Exempt organizations' UBIT provisions under tax reform
Dealing with the two largest unknowns
October 2018 Footnote
When the Tax Cuts and Jobs Act (TCJA)1became law, two provisions altered the calculation of the not-for-profit sector's unique income tax -- the unrelated business income tax (UBIT) -- required by Internal Revenue Code (IRC or Code) section 511. Newly enacted Code sections 512(a)(6) and 512(a)(7) (their respective effective dates are in endnote2) alter what goes into bottom-line unrelated business taxable income (UB-TI).
These provisions alter the pre-TCJA landscape in which most exempt organizations were not required to file Form 990-T (due to the $1,000 filing exception for those whose gross receipts subject to UBIT were $1,000 or less3). Furthermore, the majority of taxpayers who had filed Form 990-T had UB-TI of under $50,000, which was taxed at a 15-percent bracket rate and is now taxed at 21 percent under the TCJA.
Summary of the new Code sections
512(a)(6) requires taxpayers to segregate each separate unrelated trade or business activity (ST/BA) and then calculate overall gain/loss within each ST/BA. Thereafter, UB-TI is calculated taking solely into account only those ST/BAs with gains (an ST/BA with a loss has same suspended with possible application only to the same ST/BA in future years). This UBIT "siloing" will increase UB-TI amounts from those under pre-TCJA law!
Two lines of questions still await answers: How is an ST/BA defined along with its connected (and deductible) expenses, and what happens to an ST/BA's suspended losses? The largest concerns and issues of the unknowns here are fourfold:
- When multiple revenue streams exist in one cost center (such as periodical sales and advertising in a periodical) or when similar activities occur through various separate platforms, when do activities together constitute an ST/BA?
- What methodologies will be allowed when allocating indirect costs to an ST/BA?
- How are revenues/losses to be characterized when coming from a taxpayer's share of activities conducted by a partnership or other pass-through entity that the taxpayer participates in?
- What happens to the suspended losses of an ST/BA if it is no longer conducted or is sold?
512(a)(7) requires an "add-in" to UB-TI for the amount of expenses that are paid or incurred in favor of providing employees with the Code Section 274(a)(4) qualified (i.e., nontaxable employee) benefits that the TCJA has made ineligible for business-expense deductibility by taxable organizations who provide these to their employees. This measure supposedly "levels the playing field" in its reach of tax-exempt organizations who typically had no tax deduction when providing such benefits. The two common benefit categories affected (i.e., their expenses being required UB-TI add-in) are:
- Qualified transportation fringe benefits under Code Section 132(f) (aka mass transit).
- Those for any parking facility used in connection with qualified parking (as defined in Code Section 132(f)(5)(C)).
Multiple questions and concerns abound here (especially as the Senate version, which was ultimately enacted, stripped out key references to certain Code Section 274 provisions):
- When the amount of expense paid or incurred in providing these fringe benefits is "added" to UB-TI, are the other costs of providing such benefits deductible from UB-TI (and, if so, to what extent)?
- Are parking facilities captured as part of a nontaxable benefit reached by TCJA's relevant amendments to Code Section 274? If they are, what constitutes an expense in favor of a parking facility?
- And, of course, the question of, "Why is an expense being taxed in the first place?"
Treasury/IRS and related developments to date
On Aug. 21, the IRS released Notice 2018-67 (formal publication date is Sept. 4) providing the government's initial posture on the impact of Code Section 512(a)(6), including how its provisions connect with 512(a)(7)'s UB-TI add-in. The notice also requests comments on specific aspects of the new law's application.
There are four key arenas in the notice that practitioners need to be aware of:
- On the issue of what is an ST/BA for purposes of the required siloing, the notice's Section 3.03 acknowledges that the statute itself has set out no criteria and the Treasury/IRS will propose regulations for determining how to identify when an exempt organization has more than one unrelated trade or business (i.e., ST/BAs). Until such issuance, the notice allows exempt organizations to rely on a reasonable, good faith interpretation of the law, including application of the NAICS six-digit codes. This section also confirms that principles of existing regulations remain intact and, thus, unrelated advertising in a periodical that has exempt function content is a "separate" unrelated trade or business.
- As to the determination of what are direct and indirect deductible costs associated with an ST/BA, Section 3.04 points to existing regulations that reach all direct costs and require indirect costs to be allocated "reasonably" between exempt function versus unrelated activities. The notice highlights that the existing Priority Guidance Plan has an item to specify what constitutes such a reasonable methodology and notes that such item will now be expanded to address allocation methodologies between ST/BAs.
- On the issue of partnership investing, Section 5.02 of the notice provides a helpful (and largely administratively convenient) result setting out first that the Treasury/IRS "intend to propose regulations treating certain activities in the nature of an investment of an exempt organization as one trade or business for purposes of 512(a)(6)(A) in order to permit exempt organizations to aggregate gross income and directly connected deductions from 'investment activities.'"
Until such proposed regulations are issued, Section 6 sets out two helpful interim rules that taxpayers may now rely upon:
- Section 6.01(2) allows the exempt organization to aggregate its partnerships' results for those in which the taxpayer has a "qualifying partnership interest" under either:
Note: Under both of the preceding tests, related interests of certain other parties need to be factored in.
- Section 6.02's de minimis interest rule (taxpayer does not directly hold more than 2 percent of either profits or capital interests).
- Section 6.03's control test (taxpayer does not directly hold more than 20 percent of the capital interest and does not have control or interest over the partnership)
- Section 6.04 sets out a transition rule obviating the need to apply either of the preceding tests for partnership interests acquired prior to Aug. 21, 2018.
- On the issue of the "parking/mass transit tax" mandated by new Section 512(a)(7) and how it will fit with new Section 512(a)(6)'s changes to the UB-TI calculation, Section 8.02 states that 512(a)(7) income is not subject to 512(a)(6), as follows:
"... 512(a)(7) does not treat amounts included in UB-TI as a result of that section as an item of gross income derived from an unrelated trade or business (see Section 4 of this notice). Furthermore, the Treasury Department and the IRS do not believe that the provision of the fringe benefits described in 512(a)(7) is an unrelated trade or business. Accordingly, any amount included in UB-TI under 512(a)(7) is not subject to 512(a)(6)."
In plain English, the Treasury/IRS thus have almost confirmed that amounts constituting UB-TI under 512(a)(7) can be offset by UB-TI loss from other activities (conclusion by author relates to fact that the IRS has already said that 512(a)(7) income is to be reported on Part 1, Line 12 of Form 990-T).
At the time of publication, no guidance had been issued on new Code Section 512(a)(7) and none was expected prior to early October (by optimists) or by late December (by pessimists). The American Bar Association (ABA) Section of Taxation's Aug. 28 comments on this Code section seek much practical guidance, including:
- Clarification that Section 512(a)(7) applies only to amounts paid or incurred for qualified transportation fringes for which a deduction is not allowable by reason of Section 274(a)(4). Such a clarification would mean that this section does not apply separately to a parking facility used in connection with qualified parking.
- Guidance that the UB-TI inclusion here is the lesser of (a) the amount of the expense disallowed under Section 274 that is incurred in providing the qualified transportation fringe and (b) the value of the qualified transportation fringe. The ABA also requested confirmation that existing guidance under Code Sections 61 and 132 related to valuing qualified transportation fringe applies for this purpose and, that, in applying that guidance, all users of parking facilities other than employees of the organization are to be considered "customers."
- Confirmation that a qualified transportation fringe provided to an employee gives rise to UB-TI under Section 512(a)(7) only to the extent that the amount that is excludable under Section 132(a)(5) actually is excluded from income (i.e., is not treated as additional wages to the employee). This result would allow a qualified transportation fringe to be treated entirely as additional wages without any UB-TI impact under Section 512(a)(7) (i.e., employers would have discretion to include all or a portion of the value of any benefit that otherwise would be excludable under Section 132(a)(5) in an employee's wages).
- Guidance that amounts paid or incurred for qualified transportation fringes for purposes of Section 512(a)(7) are limited to variable direct expenses connected with providing those fringes; and, in the case of a parking lot (or commuter highway vehicle), it doesn't include depreciation or capital expenses disallowed as deductions (and required to be capitalized) by Section 263, and only includes expenditures that relate to the use of the facility to provide qualified transportation fringes to employees.
Illuminated by the scope of the above unknown or undecided "fundamental issues," there has been a hue and cry to have some or all of 512(a)(7) overturned. Several bills have already been introduced in Congress in line with such demands.
Eve R. Borenstein, JD, operates BAM Law Office LLC, a national tax and compliance practice that has served the needs of not-for-profit organizations for nearly 30 years. In September, Eve received the Outstanding Lawyer Award from the American Bar Association for her distinguished service as outside counsel to nonprofit organizations. You may reach her at firstname.lastname@example.org.
- 1 Public Law Number 115-97, originally titled "Tax Cuts & Jobs Act," is referred to throughout this piece as TCJA.
- 2 Section 512(a)(7) is effective for amounts paid or incurred after Dec. 31, 2017. Section 512(a)(6) is effective for taxable years beginning after Dec. 31, 2017.
- 3 This threshold vests AFTER deducting COGS in the case of mining or manufacturing operations.
- 4 https://www.americanbar.org/content/dam/aba/administrative/taxation/policy/082818comments.pdf(Note: pages 26--42 provide in-depth analysis behind of the Section's 512(a)(7) recommendations).