On August 21, 2018, the IRS issued Notice 2018-67 (the Notice) requesting feedback from the public and providing interim guidance and transition rules related to IRS Code Section 512(a)(6). The Notice also addresses treatment of Global Intangible Low-Taxed Income Inclusions (GILTI) for purposes of unrelated business income (UBI).
Here’s a look at the IRS’s clarification of key transition rules, interim guidance, and expected implementation methods and timing.
Interim Guidance and Transition Rules
Separate Trade or Business
IRS Code Section 512(a)(6) requires an organization subject to UBI, with more than one unrelated trade or business, to calculate UBI separately with respect to each trade or business. The IRS, however, hasn’t yet issued guidance regarding what constitutes a separate trade or business and is requesting feedback to assist with that distinction.
In the meantime, organizations may use the North American Industry Classification System (NAICS) codes, or any other reasonable interpretation of the law, to determine separate trades or businesses.
The Fragmentation Principle
The IRS has also suggested that the fragmentation principle could be used to identify separate trades or businesses within the context of IRS Code Section 512(a)(6)—despite being used primarily to separate unrelated business trades or businesses from exempt activities. The principle can be found in Section 3 of the Notice.
According to the fragmentation principle, an activity doesn’t lose its identity as a trade or business if it’s carried on within a larger aggregate of similar activities. This same principle applies if it carries on within a larger group of endeavors, which may or may not be related to the organization’s exempt purpose.
Expense Allocations
In addition to clarifying trade or business classifications, the IRS will also provide guidance on methods of allocating expenses related to dual-use facilities and address how those methods will apply for Code Section 512(a)(6).
Debt-Financed Property and Controlled Entity Income
The IRS has stated that tracking each debt-financed property and controlled-entity income would be burdensome to both the organizations and the IRS. Aggregating income included in UBI under IRS Section 512(b)(4), (13), or (17) may be appropriate in certain circumstances.
Investment Partnerships
Activities of a partnership are generally considered activities of the partners—and can trigger UBI for tax-exempt organizations as a result. In response to this, the IRS has received some questions regarding whether organizations should determine if their partnerships have underlying investments and report them as a separate trade or business.
The IRS confirmed they intend to issue proposed regulations treating certain investment activities as one trade or business for this purpose. In the meantime, most organizations can rely on the de minimis or control tests for aggregating activities that are considered investment activities.
Here’s a look at both tests and the circumstances under which each should be applied.
- De minimis test. To use this test, an exempt organization should hold no more than 2% of the profit interest and no more than 2% of the capital interest in a partnership. The partnership’s Schedule K-1 can be used to determine ownership percentages. The test also includes aggregation rules with regards to combining related interest ownership of a partnership. The ownership test is computed using the average of the organization’s percentage interest at the beginning and end of the partnership’s taxable year. In the Notice, the IRS also addressed how to compute partnership interest that’s held for less than a year.
- Control test. For this test, an exempt organization must directly hold no more than 20% of the capital interest and can’t have control or influence over the partnership. The aggregation of related interest also applies to this test. The test’s control component is based on facts and circumstances, but the IRS does offer some examples of what constitutes control.
Transition relief was provided for partnership interest acquired prior to August 21, 2018, allowing an organization to treat partnership interest as a single unrelated business or trade—even if the ownership percentage exceeds the percentages specified in the two tests.
Clubs, Associations, and Trusts
IRS Code Sec. 512(a)(6) also applies to 501(c)(7), (9) and (17) organizations. However, due to their unique UBI rules, the IRS is asking for public feedback on how 512(a)(6) would be computed for social clubs, voluntary employee beneficiary associations, and supplemental unemployment compensation benefit trusts.
Fringe Benefits
The IRS has clarified that IRS Section 512(a)(7) isn’t subject to 512(a)(6) separate trade or business rules and computations.
Net Operating Losses
Net operating losses (NOLs) must now be tracked by each separate trade or business, and carryback losses are no longer allowed. Instead, losses are to be carried forward indefinitely starting with tax year beginning in before January 1, 2018.
If an organization has NOLs dating before 2018, it may be able to take a NOL deduction against total unrelated business taxable income, or UBTI, for the first taxable year beginning after December 31, 2017.
In the second taxable year beginning after December 31, 2017, an exempt organization with more than one unrelated trade or business may have NOLS from before and after 2018. In that circumstance, the organization is subject to different ordering rules dictated by 2017 tax reform legislation.
Given the new NOL rules, the IRS is seeking public feedback on how the NOL deduction should be taken by an organization with NOLs that date from before and after tax reform changes.
GILTI Inclusions
An organization must include GILTI in gross income under IRS Section 951A. However, the IRS has clarified that GILTI should generally be treated as dividend and excluded from UBI.
Effective Date
The IRS Section 512(a)(6) is effective for tax years beginning after December 31, 2017.
How to Provide Comments
The public has the opportunity to provide feedback to the IRS by December 3, 2018. Feedback can be provided via mail, in person, or via email, as stated in Section 12 of the Notice.
We're Here to Help
If you have questions about how tax reform might affect your organization, please contact your Moss Adams professional or visit our dedicated tax reform webpage.