Prop Regs Address Calculation of UBTI for Exempt Orgs with Multiple Businesses

(Parker Tax Publishing May 2020)

The IRS issued proposed regulations that provide guidance on how an exempt organization subject to the unrelated business income tax under Code Sec. 511 determines if it has more than one unrelated trade or business, and, if so, how the exempt organization calculates unrelated business taxable income. The proposed regulations, which expand on the guidance provided in Notice 2018-67, also address the use of the net operating loss deduction under Code Sec. 172 for exempt organizations with more than one trade or business. REG-106864-18 (4/24/20).

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). Code Sec. 512 provides two different definitions of UBTI - one in Code Sec. 512(a)(1), which applies to most exempt organizations, and one in Code Sec. 512(a)(3), which applies only to social clubs described in Code Sec. 501(c)(7), voluntary employees' beneficiary associations (VEBAs) described in Code Sec. 501(c)(9), and supplemental unemployment compensation benefits trusts (SUBs) described in Code Sec. 501(c)(17).

Under Code Sec. 512(a)(1), UBTI is the gross income derived by any exempt organization from an unrelated trade or business regularly carried on by it, less the allowed deductions that are directly connected with the carrying on of such trade or business, both computed with the modifications described in Code Sec. 512(b). Code Sec. 513(a)(3) generally defines "unrelated trade or business" as any trade or business the conduct of which is not substantially related to the exercise or performance by such exempt organization of its charitable, educational, or other purpose or function constituting the basis for its exemption. However, in the case of a trust that is exempt from tax under Code Sec. 501(a) and described in Code Sec. 401(a) (qualified retirement plans) or Code Sec. 501(c)(17) (SUBs), Code Sec. 513(b) defines ''unrelated trade or business,'' as any trade or business regularly carried on by such trust or by a partnership of which it is a member.

Reg. Sec. 1.513-1(b) generally provides that, for purposes of Code Sec. 513, the term ''trade or business'' has the same meaning as in Code Sec. 162. By contrast, Code Sec. 512(a)(3)(A) defines UBTI as the gross income (excluding exempt function income), less the income tax deductions that are directly connected with the production of the gross income (excluding exempt function income), both computed with the modifications described in Code Sec. 512(b)(6) (net operating loss (NOL) deduction), Code Sec. 512(b)(10) (charitable contribution deduction by exempt organizations), Code Sec. 512(b)(11) (charitable contribution deduction by certain trusts), and Code Sec. 512(b)(12) (specific deduction). Accordingly, UBTI under Code Sec. 512(a)(3) is not limited to the gross income derived by an exempt organization from any unrelated trade or business regularly conducted by it. Thus, any gross income that is not exempt function income (nonexempt function income) is UBTI under Code Sec. 512(a)(3).

Before the enactment of Code Sec. 512(a)(6) by the Tax Cuts and Jobs Act of 2017 (TCJA), an exempt organization deriving gross income from the regular conduct of two or more unrelated trades or businesses calculated its UBTI by determining its aggregate gross income from all such unrelated trades or businesses and reducing that amount by the aggregate deductions allowed with respect to all such unrelated trades or businesses. However, Code Sec. 512(a)(6) changed this calculation by no longer permitting the aggregation of income and deductions from all unrelated trades or businesses when calculating UBTI. Code Sec. 512(a)(6) applies to tax years beginning after December 31, 2017, but not to net operating losses (NOLs) arising before January 1, 2018, that are carried over to tax years beginning on or after that date.

In August 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. Last week, the IRS issued proposed regulations that provide updated guidance in response to the comments received on Notice 2018-67.

Proposed Regulations

Because Code Sec. 512(a)(6) disallows the aggregation of income and deductions from all unrelated trades or businesses, the proposed regulations revise Reg. Sec. 1.512(a)-1(a) to state that, in the case of an organization with more than one unrelated trade or business, UBTI is calculated separately with respect to each such trade or business as provided in Prop. Reg. Sec. 1.512(a)-6.

According to the IRS, 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). Accordingly, the proposed regulations establish the method for determining whether an exempt organization has more than one unrelated trade or business and identifying separate unrelated trades or businesses for purposes of calculating UBTI.

The proposed regulations also clarify that, for purposes of the UBIT generally, and the application of Code Sec. 512(a)(6) specifically, an individual retirement plan described in Code Sec. 408(e) uses the definition of "unrelated trade or business" in Code Sec. 513(b) applicable to trusts. Additionally, the proposed regulations clarify that inclusions of subpart F income under Code Sec. 951(a)(1)(A) and global intangible low-taxed income under Code Sec. 951A(a) are treated in the same manner as dividends for purposes of Code Sec. 512(b)(1).

NOLs and UBTI

Code Sec. 512(b)(6), which was not amended by TCJA, provides that the net operating loss (NOL) deduction under Code Sec. 172 is available to exempt organizations that are subject to the UBIT, including organizations with more than one unrelated trade or business.

As noted in Notice 2018-67, Code Sec. 512(a)(6) changed how an exempt organization with more than one unrelated trade or business calculates and takes an NOL into account with respect to a trade or business. Specifically, Code Sec. 512(a)(6)(A) requires the organization to calculate UBTI, including for purposes of determining any NOL deduction, separately with respect to each trade or business for tax years beginning after December 31, 2017. Accordingly, the proposed regulations clarify that, if an exempt organization has more than one unrelated trade or business, Reg. Sec. 1.512(b)-1(e), which explains the application of Code Sec. 172 within the context of the UBIT, applies separately with respect to each such unrelated trade or business. Additionally, the proposed regulations add a new paragraph to Reg. Sec. 1.512(b)-1(e) that refers an exempt organization with more than one unrelated trade or business to Prop. Reg. Sec. 1.512(a)-6(h) regarding the computation of the NOL deduction.

To preserve NOLs from tax years prior to the effective date of TCJA, a special transition rule applies for NOLs arising in a tax year beginning before January 1, 2018 (pre-2018 NOLs). TCJA Section 13702(b)(2) provides that Code Sec. 512(a)(6)(A) does not apply to pre-2018 NOLs; rather, pre-2018 NOLs are taken against the total UBTI calculated under Code Sec. 512(a)(6)(B). However, when an exempt organization has pre-2018 NOLs, which are subject to a carry-forward limitation, and NOLs arising in a tax year beginning after December 31, 2017 (post-2017 NOLs), which are not subject to a carryforward limitation, a question arises regarding the order in which such losses should be taken.

Notice 2018-67 states that Code Sec. 512(a)(6) may have changed the order in which an organization would ordinarily take losses. For example, if Code Sec. 512(a)(6) is read as a more specific ordering rule for purposes of calculating and taking the NOL deduction into account than the one found in Code Sec. 172, post-2017 NOLs would be calculated and taken before pre-2018 NOLs because the UBTI with respect to each separate unrelated trade or business is calculated under Code Sec. 512(a)(6)(A) before calculating total UBTI under Code Sec. 512(a)(6)(B). In response to Notice 2018-67, several practitioners addressed possible ordering rules for organizations subject to Code Sec. 512(a)(6). These practitioners noted that the language should not alter the ordering rules under Code Sec. 172 such that pre-2018 NOLs should be allowed before post-2017 NOLs, especially because pre-2018 NOLs remain subject to a carry-forward limitation.

According to the IRS, the language of Code Sec. 512(a)(6) and TCJA Section 13702(b) do not alter the ordering rules under Code Sec. 172. Thus, the proposed regulations provide that an exempt organization with both pre-2018 and post-2017 NOLs will deduct its pre- 2018 NOLs from its total UBTI under Code Sec. 512(a)(6)(B) before deducting any post- 2017 NOLs with regard to a separate unrelated trade or business from the UBTI from such unrelated trade or business. The proposed regulations clarify that pre-2018 NOLs are deducted from total UBTI in the manner that results in maximum utilization of the pre-2018 NOLs in a tax year.

At the same time Congress added Code Sec. 512(a)(6), it also made extensive changes to Code Sec. 172. These changes included limiting the NOL deduction to 80 percent of taxable income, generally prohibiting the carryback of NOLs, and allowing the indefinite carryover of NOLs. However, shortly before publication of the proposed regulations, Congress enacted the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), which temporarily repeals the 80 percent income limitation and permits the carryback of NOLs arising in tax years beginning after December 31, 2017, and before January 1, 2021, to each of the five tax years preceding the tax year of such loss. The IRS said that it will further consider how the changes to Code Sec. 172 made by the CARES Act affect the calculation of UBTI under Code Sec. 512(a)(6) and may issue additional guidance on the issue.

Proposed Applicability Dates

The proposed regulations are proposed to apply to tax years beginning on or after the date they are published as final regulations. For tax years beginning before the date the proposed regulations are published as final, an exempt organization may rely on a reasonable, good-faith interpretation of Code Sec. 511 through Code Sec. 514 considering all the facts and circumstances, when identifying separate unrelated trades or businesses for purposes of Code Sec. 512(a)(6)(A). In addition, for these same tax years, an exempt organization may rely on the proposed regulations in their entirety. Alternatively, for these same tax years, exempt organizations may rely on the methods of aggregating or identifying separate trades or businesses provided in Notice 2018-67.

For a discussion of the rules applicable to unrelated business taxable income, 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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