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Tax-Exempt Organizations and Their Net Operating Losses

The Tax Cuts and Jobs Act (TCJA) made many changes that affect tax-exempt organizations and how items are reported on the Form 990 and Form 990-T. One significant change is the treatment of net operating losses (NOL). This article outlines the guidance we have gotten thus far in order to properly report net operating losses on the tax-exempt organization’s Unrelated Business Income Tax Return (Form 990-T).

Prior to the TCJA changes, organizations were allowed to offset net operating losses from one unrelated trade or business with net income from a different unrelated trade or business. This allowed the organization to reduce income to zero in some cases, therefore not owing to any unrelated business income tax (UBIT). The new law (IRC 512(a)(6)) requires an organization subject to UBIT with more than one trade or business, to calculate unrelated business taxable income (UBTI) separately with respect to each trade or business (commonly called “siloing”). This means that an organization cannot offset activities with losses against those with income. This will result in more tax-exempt organizations paying UBIT.

The IRS released Notice 2018-67 in August 2018 as Interim Guidance until the IRS issues Proposed Regulations on the topic. This guidance is still the only authority interpreting the new law. Even with this Notice, there is still ambiguity and unanswered questions as the IRS has requested public comment on many issues. Siloing is effective for tax years beginning after December 31, 2017, and applies to organizations described in IRC §511(a)(2) and trusts described in §511(b)(2).

One of the big questions around this new siloing rule is how to determine which unrelated business activities can be aggregated and which must be reported separately. How this is determined can affect an organization’s UBTI and in the end, how much tax they pay, if any.

Good-faith interpretation

The guidance states that all organizations may rely on a good-faith interpretation of §§ 511-514, taking into account the facts and circumstances when determining whether an exempt organization has more than one unrelated trade or business. The use of the NAICS 6-digit codes will be considered a reasonable, good-faith interpretation until regulations are proposed. The IRS has asked for more public comment on this issue in order to ease the burdens and administration costs of tax-exempt organizations, as well as those policing costs to the IRS.

Aggregating income from partnership investments

There are two types of aggregations when it comes to partnership investments:

  1. Aggregating unrelated trades or businesses of a single partnership interest which may include lower-tiered investments which can result in multiple trade or businesses
  2. Aggregating unrelated trades or businesses of separate partnership investments as one unrelated trade or business.

An organization may aggregate its UBTI from (1) and (2) above as long as the organization does not significantly participate in any partnership trade or business and meets either the DeMinimis Test or the Control Test:

  • DeMinimis Test – a partnership interest is a qualifying interest that meets this requirement if the organization holds directly no more than two percent of the profits interest and no more than two percent of the capital interest.
  • Control Test – a partnership interest is a qualifying partnership interest that meets the requirements of this test if the organization (1) directly holds no more than 20 percent of the capital interest; and (2) does not have control or influence over the partnership. All facts and circumstances are relevant for determining whether an organization has control or influence over a partnership.

When calculating the organization’s percentage partnership interest, the interests of related parties must be included. Related parties include disqualified persons (§4958(f)), a supporting organization (§509(a)(3)), and a controlled entity (§512(b)(13)(D). The organization may rely on the Schedule K-1, Part II, Sch J, to calculate the percentage interest held. The average of the organization’s percentage interest at the beginning and the end of the partnership’s taxable year is taken into consideration in the calculation.

Meeting these requirements will allow an organization to aggregate their qualifying partnership investments. This will permit partnership investment activities with losses to be offset by those with income.

Aggregation transition rule

For a partnership interest acquired prior to August 21, 2018, an exempt organization may treat each partnership interest as a single trade or business for the siloing rule, whether or not there is more than one trade or business directly or indirectly conducted by the partnership or lower-tiered partnership. For example, if an organization has a 25 percent interest in a partnership prior to August 21, 2018, it can treat the partnership as being in a single unrelated trade or business even if the partnership investments generate UBTI from multiple types of trades or businesses including lower-tiered partnerships.

Unrelated debt-financed income aggregation

The unrelated business income that may be aggregated under these rules includes any unrelated debt-financed income (§514) that arises in connection with the qualifying partnership (that meets either the de minimis or control tests).

Fringe benefit income

TCJA also added §512(a)(7) which increases UBTI for qualified fringe benefits paid by an organization. Qualified fringe includes qualified transportation fringe, any parking facility used in connection with qualified parking, or any on-premises athletic facility. Since the qualified fringe is not treated as an item of gross income derived from an unrelated trade or business, it is not subject to IRC §512(a)(6). Accordingly, there is no aggregation or netting of operating losses incurred after 2017.

Net operating loss carryovers

The net operating loss deduction is allowed by organizations to reduce UBTI. TCJA made changes to the carryover provisions eliminating the carryback rule of two years and only allows the losses to be carried forward (indefinitely instead of a limit of 20 years). The changes also include an 80 percent taxable income limitation on the use of the carryover. Because TCJA also changed how the net operating losses are calculated by tax-exempt organizations (siloing), complications have arisen on how these NOLs should be claimed. Post-2017 NOLS are only allowed to decrease the income of the trade or business that created the NOL. In order to preserve the pre-2018 NOLs, these carryovers can be taken as a deduction against total UBTI. However, still unclear are the ordering rules for how tax-exempt organizations with post-2017 and pre-2018 NOLs can use them.

Almost two years after TCJA was enacted, tax-exempt organizations finally have some guidance as they file their initial 990-Ts that reflect these changes. However, there’s still a need for additional guidance. Organizations are trying to interpret these rules as they apply to their particular situations, and 2019 returns will bring additional questions as to the timing and use of the NOL carryovers. In summary, compliance in this area has become even more complicated and tax-exempt organizations should consult their tax advisors for assistance.

This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.