GIVE US A CALL The Tax Cuts and Jobs Act (“TCJA”) added new Section 512(a)(6) to the Internal Revenue Code (“Code”). Section 512(a)(6) now requires an organization subject to the unrelated business income tax under Section 511, with more than one unrelated trade or business, to calculate unrelated business taxable income (“UBTI”) separately with respect to each trade or business.
The IRS recently issued Notice 2018-67 that discusses, and solicits comments regarding, various issues arising under Section 512(a)(6) and sets forth interim guidance and transition rules relating to that section. Importantly, this Notice also helps to clarify how the UBTI rules apply to IRAs both generally and with respect to this new Section.
Under Section 501(a), organizations described in Sections 401(a) and 501(c) generally are exempt from federal income taxation. However, Section 511(a)(1) imposes a tax (computed as provided in Section 11) on the UBTI of organizations described in Section 511(a)(2), which includes organization described in Sections 401(a) and 501(c) (other than a trust described in Section 511(b) or an instrumentality of the United States described in Section 501(c)(1)) as well as state colleges and universities. Additionally, Section 511(b)(1) imposes a tax (computed as provided in Section 1(e)) on the UBTI of certain trusts described in Section 511(b)(2). The Notice then states that organizations described in Section 511(a)(2) and trusts described in Section 511(b)(2) are collectively referred to as “exempt organizations” throughout the Notice. To clarify how IRAs will be treated, the Notice provides:
“Section 408(e) states that an individual retirement account (IRA) is subject to the taxes imposed by Section 511. Accordingly, any reference to an exempt organization in this notice includes an IRA, without regard to whether it is a traditional IRA, Roth IRA, simplified employee pension (SEP-IRA), or savings incentive match plans for employees (SIMPLE IRA).
Background on UBTI. Section 512(a)(1) defines UBTI as the gross income derived by any exempt organization from an unrelated trade or business regularly carried on by it, less the deductions allowed under Chapter 1 of the Code that are directly connected with the carrying on of such trade or business, both computed with the modifications described in Section 512(b). An exempt organization determines whether it has income from an unrelated trade or business under the general principles of Sections 511 through 514 and the Treasury regulations thereunder.
Section 513(a) defines “unrelated trade or business” as any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such exempt organization, other than trusts described in Section 513(b)(2), of its charitable, educational, or other purpose or function constituting the basis for its exemption under Section 501. Importantly, however, in the case of a trust that is exempt from tax under Section 501(a) and described in Section 401(a) (i.e. qualified retirement plans) or Section 501(c)(17) (supplemental unemployment compensation benefits trusts (SUBS)), Section 513(b) defines “unrelated trade or business” as any trade or business regularly carried on by such trust or (most relevant for IRAs) by a partnership of which it is member.
An exempt organization, such as an IRA, may conduct an unrelated trade or business directly or indirectly through another entity, such as a partnership (including any entity treated as a partnership for federal tax purposes, like a limited liability company). Very important for IRAs, Section 512(c) provides that, if a trade or business regularly carried on by a partnership of which an exempt organization, like an IRA, is a partner is an unrelated trade or business with respect to such organization, the exempt organization includes in UBTI – subject to the exceptions, additions, and limitations of Section 512(b) – its distributive share of partnership gross income (whether or not distributed) and partnership deductions directly connected with such gross income. In determining whether a partnership conducts one or more trades or businesses that are unrelated trades or businesses with respect to any exempt organization partner, the exempt organization would use the applicable definition of “unrelated trade or business” in Sections 513(a) or (b).
The Notice then provides an important clarification regarding IRAs and what definition of “unrelated trade or business” will apply to IRAs:
Because IRAs described in Section 408 are subject to the tax imposed by Section 511, under Section 408(e), and IRAs are most similar to Section 401(a) trusts, it is reasonable to apply the definition of “unrelated trade or business” described in Section 513(b) to IRAs. The Treasury Department and the IRS intend to provide that the Section 513(b) definition of unrelated trades or businesses should be used in application of Section 511 for accounts subject to the tax in Section 511 pursuant to Section 408(e). (Emphasis added)
The Notice then notes that Section 512(c) applies regardless of whether an exempt organization is a general partner or limited partner and cites Rev. Rul. 79-222, 1979-2 C.B. 236 in support of this view.
Exempt organizations exclude from the calculation of UBTI gross income from dividends, interest, annuities; royalties, rents, and gains and losses from the sale, exchange, or other disposition of property. See Section 512(b)(1), (2), (3) & (5). The Notice points out that the reason these and “similar items” are excluded from UBTI is because Congress indicated that such items “are not likely to result in serious competition for taxable businesses having similar income.” S. Rep. No. 81-2375 at 3031 (1950). Additionally, Congress stated that “investment-producing incomes of these types have long been recognized as a proper source of revenue for [exempt] organizations and trusts.” Id. However, gross income from other sources in the nature of investments are not specifically excluded by Section 512(b) and are generally included in the calculation of UBTI. For example, such gross income could include an exempt organization’s share (whether or not distributed) of the gross income of a partnership when the exempt organization is a partner and the partnership is engaged in one or more trades or businesses that are unrelated trades or businesses with respect to the exempt organization partner. The Notice then restates the application of Section 513(b):
In the case of a trust that is exempt from tax under Section 501(a) that is described in Section 401(a), Section 513(b) defines “unrelated trade or business” as any trade or business regularly carried on by a partnership of which it is a member. (Emphasis added)
An exempt organization may engage in more than one unrelated trade or business. Prior to the enactment of Section 512(a)(6), Treas. Reg. 1.512(a)-1(a) provided that, with respect to an exempt organization that derives gross income from the regular conduct of two or more unrelated trades or businesses, UBTI was the aggregate gross income from all such unrelated trades or businesses less the aggregate deductions allowed with respect to all such unrelated trades or businesses. However, Section 512(a)(6) changes this calculation for exempt organizations with more than one unrelated trade or business. 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.” H.R. Rep. No. 115-466, at 548 (2017). Specifically, Section 512(a)(6) provides that, in the case of any exempt organization (clearly now including any IRA) with more than one unrelated trade or business:
- UBTI, including for purposes of determining any net operating loss (NOL) deduction, shall be computed separately with respect to each trade or business and without regard to Section 512(b)(12) (allowing a specific deduction of $1,000.00),
- The UBTI of such organization (or IRA) shall be the sum of the UBTI so computed with respect to each trade or business, less a specific deduction under Section 512(b)(12), and
- For purposes of Section 512(a)(6)(B), UBTI with respect to any such trade or business shall not be less than zero.
Thus, Section 512(a)(6) no longer allows aggregation of income and deductions from all unrelated trades or businesses. Section 512(a)(6) applies to taxable years beginning after December 31, 2017, but not to NOLs arising before January 1, 2018, that are carried over to taxable years beginning on or after such date.
Separate Trade Or Business. In enacting Section 512(a)(6), Congress did not provide 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. The Treasury Department and the IRS will be developing proposed regulations for determining whether an exempt organization has more than one unrelated trade or business for purposes of Section 512(a)(6) and how to identify separate trades or businesses for purposes of calculating UBTI under Section 512(a)(6)(A).
Pursuant to the Notice, pending issuance of proposed regulations, exempt organizations may rely on a reasonable, good-faith interpretation of Sections 511 through 514, considering all the facts and circumstances, when determining whether an exempt organization has more than one unrelated trade or business for purpose of Section 512(a)(6). The Notice specifically notes that a reasonable, good-faith interpretation includes using the North American Industry Classification System 6-digit codes.
The Notice states that the IRS is hoping to implement a more administrative method than just a “facts and circumstances test”, because a “facts and circumstances test”: (1) increases administrative burden on exempt organizations to comply with:
- A fact-intensive analysis
- A document analysis
- A tracking and keeping records consistent with the analysis;
(2) results in inconsistency across the nonprofit sector; and (3) increases administrative burden on the IRS to implement and enforce Section 512(a)(6).
Finally, and important for IRAs that acquire investment property with debt-financing, the IRS is requesting comments regarding aggregating UBTI from all debt-financed property rather than tracking income from each debt-financed property. Such income is specifically referred to as “unrelated debt-financed income” under Section 514.
We will provide additional updates as additional guidance is issued.
Leave a Reply