The Tax Cuts and Jobs Act of 2017 added new sections to the Internal Revenue Code regarding the unrelated business income tax that will affect tax-exempt organizations’ tax liability beginning with the 2018 tax year. Leaders should have a basic understanding of the UBIT changes and talk with a tax professional about how they will affect the organization.

A tax-exempt organization generates unrelated business income (UBI) when it has regular activities that are unconnected to its purpose and that can produce income. If an activity is substantially related to the organization’s exempt purpose—that is, it contributes in a substantial way to accomplishing the organization's mission and is not conducted just for the sake of producing income—then the income is not subject to UBIT. On the other hand, if the business or trade activity does not directly support the mission, it can be subject to UBIT.

The IRS looks at the activity creating the income, not what the income is used to support. For example, if your association’s mission is to advance, assist, and advocate for educational leaders and your employees hold a bake sale each month to support the organization’s activities, that income is subject to UBIT because the sale of the baked goods does not advance, assist, or advocate for educational leaders.

There are some exceptions. Special UBIT rules allow income to remain tax exempt from activities such as tradeshows or conventions, legal bingo games, and sponsorships, among other things. The IRS also allows modifications to UBIT for most passive income, such as dividends and royalties, which enable it to remain tax exempt.

What Changed?

The new tax law made several changes to UBIT. It eliminated the progressive tax rate, taxing all UBI at a flat 21 percent. It also requires organizations to calculate each UBI activity separately for tax purposes—essentially, putting each activity in its own silo. (Associations are working to repeal a third change, which taxes certain transportation fringe benefits that nonprofit organizations offer employees. In the meantime, the Treasury Department recently issued interim guidance that provides some certainty about how the new fringe benefit tax should be handled.)

In the past, if an association had one unrelated business activity that created a loss and one that created a gain, they could offset each other. This allowed tax-exempt organizations to have several unrelated business activities but pay little to no UBIT.

The requirement that UBI silos be created to calculate the gain and loss on each individual activity will have significant implications. This new approach will create larger realized gains on some activities, potentially resulting in greater tax liability.

IRS Notice 2018-67 sets forth interim guidance and transition rules on the application of the silo provision, IRC section 512(a)(6). The notice provides guidance on several items, including a reasonable good-faith standard as to what is a separate trade or business; rules relating to treatment of income and losses from partnerships; how fringe benefit UBI might be treated; and rules on the use of net operating losses previously incurred. The IRS has requested comments on several items in the notice.

Allocation of Expenses

The allocation of expenses among activities is not a new issue for tax-exempt organizations. Expenses that are directly connected to carrying out an unrelated trade or business can generally be deducted. Where an expense relates both to an unrelated activity and exempt activities—so-called dual-use expenses—the regulations say the expense must be allocated on a “reasonable basis.” There has been some debate (and several court cases) as to what constitutes a reasonable basis, and the IRS has a project to look at this issue as one of its “priority guidance” items.

With the passage of the silo provision, not only do organizations have to allocate indirect expenses, such as general and administrative expenses, between related and unrelated activities; they also have to allocate among different unrelated trades or businesses. The notice requests comments regarding possible rules for allocation of indirect expenses and what allocation methods should be considered reasonable.

For purposes of determining what is a separate unrelated trade or business, the notice provides that an organization can rely on a reasonable good-faith interpretation of the Internal Revenue Code, considering all the facts and circumstances. It says that a “reasonable good-faith interpretation includes using the North American Industry Classification System (NAICS) six-digit codes” for classifying separate trade or business activities.

The notice gives an example of using Code 541800 for all advertising income, creating just one unrelated trade or business activity regardless of where the advertising appears. This is good news: It means an exempt organization does not have to list separate items such as advertising on a job board and advertising in a journal. Under the interim guidance, it appears that they can all be aggregated. The notice asks for comments regarding the use of the six-digit NAICS codes.

UBI and Partnerships

The notice provides rules for partnerships for most organizations until the IRS issues proposed regulations. Under the notice, an exempt organization may treat all partnership interests as one trade or business if the requirements of one of the following tests are met:

• De minimis test: An exempt organization meets this test if it directly holds no more than 2 percent of the interest in profits and 2 percent of the capital interest of the partnership. For purposes of this test, an organization must combine related interests, including those of a disqualified person, a supporting organization, or a controlled entity.
• Control test: This test is met if the organization holds no more than 20 percent of the capital interests of the partnership (including related interests) and does not have control or influence over the partnership, based on the facts and circumstances. The notice provides more detail on when it deems an exempt organization to have control.

Under a transition rule in the notice, if an organization acquired a partnership interest before August 21, 2018, it can treat the partnership interests as one trade or business, even if these tests are not met.

Other Items 

The notice suggests that it might be appropriate to aggregate the income and expense from debt-financed property and controlled organizations, and it addresses income from certain foreign corporations. It requests comments on this issue. In addition, the notice provides that amounts included in UBIT under the fringe benefits provision are not subject to the silo rule.

Finally, the tax new law made changes to the rules regarding net operating losses, and these rules will apply to UBI. Generally, losses incurred before January 1, 2018, can be taken against total UBIT after a calculation has been made for the separate trade or business limitation. The IRS has requested comments on the ordering of pre-2018 and post-2017 net operating losses.

The Tax Cuts and Jobs Act introduced many new rules for UBIT in 2018 that are not necessarily favorable to exempt organizations. Leaders of these organizations must be prepared to have a detailed discussion with their tax professional about how these changes will affect their tax liability.