Many not-for-profit organizations have unrelated business income-generating supplemental income. Not-for-profit leaders already know that this unrelated business income is taxable and has become familiar with calculating unrelated business taxable income (UBTI) separately since the Tax Cuts and Jobs Act in 2017. The IRS recently issued proposed regulations regarding separately computing UBTI for each trade or business activity that could increase a not-for-profit’s tax exposure and liability. It’s time to review accounting and tax strategies now to get ready for a year-end implementation.
Important changes at a glance:
- Effective for taxable years beginning after the regulations are made final, likely in the fall of 2020
- Exempt organizations cannot aggregate all unrelated business income and deductions
- Separate unrelated trades or businesses must be categorized using the first two digits of the NAICS code
Complexities of Not-for-Profit UBTI and New Changes
Unrelated business taxable income for not-for-profits is defined as gross income from an unrelated trade or business regularly carried less allowable deductions.
Issued in December 2017, the Tax Cuts and Jobs Act requires tax-exempt organizations with more than one unrelated trade or business to calculate UBTI separately. There have always been complexities in related or unrelated business income for not-for-profits. Museums sell admission tickets and hold events; healthcare organizations may have revenue from parking facilities or office leases; and foundations may sell merchandise or offer classes, as examples. How these and other revenue streams are defined for IRS purposes is already complicated.
The two phrases not substantially related and intent to profit have been key to interpreting what constitutes UBTI. That hasn’t changed; what will be different is that organizations are no longer allowed to aggregate income and deductions from all unrelated trades or businesses when calculating UBTI.
Now, more of a not-for-profit’s income may be considered taxable, and at the corporate rate of 21 percent. And with a tentative implementation date of January 1, 2021, for charities with a December year-end, there isn’t much time to plan.
New UBTI for Exempt Organizations
Other than the quick implementation – exempt organizations will need to be in compliance in a matter of months, on top of the financial fallout from the coronavirus – these final regulations are likely to increase many organizations’ taxable income because of how UBI is required to be calculated. The timeline for implementation could change, but as of now, it’s best to continue planning for January 1, 2021. The best place to start is by reviewing current accounting and tax policies and methods of allocation.
The tricky part is that there is still no uniform guidance on what constitutes a separate unrelated trade or business, but organizations will now have to identify unrelated trades or businesses using the first two digits of North American Industry Classification System (NAICS) codes. Organizations with multiple locations are permitted to use the same two-digit NAICS code for an unrelated trade or business, even if it’s conducted in more than one place.
Further, losses from one unrelated trade or business cannot be used to offset the profits of another. Net operating losses (NOLs) from one unrelated trade or business will need to be carryforward, while income from a second unrelated trade or business will result in taxable income.
How to Calculate UBTI
Calculating unrelated business taxable income is not new; exempt organizations with different revenue streams are already accustomed to it. A big part of the change in the proposed regulations is how it’s calculated, though. Starting in 2021, exempt organizations will need to calculate UBTI separately with respect to each trade or business. They are no longer allowed to aggregate income and deductions from all unrelated activities or use NOLs from one activity to offset the gains of another.
To calculate UBTI:
- For each unrelated trade or business, assign a two-digit NAICS code.
- Add all unrelated business income from each trade or business.
- This amount should be calculated without regard to any deductions, such as NOL or charitable contributions.
- The total UBTI is reduced by qualifying deductions, explained below.
Additionally, taxable income from each trade or business cannot be less than $0.
In the current draft, unadjusted gross UBTI is specifically mentioned as not being a reasonable method to allocate indirect expenses because it is a revenue-based method that does not account for differences in the prices charged for an activity, such as higher pricing for non-members.
Exempt organizations are permitted to deduct up to 10% of charitable contributions against total UBTI and may deduct certain NOLs.
UBTI Regulations for Exempt Organizations
There are potential trouble spots in the regulations concerning the allocation of allowable deductions. Organizations are allowed to deduct directly connected expenses from an unrelated trade or business, meaning that the deduction “must have a proximate and primary relationship” with carrying out the trade or business, such as cost of goods sold, direct labor and depreciation.
If deductible expenses can be shared between more than one unrelated trade or business, they can be allocated between both activities. What is unclear at this point is how indirect expenses should be allocated and what methods of allocation are reasonable in the eyes of the IRS.
While the final regulations could be slightly different, the general scope and extent of new UBTI calculations is likely to remain the same. Therefore, organizations can start planning for these changes now. Despite the challenges, this is a good opportunity to plan for the future of your organization, both in terms of operational changes and taxable income modifications.
Smaller organizations will have an easier time interpreting and calculating this change, while larger exempt organizations like healthcare and higher education with multiple revenue streams may have a more difficult time adjusting to the new regulations. PBMares is here to assist your organization with these changes.