Planning for the UBTI Changes

Planning for the UBTI Changes

Article posted in Income Tax on 16 January 2018| comments
audience: National Publication, Dennis Walsh, CPA | last updated: 23 January 2018
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Summary

Among the sweeping reforms passed in the new tax law are dramatic changes to the reporting of Unrelated Business Taxable Income (UBTI). Dennis Walsh clarifies the new rules. Donors and charities be aware. 

By Dennis Walsh, CPA

Recently enacted H.R. 1, the Tax Cuts and Jobs Act of 2017, Includes additions to Internal Revenue Code (IRC) Section 512(a) of importance to exempt organizations that operate a trade or business unrelated to the accomplishment of their exempt purposes.

A review of current authority for defining and grouping income-producing activities is timely in evaluating how the Treasury and IRS are likely to approach implementation of the new provisions and how UBI activities might be structured for effective tax management.

What’s different?

For tax years beginning in 2018, unrelated business taxable income (UBTI) must be computed separately for each trade or business.  If a particular activity reports a net loss for the year, the loss may not be used to reduce income from any other unrelated trade or business operated by the organization.

In addition, while a net operating loss may still be carried forward under the new law to offset UBTI realized in a later year, losses may only be applied against net income of the trade or business activity that produced the loss, effectively suspending any tax benefit until the activity becomes profitable.

Under a special transition rule, net operating losses arising in a taxable year beginning before Jan­uary 1, 2018, that are carried forward to a taxable year beginning on or after such date are not subject to this limitation.

As widely publicized, the Act also eliminates the progressive corporate tax rate structure and replaces it with a flat 21% rate.  The resulting decrease in effective tax rate for organizations with large amounts of unrelated business income (UBI) should result in substantial tax savings for such organizations.

However, organizations annually reporting UBTI of less than $90,385 will see an increase in tax from UBI activities as a result of the elimination of the 15% tax rate on an initial $50,000 of taxable income.

UBTI calculation

Unrelated business taxable income (UBTI) is the UBI that is taxable after deducting expenses directly connected to a trade or business.  Under prior law, because UBTI was calculated by totaling UBI from all activities and subtracting allowable deductions from all UBI activities, losses from unprofitable activities could be used to offset net income from those that are profitable, reducing the amount of UBI subject to tax.

In order to properly calculate UBTI under the new law, exempt organizations will need to assure that activities are reasonably defined.  To the extent that multiple income-producing endeavors are viewed separately or aggregated and viewed as one activity will determine when losses from unprofitable activities may be offset against net income from profit-producing activities.  

Single trade or business?

Absent from H.R. 1 and the Senate Finance Committee report is discussion of criteria for defining a single trade or business activity.  Until regulations and administrative guidance are issued on distinguishing and disaggregating activities when required, organizations and their advisors can glean insights from the IRS 2013 Colleges and Universities Compliance Project (CUCP) report.  The report findings are now of increased importance to all exempt organizations with UBI activities.            

Key CUCP findings

The multi-year CUCP final report was issued in April 2013.  Findings regarding unrelated business income (UBI) practices from among the 400 institutions surveyed and 34 audited laid the groundwork for the current addition to IRC §512(a). 

As summarized in the report, UBI examinations resulted in:

  • increases to unrelated business taxable income (UBTI) for 90% of the colleges and universities examined
  • Nearly 70 percent of examined organizations reporting losses from activities for which expenses had consistently exceeded UBI for many years and where the organization failed to show a profit motive
  • Disallowance of more than $170 million in Net Operating Losses (NOLs), including loss carryforwards, amounting to more than $60 million in assessed taxes

In addition, Expense deductions were disallowed on more than 60 percent of the Form 990-Ts examined because they were based on improper allocations between exempt and unrelated business activities.  Although not the subject of this article, shared costs of conducting UBI activities, including costs of dual-use facilities, must be reasonably and consistently allocated among separate UBI trades or businesses and between related and unrelated activities.

Viewing the current enactments in light of the CUCP findings, exempt organizations should consider the following questions regarding any current or planned UBI activities:

  1. Is the trade or business activity appropriately defined, or might it be reasonably viewed as comprising more than one activity?
  2. If a particular trade or business, appropriately defined, has a history of recurring losses, is it supportable as an activity engaged in for profit?

Unrelated trade or business

For an organization to be engaged in an unrelated trade or business activity as defined in IRC §513, the activity must:

  • Qualify as a trade or business
  • Be regularly carried on, and
  • Not be substantially related to exempt purposes

Trade or business

For purposes of IRC §513, the term "trade or business" has the same meaning it has in §162, and generally includes any activity carried on for the production of income from the sale of goods or performance of services.

Trade or business is not limited to integrated aggregates of assets, activities, and goodwill which comprise businesses for the purposes of certain other provisions of the Code.  Activities of producing or distributing goods or performing services from which a particular amount of gross income is derived do not lose identity as trade or business merely because they are carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purposes of the organization.  Treas. Reg. §1.513–1(b).

As in the past, careful analysis of income producing endeavors is also needed to properly carve UBI activities operated within core exempt functions.  For example, as illustrated in existing Regulations, the regular sale of pharmaceutical supplies to the general public by a hospital pharmacy does not lose identity as a trade or business merely because the pharmacy also furnishes supplies to the hospital and patients of the hospital in accordance with its exempt purposes.  Similarly, activities of soliciting, selling, and publishing commercial advertising do not lose identity as a trade or business even though the advertising is published in an exempt organization periodical.  Treas. Reg. §1.513-1(b).

Characteristics of an activity

The Regulations under IRC §183 relating to the disallowance of losses by individuals and S corporations from activities not engaged in for profit provide helpful insight as to the type of factors the IRS might use in issuing guidance as to the extent an activity comprised of more than one undertaking may be properly classified as a single trade or business. 

The most significant factors in making this determination follow.  Treas. Reg. §1.183-1(d)(1).

o   The degree of organizational and economic interrelationship of various undertakings

o   The business purpose which is (or might be) served by carrying on the various undertakings separately or together in a trade or business or in an investment setting

o   The similarity of various undertakings.

The Regulation provides that the IRS will generally accept the characterization by the taxpayer of several undertakings either as a single activity or as separate activities, except where it appears that it is artificial and cannot be reasonably supported under the facts and circumstances.

The following criteria from the passive loss requirements of Treas. Reg. §1.469-4(c)(2) are also helpful in sorting through facts and circumstances in defining a single trade or business activity: 

o   Similarities and differences in types of trades or businesses

o   Extent of common control

o   Extent of common ownership

o   Geographical location

o   (Interdependencies between or among activities

Examples of such interdependencies include the extent to which the activities:

o   Purchase or sell goods between or among themselves

o   Involve products or services that are normally provided together

o   Have the same customers

o   Have the same employees

o   Are accounted for with a single set of books and records

Profit motive

For deductions to be allowable under IRC §162, an activity must be entered into with a profit motive.  The most common reason for disallowance of current year losses and net operating loss carryforwards in the CUCP audits was that claimed losses were connected with an activity for which the school lacked a profit motive, as evidenced by years of sustained losses.

Organizations were asked, for each income producing activity regardless of whether reported on Form 990-T, if they incurred a loss from the activity in at least 3 of the 5 previous years.  For activities with a “yes” answer, respondents were then asked to select from among the following as the predominant reason for the losses:

o   Business was in startup phase

o   Actual costs were significantly greater than anticipated

o   Competitive pressures prevented pricing to allow for full recovery of costs

o   Less demand for product or service than was projected

o   Business was in business cycle downturn

o   Budgeted to operate at breakeven or a loss because doing so contributed to the organization’s exempt mission

o   Business was in winding-up phase

o   Other

Organizations were also asked whether, for each loss activity, they have plans for making a profit.

IRC §183(d) provides a safe harbor for individuals and S corporations by creating a rebuttable presumption that an activity is engaged in for profit if a net profit is reported for any 3 years within a consecutive 5-year period.  Although the safe harbor is not applicable to exempt organizations with UBI activities, it is noteworthy that in the CUCP survey the IRS asked whether a particular activity incurred a loss in at least 3 of the 5 previous years as a benchmark for asking for the predominant reason for the losses and if there are plans for making a profit. 

The Regulations accompanying IRC §183 provide characteristics of an activity engaged in for profit that may be helpful in substantiating profit motive in the conduct of UBI activities.  The following items, summarized from Treas. Reg. §1.183-2(b), are among the types of factors considered:

  • Activity carried on in businesslike manner
  • Accurate and complete books and records kept
  • Carried on in manner similar to like profitable activities
  • New methods to improve profitability are adopted
  • Taxpayer or advisors hold sufficient expertise
  • Advance study of activity was conducted
  • Significant time and effort is expended
  • Expectation of increase in asset value
  • Success in carrying on similar or dissimilar activities
  • Profit/loss history of activity, considering losses sustained for reasons beyond taxpayer’s control
  • Profits earned relative to cumulative losses and investment in activity
  • Dependence on income from the activity
  • Reasons for entering the activity indicate profit motive

Use of controlled entity

Operation of UBI activities within a wholly-owned for-profit subsidiary, a so called “feeder organization,” might be an effective alternative in some situations to circumvent the new Section 512(a) requirements previously summarized. 

This is also a time-tested strategy for reducing threat to tax-exempt status when unrelated business activity has reached a level that is more than insubstantial relative to exempt activity.  And use of a protective entity may also help shield assets dedicated to core exempt functions.

When structured and operated appropriately, this form of organization may remove UBI activities from the purview of the UBIT rules, including the limitations created by the current additions to IRC §512(a).  Earnings of former UBI activities may be passed to the controlling exempt organization in the form of dividends exempt from the unrelated business income tax.

But as demonstrated by the CUCP tax audit assessments, an activity must also be able to clear the IRC 162 profit motive hurdle for a loss to be deductible.  Thus, this strategy may not prove effective for an activity that cannot be shown to be engaged in for profit.

Takeaways

Exempt organizations frequently operate income producing activities unrelated to the accomplishment of their exempt purposes.  Such endeavors may complement other activities and be vital to overall mission sustainability as funding sources. 

However, under the new law separate UBI activities are no longer aggregated for calculation of UBTI as in the past.  Disaggregation of business units when required is also likely to expose separate activities with recurring losses to greater scrutiny regarding profit motive, which may further limit an organization’s ability to realize tax benefit from current and prior year net operating losses.

Accordingly, pending authoritative guidance, Organizations should review and group UBI activities carefully, and be ready to defend aggregation of activities when necessary based on reasonable application of the types of factors previously listed, taking into account commercial practices for similar endeavors. 

Management and those charged with governance should operate UBI activities in a business-like manner pursuant to a business plan and document decisions designed to improve unprofitable operations in organization minutes.

Accurate records substantiating current and carryforward net operating loss deductions for each activity must be maintained.  Methods of allocating costs among activities must be reasonable and consistently applied.

Operating UBI activities through a wholly-owned for-profit subsidiary may be a viable alternative where activities with recurring losses demonstrate the requisite profit motive.  But operation of the subsidiary must be kept at arm’s length from the controlling organization.  Expert advice should be sought before pursuing this type of arrangement.

Taken together, these actions will help organizations manage UBIT liability under the new law and reduce the likelihood of unexpected and costly assessments of income taxes.

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