Net Operating Losses of Tax-Exempt Organizations with More Than One Unrelated Trade or Business

Sign Up for our COVID-19 Mailing List.
Visit our Beyond COVID-19 Resource Center.

Since the enactment of the unrelated business income tax in 1950, section 512(b)(6)[1] and its predecessor allowed organizations subject to the unrelated business income tax (UBIT) to use the net operating loss (NOL) deduction in section 172 derived from net losses from one unrelated trade or business to reduce their overall “unrelated business taxable income” (UBTI) - even if derived from other, different, unrelated trades or businesses, subject to certain limitations. Such losses would include allocations of indirect costs - such as staffing, depreciation and other overhead. Under the old and new rules alike, if an activity is not carried on with the requisite profit motive to cause the activity to be treated as a trade or business in the first place, NOLs associated with that activity would be disallowed and could not be used to reduce UBTI from other, taxable lines of business.[2]

New rules, for taxable years beginning after December 31, 2017, require the “siloing” of profits and losses within each particular line of unrelated trade or business. Section 512(a)(6) now requires a tax-exempt organization with more than one unrelated trade or business to calculate UBTI separately, including any NOL deduction, with respect to each trade or business.[3] At the same time, the NOL rules in section 172 were changed dramatically, including generally repealing NOL carrybacks while permitting indefinite carryforwards.[4]

The new rules applicable to NOLs (and related UBIT calculations of tax-exempt organizations) were further modified in 2020 by the CARES Act,[5] which provides that any NOL arising in a taxable year beginning after December 31, 2017 and before January 1, 2021 (CARES Act NOLs) may be carried back to the five taxable years preceding the taxable year of such loss, which includes taxable years prior to the effective date of section 512(a)(6).

Key issues to consider with the UBIT siloing and NOL rules, including with respect to CARES Act NOLs, include:

1. The interplay of CARES Act NOLs and the UBIT siloing rules, as discussed below. Tax-exempt organizations with UBTI in prior years may be able to retroactively reduce their UBIT by carrying back CARES Act NOLs.
2. Tax-exempt organizations may wish to consider placing multiple lines of unrelated businesses into a wholly-owned taxable C corporation, such that NOLs from a loss trade or business once again can be used to offset taxable income from other separate (and profitable) lines of unrelated trades or businesses. Note that a “drop down” of assets into a taxable corporate subsidiary in exchange for 100% of its shares typically will not constitute a taxable event.
3. NOLs can now be carried forward in perpetuity (replacing the former 20-year carryforward limitation). Typically, start-up lines of business tend to generate losses, at least in the initial start-up phase. So, with respect to unrelated lines of business, tax-exempt organizations may wish to place those startups in a new or existing “cross-pollinating” taxable corporate subsidiary, and use the expenses to offset current taxable income from other sources. Alternatively, if the new business is being incubated “in-house” (within a tax-exempt corporation), the now perpetual life of NOLs makes it all the more important to identify all appropriate UBIT deductions and expenses and, as a protective measure, report those on their Form 990-Ts, particularly while the activities are in “start-up” mode.
4. Finally, we note that the IRS may be challenged in denying the existence of a profit motive in a line of business (and the resulting NOLs) just because it hasn’t achieved profitability in 5 or 10 years’ time, a fairly typical IRS position. Per Congress, even 20 years was too short a duration, so the rule change may provide a ripe avenue for challenging a denial of NOLs for want of a “profit motive” evidenced merely by a lack of profits in the relatively short-term. The likes of Tesla and Amazon could make for good analogies - clearly for-profit businesses that have had substantial NOLs for many years.

Application of Section 512(b)(6) NOL Rules Applicable for Taxable Years Beginning Prior to January 1, 2018

The NOL rules in place prior to their amendment in 2017 continue to apply to NOLs generated in taxable years beginning prior to January 1, 2018. Thus, if a tax-exempt organization had NOLs that were unused in those taxable years and therefore can be carried forward to an unlimited number of tax years, an uncodified transition rule allows them to be carried forward and used to reduce UBTI from all other unrelated trades or businesses as under prior law.[6] In other words, those old NOLs can be used to offset UBTI in any post-January 1, 2018 “silo” - whether unrelated debt-financed investment income or operating UBTI.

The proposed regulations include an ordering rule for purposes of coordinating the use of pre-2018 and post-2017 NOLs. Basically, pre-2018 NOLs are to be used first against total unrelated business taxable income, which is the sum of the unrelated business taxable income of each separate unrelated trade or business,[7] in order to maximize the use of pre-2018 NOLs. Once pre-2018 losses are exhausted, post-2017 NOLs will be used subject to the siloing rules.[8]

Changes to Section 512(b)(6) Effective for Taxable Years Beginning On or After January 1, 2018

For taxable years beginning on or after January 1, 2018, a tax-exempt organization with more than one unrelated trade or business is required to calculate NOLs separately for each such trade or business without regard to the $1,000 specific deduction contained in section 512(b)(12).[9] Then, the unrelated business taxable income related to each unrelated trade or business will be computed, less a specific deduction for each separate trade or business.[10]

Proposed regulations provide guidance as to how these NOL rules apply in a number of situations.[11]

Identifying Separate Trades or Businesses

The proposed regulations prescribe methods for identifying an organization’s separate trades or businesses.

In general, an organization will identify each of its separate trades or businesses using the first two digits of one of the 92 the North American Industry Classification System (NAICS) codes that most accurately describes the trade or business. The NAICS is the standard used by the Federal statistical agencies in classifying business establishments for the purpose of collecting, analyzing and publishing statistical data related to the US business economy.[12]

For example, two codes, 61 for educational services and 62 for health care and social assistance broadly encompass two of the largest segments of the entire tax-exempt sector. Code 61, for example, includes elementary schools, trade schools, colleges, universities and trade schools—i.e., virtually all forms of educational organizations and education and training. Similarly, code 62 includes all types of hospitals, outpatient facilities, and professionals such as physicians and dentists and their professional offices. However, in the case of educational organizations, code 51 applies to several activities typically conducted by colleges and universities such as publishing, operating radio stations and libraries. Similarly, in the case of hospitals, code 44, which applies to retail trade, applies to hospital pharmacies and gift shops. Thus, when the fragmentation principles of section 513(c) are applied, a tax-exempt organization, particularly a medium sized or large organization, will likely have several separately-identifiable trade or business lines.

In fact, the proposed regulations make it clear that a college or university cannot use code 61 for educational services to identify all its unrelated trades or businesses[13] and a multi-hospital system with multiple pharmacies at multiple locations must use code 44 for all of them even if the hospital system maintains separate books and records for each pharmacy.[14]

Investment Activities

In general, investment activities, with certain exceptions, are treated collectively as a separate unrelated trade or business. The proposed regulations limit an “organization’s investment activities” to three buckets:

1. qualifying partnership interests (including LLCs classified as partnerships),
2. qualifying S corporation interests, and
3. unrelated debt-financed properties.[15]

Qualifying partnership interests (QPIs) include directly-held partnership interests as well as indirectly-held partnership interests that satisfy either a control test or a de minimis test.

To satisfy the control test, the organization may not own more than 20 percent of the capital interest and may not control the partnership.[16] Importantly, the proposed regulations require the combining of interests of related supporting organizations described in section 509(a)(3) and controlled organizations within the meaning of section 512(b)(13)(D) for purposes of determining whether the percentage ownership requirement of the control test is satisfied.[17] As for the absence of control element of the control test, the proposed regulations employ a “facts -and-circumstances” test but also specify certain conditions in which control will be deemed to exist[18]:

• The organization, by itself, may require the partnership to perform an act that significantly affects the partnership or prevent the partnership from performing such an act.
• Any of the organization’s officers, directors, trustees or employees have rights to participate in the management of the partnership at any time or conduct the partnership’s business at any time.
• The organization, by itself, has the power to appoint or remove any of the partnership’s officers or employees or a majority of its directors.
• When the organization is the general partner (regardless of the organization’s percentage interest).

To satisfy the de minimis test, an organization may hold, directly or indirectly, no more than two percent of the partnership’s profits and capital interests.[19]

The proposed regulations provide guidance for determining an organization’s percentage interest for the purposes of the control test and the de minimis test. First, the organization may rely on the Schedule K-1 (Form 1065) it receives from the partnership as long it lists the organization's percentage profits interest or its percentage capital interest, or both, at the beginning and end of the year.[20] Second, an organization determines its percentage interest by taking the average of its interest at the beginning and the end of the year (or the period of ownership if less than a year).[21]

In the case of S corporations, each S corporation is treated as a separate unrelated trade or business.[22] The UBTI is the amount described in section 512(e)(1)(B). However, if an organization’s interest in an S corporation satisfies either the control test or the de minimis test applicable to QPIs, the organization may aggregate the UBTI from such S corporation in its “investment activities” UBIT silo.[23]

Finally, a special rule applies to organizations described in sections 501(c)(7) (social clubs), 501(c)(9) (voluntary employees’ beneficiary associations), and 501(c)(17) (trusts providing for supplemental unemployment compensation benefits). In general, income from investment activities includes income that otherwise would be excluded under section 512(b)(1) (dividends), (2) (royalties), (3) (rents from real property), and (5) (gains from the sale of capital assets).[24]

Modifications to Section 172 in the CARES Act

In the Tax Cuts and Jobs Act, Congress amended section 172 to eliminate the two-year loss carryback that was generally available for taxable years beginning on or after January 1, 2018, and eliminated the 20-year limitation on NOL carryforwards. Congress also amended section 172 limit the NOL deduction for taxable years beginning on or after January 1, 2018 to 80 percent of taxable income (as computed without regard to the NOL).

With the CARES Act, however, Congress made two temporary changes to the NOL rules in section 172 that affect the unrelated business income tax. First, section 2303(a) of the CARES Act amended section 172(a):

• Section 172(a)(1) provides that in the case of a taxable year beginning before January 1, 2021, the NOL deduction is the aggregate of NOL carryovers to such year, plus the NOL carrybacks to such year.
• Section 172(a)(2) provides that in the case of a taxable year beginning after December 31, 2020, the NOL deduction is the sum of the aggregate amount of NOLs arising in taxable years beginning before January 1, 2018 carried to such taxable year, plus the lesser of the aggregate amount of NOLs arising in taxable years beginning after December 31, 2017, carried to such taxable year or 80 percent of the excess (if any) computed without regard to the NOL, over the aggregate amount of NOLs arising in taxable years beginning before January 1, 2018 carried to such tax year.

(We suggest letting your accountants help with this one.)

Congress also reinstated a five-year CARES Act NOL carryback for losses arising in 2018, 2019, and 2020.[25] A CARES Act NOL must be carried back five years under section 172(b)(1)(D) unless the organization waives the CARES Act NOL carryback. Thus, a 2018 CARES Act NOL is carried back to 2013, a 2019 CARES Act NOL is carried back to 2014, and a 2020 CARES Act NOL is carried back to 2015. Taxable years 2013 through 2017 are taxable years when the siloing rules did not apply.

Thus, a tax-exempt organization with multiple UBIT silos can deduct CARES Act NOLs against aggregate UBTI in a taxable year beginning before 2018 when carrying the NOL back to such taxable year (because the UBIT silo rules don’t apply to those taxable years).

It seems likely that a large number of tax-exempt organizations that had net UBTI in taxable years before 2018 will experience CARES Act NOLs in 2020 due to the shutdown of the economy in 2020 (when the siloing rules are in effect). According to FAQs posted on the IRS website on June 8, 2020,[26] CARES Act NOLs, if carried back to a year beginning before January 1, 2018 (pre-siloing) can be used to reduce UBTI in the aggregate because section 512(b)(6) does not apply to those years. As noted, however, CARES Act NOL carrybacks that are used in 2018, 2019 and 2020 are subject to the siloing rules.

This retroactive reinstatement of a five-year carryback for 2018 and 2019 may necessitate action on the part of tax-exempt organization now, in 2020, particularly if the Form 990-T for 2019 has not yet been filed because it is on extension.

Waiving the Carryback

Section 172(b)(3) allows a taxpayer to waive the CARES Act NOL carryback, but the election to waive the carryback period must be made with great care. The election is irrevocable.[27]

Revenue Procedure 2020-24[28] provides guidance on when and how to waive the CARES Act NOL carryback. The election to waive the carryback period for CARES Act NOLs arising in taxable periods beginning in 2018 or 2019 must be made no later than the due date, including extensions, for the filing of the organization’s Form 990-T for the first taxable year ending after March 27, 2020. Effectively, if the five-year carryback is waived, then all CARES Act NOLs would remain subject to the section 512(b)(6) siloing rules during the carryforward tax years.

Conclusion and Recommendations

As detailed herein, the UBIT siloing rules and related changes to the use of NOLs, including CARES Act NOLs, give rise to several key planning considerations, including:

1. Tax-exempt organizations may wish to determine their ability to retroactively offset UBTI from prior years by carrying back CARES Act NOLs.
2. Tax-exempt organizations may wish to consider placing multiple lines of unrelated businesses into a single taxable corporate subsidiary, such that NOLs once again can be “cross-pollinated” and used to offset taxable income from separate (and profitable) lines of unrelated trades or businesses.
3. Tax-exempt organizations may wish to place new unrelated trades or businesses - startups - in a new or existing “cross-pollinating” taxable C corporation subsidiary, and use the start-up losses to offset current UBTI from other sources (including taxable investment activities).
4. Alternatively, if a new business is being incubated “in-house” (within a tax-exempt corporation), the now perpetual life of NOLs makes it all the more important to identify all appropriate UBIT deductions and expenses and, as a protective measure, report those on their Form 990-Ts, particularly while the activities are in “startup” mode.

 

---

[1] All Section references are to the Internal Revenue Code unless otherwise noted.

[2] The seminal decision about profit motive and the UBIT is Portland Golf Club v. Commissioner, 497 US 154 (1990) (involving a section 501(c)(7) social club). The most recent decision finding the absence of profit motive in the UBIT context, also involving a section 501(c)(7) social club, is Losantiville Country Club v. Commissioner, 906 F.3d 468 (6th Cir. 2018).

[3] Tax Cuts and Jobs Act § 13702, Pub. L. 115-97, 131 Stat. 2054 (2017) (Tax Cuts and Jobs Act).

[4] Tax Cuts and Jobs Act § 13302.

[5] Coronavirus Aid, Relief, and Economic Security Act § 2303, Pub. L. 116-136, 116 Cong., 2d Sess. (2020) (CARES Act).

[6] Tax Cuts and Jobs Act § 13702(b)(2).

[7] Prop. Reg. § 1.512(a)-6(g)(1).

[8] Prop. Reg. § 1.512(a)-6(h)(2).

[9] IRC § 512(b)(6)(A).

[10] IRC § 512(b)(6)(B).

[11] Prop. Reg. § 1.512(a)-6, 85:80 Fed. Reg. 23172-23199 (April 24, 2020).

[12] Prop. Reg. § 1.512(a)-6(b).

[13] Prop. Reg. § 1.512(a)-6(b)(1).

[14] Prop. Reg. § 1.512(a)-6(b)(2).

[15] Prop. Reg. § 1.512(a)-6(c)(1).

[16] Prop. Reg. § 1.512(a)-6(c)(3).

[17] Prop. Reg. § 1.512(a)-6(c)(4)(ii).

[18] Prop. Reg. § 1.512(a)-6(c)(4)(iii).

[19] Prop. Reg. § 1.512(a)-6(c)(3).

[20] Prop. Reg. § 1.512(a)-6(c)(5)(i).

[21] Prop. Reg. § 1.512(a)-6(c)(5)(ii).

[22] Prop. Reg. § 1.512(a)-6(e)(2)(i).

[23] Prop. Reg. § 1.512(a)-6(e)(2)(i).

[24] Prop. Reg. § 1.512(a)-6(c)(6).

[25] IRC § 172(b)(1)(D) (for losses other than farming losses or losses of insurance companies).

[26] IRSMISC_faq.

[27] The courts have uniformly rejected attempts by taxpayers to rescind an election to waive the NOL carryback period, even in a case where the waiver was due to the return preparer’s negligence. See, e.g., Bankers & Farmers Life Insurance Company v. United States, 643 F.2d 234 (5th Cir. 1981); Young v. Commissioner, 783 F.2d 1201 (5th Cir. 1986; Bea v. Commissioner, 123 AFTR 2d 2019-585 (11th Cir. 2019)(return preparer negligence).

[28] Rev. Proc. 2020-24, 2020-18 IRB 750.