The recently passed Tax Cuts and Jobs Act (“TCJA”) includes a number of provisions that affect tax-exempt organizations, particularly changes to the calculation of net Unrelated Business Taxable Income (UBTI).
When an organization that is tax-exempt under Section 501(a) derives income from a trade or business that is not substantially related to its exempt purposes, the income is generally subject to unrelated business income tax (UBIT).
Prior to the passage of the TCJA, in determining unrelated business taxable income (UBTI), an organization that operated multiple unrelated trades or businesses aggregated income from all those activities and subtracted the aggregate of deductions from the aggregate gross income. As a result, an organization was able to use a deduction from one unrelated trade or business to offset income from another, thereby reducing total UBTI.
The TCJA amends the unrelated business taxable income provisions by adding a new Section 512(a)(6), which requires organizations operating one or more unrelated trades or businesses to compute UBTI separately for each trade or business (without regard to Section 512(b)(12) which provides a specific deduction equal to the lower of $1,000 or the gross UBTI).
The result is that a deduction/loss from one unrelated trade or business may not be used to offset the income from a different unrelated trade or business. However, net losses from a specific unrelated business activity may be used to offset income from the same trade or business in another taxable year.
Under a special transition rule, net operating losses arising in a taxable year before January 1, 2018 that are being carried forward are not subject to this new provision.
It remains unclear what separates lines of unrelated businesses under this fragmentation rule. For example, will all investment income reside in a single UBIT silo? If a tax exempt entity invests in several partnerships, does each investment constitute a single line of business? These questions may result in additional planning opportunities pending further guidance.
This new provision has the effect of placing exempt organizations at a competitive disadvantage to for-profit corporations, which are permitted to offset profits from activity with losses from an unrelated activity. Tax-exempt organizations with a variety of unrelated business activities should consider whether now is the time to incorporate a taxable subsidiary under which to conduct such operations, which would permit this aggregation, and place them back on par with the private sector.
Additionally, nonprofits may wish to consider a review of their UBTI producing activities, including their UBTI producing private equity and other investments, in order to capture and report all expenses reasonably allocable and directly connected to that activity. This may include allocable amounts of employee compensation, investment advisory fees, and other administrative overhead.
Many exempt organizations generate some unrelated business income. The inability to offset losses from one unrelated trade or business against gains from another (or against gains and losses from alternative investments or pass-through entities) would likely increase a tax-exempt organization’s overall UBIT burden. On the positive side, if UBIT is triggered, it will now be taxed at the new lower corporate rate of 21 percent.
Please contact your Mazars USA LLP professional for additional information.