In Notice 2018-67, released on August 21, 2018, the Internal Revenue Service (IRS) sought comments and provided interim guidance on changes in the calculation of unrelated business income tax (UBIT) enacted in the Tax Cuts and Jobs Act (TCJA), which in certain circumstances will be pertinent to employee benefit arrangements.
- Employee benefit arrangements organized in the form of tax-exempt organizations—such as qualified retirement plans, individual retirement accounts (IRAs), voluntary employee benefit organizations (VEBAs), and supplemental unemployment benefit (SUB) trusts—are not subject to federal income tax unless they engage in “unrelated business” activities. Broadly speaking, if a tax-exempt organization is conducting business activities unrelated to its exempt function and thus in competition with taxable entities, the Internal Revenue Code (IRC) provides as a matter of equity that the tax-exempt organization also pay tax on its “unrelated business taxable income” (UBTI).
- The IRC also provides that debt-financed property, for example, or the holding of reserves in excess of certain limits by VEBAs and SUB trusts can give rise to UBIT.
- Exempt organizations manage UBIT exposure in a variety of ways. As applicable, for example, they might make use of exceptions in the statutory definition of UBTI, or participate in an investment that otherwise throws off UBIT through a “UBIT blocker” like a taxable corporation, or otherwise structure to avoid UBIT.
- These are not universal solutions, however, and benefit arrangements sometimes have a UBIT obligation.
Accordingly, this guidance project will apply to some benefit arrangements, primarily depending on their form and the manner in which their investment affairs have been organized. Comments are due by December 3, 2018.
The significant change enacted in the TCJA, effective for tax years beginning after December 31, 2017, was to require the calculation of UBIT separately for each separate unrelated trade or business an exempt organization may conduct, with the result that losses in one trade or business no longer will offset gains in a different trade or business. Thus the ongoing efficacy of UBIT strategies that relied on such offsets should be reconsidered.
Matters Specific to Benefit Arrangements
In developing and seeking comments on a methodology for calculating UBIT under this new rule, the Notice provides guidance on two benefit-related issues, and seeks comment on another.
- Fringe Benefits. The “separate unrelated trade or business” concept is alien to another new UBIT rule (IRC section 512(a)(7)) providing that UBTI will be increased by any non-deductible amount paid or incurred by the exempt organization for a qualified transportation fringe, parking facility used in connection with qualified parking or on-premise athletic facility (all as defined in IRC section 132). The Notice properly provides that any amount included in UBTI under section 512(a)(7) will not be subject to the new “separate unrelated trade or business” rule.
- VEBAs and SUB Trusts. Unlike for most other exempt organizations, UBTI for VEBAs and SUB trusts is computed under IRC section 512(a)(3) as gross income excluding any “exempt function income,” less deductions directly connected with the production of gross income, subject to certain modifications. Non-exempt function income generally includes investment income as well as income from unrelated business activities. The Notice seeks comments on any special considerations that should be taken into account in applying the “separate unrelated trade or business” rule in this context, specifically including the treatment of investment income.
Although not mentioned in the Notice, the treatment of other UBIT rules specific to benefit arrangements—such as the section 512(a)(3)(E) reserve limitation for VEBAs and SUB trusts and the section 514(c)(9) qualified organization exception to the debt-financed property rules—also merits attention, as well as any corollary consequences under the section 419A(g) “deemed UBIT” rule for non-exempt welfare benefit funds.
- IRAs. In a footnote, the Notice also announced that the IRS intends to provide that the broader section 513(b) definition of “unrelated trade or business” (which for UBIT purposes attributes a trade or business conducted by a partnership to its tax-exempt general or limited partner), rather than the general section 513(a) definition, will apply to IRAs as well as to qualified plans. This development appears (i) not to be driven directly by the TCJA, and (ii) intended to formalize a position the IRS has taken in the past (e.g., PLR 9703026) with which taxpayers have sometimes disagreed.
More General Matters
The Notice covers and seeks comments on a range of topics under the “separate unrelated trade or business” methodology that will be of interest to benefit arrangements that are potential UBIT taxpayers, including:
- General concepts for identifying separate trades or businesses for these purposes, and an interim reasonable, good faith rule that can be satisfied by use of the North American Industry Classification System (NAICS) six-digit codes;
- Certain of the section 512(b) modifications to the UBTI definition;
- Partnerships and debt-financed income from partnerships, including interim rules;
- Net operating losses (NOLs); and
- Any inclusion of global intangible low-taxed income (GILTI) under new section 951A, which is to be treated in the same manner as an inclusion of subpart F income and thus as a dividend generally excluded from UBTI.