On April 23 the IRS released long-awaited proposed regulations providing guidance on how nonprofits with more than one unrelated trade or business should calculate unrelated business taxable income (UBTI).
Background on Proposed Regulations
Historically, nonprofits measured their UBTI, and thus determined their unrelated business income tax (UBIT) liability, on an aggregated basis. Thus, because UBIT is paid on a nonprofit's net UBTI, all sources of gross UBTI could be reduced by the aggregate costs and expenses incurred in connection with the conduct of any unrelated trade or business activities giving rise thereto. Section 512(a)(6) of the Internal Revenue Code, added as part of the 2017 Tax Cuts and Jobs Act, introduced a new UBIT "silo" concept, requiring nonprofits with more than one unrelated trade or business to calculate UBTI separately for each trade or business. However, the enactment of Section 512(a)(6) raised many questions, principally because the 2017 legislation did not define what constitutes (or does not constitute) a "separate" trade or business. The IRS released interim temporary guidance in August 2018 (Notice 2018-67), which provided preliminary answers to some of these questions, but left many unanswered. The proposed regulations issued on April 23 provide additional clarity for nonprofits that have more than one unrelated trade or business. Until the proposed regulations are finalized, nonprofits have the option of relying on either the proposed regulations or any other reasonable, good-faith interpretation of Section 512(a)(6). The IRS has invited comments on several aspects of the proposed regulations, and the final regulations may differ from the proposed regulations.
Issues Addressed by the Proposed Regulations
Separate Unrelated Trades or Businesses
The proposed regulations instruct nonprofits to generally identify their separate unrelated trades or businesses using the first two digits of the North American Industry Classification System (NAICS) codes (NAICS 2-digit codes) that most accurately describe the nonprofit's trade or business. NAICS 2-digit codes separate trades or businesses into 20 different sectors. In contrast to the proposed regulations, in Notice 2018-67 the IRS had previously instructed nonprofits to determine separate trade or business activities based on any reasonable method, while indicating that the use of NAICS 6-digit codes would be deemed reasonable. There are more than 1,000 NAICS 6-digit codes, and a requirement to define trades or businesses according to that level of detail would have placed a significant administrative burden on nonprofits and, by extension, the IRS. Thus, the use of 2-digit codes, as opposed to 6 digit codes, significantly reduces the administrative burden for nonprofits with multiple unrelated trades or businesses. Furthermore, the use of 2-digit codes naturally permits the aggregation of broadly similar activities when computing UBTI, and thus allows nonprofits to offset income from one activity with losses from another activity, as long as the two activities are classified within the same broad sector.
The proposed regulations state that a nonprofit cannot use the 2-digit code that describes its exempt activities to identify its unrelated trades or businesses. For example, a university may not use the NAICS 2-digit code for education as an umbrella classification for all of the university's UBTI-generating activity. Furthermore, the IRS declined to adopt a suggested exception from the "silo rules" for nonprofits reporting less than $100,000 of gross UBTI. Thus, there is no de minimis exception from the silo rules for nonprofits with relatively modest amounts of UBTI; all organizations must report their UBTI consistent with the silo rule requirements.
Allocation of General Overhead Expenses
The proposed regulations state the IRS's intent to issue future additional proposed regulations regarding how a nonprofit's general overhead expenses should be allocated between trades or businesses, including a nonprofit's core exempt activities and its unrelated trades or businesses. Until the IRS issues such additional guidance, the proposed regulations permit nonprofits to allocate general overhead expenses using any reasonable method.
The proposed regulations offer certain exceptions to the silo rules, particularly with respect to specific forms of investment activities. Consistent with Notice 2018-67, the proposed regulations generally allow the aggregation of UBTI-generating investment activities that satisfy either a "de minimis" test or a "control" test. Namely, if a nonprofit holds an interest in a pass-through entity (such as a partnership, limited liability company, or S corporation), and the scope of the nonprofit's ownership in such entity satisfies either of these tests, then the nonprofit may aggregate all UBTI that it receives through such pass-through entity – even if those activities would otherwise constitute multiple trades or businesses under the NAICS 2-digit codes. Moreover, the nonprofit may aggregate all of its pass-through interests that satisfy one of these tests together as constituting a single trade or business, such that all UBTI gains and losses flowing through these interests would be reported together as from a single trade or business. Conversely, if a nonprofit holds an investment interest in a pass-through entity and the interest does not satisfy either the "de minimis" or "control" test, then the nonprofit will need to classify the UBTI it receives based on the underlying activities engaged in by the pass-through entity or entities, which could result in reporting multiple trade and business categories.
- De Minimis Test. The de minimis test is satisfied if the nonprofit holds directly no more than 2% of the profits and no more than 2% of the capital interest (2% of the stock in the case of an interest in an S corporation) in a pass-through entity. The proposed regulations dropped the rule provided in Notice 2018-67 that would have required nonprofits to combine interests held by board members, other related persons, "supporting organizations," or controlled entities in determining whether an interest met the requirements of the de minimis test.
- Control Test. The control test is satisfied if the nonprofit (i) directly holds no more than 20% of the capital interest (20% of the stock in the case of an interest in an S corporation) in a pass-through entity; and (ii) does not have control or influence over the decision making of the entity. All facts and circumstances are relevant for determining whether a nonprofit has control or influence. For purposes of determining whether a nonprofit's ownership interest exceeds 20%, interests held by "supporting organizations" or entities controlled by the nonprofit are combined with the nonprofit's interest. However, the proposed regulations drop the rule in Notice 2018-67 that would have required nonprofits to combine interests held by board members and other, related persons.
- Look-Through Rule. The proposed regulations also provide a "look-through" rule for nonprofits that hold indirect interests in lower-tier partnerships. Pursuant to these rules, if a nonprofit does not control a partnership in which it holds a direct interest of more than 20%, any lower-tier partnership in which the nonprofit holds an indirect interest of no more than 2% will satisfy the de minimis test. For example, if a nonprofit holds 50% of the capital interest of partnership X and the nonprofit does not control partnership X, and partnership X in turn holds 4% of the capital and profits interest of a lower tier partnership Y, the nonprofit's interest in partnership Y will be deemed to satisfy the de minimis test (i.e., because 50% of 4% = 2%), such that any UBTI flowing from partnership Y to the nonprofit will be eligible for the reporting exceptions available for investment activities.
- Reliance on K-1 Schedules. For purposes of measuring a nonprofit's ownership interest in a pass-through entity to determine eligibility for the exceptions stated above, the proposed regulations permit a nonprofit to determine its percentage interest in such pass-through entity by relying on the Schedule K-1 it receives from the entity. However, not all K-1 Schedules necessarily contain this level of detail. If the K-1 Schedule does not list the nonprofit's ownership interest, or lists the interest as "variable," the nonprofit must utilize other information sources to determine its ownership percentage.
The proposed regulations permit nonprofits to treat "unrelated debt-financed income" (i.e., "passive" income that is typically not subject to UBTI, such as interest, dividends, or rental income, but is treated as UBTI by virtue of debt financing) as income from investment activities, rather than as income from a separate unrelated trade or business. However, if the income from a nonprofit's debt-financed property would be treated as UBTI even if it were not debt financed, the income is treated as income from a separate unrelated trade or business that must be identified using the NAICS 2-digit codes. For example, if a nonprofit uses debt financing to purchase real property and leases the real property in exchange for rental income based on a percentage of the lessee's net profits, the nonprofit must identify the leasing business using the NAICS 2-digit codes, because the rental income would be UBTI regardless of the debt-financing rules.
Nonprofits that incur UBTI can reduce their tax liability by making tax deductible charitable contributions. The proposed regulations provide that charitable contribution deductions are taken against total UBTI (i.e., after all "silo" amounts have been aggregated) rather than being allocated among unrelated trades or businesses.
Net Operating Losses
The proposed regulations clarify that "grandfathered" net operating losses (NOLs) from tax years prior to the enactment of the 2017 Tax Act (pre-2018 NOLs) are allowed to be applied against a nonprofit's UBTI prior to NOLs arising in tax years after the 2017 Tax Act (post-2017 NOLs). The pre-2018 NOLs may be used to offset 100% of UBTI and are deducted from a nonprofit's total UBTI. By contrast, the deduction available for post-2017 NOLs is limited to 80% of UBTI and may only be used to offset UBTI from the unrelated trade or business "silo" that generated the NOL. However, the pre-2018 NOLs expire after 20 years, while the post-2017 NOLs may be carried forward indefinitely. By clarifying that the pre-2018 NOLs are allowed to be used prior to the post-2017 NOLs, the proposed regulations permit nonprofits to maximize utilization of their pre-2018 NOLs, which are more advantageous than the post-2017 NOLs.
In the wake of the current coronavirus (COVID-19) pandemic, the recently passed Coronavirus Aid, Relief, and Economic Security Act (CARES Act) temporarily repealed the 80% UBTI limitation for NOLs arising in taxable years beginning in 2020, thereby increasing the economic utility of certain post-2017 NOLs. The CARES Act also permits nonprofits with NOLs arising in 2018, 2019, and 2020 to "carry back" the NOL to each of the five years preceding the NOL and thereby obtain a refund of some or all of the UBIT that the nonprofit paid in those years. Notwithstanding these aspects of the CARES Act, the IRS declined to issue proposed regulations on how these temporary changes to the NOL rules would affect the calculation of UBTI under the silo rules, instead noting that it may issue additional necessary guidance on the future.
Public Support Tests
Some charitable nonprofits are classified as "public charities" (as opposed to private foundations) by meeting one of a series of financial tests designed to measure the level of support that the nonprofit receives from the general public (i.e., the nonprofit's "public support"). The proposed regulations provide that a nonprofit's total UBTI is considered for purposes of calculating the nonprofit's total support, and the silo rules are disregarded for purposes of the public support tests. The rationale for this rule is that applying the silo rules could have the unintended effect of raising the public support threshold for nonprofits seeking to qualify as public charities. That is, because Section 509(d) includes net income from unrelated business activities in the calculation of total support, the silo rules could increase the nonprofit's amount of total support if the losses from one unrelated trade or business could not offset the gains from another, separate unrelated trade or business.
The use of 2-digit NAICS codes to identify separate trades or businesses significantly eases administrative burdens placed on nonprofits, at least when compared to the prospect of using 6 digit NAICS codes as contemplated in IRS Notice 2018-67. Likewise, the use of 2-digit NAICS codes affords greater leeway for nonprofits to offset income from one unrelated trade or business with losses from another, as long as the two unrelated trades or businesses are within the same broad industry sector. Although the proposed regulations declined to adopt recommendations for an ownership threshold above 20% for purposes of aggregating investment interests, the proposed regulations limit the circumstances in which a nonprofit must aggregate its ownership interest with interests held by related persons or entities. The proposed regulations also contain favorable rules for nonprofits with pre-2018 NOLs and those that offset UBTI liability with charitable contributions.
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The IRS and the Treasury Department have indicated that they want to finalize the proposed regulations before the end of 2020. Comments on the proposed regulations and requests for a public hearing are due by June 23, 2020.