New Guidance on Unrelated Business Income “Silo” Requirements
(How Revenue Procedure 2018-67 Impacts Tax-Exempt Organizations)
While most of the provisions in the Tax Cuts and Jobs Act of 2017 (the Act) passed by Congress in December of 2017 focus on for-profit entities and individuals, there were a handful of provisions that will directly impact tax-exempt organizations. As with many of the aspects of the Act that pertain to for-profit entities and individuals, tax-exempt organizations were not short on questions after reading through the Act. Significant guidance was needed to clarify and define various provisions in the Act and to instruct taxpayers how to implement the new rules. This week’s release of Revenue Procedure 2018-67 represents the first formal guidance received on the matter, and its contents are summarized in this article.
- Tax-exempt entities, while generally not subject to tax, are taxable on unrelated business income (“UBI”).
- December 2017’s Tax Cuts and Jobs Act introduced new “silo” rules prescribed by Internal Revenue Code Section 512(a)(6), requiring organizations with multiple sources of UBI to forgo the historically-allowed netting of the income of one entity with the losses of another. Organizations must now pay tax currently on profitable activities, while deferring the deductions of unprofitable activities through the use of net operating losses. The net effect will accelerate tax for many organizations.
- These new requirements of Section 512(a)(6) do not provide much detail, leaving much speculation regarding how to group certain activities and allocate expenses.
- New guidance was provided this week in the form of Revenue Procedure 2018-67 (the subject of this article), but many question remain and we await answers in the form of expected Treasury Regulations.
Under new Internal Revenue Code Section 512(a)(6), tax-exempt organizations with multiple different unrelated business activities must separately compute (or “silo”) net unrelated business income on an activity by activity basis. In other words, expenses from one unrelated business activity can no longer be used to offset the income from another. Earlier this year, the IRS indicated they would provide guidance regarding this provision by June 30, 2018.
What is considered to be a separate unrelated business activity was not precisely defined in the Act, nor was there much guidance on how to bifurcate expenses that may apply to multiple streams, such as administrative costs and overhead. Also, one of the most significant uncertainties was whether a tax-exempt organization with multiple K-1s from passive investment activities would have to report and pay tax on each K-1 separately, drastically increasing the administrative burden of filing its 990-T. Notice 2018-67 unfortunately doesn’t give us all the answers we were looking for, but it does give us some guidance on how to proceed with unrelated business income reporting for tax years beginning after January 1, 2018.
There was initially some speculation from the AICPA and EO Council that the IRS might delay the effective date of the new tax Act’s provisions on non-profits, but it is clear from the preliminary guidance released this week that there will be no change in the effective date of the new legislation at least as it relates to the unrelated business income silo requirement.
While what constitutes a separate trade or business is still not clearly defined, we are allowed to use a “reasonable and good faith effort” in grouping multiple trade or business activities that may be similar to one another into one silo of unrelated business income. In coming up with a reasonable and good faith grouping methodology the IRS permits using the NAICS codes as a guide. For example, a tax-exempt organization that may have unrelated business income from management service agreements would be allowed to group the income and expenses related to all of its management contracts into one unrelated business income silo using code 541611.
The grouping of various K-1s that allocate unrelated business income to a tax-exempt entity is a bit more complicated. Assuming that the unrelated business income on the K-1 is more than just investment income (such as interest, dividends, capital gains, etc.) which arguably could be grouped together using the 523999 NAICS code, a tax-exempt organization will have to look at its ownership percentage on the K-1 to determine whether or not it can group together multiple K-1s. Unrelated business income from multiple K-1s can be grouped together if the tax-exempt organization’s interest is “de minimis”, which is defined as owning less than 2% of the profit/loss or capital on the K-1. For the purpose of the 2% test, the organization must combine its own ownership percentage with those of its disqualified persons (board members, officers, substantial contributors, etc.), and certain related organizations.
If the de minimis test is failed, the organization can still group multiple K-1 investments together if it controls less than 20% of the profit/loss or capital interest and does not have control or influence over the partnership. What constitutes an acceptable level of control or influence was not defined in the recent guidance.
The IRS is still working on more substantial guidance on 512(a)(6) and plans to issue proposed regulations sometime in the near future. It is soliciting comments and feedback during this time and will consider that feedback while it irons out these new rules.
We are also still awaiting guidance on the other provisions of the Act impacting tax-exempt organizations, such as the taxability of certain transportation and parking fringe benefits and the 21% excise tax on compensation over $1,000,000. As soon as we see further guidance from the IRS we will relay that information to you so please stay tuned for future tax alerts.
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