IRS Issues Guidance on Tax Reform Provisions Impacting Unrelated Business Income Tax
The IRS recently released Notice 2018-67 (the “Notice”) as guidance concerning new Section 512(a)(6) of the Internal Revenue Code (the “Code”), which was added to the Code by the Tax Cuts and Jobs Act (the “Act”) signed into law by President Trump on December 22, 2017. This notice provides guidance on calculating unrelated business taxable income (“UBTI”) for exempt organizations with more than one unrelated trade or business, provides interim guidance and transition rules for aggregating certain income from investment activities and addresses the treatment of global intangible low-taxed income (“GILTI”) for purposes of the unrelated business income tax.
Section 512(a)(6) of the Code requires an organization subject to the unrelated business income tax under Section 511 with more than one unrelated trade or business to calculate UBTI separately with respect to each trade or business. Congress intended that a deduction from one trade or business for a taxable year would not be used to offset income from a different unrelated trade or business for the same taxable year. Congress, however, did not provide 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 purposes of calculating UBTI. The Treasury Department and the IRS intend to propose regulations to clarify.
According to the Notice, pending issuance of proposed regulations, exempt organizations may rely on a reasonable, good-faith interpretation of the unrelated business income provisions of the Code (Sections 511 through 514), considering all the facts and circumstances, when determining whether an exempt organization has more than one unrelated trade or business. A reasonable, good-faith interpretation includes using the North American Industry Classification System six-digit codes. It can also include using the “fragmentation” principle in Section 513(c) and Regulation Section 1.513-1(b), and related guidance. The fragmentation principle, which 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 which may or may not be related to the exempt purposes of an organization, has primarily been used to separate unrelated trades or businesses from exempt activities, but it might also be helpful in identifying separate trades or businesses for purposes of Section 512(a)(6)(A).
Until the issuance of proposed regulations, in the case of exempt organizations with partnership investments, the Notice provides interim and transition rules specifically for aggregating partnership interests and activities in addition to the general reasonable, good faith standard.
Interim Rule: An exempt organization may aggregate its UBTI from its interest in 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 meets the requirements of either the de minimis test or the control test.
- A partnership interest is a qualifying partnership interest that meets the requirements of the de minimis test if the exempt organization holds directly no more than 2% of the profits interest and no more than 2% of the capital interest. When determining an exempt organization’s percentage partnership interest, the interest of a “disqualified person,” a “supporting organization,” or a “controlled entity” in the same partnership will be taken into account.
- A partnership interest is a qualifying partnership interest that meets the requirements of the control test 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. An exempt organization has control or influence if the exempt organization may require the partnership to perform, or may prevent the partnership from performing, any act that significantly affects the operations of the partnership. An exempt organization also has control or influence over a partnership if any of its officers, directors, trustees, or employees have rights to participate in the management of the partnership or conduct the partnership’s business at any time, or if it has the power to appoint or remove any of the partnership’s officers, directors, trustees, or employees.
Under this interim rule, an exempt organization may also aggregate all qualifying partnership interests meeting the de minimis or control test and treat the aggregate group of qualifying partnership interests as comprising a single trade or business for purposes of Section 512(a)(6)(A).
Transition Rule: For a partnership interest that does not meet the de minimis or control test, and which is acquired prior to August 21, 2018, an exempt organization may treat each such partnership interest as comprising a single trade or business for purposes of Section 512(a)(6) whether or not there is more than one trade or business directly or indirectly conducted by the partnership or lower-tier partnerships.
Any unrelated debt-financed income that arises in connection with a partnership interest that meets the requirements of the interim rule (either the de minimis test or the control test) or the transition rule may be aggregated with the other UBTI that arises in connection with that partnership interest.
Other issues addressed by Notice 2018-67:
- Qualified transportation fringe benefits that are now taxable under Section 512(a)(7) will not be treated by the IRS as an unrelated trade or business for purposes of UBTI. This would mean that just because a tax-exempt entity has taxable fringe benefits, it would not necessarily be subject to the special rules for an organization with more than one unrelated trade or business. While, according to this Notice, the IRS and Treasury do not view these fringe benefits as a separate unrelated trade or business for purposes of applying Section 512(a)(6), the amount of these benefits is still subject to unrelated business income tax and reportable on IRS Form 990-T.
- Section 512(a)(6)(A) requires exempt organizations to calculate UBTI, including for purposes of determining any net operating loss (“NOL”) deduction, separately with respect to each trade or business for taxable years beginning after December 31, 2017. The Congressional intent behind this change is to allow an NOL deduction only with respect to a trade or business from which the loss arose. In order to preserve NOLs from tax years prior to the effective date of the Act, Congress created a special transition rule to permit the carryover of any NOL arising in a taxable year beginning before January 1, 2018. Notice 2018-67 suggests that post-2017 NOLs will be calculated and taken before pre-2018 NOLs, with the possibility that pre-2018 NOLs may expire in a given tax year if not taken before post-2017 NOLs.
- The Treasury and the IRS have determined that an inclusion of GILTI under Section 951A(a) is to be treated the same way as subpart F income is generally treated for UBTI purposes. The income is to be treated as a dividend, which is generally excluded from UBTI under section 512(b)(1), unless it constitutes debt-financed income under Section 512(b)(4).
The guidance provided in Notice 2018-67 is complex and leaves many questions still unanswered. Hopefully these questions will be addressed by future regulations to be issued by the IRS.