset income from a different unrelated trade or business for the same taxable year. In August 2018, the Treasury Department and the IRS issued Notice 2018-67 , which discussed various issues arising under IRC Sec. 512(a)(6) and set forth interim guidance and transition rules relating to this Internal Revenue Code (“Code”) section.

The proposed regulations accomplish the following:

• Establish the method for determining whether an exempt organization has more than one unrelated trade or business for purposes of IRC Sec. 512(a)(6) and identify separate unrelated trades or businesses for purposes of calculating UBTI under this Code Section.
• Clarify that, for purposes of UBIT generally and the application of IRC Sec. 512(a)(6) specifically, an individual retirement plan (“IRA”) described in IRC Sec. 408(e) uses the definition of “unrelated trade or business” in IRC Sec. 513(b) applicable to trusts.
• Clarify that inclusions of subpart F income under IRC Sec. 951(a)(1)(A) and global intangible low-taxed income (“GILTI”) under IRC Sec. 951A(a) are treated in the same manner as dividends for purposes of IRC Sec. 512(b)(1).

Separate Unrelated Trade or Business

There is no general statutory or regulatory definition of what activities constitute a “trade or business” for purposes of the Code. Notice 2018-67 permitted a reasonable, good-faith interpretation of IRC Sec. 511 through IRC Sec. 514, considering all the facts and circumstances, when determining whether an exempt organization has more than one unrelated trade or business for purposes of IRC Sec. 512(a)(6). In the Notice, the Treasury Department and the IRS provided that a reasonable, good-faith interpretation included using the most specific level of the North American Industry Classification System (“NAICS”) six-digit codes (“NAICS 6-digit codes”). The proposed regulations, however, provide that an exempt organization can identify its separate unrelated trades or businesses using the first two digits of the NAICS codes (“NAICS 2-digit codes”). The NAICS 2-digit code describes a broader sector of the economy, making it more likely that taxpayers engaged in similar activities that could possibly be described in more than one NAICS 6-digit code will now be able to report those activities as part of the same overall unrelated business activity, and, at the same time, will not allow the offsetting of losses between the 20 sectors of unrelated trades or businesses distinguished by the NAICS 2-digit codes. This approach should be less burdensome on nonprofits.

Organizations may reduce the income from an unrelated trade or business by expenses that are directly connected with the carrying on of the trade or business. Regarding the allocation of indirect expenses, the Treasury Department and the IRS continue to consider the allocation issue and intend to publish a separate notice of proposed rulemaking providing further guidance on this issue. In the interim, these proposed regulations incorporate the existing allocation standard in Treas. Reg. Sec. 1.512(a)-1(c), which provides that an exempt organization must allocate deductions on a reasonable basis between separate unrelated trades or businesses. An allocation of expenses on an unadjusted “gross to gross” method is not reasonable.

Activities in the Nature of Investments

Consistent with Notice 2018-67, the proposed regulations generally permit the aggregation of the investment activities specifically listed in the proposed regulations as a separate unrelated trade or business for purposes of IRC Sec. 512(a)(6) to mitigate the burden on exempt organizations, particularly those with interests in multi-tier partnerships. Notice 2018-67 stated that, as a matter of administrative convenience, the proposed regulations would treat an exempt organization’s investment activities as one trade or business for purposes of IRC Sec. 512(a)(6)(A) in order to permit the exempt organization to aggregate gross income and directly connected deductions from possibly multiple separate unrelated trades or businesses. Under the proposed regulations, for most exempt organizations, such investment activities are limited to:

1. Qualifying partnership interests (“QPI”)
2. Debt-financed properties
3. Qualifying S corporation interests

A partnership interest is a QPI if it meets the requirements of either a “de minimis” test or a “control test.” The de minimis test is met if the exempt organization holds directly no more than 2% of the profits interest and no more than 2% of the capital interest. The control test is met if the exempt organization (i) directly holds no more than 20% of the capital interest and (ii) does not have control or influence over the partnership. Similarly, while the general rule is that each S corporation interest is treated as a separate unrelated trade or business, the proposed regulations permit an exempt organization to aggregate its UBTI from an S corporation interest with its UBTI from other investment activities if the exempt organization’s stock ownership in the S corporation meets the requirements provided in the de minimis test or the control test for QPIs.

Net Operating Losses (“NOLs”) and UBTI

Notice 2018-67 explained that IRC Sec. 512(a)(6) changes how an exempt organization with more than one unrelated trade or business calculates and takes NOLs into account. In taxable years beginning after December 31, 2017, NOL deductions must be calculated separately with respect to each trade or business. The proposed regulations clarify that an exempt organization with both pre-2018 and post-2017 NOLs will deduct its pre-2018 NOLS from its total UBTI under IRC Sec. 512(b)(6) before deducting separate post-2017 NOLs from each separate trade or business’s UBTI.

Foreign Income

The proposed regulations provide that subpart F income and GILTI are to be treated in the same manner as dividend income for purposes of Sec. 512.

Effective Date

These proposed regulations will apply to taxable years beginning on or after the date they are published as final regulations. For taxable years beginning before that date, an organization may continue to rely on reasonable, good-faith interpretation of IRC Sec. 511 through IRC Sec. 514 when identifying separate trades or businesses as well as on these proposed regulations and on Notice 2018-67. The IRS intends to update the Form 990-T and related schedules, and the instructions thereto, as appropriate.