Background
The Internal Revenue Service (IRS) recently released Notice 2018-67 (the Notice), which provides temporary guidance on how nonprofit organizations can apply the new rules governing the calculation of unrelated business taxable income (UBTI) until the IRS issues regulations in this area. The Tax Cuts and Jobs Act (the Act), which was passed in December 2017, requires nonprofit organizations that have more than one unrelated trade or business to calculate UBTI separately for each unrelated trade or business (siloing) for taxable years beginning after December 31, 2017. This significant change from previous law reduces the ability of nonprofit organizations to offset losses from one type of unrelated business activity against profits from a different more successful unrelated business activity, and may inhibit nonprofits' ability to pilot new and innovative revenue-generating activities that are unrelated to a nonprofit's tax-exempt purposes.
The Act raised many questions—how do you determine if a particular activity is a separate unrelated trade or business? For example, should advertising in an organization's periodicals be treated separately from advertising provided on an organization's website? Should investment holdings in multiple partnerships be considered one unrelated trade or business, or should an organization's interest in each partnership be treated as a separate unrelated trade or business? How should expenses for multiple unrelated trades or businesses be allocated? The IRS has provided preliminary answers to some of these questions in the Notice and has requested comments on how to address certain unanswered questions as it begins to draft the regulations that will provide official guidance on this topic.
What Guidance Does the Notice Provide?
The Notice provides guidance on the following:
- More than One Unrelated Trade or Business. The new siloing rule only applies to nonprofit organizations that have more than one unrelated trade or business. Nonprofit organizations may use a "reasonable, good-faith interpretation" of the UBTI rules in determining whether they have more than one unrelated trade or business until regulations are issued.
- Separate Unrelated Trades or Businesses. An organization may use the North American Industry Classification System (NAICS), which provides classification codes for different types of activities, to identify separate unrelated trades or businesses until regulations are issued. For example, based on the NAICS codes, a nonprofit organization likely would be permitted to treat all income derived from advertising activities, regardless of the source of advertising, as a single unrelated trade or business.
- Allocation of Expenses. An organization is permitted to deduct expenses that are directly connected to conducting a particular trade or business from the gross income derived from that trade or business. If an organization has expenses associated with several unrelated trades or businesses, or associated with both related and unrelated trades or businesses, the organization must allocate the expenses on a "reasonable" basis. The IRS has indicated that it will provide further guidance on what allocation methods will be considered reasonable for purposes of allocating UBTI-related expenses.
- Unrelated Debt-Financed Income. Organizations will need to apply these new siloing rules to "unrelated debt-financed income," income that is ordinarily excluded from UBTI but treated as UBTI by virtue of debt financing (e.g., interest, royalties, or rents). The IRS has suggested that, until regulations are issued, organizations may aggregate unrelated debt-financed income based on the type of activity, as opposed to the source of the activity, e.g., aggregating rent from all debt-financed properties rather than treating each debt-financed property as a separate unrelated trade or business.
- Investment Activities. Until regulations are issued, if a nonprofit organization's interest in a partnership satisfies one of two tests that are described in the Notice, the organization may aggregate the UBTI received from its interest in a single partnership that engages in multiple trades or businesses and may treat all such partnership interests as constituting a single trade or business. The Notice states that an organization may apply these interim aggregation rules if a partnership interest meets the "de minimis test," which requires a nonprofit organization to hold directly no more than two percent of the profits interest and no more than two percent of the capital interest in the partnership, as indicated on the K-1 received by the nonprofit organization. Alternatively, a nonprofit organization may apply these aggregation rules if the "control test" is met, which requires a nonprofit organization to hold no more than 20 percent of the capital interest in the partnership and, based on all the facts and circumstances, not have control or influence over the partnership.
- Other Matters. The Notice provides guidance on other various matters, including whether the siloing rules apply to expenses incurred in connection with qualified transportation fringe, qualified parking, or on-premises athletic facility benefits (they do not) and how to treat certain net operating losses (it depends on when the net operating loss was incurred).
What Else Should We Expect from the IRS?
Although the Notice has provided preliminary answers to certain questions, it still leaves many questions unanswered. The IRS has requested that comments on the interim guidance be submitted by December 3, 2018.
We will be monitoring developments and can provide guidance as needed.