The recently enacted tax reform bill changes how exempt organizations must calculate unrelated business taxable income (UBTI) and how that income will be taxed. These changes will have wide-reaching effects. According to the National Center for Charitable Statistics, public charities reported over $1.74 trillion in total revenues in 2013, 72% of which was earned. These “business” activities are often related to the nonprofit’s charitable mission (i.e. program services), but many regularly carried-on activities, such as selling toys from a gift shop, do not qualify as related — even if the income produced is used to further tax-exempt purposes.
The new rules have pluses and minuses. On the one hand, small nonprofits with only one unrelated business may actually benefit from lower corporate and trust tax rates. On the other hand, nonprofits running more than one business could face major costs from the additional accounting required to separately track each activity. In addition, amounts paid for certain fringe benefits provided to employees of exempt organizations must now be included in UBTI.
UBTI must now be separately computed for each trade or business activity
When an exempt organization earns income from a trade or business that is not substantially related to its exempt purposes, that income is generally subject to tax. The tax on UBTI is calculated using the corporate tax rates if the exempt organization is a corporation or the trust tax rates if the exempt organization is a trust.
Prior law
Before January 1, 2018, Treasury regulations allowed an organization with multiple unrelated businesses to calculate UBTI by aggregating all income and related expenses from those activities. Thus, an organization with Business A and Business B could offset income from A with losses from B, or vice versa. Net operating losses (NOLs) could generally be carried back two years or forward 20 years and could fully offset taxable income.
New law
Under the Tax Cuts and Jobs Act, for tax years beginning after December 31, 2017, organizations operating more than one unrelated trade or business must compute UBTI separately for each activity. An organization would be able to claim an NOL deduction only for the trade or business that generated the loss.
NOLs that arise in a tax year ending after 2017 may not be carried back, but they may be carried forward indefinitely. The amount of NOL that can be applied in a single year equals the available NOL carryover or 80% of taxable income (without regard to the NOL), whichever is less. Those NOLs incurred in prior years may be used in accordance with the rules in effect for the years in which they were incurred.
Impact
The impact of the new rules on nonprofits with UBTI from multiple activities varies widely. Key factors include whether more than one unrelated business has a loss, plus what and how costs are allocated among businesses. Since tracking businesses separately will require significant additional accounting, however, these nonprofits may face major costs, especially during initial implementation of new accounting systems.
Nonprofits running a single unrelated trade or business may benefit from lower corporate and trust tax rates. Instead of the previous graduated corporate rates, a 21% flat rate applies to income, even nonprofit UBTI, over $125,000. Charitable trusts will also see a tax break in the form of lower graduated rates, with the top marginal rate decreasing from 39.6% on income over $12,500 to 37% at the same threshold.
However, even nonprofits running a single trade or business may face increased accounting costs. Remember that the IRS may treat what would normally be considered a single trade or business as multiple trades or businesses for tax purposes. For example, a museum’s gift shop would ordinarily be regarded as a single business, but, for purposes of the UBIT, the IRS may treat the sales of different items as different trades or businesses: e.g. income from a history museum’s sale of history books would be considered related, while income from the same museum’s sale of t-shirts would not. Under the new rules, the museum could not offset profit from t-shirt sales with losses from book sales. Related and unrelated sales will have to be tracked separately.
The new rules may also affect some nonprofits’ decision to use “blocker” corporations, where business activities are run through a subsidiary entity such as an LLC, a supporting organization, or a traditional C-corporation. A blocker corporation may shield the charity from liability related to the business activity and allow the charity to generate substantial revenue that would otherwise be considered UBIT. Additional guidance will be necessary to determine how to segregate these businesses, especially pass-through investment vehicles.
Certain fringe benefit and entertainment expenses now increase UBTI
Exempt organizations may provide their employees with fringe benefits, such as free transportation or parking and on-premises gyms, just as taxable entities may. Under prior law, these benefits were not taxed at the employer or the employee level; employers could deduct the cost of the benefits and employees could exclude the value of the benefits from their taxable incomes. After 2017, however, funds used to pay for such benefits will be treated as UBTI. This replicates the change’s effect on taxable entities, which may no longer deduct these expenses. Because of the anti-aggregation rule described above, it seems that these expenses would be categorized as a separate unrelated trade or business. This rule does not apply to such benefits when they are provided to volunteers.
Entertainment expenses that are not directly related to an organization’s trade or business are not deductible by either taxable or exempt organizations. The new law now adds such non-deductible expenses to UBTI.
For questions or more information about this article, please contact Donita Joseph at djoseph@windes.com or 844.4WINDES.
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