Questions arise around unrelated business taxable income
With the recent passage of H.R. 1, the Tax Cuts and Jobs Act (TCJA), one provision of interest to the exempt organization community is the establishment of new code section 512(a)(6). In summary, and effective for tax years beginning after Dec. 31 2017, section 512(a)(6) provides:
For an organization with more than one unrelated trade or business, the provision requires that unrelated business taxable income first be computed separately with respect to each trade or business and without regard to the specific deduction generally allowed under section 512(b)(12). The organization’s unrelated business taxable income for a taxable year is the sum of the amounts (not less than zero) computed for each separate unrelated trade or business, less the specific deduction allowed under section 512(b)(12). A net operating loss deduction is allowed only with respect to a trade or business from which the loss arose.
The result of the provision is that a deduction from one trade or business for a taxable year may not be used to offset income from a different unrelated trade or business for the same taxable year. The provision generally does not, however, prevent an organization from using a deduction from one taxable year to offset income from the same unrelated trade or business activity in another taxable year, where appropriate.
Under a special transition rule, net operating losses arising in a taxable year beginning before Jan. 1, 2018, that are carried forward to a taxable year beginning on or after such date are not subject to the rule of the provision.
Analyzing the statutory language used in new section 512(a)(6) provides the following:
(6) Special rule for organizations with more than one unrelated trade or business. — In the case of any organization with more than one unrelated trade or business—
(A) unrelated business taxable income, including for purposes of determining any net operating loss deduction, shall be computed separately with respect to each such trade or business and without regard to subsection (b)(12),
(B) the unrelated business taxable income of such organization shall be the sum of the unrelated business taxable income so computed with respect to each such trade or business, less a specific deduction under subsection (b)(12),and
(C) for purposes of subparagraph (B), unrelated business taxable income with respect to any such trade or business shall not be less than zero.
As can been seen, there are a number of issues raised and appear to be unanswered either by the legislative language or via any explanation provided by Congress in setting forth the intent of the new law and its application. Specifically, the following questions are unanswered:
1) What is meant by “…any organization with more than one unrelated trade or business?” How does one determine how many unrelated trade or businesses are present? Does it mean that each activity stands on its own, or do like activities come within the definition of what a trade or business may be and those activities may be combined together as one unrelated trade or business?
For example, tax-exempt organization A owns two alternative investments. Both are in the trade or business of real estate. Alternative investment X has passed out an unrelated business income amount of $20,000, alternative investment Z has passed out an unrelated business income loss of ($20,000). For the purposes of new section 512(a)(6), is organization A, operating only in one unrelated trade or business or real estate rental and as such, allowed to net both of these unrelated business income amounts together for a net unrelated taxable income result of zero (before any standard exemption amount)? Or, does organization A actually have more than one trade or business, the trade or business operated by alternative investment X and a second trade or business operated by alternative investment Z? In that case, since losses from one trade or business cannot offset income from another trade or business under section 512(a)(6), organization A would have unrelated business taxable income of $20,000 (before any specific exemption amount) with a suspended loss amount to be carried to the next tax year for alternative investment Z of ($20,000).
The main focus of the above uncertainty lies in what the actual definition of trade or business is, and what is meant when an organization has more than one trade or business. Could it actually mean that the trade or business of the exempt organization generating the unrelated business income is from the trade or business of investing? In that case, can an exempt organization combine all its investment holdings, many of which may pass through to the exempt partner unrelated business income and unrelated business losses?
Is the determination of an exempt organization having more than one unrelated trade or business made more simply, from an activity perspective? Clearly, if the bar was set as an activity, one could easily argue that the trade or business activity of alternative investment X has nothing to do with the trade or business activity of an unrelated alternative investment Z. In this case, it seems as if it would be clear that the exempt organization would be involved with more than one trade or business and unable to group the two together and not be able to use the losses of alternative investment Z activity to offset income from alternative investment X activity.
Or, is the activity that the exempt is partaking in an investment activity that generates unrelated business income? As you can see this is a circular analysis which will require some additional explanation of the provision and its application.
From a practical perspective, being required to account for 200 separate alternative investment activities with some passing through income and others passing through losses seems quite burdensome. Or is this the intent of Congress in passing this law? How can an activity of one partnership not be considered a separate trade or business of another unrelated partnership activity for the purposes of application of this rule?
2) Another potential approach to the above definitional problem, may lie in use of a unique rule that is applied by tax-exempt organizations in identifying activities that may generate unrelated business income subject to tax. This rule is called the fragmentation rule. Could the application of this concept be what was intended to be used in identifying how many trades or businesses an exempt organization actually is partaking in?
Under the fragmentation rule each activity of an exempt organization will be examined separately to determine whether it is a trade or business as provided for in section 513(c). This fragmentation rule means that 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 as explained in Income Tax Regulations section 1.513-1(b).
In addition, the regulations, in section 1.513-1(b) give as examples of the fragmentation rule’s application the sales of pharmaceutical supplies to the general public by a hospital pharmacy and of advertising in an exempt organization journal in which the editorial content is related to the organization's exempt purpose. Another common example is a museum gift shop selling some items related to the museum's exempt purpose and other items not related. For purposes of determining whether the trade or business activities are substantially related to the museum's exempt purpose, the IRS will examine each item (or line of items) sold at the gift shop to determine its relationship to the museum's exempt purpose. In Technical Advice Memorandum (TAM) 9550003, the various activities of a museum were analyzed separately for relatedness.
Lastly, and specifically in section 513(c), it provides that “[w]here an activity carried on for profit constitutes an unrelated trade or business, no part of such trade or business shall be excluded from such classification merely because it does not result in profit.” This definition could potentially be problematic in resulting in each activity standing alone, and treated as separate activities, with each generating its own unrelated business income or loss tax attributes. If this is the ultimate answer to these very important unanswered questions associated with the application of the rules of new section 512(a)(6), the obvious result will no doubt required expanded accounting systems to properly account for each activity separately so that the provision may be followed in practice.
So taking this concept to the next practical step, a third question arises:
3) Let’s say an exempt organization partakes in publishing activities, and in those publishing activities, it sells advertising in separate periodicals, on its website it sells, in the form of banner ads, advertising on its website, and also as a part of its website, it has a webpage that is a job bank. How separate are all of those trade or businesses for the purposes of this rule?
There are a few moving parts related to the above scenario. One is clear cut, but others are not. For instance, clearly, the job bank activity that generates unrelated business income is a separate trade or business activity from the others listed. So this seems clear. However, selling advertising in multiple periodicals, and on a website, is less clear. Is advertising the trade or business, which may indicate that all of these different periodicals and the website advertising income all be considered one trade or business? Or do we have separate activities, as the fragmentation rule may suggest, where the exempt organization looks at each one separately (each publication separately and each website activity separately) in determining whether or not each generates unrelated business income? If that is the case could each component be a separate activity for the purposes of applying the separation rules in section 512(a)(6)?
For example, is the acceptance of banner advertising from the payers, along with design of the banner ads, etc., a separate trade or business activity from the periodical advertising and design sales? Or is it all just advertising trade or business activity? To make the analysis even more problematic, if an exempt organization has three periodicals, A, B and C, and A and B generate advertising income, A operates at an overall profit, but B at an overall loss, and C has no advertising, does the exempt organization have an overall trade or business of publishing, or is there three potential different trade or business activities generating or not generating unrelated business income here?
As can be seen from the above analysis, there are many unanswered questions related to how to apply section 512(a)(6) from a practical perspective. However, and until such time the government clarifies the application of section 512(a)(6) principles, the following taxpayer advocate positions should apply:
a) The concept of trade or business refers to the activity that the exempt organization is partaking in that generates such trade or business income. Therefore, all unrelated business income from advertising, whether it be in multiple periodicals or on a website or other, should be able to be lumped together as one trade or business of the exempt, that being the advertising trade or business.
b) For an exempt generating unrelated business income from multiple alternative investments, the trade or business of the exempt organization should be considered to be that of investing (or investment), and as such, all unrelated business income and losses should be able to be combined before the application of the principles of section 512(a)(6).
c) By applying the concepts of section 512(a)(6) to the exempt organization itself, it should be clear that an investment trade or business, insurance trade or business, advertising trade or business or job bank trade or business are the separate trades of business types contemplated by the statute.
We are anticipating some clarifying guidance for this new section added to the Internal Revenue Code by the TCJA. As soon as such guidance is made public, we will report the results to you with an explanation of its application as it pertains to the new rules related to accounting for separate trade or businesses entered into by a tax-exempt organization for the purposes of properly reporting taxable income from unrelated business income generating activities.