Do your nonprofit’s deductions exceed unrelated business income in a given year? If so, you are eligible to take a net operating loss (NOL) in the exceeding amount. While this concept is not new to nonprofit leaders, the way NOLs are tracked and applied has changed, thanks to tax reform. Let’s take a look at what organizations can expect moving forward and identify some ways to prepare.
Previous NOL treatment
Before tax reform, organizations were able to carry back NOLs for two years and then carry them forward for 20 years. The IRS did not limit the amount of taxable UBI that a nonprofit could offset with NOLs.
Tax reform changes to NOLs
Tax reform sets new rules for NOL carryforwards at 80 percent of taxable income. It eliminates carryback of NOLs and allows carryforwards indefinitely. Perhaps the most significant change is related to the calculation of the NOLs for organizations with more than one unrelated trade or business. Starting in 2018, organizations must calculate unrelated business income (UBI) separately for each trade or business and must apply this standard for NOL determinations as well. “Cross-pollination” or aggregation of UBI or NOLs is no longer permitted. According to the IRS, this change was intended by Congress in order to directly link an NOL with the trade or business from which it arose.
To help organizations comply with this new approach, the IRS issued guidance in late August 2018 that sets ordering rules for how pre-2018 and post-2017 NOLs can be used. Under these rules, post-2017 NOLs should first be used against the associated income from which they are derived. Then, use the pre-2018 NOLs against the total UBI until the pre-2018 NOLs are completely exhausted.
In order to preserve NOLs that pre-date the passage of the Tax Cuts and Jobs Act, Congress allows for a transition period to permit the carryover of any NOL occurring in a taxable year before 2018.
Best practices for NOL tracking, application
Here are two key ways nonprofits can prepare for this new approach for tracking and applying NOLs under the new tax reform requirements.
Review ongoing loss activities to determine whether or not they should be continued by your organization. If a loss activity is not contributing to your organization’s financial health or directly supporting its mission, perhaps it should be discontinued. Often times, nonprofit unrelated business losses are byproducts of complicated investment vehicles like hedge funds. Consult with your investment advisor to determine if that type of investment is right for your organization – perhaps your organization could achieve similar returns using a more traditional investment vehicle that will produce excluded income.
Track NOLs by activity/business for carryforward purposes. At the time of this writing, the nonprofit sector continues to anxiously await a revised Form 990-T that will provide a standard format for tracking individual trade or business NOL carryforwards. Until this updated form is released, each organization will be required to track losses from its different activities in what the IRS deems “a reasonable and good faith interpretation.” One way to adhere to this method would be to categorize each unrelated activity into a corresponding NAICS code. Losses from one activity within each code could offset income from the same type of activity in that classification.
Additional guidance from the IRS also allows for the aggregation of activities flowing through from some individual partnerships to be categorized as one “investment activity” and does not force the organization to comb through the partnership to individually classify each of its underlying activities.
RKL’s Not-for-Profit team can help
To preserve vital dollars for mission-driven activities, nonprofits must ensure proper tracking and application of NOLs. Ready to implement the best practices outlined above or need more information? RKL’s dedicated team of nonprofit tax experts can support your organization during this transition period and beyond. Contact Partner and Not-for-Profit Industry Group Leader Doug Berman to get started today.