Understanding the Changes to Unrelated Business Income
By Jeffrey A. Kowalczyk, CPA, CFE, CGAP
While most nonprofits are tax exempt, that doesn’t mean they won’t pay business income tax. When nonprofits generate income from unrelated activities, the activities can be taxed as unrelated business income (UBI) by the IRS. To be taxed under UBI, an activity must generally meet three rules:
- It must be a trade or business, which the IRS defines as any activity which is carried on for the production of income from the sale of goods or performance of services.
- It must be carried on regularly.
- It must not be related substantially to the organization’s exempt purposes.
The legislation passed by Congress in December 2017, contains many provisions that will impact tax-exempt organizations. It is important for non-profit organizations to be mindful of these provisions. To help clarify areas where we are seeing the most questions, we have highlighted a few of the most pertinent details below.
1. Provision: Disallowed Fringe Benefits Subject to Unrelated Business Taxable Income
Fringe benefits have traditionally been a benefit nonprofits could provide to their employees without those benefits being treated as UBI or included as taxable wages to the employee. However, under the 2017 Tax Reform Act, some of those benefits have changed. The following fringe benefit expenses, paid or incurred by the organization after 2017, will be now be disallowed and included as unrelated business income to the tax-exempt organization.
- Qualified transportation fringe includes transportation in a commuter highway vehicle. The transportation must relate to travel between the employee’s home and workplace. It also includes any transit pass and qualified bicycle commuting reimbursement.
- Qualified parking fringe includes parking provided to an employee on or near the businesses premises or near a location from which the employee commutes to work by transportation.
- On-Premises Athletic Facility. The value of the use of on-premises athletic facilities which are operated by the employer and used exclusively by the employees and their dependents will be included as unrelated business income.
What is the impact?
Tax-exempt organizations that choose to continue offering nondeductible fringe benefits must pay tax on these employee benefits at the corporate tax rate and file a Form 990-T.
Tax-exempt organizations can also choose to increase an employee’s overall wages and discontinue offering these fringe benefits. The increase in wages should help make up for the new expenses the employee will incur.
2.Provision: Special Rule for Organizations with More Than One Unrelated Trade or Business
Tax-exempt organizations can no longer use the income and deductions between various unrelated trades or businesses to offset how much tax is owed. Effective December 31, 2017, organizations that carry on multiple unrelated trade or business will be required to calculate and apply gains and losses separately.
Net operating loss deductions are limited to 80 percent of taxable income for tax years beginning after December 31, 2017. Carryover of operating losses occurring before January 1, 2018 are still permissible to offset income from another unrelated trade or business.
What is the impact?
Developing a process to categorize income is the first step to ensure compliance. Tax-exempt organizations should analyze unrelated business tax costs to make sure they are properly allocating the expenses to the correct unrelated trade or business. One strategy to consider is moving current activities into a separately-owned corporation. This may allow a tax-exempt organization to report and offset unrelated trade or businesses under one entity.
3.Provision: Net Operating Loss Deduction
Net operating losses were previously allowed to be carried back two years and forward twenty. There was no limit regarding how much taxable income could be offset by a net operating loss, allowing an entire loss to be used to counteract 100 percent of the taxable income in that current year. Going forward, however, the net operating loss deduction will be limited to 80 percent of a tax-exempt organization’s taxable income and the carryforward period will be eliminated, allowing net operating losses to be carried forward indefinitely.
What is the impact?
Organizations with an unrelated trade or business that have a net operating loss will pay 20 percent of their unrelated business income.
Many nonprofit entities have a difficult time classifying income for tax purposes as related or unrelated to the entity. The tax reform law further complicates the treatment of unrelated business income. On February 23, 2017, the American Institute of CPAs submitted a comment letter to the Internal Revenue Service, proposing guidelines on how to address the allocation of unrelated business income expenses of tax-exempt organizations for dual-use facilities and/or personnel. The AICPA recommended that the IRS provide a simplified method for small businesses who lack the resources to adequately document the information needed to identify expenses relating to dual-use facilities and unrelated activities. The IRS has yet to respond to the letter.
If you would like more information on the unrelated business income tax or assistance in developing a process to categorize your income, contact:
Jeffrey A. Kowalczyk, CPA, CFE, CGAP