Beginning in 2018, unrelated business taxable income (UBTI) must be computed separately for each unrelated trade or business. Net operating losses (NOL) from one unrelated trade or business may not be used to offset income from another unrelated trade or business. The unused NOL may be carried forward to future years but may only reduce income from the same trade or business that generated it.
This is a radical departure from previous law, where unrelated businesses, except for advertising or exploited exempt activities, were commingled in computing (UBIT). The new subsection was created in response to concerns that net operating losses from activities in which there is no profit motive were offsetting the income from other unrelated business activities. However, it brought with it significant challenges from many unanswered questions.
Defining Separate Trade of Business
How should the organization determine if an activity is a separate trade or business? Are all sales activities considered one business? Or must the organization segregate sales by inventory type, event, venue, location, or other category? Organizations should consider prior filing positions in making this determination.
For example, if multiple parking facilities were reported as one trade or business in prior reporting, and in the organization’s books and records, continuing to do so makes sense. Some other considerations may be the underlying business purpose served by the activity. How similar are the activities or customers served? How interrelated are the activities? Until the Treasury issues guidance, organizations will need to develop a filing position. We recommend a filing position consistent with past filing positions.
Taxable Income not from a Trade or Business
Another challenge is the definition of trade or business income. Not all income subject to unrelated business income tax is from a trade or business. Some is income statutorily included in unrelated business income, such as unrelated debt financed income, passive income from a controlled subsidiary, or the new Code Sec. 512(a)(7): Increase in unrelated business taxable income by disallowed fringe benefits. Because the income does not arise from a trade or business, should taxpayers be allowed to aggregate any losses from these types of activities with other unrelated business income?
This segregation of activities may have an additional impact on organizations’ UBTI. It may reveal activities that have sustained losses over many years, which may indicate the activity does not have a profit motive and does not qualify as unrelated trades or businesses at all. This further restricts use of losses to offset income from similar unrelated trades or businesses. However, some losses are generated by depreciation, which may indicate a tax loss but not an economic loss.
Until further guidance is provided, organizations should carefully scrutinize their unrelated trades and businesses. Which are profitable and which have been operating at a tax loss? Which have profit motive with real economic substance that are feeding the organization? What has been the tax treatment of the activities in the past? Which are similar enough or integrated enough to be aggregated as a single trade or business in the future? Are there examples of similar trades or business operating as a single business in the for-profit sector? Which are trades or businesses and which are merely statutorily taxable under UBIT tax law? Clearly document the position for each activity in writing, including all the factors considered that resulted in the conclusion.
Consider whether moving some activities to a wholly owned for-profit subsidiary would be advantageous. Taxable corporate subsidiaries of exempt organizations are not subject to the trade or business segregation rule. Wholly owned for-profit subsidiaries have long been used to operate substantial unrelated businesses for organizations, thereby shielding them from risk of loss of exemption. However, all of the considerations for setting up a separate for-profit subsidiary must still be observed, including proper capitalization and respecting the separate corporate form. [See Moline Properties.] The burden of setting up and operating as a separate for-profit subsidiary may outweigh the tax benefits, if there are any, and profit motive under Code Section 162 may still be an issue. See your tax advisor regarding whether this would be a good structure for your operations.
This new law may affect your quarterly estimated tax payments that must be paid this year. Therefore, if your organization has more than one unrelated business activity, speak with your tax advisor as soon as possible.
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