Amid the Covid-19 pandemic, the IRS finally released proposed regulations regarding unrelated business and separate trades or businesses, also known as siloing. The Tax Cuts and Jobs Act (TCJA), the major tax act passed at the end of 2017, included a new code section, IRC Section 512(a)(6), which requires that non-profits with more than one unrelated trade or business separately compute the taxable income from each trade or business when determining unrelated income tax.
The new section disallows the offset of a loss from one trade or business against income from a different trade or business. The TCJA provided no real guidance on how to determine what activities make up a trade or business, and what activities require multiple trades or businesses that need to be treated separately. Notice 2018-67 (“the Notice”) was published in August 2018 as a first attempt to clarify the concept of separate trades or businesses.
Both the Notice and the proposed regulations rely heavily on the North American Industry Classification System (NAICS) to define separate trades or businesses. The biggest difference between the two is the number of digits used for business classifications. The NAICS coding system uses two to six digits to classify businesses, with each digit creating a narrower category. The first two digits represent the economic sector, the third digit represents the subsector, the fourth the industry group, the fifth the NAICS industry and the sixth represents the national industry.
The Notice stated that businesses with the same six-digit NAICS code should be grouped together as one trade or business. The proposed regulations, however, allow for a much broader grouping, by using just the two-digit NAICS code to determine which trades or businesses can be grouped together. This should greatly reduce the number of different businesses that will need to be separately tracked on Form 990-T. In determining the appropriate NAICS code for unrelated business activities, the proposed regs state that the code that applies to the related activity cannot be used for any unrelated activities. For example, a college or university cannot use code 61, the code for Educational Services, to define any of its businesses reported on Form 990-T.
If a non-profit has multiple trades or businesses, an appropriate allocation of costs among those businesses will be important. The deduction of expenses directly connected to each trade or business will be allowed, and is generally easier to determine. The allocation of mixed costs becomes more challenging. The proposed regulations do not prescribe a method of allocation, but they do state that an allocation based on unadjusted gross income is not appropriate because it does not take into account differences in prices charged in each business. The preamble to the regulations seems to suggest that the Treasury intends to publish a notice with more guidance on the allocation of expenses, but no date was provided.
Many non-profits invest in partnerships or subchapter S-corporations (pass-throughs). These investments generate various types of income, and more often than not, create some amount of unrelated business income. Currently the NAICS code is not listed on pass-through K-1s, making it impossible for investors to know the trade or business involved. Similar to the Notice, the proposed regulations allow pass-through entity investments to be grouped together as long as either the de minimis test or the control test is met. The de minimis test allows a pass-through interest to be considered an investment if the ownership of profits and capital is at or below 2 percent. The control test allows a capital ownership interest of up to 20 percent, as long as the non-profit cannot exercise control over the pass-through entity. Control will be determined by the facts and circumstances, and a non-profit will be deemed to control a pass-through entity if it can dictate the operations of the pass-through entity, or if any of the non-profit’s officers and directors also participate in management of the pass-through entity. Neither the control nor the di minimis tests can be met if the non-profit owns a general partnership interest.
The proposed regulations indicate that income from a controlled taxable entity should be grouped with other income from the same controlled entity, regardless of the type of income. If there is more than one controlled entity, both making payments to the non-profit, the income from each controlled entity will need to be reported separately on Form 990-T.
Separate activity tracking creates complexity when the rules around net operating losses are considered. The TCJA allows full utilization of net operating losses that were generated in taxable years beginning before January 1, 2018, but creates a limit of up to 80 percent of taxable income on new losses generated in years beginning after December 31, 2017. Additionally, pre-TCJA losses will expire 20 years after the year of creation, and post TCJA losses carry forward indefinitely. The proposed regulations provide much needed ordering rules for application of pre- and post-TCJA losses on the 990-T. Pre-TCJA losses will reduce aggregate unrelated business income before considering any post-TCJA losses. The publication of the proposed regulations coincided too closely with the NOL carryback changes, which resulted from the recently passed CARES Act. More guidance will be needed to sort through this additional complexity.
Lastly, the proposed regulations state that subpart F income under IRC 951(A)(a) and global intangible low-taxed income (GILTI) are treated as dividends and will be excluded from UBI unless the investment generating the dividends is debt financed. Prior to the issuance of these regulations, it was unclear whether this income would be unrelated or a dividend.
The newly issued regulations have provided much needed guidance. Decisions made today regarding the classification of unrelated business activities will impact a non-profit’s tax bills for many years to come. We are here to help you make determinations about how to classify each of your unrelated activities. Please contact your CSH representative for assistance, or contact us to learn more.