In December 2017, Congress passed the Tax Cut & Jobs Act (TCJA) which represented the greatest tax overhaul in more than 30 years. Changes that were endorsed as pro-taxpayer included:
- reductions in the corporate tax rate from a maximum of 35% to a flat 21%;
- a new 20% deduction of qualified business income for pass-through owners to compensate for the corporate tax rate reduction;
- an increase to the lifetime exemption amount for estate taxes to $11 Million per person;
- doubling the standard deduction for individuals; and
- increases to exemption amount to reduce the sting of the Alternative Minimum Tax.
In order to get the TCJA passed, there needed to be revenue raisers to counter-balance the cost to the U.S. Treasury for all of the tax cuts in the legislation. The TCJA introduced two new code sections specific to nonprofit organizations that were designed to improve revenues to the U.S. Treasury.
- Section 512(a)(6) requires an exempt organization with more than one unrelated trade or business to calculate unrelated business taxable income (UBTI) separately with respect to each trade or business.
- Section 512(a)(7) imposed a tax on nonprofits for providing qualified transportation fringe benefits, also known as the parking tax. The parking tax was so unanimously disliked by all exempt organizations that Congress repealed section 512(a)(7) with the December 2019 Spending Bill, retroactively back to 2017.
Nonprofits are now required to silo Net Operating Losses (NOLs) from one unrelated business activity so that it doesn’t create a reduction of taxable income from another profitable unrelated business activity.
Congress intended that a deduction from one trade or business for a taxable year may not be used to offset income from a different unrelated trade or business for the same taxable year. Section 513 defines unrelated trade or business as any trade of business the conduct of which is not substantially related to the exercise or performance by such exempt organization of its exempt purpose. Thus nonprofits are no longer allowed to aggregate income and deductions from all unrelated trades or businesses.
Exempt Organizations and the Reasonable and Good-Faith Interpretation
The Internal Revenue Service issued Notice 2018-67 in August 2018, which provided interim guidance, described planned regulations and requested comments regarding the calculation of unrelated business taxable income under Section 512(a)(6). The IRS Notice instructs that exempt organizations may rely on a reasonable and good-faith interpretation of code sections 511-514, considering all the facts and circumstances, when determining whether the exempt organization has more than one unrelated trade or business. A reasonable and good-faith effort would include using the North American Industry Classification System (NAICS) 6-digit codes. If an exempt organization could classify multiple unrelated business activities in more than one NAICS code, then they would have more than one unrelated trade or business. The IRS Notice provides an example of an exempt organization’s advertising activities and related services that might be considered one unrelated trade or business activity, regardless of the source of the advertising income.
Exempt Organizations with Multiple Unrelated Trades or Businesses
The IRS guidance also points out the fragmentation principle in regulation 1.513-1(b) as useful in determining if an exempt organization has multiple unrelated trades or businesses. The fragmentation principle 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. For example, the regular sale of pharmaceutical supplies to the general public by a tax-exempt hospital pharmacy does not lose its status as a trade or business merely because the pharmacy also furnishes supplies to the hospital and patients in accordance with its exempt purposes. The hospital pharmacy sales to the general public would constitute an unrelated trade or business that is distinct and separate from the hospital’s exempt purpose to provide health care.
Exempt Organizations with Ownership Interest
Some nonprofits hold investments in partnerships. The IRS has received comments regarding the potential significant reporting and administrative burden that section 512(a)(6) imposes on exempt organizations with ownership interest in multi-tier partnership structures that generate UBTI. The administrative burden related to owning partnership interests would be heightened by the difficulty of obtaining sufficient information regarding the trade or business activities of lower-tier partnerships. As a matter of convenience, the IRS intends to issue regulations to allow aggregate reporting of all such “investment activities” as one trade or business.
Changes to How Exempt Organizations Can Utilize NOLs
The TCJA also imposed changes to how NOLs could be utilized. Previously, NOLs could be carried back two years and carried forward for 20 years. After 2017, NOLs can only be carried forward and the NOL deduction is limited to the lesser of the NOL available or 80% of the taxable income computed without regard to the NOL deduction. Because of the changes to NOLs, Congress has created a special transition rule to permit the carryover of any NOL arising in a taxable year prior to 2018. For the first year after 2017, an exempt organization may take an NOL deduction against total UBTI calculated, even if they have multiple business activities. Then for any year after the first year, NOLs will be calculated and taken before any pre-2018 NOLs because of the ordering requirements of section 512(a)(6) to calculate UBTI by each separate activity. This will require maintaining a schedule of pre and post NOL activity with separate NOLs for post-2017 business activity.
Due to section 512(a)(6), nonprofits will need to make a reasonable and good-faith effort to identify whether they have multiple unrelated business activities. If multiple unrelated business activities are identified, the exempt organization will need to calculate the taxable income or loss from each unrelated business activity separately so that a loss from one unrelated business activity does not create a reduction in taxable income from profitable unrelated business activity. This will also necessitate the tracking of separate NOLs by each unrelated business activity. This will certainly create additional complexities and administrative burdens for exempt organizations with multiple unrelated business activities. The comment period for IRS Notice 2018-67 regarding section 512(a)(6) has closed, but look for the IRS to issue final regulations and procedures in the near future.
If you have questions or concerns about this new code section, contact a tax professional from PBMares for further guidance by filling out the form below.