On April 24, the Department of the Treasury (Treasury) and the Internal Revenue Service (the Service) issued proposed regulations (REG-106864-18) addressing the manner in which tax-exempt organizations calculate their unrelated business taxable income (UBTI). The proposed regulations should reduce the administrative complexity associated with such calculations and allow tax-exempt organizations to aggregate certain income streams and corresponding deductions.
Section 512(a)(6) was enacted into law through the 2017 Tax Cuts and Jobs Act (TCJA) and has the effect of creating separate tranches, or “silos,” of UBTI for purposes of calculating a tax-exempt organization's tax liability. Prior to this change under the TCJA, UBTI was computed by reducing the gross income of all unrelated trades or businesses by the allowed deductions from all unrelated trades or businesses.
Shortly after the TCJA was signed into law, the Service issued interim guidance in Notice 2018-67 permitting taxpayers to identify separate trades or businesses by using the six-digit codes used by the North American Industry Classification System (NAICS).
1. Simplified Classification
Under the proposed regulations, a taxpayer can use the two-digit NAICS codes rather than the six-digit codes to silo UBTI. The two-digit NAICS codes are meant to indicate a broad sector of economic activity, such as retail trade, real estate and rental and leasing, health care and social assistance, and accommodation and food services.
The change from six-digit codes to two-digit codes reduces administrative complexity and costs associated with tracking various activities. Treasury noted that using the NAICS six-digit codes would result in significant administrative burden because a tax-exempt organization would have to determine which of more than 1,000 NAICS six-digit codes most accurately describes its trades or businesses. In contrast, by using the NAICS two-digit codes, a tax-exempt organization would have to determine which of only 20 codes most accurately describes its trades or businesses.
Additionally, through the reduction of possible UBTI silos (from 1,000 to 20), the proposed regulations allow a tax-exempt organization to use deductions from one trade or business against the income from another trade or business, assuming that both businesses are in the same two-digit activity code. However, Treasury did note that an organization cannot use losses from an activity that consistently generates losses to offset income from a profitable trade or business unless the organization can show that the loss-producing activity is conducted with the requisite profit motive.
2. Investment Activities as One Trade or Business
Consistent with Notice 2018-67, the proposed regulations provide that a tax-exempt organization's various investment activities are generally treated as a separate single unrelated trade or business. For example, qualifying partnership interests, debt-financed properties and qualifying S corporation interests may be treated as one separate unrelated trade or business.
3. Use of Foreign Blockers
The proposed regulations confirm a long-standing position of the Service that an inclusion of subpart F income under Section 951(a)(1)(A) is treated in the same manner as a dividend for purposes of Section 512(b)(1), and, therefore, is generally excluded from the calculation of UBTI under Section 512(b)(1). Similarly, the proposed regulations confirm that an inclusion of GILTI under Section 951A(a) should be treated in the same manner as an inclusion of subpart F income under Section 951(a)(1)(A) for purposes of Section 512(b)(1) and, therefore, is treated as a dividend that generally is excluded from UBTI.
The foregoing confirmation is relevant because many tax-exempt organizations invest in offshore active trades or business through so-called “blocker corporations.” By confirming the treatment of subpart F income and GILTI under Section 512(b)(1), Treasury has confirmed that such blocker corporations effectively block UBTI inclusion events with respect to offshore income streams.
4. NOL Ordering Rules
Finally, the proposed regulations clarify that the language of Section 512(a)(6) and Section 13702(b) of the TCJA do not alter the ordering rules under Section 172. Accordingly, the proposed regulations provide that a tax-exempt organization with both pre-2018 and post-2017 net operating losses (NOLs) will deduct its pre-2018 NOLs from its total UBTI under Section 512(a)(6)(B) before deducting any post-2017 NOLs with regard to a separate unrelated trade or business from the UBTI from such unrelated trade or business. The proposed regulations clarify that pre-2018 NOLs are deducted from total UBTI in the manner that results in maximum utilization of the pre-2018 NOLs in a taxable year.
To illustrate the foregoing, consider the following example:
- TE Inc. (TE), a tax-exempt organization, has a 2017 NOL of ($1,000) from unrelated trade or business A, a 2019 NOL of ($500) from unrelated trade or business B, and 2020 net UBTI of $400 from unrelated trade or business C.
- TE will first apply the 2017 NOL to the 2020 UBTI, thereby reducing its 2020 UBTI to zero.
- Going forward, TE will have an used 2017 NOL of ($600), which can be used to offset UBTI from any unrelated trade or business, and a 2019 NOL of ($500), which can be used only to offset UBTI from unrelated trade or business B.
Originally published May 04, 2020
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