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).