The 2017 Tax Cuts and Jobs Act (TCJA) resulted in significant changes for taxpayers, and exempt organizations are no exception.
As a result of the new IRC § 512(a)(6), tax exempt organizations are no longer able to aggregate gross income from multiple unrelated trades or businesses for the purposes of calculating their unrelated business taxable income (UBTI).
With the arrival of the TCJA and its changes to how UBTI is calculated, the consequences of unintentionally engaging in an unrelated trade or business can be costlier than ever for tax exempt organizations. As a result, it is essential that exempt taxpayers are able to anticipate the potential tax consequences of trade or business activities.
This article covers the following key topics:
- A Review of Unrelated Business Taxable Income
- A Brief Overview of § 512(a)(6)
- When to Separate Unrelated Trades or Businesses
- How Machine Learning Can Reduce Uncertainty in Tax Positions
A Review of Unrelated Business Taxable Income
Exempt organizations are subject to taxation on their unrelated business taxable income (UBTI), defined in § 512(a)(1) as the gross income derived by any exempt organization from an unrelated trade or business regularly carried on by it, less deductions allowed by Chapter 1 that are directly connected with the carrying on of a trade or business.
An unrelated trade or business is defined in § 513(a) as any trade or business which is not substantially related (aside from the need for funds) to the function constituting the basis for the organization’s exemption under section 501.
As a result of these provisions, organizations that are exempt from taxation under § 501(a) are nonetheless obligated to pay tax on income derived from a trade or business that is regularly carried on and which is not substantially related to the organization’s exempt purpose.
A Brief Overview of § 512(a)(6)
The TCJA introduced changes to the way exempt organizations that engage in two or more trades or businesses calculate UBTI. The new § 512(a)(6) section reads as follows:
§ 512(a)(6) Special rule for organization with more than 1 unrelated trade or business
In the case of any organization with more than 1 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.
Prior to the enactment of this section, the UBTI of an organization that derived gross income from two or more unrelated trades or businesses was calculated as the aggregate gross income from all such trades or businesses, less aggregate deductions allowed with respect to all such trades or businesses.
Now, thanks to § 512(a)(6), aggregation of income and deductions from more than one trade or business is no longer allowed.
When to Separate Unrelated Trades or Businesses
Taxpayers may rightly wonder how the IRS will determine when a particular activity constitutes a separate trade or business. So far, Congress and the IRS have provided little guidance on this question. Furthermore, the Internal Review Code contains no general statutory definition of the term “trade or business.” For the purpose of UBTI, “trade or business” has the same meaning as in § 162 (concerning the deductibility of trade or business expenses) and generally includes any activity carried on for the production of income from the sale of goods or performance of services.
The IRS has solicited comments regarding the implementation of § 512(a)(6). In the interim, the IRS has stated that taxpayers should rely on a “reasonable, good faith interpretation” to determine what constitutes a separate trade or business. Until further guidance is provided, reliance on the North American Industry Classification System (NAICS) 6-digit codes will be considered a reasonable, good-faith interpretation.
One effect of relying on NAICS to separate out trades or businesses is that all of an exempt organization’s advertising activities could be considered one trade or business activity, regardless of the source of the advertising income.
The fragmentation principle may also provide helpful guidance in determining when an activity is considered a separate trade or business. This principle, described in § 513(c) and Treasury Regulation § 1.513-1(b), states that an activity does not lose its identity as a trade or business merely because it is 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.
How Machine Learning Can Reduce Uncertainty in Tax Positions
In a rapidly changing legal landscape, it can be difficult for taxpayers to determine their tax position in advance. Nevertheless, it is essential that exempt organizations be able to predict whether or not their income-generating activities may give rise to tax liability. In some cases, this may mean the difference between whether or not an unrelated trade or business is viable at all.
The recent changes to how UBTI is calculated mean that there is even less room for error and the consequences of unintentionally engaging in an unrelated trade or business can be even more costly than before.
Blue J Legal’s machine learning platform is part of a new generation of legal research tools using machine learning to predict likely legal outcomes based on the universe of past decisions. By focusing on key factors, our algorithm is able to determine how likely it is that a court would find that an activity constitutes an unrelated trade or business.
If you’re interested in learning more about how machine learning can help practitioners navigate unrelated business income tax decisions, watch our US Tax Reform for Exempt Organizations Webinar on demand.