Category Archives: Tax Reform

Tax Reform 2017: Senate Passes Final Version of Its Tax Bill

Posted on by

The initial U.S. Senate tax reform bill contained two amendments to the UBIT that would result in additional taxes being imposed on some exempt organizations: the taxation of income from licensing an organization’s name or logo and the prohibition of netting income and losses from multiple trades or businesses. The initial Senate bill is discussed here. The U.S. Senate passed a final version of its tax reform bill on December 2, 2017. The final bill omits the change in licensing income but retains the netting restriction.

Sale or Licensing of Exempt Organization’s Name or Logo

Although royalties are generally excluded from the UBIT as passive income, the initial Senate bill proposed to tax royalty income from the licensing of an exempt organization’s name or logo to a for-profit company. The final bill omits the name and logo licensing provision and allows such licensing income to be excluded as royalty income.

This change comes as particularly good news to colleges and universities, which derive considerable royalty income from the sale of apparel and other items displaying their names and logos.

UBTI of Multiple Unrelated Trades or Businesses Separately Computed

The final Senate tax bill retains the provision that prevents an exempt organization from netting income and losses of multiple trades or businesses. If, for example, an exempt organization conducts Unrelated Business A for a profit and incurs a loss in Unrelated Business B, the present law would allow the organization to net the income and loss. The loss from Business B would reduce the UBIT payable on the income from Business A. Under the Senate proposal, the organization would report UBTI from Business A and would deduct the loss from Business B in accordance with the net operating loss rules.

The anti-netting provision would only affect organizations that carry on two or more unrelated trades or businesses. As a reminder, the IRS may treat what would normally be considered a single trade or business as multiple trades or businesses for purposes of the UBIT. For example, a museum’s gift shop would ordinarily be regarded as a single trade or business. For purposes of the UBIT, however, the IRS may treat the sales of different items as different trades or businesses. For example, assume that an art museum sells art books and history books in its gift store. The IRS would treat the sale of art books as a related business, but the sale of history books would likely be considered an unrelated business. The sale of apparel and toys would also be evaluated as separate trades or businesses. Under the Senate proposal, the museum could not offset a profit from the unrelated business of selling history books with a loss from the unrelated business of selling toys. 

Next Steps

Because there are significant differences between the tax reform bills passed by the House and Senate, it is likely that a reconciliation procedure will be used to come up with a bill that can be passed by both bodies and signed by the president. If the bill becomes law before the end of the year, the provisions affecting the UBIT will take effect for tax years beginning in 2018.

Tax Reform 2017: UBIT Rates Would Decrease to Reflect Reduced Corporate and Trust Rates

Posted on by

One of the main goals of the current tax reform efforts is to reduce income tax rates on individuals and corporations. The tax on UBTI is calculated using the corporate tax rates, if the exempt organization is a corporation, or the trust tax rates, if the exempt organization is a trust. Thus, a reduction in the tax rates for corporations and trusts will result in lower taxes imposed on most exempt organizations with respect to their unrelated businesses. Whether the lower rates result in lower UBIT depends upon the deductions contained in the final legislation.

H.R.1, the proposed tax reform bill of the House of Representatives entitled “Tax Cuts and Jobs Act,” appears here. For a description of the Senate proposal, click here.

Corporations

The rate of tax for exempt organizations that are not trusts, and for state colleges and universities, is governed by the corporate income tax rates under §11. §511(a). Under present law, four graduated tax brackets apply:

  • 15% on taxable income that does not exceed $50,000 
  • 25% on taxable income that exceeds $50,000 but does not exceed $75,000 
  • 34% on taxable income that exceeds $75,000 but does not exceed $10,000,000, and 
  • 35% on taxable income that exceeds $10,000,000.

Additional income taxes of up to $11,750 or $100,000 are imposed if a corporation has taxable income exceeding $100,000 or $15,000,000, respectively.

Under both the House and Senate tax reform proposals, the four graduated rates under current §11 are repealed and replaced by a single corporate tax rate of 20%. H.R. 1, §3001(b)(1). Under the House proposal, the 20% rate would take effect for tax years beginning after December 31, 2017. Under the Senate version, the flat rate would apply for tax years beginning after December 31, 2018.

The proposed flat tax rate of 20% is greater than the rate currently imposed on UBTI not exceeding $50,000 but is less than the three other rates currently imposed when UBTI exceeds $50,000. Thus, most exempt organizations would have their UBIT rates reduced under the proposed plan.

 Example: Exempt organization Z is a charity that operates as a corporation. Z derives income from the regular conduct of an unrelated trade or business. During the tax year, Z derived $700,000 in gross income from the unrelated business and incurred $600,000 in expenses. Assume Z’s UBTI is $100,000. Under present law, Z would owe $22,250 unrelated business income tax before credits or any other adjustments. Under the proposed flat rate of 20%, Z’s unrelated business income tax would be $20,000 before credits or any other adjustments.

 Comment: The U.S. has traditionally had a progressive tax rate system with graduated tax rates. The arguments generally made in favor of graduated rates are that they reduce income inequality and promote fairness by placing the greatest burden on those able to pay more. Opponents argue that progressive rates inhibit economic growth by reducing savings and investment. The replacement of the graduated corporate tax rates with a flat rate represents a significant change in the area of corporate taxation.

Trusts

For those exempt organizations that operate in trust form, the current income tax rates range from 15% to 39.6%, with the highest rate payable on income exceeding $12,500. §1(e).The trust tax rates imposed in H.R. 1 range from from 12% to 39.6%, applied as follows:

  • 25% bracket threshold amount 2,550 §1(b)(1)(D)
  • 35% bracket threshold amount 9,150 §1(b)(2)(D)
  • 39% bracket threshold amount 12,500 §1(b)(3)(C)

These dollar amounts are adjusted for inflation for tax years beginning after 2018. §1(c).

Under the Senate’s proposed plan, the current brackets for trusts would be replaced by rates ranging from 10% to 38.5%, with the highest rate payable on income exceeding $12,500.

Thus, under either the 2017 tax reform plans, the UBIT on exempt organizations taxed as trusts would be only marginally reduced. Taking into account tax deductions that may no longer be available, exempt organizations taxed as trusts may actually see an increase in their UBIT.  

Conclusion

The status of tax reform is changing daily. Lower income tax rates increase the federal deficit unless they are offset by spending cuts. Given the differing priorities of our representatives in Congress, compromises must be reached before any tax reform can be enacted. This post is just a reminder that lower income tax rates for individuals, trusts, and corporations will affect tax rates for purposes of the UBIT.

 

Additional Resources:

Andrew Kreighbaum, Taxing T-shirt Revenue, Inside Higher Education (November 13, 2017)

 

Net Operating Losses in an Unrelated Trade or Business

Posted on by

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: Senate Proposes Changes to the UBIT

Posted on by

On November 2, 2017, the U.S. House of Representatives released a proposed tax reform bill. The proposals in the House bill that affect the UBIT are described in Tax Reform 2017: House Proposes Changes to the UBIT. On November 9, 2017, the Senate Finance Committee announced the Senate version of tax reform, which is described by the Joint Committee on Taxation in a document scheduled for markup by the Finance Committee on November 13, 2017. Senate proposals that would affect the UBIT are described in this post.

Sale or Licensing of Exempt Organization’s Name or Logo

Income from passive sources, such as dividends, interest, royalties, certain rents, and gain from the sale of property, is generally excluded from the scope of the UBIT. Under present law, if an exempt organization licenses its name or logo to a for-profit company in return for a fee, the fee is treated as an excluded royalty payment, so long as the organization is not required to render considerable services under the arrangement.

The Senate proposal retains the general exclusion of royalties from the UBIT but eliminates the exclusion for income derived by an exempt organization from selling or licensing its name or logo. Specifically, the Senate version treats the sale or licensing of a name or logo as an unrelated trade or business that is regularly carried on by the organization. Moreover, income from licensing a name or logo is expressly included in an organization’s unrelated business taxable income, regardless of any provisions that exclude various categories of passive income, such as royalties. The Joint Committee description does not state that income from the sale of an organization’s name or logo is expressly included in UBIT, but that would be the logical result of treating the sale of a name or logo as a regularly conducted trade or business.

Many exempt organizations will be adversely affected if income from licensing their names and logos becomes taxable. The taxation of such licensing income seems inconsistent with the underlying structure and purpose of the UBIT. Most passive income is expressly excluded from the scope of the tax. The exclusion covers dividends, interest, royalties, some rents, and gains from the sale of property, so long as the passive income is not derived from debt-financed property. A fee paid for the use of an exempt organization’s name or logo is a classic royalty payment, provided that the organization does not render excessive services under the license agreement.

Moreover, ever if licensing a name or logo were treated as a trade or business, at least some name and logo licensing would be considered a related trade or business not subject to the UBIT. For example, when a university licenses its name and logo to a company that makes apparel, students, alumni, and friends of the university purchase the items to show their loyalty and school spirit. The appearance of the name and logo promotes the university and its programs, which is a purpose that is related to the educational function of the university. In contrast, if an exempt organization licenses its name and logo to an insurance company for the purposes of selling insurance policies to the organization’s members, the relationship between the promotion of the insurance and the organization’s exempt function is likely too tenuous for purposes of the UBIT. Even so, however, the licensing fee continues to be a royalty, which has always been excluded from the scope of the tax.

UBTI of Multiple Unrelated Trades or Businesses Separately Computed

Some exempt organizations carry on more than a single unrelated trade or business. When there are multiple unrelated businesses, UBTI is computed by aggregating the gross income of the organization from all unrelated businesses and subtracting the deductions directly connected with such businesses. Thus, deductions from one unrelated trade or business would be used to offset income from a different unrelated trade or business.

Under the Senate proposal, each of an exempt organization’s unrelated businesses is treated as a separate business for purposes of determining UBTI. Thus, deductions from an unprofitable unrelated business could not be used to reduce taxable income of another unrelated business. An exempt organization may use a single specific deduction of $1,000, however, irrespective of the number of unrelated businesses it conducts. After the net income or loss is calculated for each trade or business separately, the specific deduction applies. Moreover, net operating losses from a particular unrelated trade or business can only be carried forward to offset income of that same unrelated business in future tax years, in accordance with the net operating loss rules of §172.

Effective Date

The Senate proposals are effective for taxable years beginning after December 31, 2017.

Comparison of House and Senate Proposals

Regarding the UBIT, the House and Senate tax reform proposals are different. The House proposal clarifies that state and local tax-exempt entities, such as pension funds of state organizations, are subject to the UBIT. In addition, the House bill seeks to narrow somewhat one of the exclusions for research income. Addressing neither of these topics, the Senate proposal seeks to tax gain or royalties from the sale or licensing of an exempt organization’s name or logo and eliminates the ability of an exempt organization to aggregate the income and deductions of multiple trades or businesses when computing its UBTI.

As the relatively minor proposed changes to the UBIT are taking a back seat to the talk of individual and corporate rate reductions and the elimination of popular deductions, we may not know which, if any, of the proposed changes to the UBIT will become law if and until a new tax law is passed.

Additional Resource:

Andrew Kreighbaum, “Taxing T-shirt Revenue,” Inside Higher Education (November 13, 2017)

Tax Reform 2017: House Proposes Changes to the UBIT

Posted on by

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.

Tax Reform and the UBIT

Posted on by

Speaking for the Obama administration today, Treasury Secretary Timothy Geithner proposed reducing the highest corporate tax rate from 35% to 28% (25% for manufacturing). The proposal would also do away with some corporate tax deductions and subsidies to compensate for the lost tax revenues. Leading Republican presidential candidates have called for even lower corporate tax rates. Mitt Romney has proposed a 25% top corporate tax rate. Rick Santorum’s plan would reduce the top rate to 17.5%.

 How is the possibility of corporate tax reform relevant to exempt organizations?  Continue reading →