A nonprofit organization is exempt from paying taxes on the activity that it applied for the exemption. Unrelated Business Income (UBI) is a trade or business regularly carried on and not substantially related to the exempt purpose of a nonprofit organization. The purpose of the UBI is to make a nonprofit conducting an activity or business outside of its exempt purpose equitable to a for-profit business.
Recently, new laws were passed as part of the Internal Revenue Service (IRS) Tax Cuts and Jobs Act (TCJA) which mandates that exempt organizations must separate each UBI activity into different silos or buckets. It’s important to note that net losses from one bucket cannot offset net income from another bucket. Nonprofit organizations can categorize these UBI activities based on a two-digit NAICS Code, which uses a broad scope for organizing the activities and allows nonprofits to group many activities together as one.
Investment income from a K-1 is generally classified as UBI, since the nonprofit is considered an owner in the business and therefore unrelated to its exempt activity. Each K-1 is treated as a separate activity, unless the nonprofit can meet either the de minimis test (which states that the nonprofit directly holds 25% or less of capital or profits interest) or the control test (which states that the nonprofit directly holds 20% or less capital interest and holds no control) in order to group the activities together.
While the IRS has not yet given any guidelines for allocating expenses to the UBI, they have reaffirmed that a gross-to-gross allocation of expenses is not permissible, meaning an organization cannot allocate all expenses based on the percentage of UBI to total income. However, an organization can allocate expenses that are directly related to the particular activity. For indirect expenses, an organization can use a reasonable allocation of those expenses.
The IRS does plan to provide additional guidance on this topic. In the meantime, SST experts recommend documenting how your organization determined the allocations used, as well as your reasoning. For an in-depth look at this update and how it impacts your nonprofit, contact us today.
Thanks to SST tax supervisor Christina Nichols Morris for the content of this blog post. Click here to learn more about Christina.