IRS Adopts Rules for Exempt Organizations with More Than One Unrelated Business

(Parker Tax Publishing December 2020)

The IRS issued final regulations on how an exempt organization subject to the unrelated business income tax determines if it has more than one unrelated trade or business, and, if so, how the exempt organization calculates unrelated business taxable income. In the final regulations, the IRS removed the restriction on changing NAICS 2-digit codes and instead requires an exempt organization that changes the identification of a separate unrelated trade or business to report the change in the tax year of the change in accordance with forms and instructions. T.D. 9933.

Background

Code Sec. 511 imposes an unrelated business income tax (UBIT) on the unrelated business taxable income (UBTI) of organizations that are exempt from tax under Code Sec. 501(a). Under Code Sec. 512(b)(12), a special deduction is allowed for each tax-exempt entity. A new provision, Code Sec. 512(a)(6), was enacted in the Tax Cuts and Jobs Act of 2017 (TCJA). For an organization with more than one unrelated trade or business, Code Sec. 512(a)(6) requires that UBTI first be computed separately with respect to each trade or business and without regard to the specific deduction generally allowed under Code Sec. 512(b)(12). Congress did not provide explicit criteria for determining whether an exempt organization has ''more than one unrelated trade or business'' or how to identify ''separate'' unrelated trades or businesses for purposes of calculating UBTI in accordance with Code Sec. 512(a)(6).

An organization's UBTI for a tax year is the sum of the amounts (not less than zero) computed for each separate unrelated trade or business, less the specific deduction allowed under Code Sec. 512(b)(12). A net operating loss (NOL) deduction is allowed only with respect to a trade or business from which the loss arose. Thus, under Code Sec. 512(a)(6), unlike in years before TCJA, a deduction from one trade or business for a tax year may not be used to offset income from a different unrelated trade or business for the same tax year. Code Sec. 512(a)(6) generally does not, however, prevent an organization from using a deduction from one tax year to offset income from the same unrelated trade or business activity in another tax year, where appropriate. It provides that all entities exempt from tax under Code Sec. 501(a), notwithstanding the entity's exemption under any other provision of the Code, are subject to the UBIT rules. Code Sec. 512(a)(6) applies to tax years beginning after 2017. Under a special transition rule, NOLs arising in a tax year beginning before January 1, 2018, that are carried forward to a tax year beginning on or after such date are not subject to Code Sec. 512(a)(6).

In 2018, the IRS issued Notice 2018-67, which discussed and solicited comments regarding various issues arising under Code Sec. 512(a)(6), and set forth interim guidance and transition rules. In April of 2020, in REG-106864-18, the IRS issued proposed regulations providing guidance on how an exempt organization subject to UBIT determines if it has more than one unrelated trade or business, and, if so, how the exempt organization calculates UBTI. The IRS has now finalized these regulations in T.D. 9933.

Final Section 512(a)(6) Regulations

In T.D. 9933, the final regulations provide that, with respect to most unrelated trade or business activities, an exempt organization determines whether those activities are separate unrelated trades or businesses for purposes of Code Sec. 512(a)(6) based on the most accurate NAICS 2-digit codes describing the activities. In response to questions as to how to determine the most accurate code for a business, the IRS added in the final regulations that this determination is based on the more specific NAICS code, such as at the 6-digit NAICA level, that describes the activity that it conducts. The final regulations also state that the descriptions in the current NAICS manual (available at www.census.gov) of trades or businesses using more than two digits of the NAICS codes are relevant in this determination. The final regulations incorporate a rule used in NAICS for identifying certain industries and provide that, in the case of the sale of goods, both online and in stores, the separate unrelated trade or business is identified by the goods sold in stores if the same goods generally are sold both online and in stores. In determining whether services provided in connection with hosting an event should be aggregated or not, the IRS said that depends on the facts and circumstances, including the language of the contract or contracts, the services provided, who is providing the services, etc.

According to the IRS, because the NAICS at the 2-digit code level aggregates all trade or business activities into only 20 separate trades or businesses, many trade or business activities that could be considered separate trades or businesses, such as the provision of food or lodging, are already aggregated into broad categories (e.g., NAICS code 72 includes both lodging and food services) and are therefore treated as one trade or business under the final regulations. Accordingly, if an exempt organization determines that, based on the facts and circumstances, its trade or business activities must be separated into two or more unrelated trades or businesses under NAICS 2-digit codes, the IRS said it views that result as appropriate to achieve the balance of tax administrability and carrying out the purposes of Code Sec. 512(a)(6). Thus, under the final regulations, if trade or business activities would be best described by different NAICS 2-digit codes, those activities should be identified using different NAICS 2-digit codes and treated as separate unrelated trades or businesses.

In addition, consistent with the proposed regulations, the final regulations continue to provide that the NAICS 2-digit code must identify the separate unrelated trade or business in which the exempt organization engages (directly or indirectly). The NAICS 2-digit code cannot describe activities the conduct of which are substantially related to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under Code Sec. 501 (or, in the case of an organization described in Code Sec. 511(a)(2)(B), to the exercise or performance of any purpose or function described in Code Sec. 501(c)(3)). For example, the IRS said, a college or university described in Code Sec. 501(c)(3) or Code Sec. 511(a)(2)(B) cannot use the NAICS 2-digit code for educational services to identify all of its separate unrelated trades or businesses, and a qualified retirement plan described in Code Sec. 401(a) cannot use the NAICS 2-digit code for finance and insurance to identify all of its unrelated trades or businesses.

In response to comments on the proposed regulations' restriction on changing NAICS 2-digit codes, the final regulations removed the restriction and now require an exempt organization that changes the identification of a separate unrelated trade or business to report the change in the tax year of the change in accordance with forms and instructions.

The final regulations also provide that, although an exempt organization may have used NAICS 6-digit codes to identify its separate unrelated trades or businesses in tax years beginning before the date the final regulations are published in the Federal Register, the transition from NAICS 6-digit codes to NAICS 2-digit codes does not require the reporting of a code change because the exempt organization will be using the same NAICS code to identify its separate unrelated trades or businesses - just with fewer digits. The move from NAICS 6-digit codes to NAICS 2-digit codes, the IRS said, may result in the combination of NOLs if an exempt organization has trade or business activities that would be separate unrelated trades or businesses if identified using NAICS 6-digit codes but would be one unrelated trade or business if identified using NAICS 2-digit codes. An exempt organization may choose, but is not required, to amend Forms 990-T filed prior to the date the final regulations are published in the Federal Register to report separate unrelated trades or businesses using NAICS 2-digit codes.

The IRS noted that the proposed regulations had clarified that the Code Sec. 513(b) definition of "unrelated trade or business" applies to individual retirement accounts (IRAs). According to the IRS, no comments were received with respect to this provision and thus the final regulations adopted it without change. Accordingly, Reg. Sec. 1.513-1(f) provides that an IRA will apply the definition of ''unrelated trade or business'' in Code Sec. 513(b) when determining whether it has more than one unrelated trade or business within the meaning of Code Sec. 512(a)(6).

The IRS also rejected a practitioner's request to adopt a de minimis exception under which an exempt organization with less than $10,000 of total gross revenues would be permitted to treat all its unrelated trades or businesses as one trade or business for purposes of Code Sec. 512(a)(6). The IRS noted that it lacked the authority to provide a de minimis exception.

Effective Date

The final regulations apply to tax years beginning on or after the date the final regulations are published in the Federal Register.

For a discussion of the taxation of unrelated trade or business income of a tax-exempt entity, see Parker Tax ¶66,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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