The legislative language of the Tax Cuts and Jobs Act contained many areas of ambiguity and unclear definitions, and the provisions pertaining to nonprofits were no exception. Organizations have been eagerly anticipating additional federal regulatory guidance on how to apply many of the new requirements of tax reform, particularly the new requirement for calculating unrelated business income (UBI), which we previously discussed on our blog.
Just in time for year-end planning, the IRS recently issued regulations that provide clearer direction on how organizations should account for UBI from multiple unrelated businesses.
Previously, a nonprofit could aggregate UBI from its various trades or businesses for the purpose of calculating how much tax it owed to the IRS. Tax reform changed this model and starting in 2018, organizations must calculate UBI for each individual trade or business. This means losses from one activity or business may not be offset by profit from another activity or business.
Questions remained about this approach due to unclear legislative definitions for trade or business, including whether investments in multiple real estate partnerships counted as one trade or business or should each partnership be counted separately? Read on to find out what this means for your nonprofit’s procedures.
Defining non-partnership trade or business activity
In this regulatory update, the IRS permits nonprofits to use the North American Industry Classification System (NAICS) six-digit codes to characterize its trades or businesses. This methodology will suffice until final regulations are published. The NAICS codes will help organizations define businesses or activities for the purposes of offsetting profits or losses. While NAICS may cover most activities, there are some that may not be addressed under this system. Contact your RKL advisor for assistance in determining the appropriate code for your trades or businesses.
Defining trade or business in partnership interests
In late August 2018, the IRS issued interim guidance that addressed income from partnership interests. A nonprofit is permitted to aggregate its unrelated business taxable income (UBTI) from its interest in a single partnership with multiple trades or businesses as long as it passes either the de minimis or control test.
- A nonprofit meets the de minimis test if it directly holds no more than two percent of the capital interest and no more than two percent of the profits interest in a partnership.
- A nonprofit meets the control test if its partnership interest does not exceed 20 percent of the capital interest and it has control or influence over the partnership.
Information on Schedule K-1 may be used to determine if the nonprofit meets one or both of these tests. This interim guidance also provides a transition rule to allow the aggregation of income within each direct partnership interest acquired before August 21, 2018.
Best practices for new partnership income reporting
Since the new aggregated reporting requirement took effect at the start of 2018, nonprofit leaders will need to go back through their books and apply the de minimis or control tests on all partnership income. Here are some best practices to adopt the new aggregated reporting method for UBI moving forward.
- Evaluate control issues and interests for all partnership holdings.
- Allocate the appropriate general or shared expenses to each trade or business to maximize benefit and minimize tax burden.
- Move multiple taxable trade or business activities into a wholly owned corporation to offset profitable activities with loss activities (consider with the consultation of a tax advisor).
As always, be sure to review estimated taxes and safe harbor status in light of the tax rate changes.
RKL not-for-profit advisors can help
As the end of the calendar year approaches, RKL’s team of tax experts focused on serving nonprofits is here to assist financial teams in applying the aggregated method and calculating partnership income. Contact your RKL advisor to get started today.