Net Operating Losses in an Unrelated Trade or Business

NOL Deduction

Like individuals and corporations, an exempt organization can incur a net operating loss (NOL) in the conduct of an unrelated trade or business. Subject to certain modifications, a net operating loss is the excess of the organization’s deductions over its gross income. A net operating loss can be carried back to the two tax years preceding the loss year and carried forward to the 20 tax years succeeding the loss year. Thus, a NOL can reduce taxable income in a carryback or carryover year. The net operating loss deduction is authorized under §172.

Section 512(b)(6) provides that the net operating loss deduction is allowed in determining an exempt organization’s UBTI. Two special rules apply. An organization’s NOL is determined without taking into account any item of income or deduction that is excluded in determining UBTI. In addition, an exempt organization cannot carry a NOL back or forward to a tax year in which the organization was not subject to the UBIT.

Multiple Unrelated Trades or Businesses

If an organization conducts more than one unrelated trade or business, UBTI is determined by aggregating the gross income from all the unrelated businesses and subtracting the deductions directly connected with the businesses. Thus, a loss in one unrelated trade or business may offset taxable income from another unrelated trade or business. If a loss remains after the income and deductions of all unrelated businesses are aggregated, then the net operating loss deduction becomes applicable.

Under the tax reform proposal announced by the U.S. Senate last week, each of an exempt organization’s unrelated businesses must be treated as a separate trade or business in determining UBTI. Under this approach, a NOL in one unrelated trade or business can be carried back or forward to offset future income from the same unrelated business but not from a different unrelated business. The proposal is disadvantageous to exempt organizations because they cannot use a loss from one unrelated business to offset income from a different unrelated business in the same tax year. If the Senate proposal becomes law, the net operating loss deduction will likely figure more prominently in computing UBTI of organizations with multiple unrelated businesses. Also, an exempt organization may decide to discontinue an unrelated business that consistently produces a loss because such loss cannot be used against income from another unrelated business.

The proposed Tax Cuts and Jobs Act proposed by the House of Representatives does not contain the ban on aggregation of items from separate trades or businesses.

Taxpayers Cannot Deduct UBIT Losses from Their IRAs

Pension plans and IRAs may incur unrelated business income tax liability if they invest in debt-financed assets. The portion of income or loss taken into account as UBTI is determined by applying a debt/basis percentage to the income and deductions from the property. §514(a). If there is a NOL in an IRA, for example, the loss could be carried back and forward under the net operating loss rules.

The Tax Court considered a case in which a taxpayer sought to use a NOL in his IRA to offset income on his personal income tax return. The taxpayer argued that an IRA is similar to a grantor trust in that income and deductions should pass through to the individual creating the account. Rejecting this contention, the Tax Court held that an IRA is a tax-exempt entity and not a pass-through entity. Thus, distributions from the IRA to the taxpayer were included in his income, but losses within the IRA were not available for his personal use. See Fish v. Commissioner, T.C. Memo 2015-176, aff’d, 2017 U.S. App. Lexis 20565 (9th Cir. 2017).


Tax Reform 2017: House Proposes Changes to the UBIT

The draft tax reform bill released by the House of Representatives contains provisions that, if enacted, will affect the unrelated business income tax. While it is uncertain that any tax reform law will be enacted and unlikely that the House bill will be enacted as proposed, we will keep track of the proposed changes affecting the UBIT during the tax reform negotiations.

Note: The tax reform bill is H.R. 1, entitled Tax Cuts and Jobs Act. To read the entire text of the proposed bill, click here.

Application of UBIT to State and Local Entities

Section 501(c) lists numerous categories of exempt organizations that are exempt from income taxes. Notwithstanding the exemptions, most exempt organizations are nevertheless subject to the unrelated business income tax. State instrumentalities are not mentioned in §501(c) but are exempt from taxation under §115. The exemption applies to income derived from a public utility or the exercise of any essential governmental function and accruing to a state or political subdivision thereof, or the District of Columbia.

The UBIT applies to organizations described in §501(a), employer provided pension plans described in §401(a), and state colleges and universities. Because the UBIT expressly applies to state colleges and universities but not to other state instrumentalities, state and local entities, including pension plans, had been thought to be outside the scope of the UBIT.

The proposed House bill specifically states that an organization or trust shall not fail to be treated as exempt from taxation under this subtitle by reason of section 501(a) solely because such organization is also exempt, or excludes amounts from gross income, by reason of any other provision of this title. H.R. 1, §5001(a). Thus, for purposes of the UBIT, state and local entities are treated as described in §501(a) notwithstanding the fact that their income is also excluded under §115.

Limitation on Exclusion for Research Income

Section 512(b)(9) contains an exclusion from UBTI that applies to organizations operated primarily for purposes of carrying on fundamental research the results of which are freely available to the general public. Under present law, such organizations can exclude from UBTI all income from research performed for any person. The requirement that the organization be operated primarily to carry on fundamental research that is made freely available to the general public means that the organization remains eligible for the exclusion when it performs fundamental research that is not made freely available to the general public so long as the primary purpose requirement is met.

The proposed bill would narrow the exclusion to cover only income from research the results of which are freely available to the general public. H.R. 1, §5002(a) Thus, if an organization operated primarily for purposes of carrying on fundamental research with results freely available to the general public performs fundamental research that is not made freely available, income from such research is subject to the UBIT.

Effective Date

The proposed effective date for both amendments is December 31, 2017.

Scope of Notational Principal Contract Exclusion from UBTI Clarified in Proposed Regs

This post is a heads up for exempt organizations that invest in nontraditional investments such as interest rate swaps and other notational principal contracts (NPCs). Income from NPCs is excluded from UBTI by Treas. Reg. §1.512(b)-1(a), which includes income from NPCs with other passive investment income such as dividends, interest, and annuities.

Note: Section 512(b)(1) lists five categories of passive income that are excluded from UBTI: dividends, interest, payments with respect to securities loans, amounts received or accrued as consideration for entering into agreements to make loans, and annuities. Although income from NPCs is not specifically mentioned in §512(b)(1), Treas. Reg. §1.512(b)-1(a)(1) does expressly identify income from NPCs as excludable passive investment income.

 What Are Notational Principal Contracts?

 An NPC is a financial agreement calling for the exchange of payments between two parties, at least one of which periodically pays amounts calculated by applying a rate determined by reference to a specified index to a notional principal amount in exchange for specified consideration or a promise to pay similar amounts.

 What Amendments Are Proposed?

 The proposed amendment to Treas. Reg. 1.512(b)-1(a)(1) is a conforming amendment to proposed amendments to Treas. Reg. §§1.1256(b)-1(a) and 1.446-3(c). Section 1256 provides special income tax treatment for section 1256 contracts, such as regulated futures contracts, that are marked to market and traded on a qualified board or exchange. Gain or loss on section 1256 contracts is generally treated as 60% long-term and 40% short-term capital gain or loss. Current §1256(b)(2)(B), added by the Dodd-Frank Act of 2010, provides that various types of swaps and similar contracts are not treated as section1256 contracts. The excluded contracts are almost identical to those listed as notational principal contracts under present Treas. Reg. §1.446-3(c), which discusses the recognition of income from NPCs that is necessary clearly to reflect income under §446.

 To resolve some uncertainties regarding the treatment of swaps that are traded on regulated exchanges, Proposed Treas. Reg. §1.1256(b)-1(a) provides that notational principal contracts described in Treas. Reg. §1.446-3(c) are excluded from treatment as section 1245 contracts. In turn, Proposed Treas. Reg. §1.446-3(c) clarifies some questions about NPCs and allows additional types of contracts to be classified as NPCs. For example, the proposed regulation provides that one party to a NPC must make a minimum of two payments to the other contracting party. The proposed regulation also includes as NPCs credit default swaps and swaps based on non-financial indices, such as weather-related swaps. Under the current regulation, a specified index includes only financial indices.

 What Is the Current Status of the Proposed Regulations?

 A public hearing about the proposed regulations was conducted on January 19, 2012, with 13 in attendance and one speaker.

Partial Exclusion for Post-2005 Payments Received from a Controlled Subsidiary under a Pre-Aug. 18, 2006 Contract Expired in 2011

In Publication JCX-6-12, dated January 27, 2012, the Joint Committee on Taxation listed tax provisions that expired in 2011 and provisions slated to expire through 2022. Only one item mentioned in the publication applies to the UBIT. Section 512(b)(13)(E), regarding certain payments received from controlled subsidiaries, expired for payments made after December 31, 2011.  Continue reading