New Tax Reform Guidance Changes UBI Reporting for Health Care Organizations
The tax reform bill, commonly referred to as the Tax Cuts and Jobs Act (TCJA), made sweeping changes to the Internal Revenue Code (IRC) that impact both taxable and tax-exempt organizations. Chief among them are multiple changes to how tax-exempt organizations report unrelated business income (UBI) in 2018 and going forward. Many organizations that have not filed a 990-T in the past will suddenly need to report UBI, and some will have to pay taxes on UBI for the first time.
Because tax-exempt health care organizations generate revenue in many different ways, your organization must pay particular attention to whether your activities generate UBI. Some activities that might seem health care-related may be deemed unrelated by the Internal Revenue Service (IRS). At the same time, the determination of whether an activity generates UBI can be based on a nuanced set of facts, so knowing how to categorize your activities, and the impact UBI will have on your organization, is more important than ever before.
What is an unrelated business activity?
An unrelated business activity is defined as a trade or business that meets the following three criteria:
- The activity consists of a trade or business carried on for the production of income
- The activity is regularly conducted
- The activity is not substantially related to the organization’s exempt purpose
Generally, the provision of direct health care services is related to your health care organization’s exempt purpose. However, the following are examples of activities that may be classified as UBI:
- Pharmacy sales
- Cafeteria and gift shop sales
- Reference lab services for other organizations
- Fitness center revenues
- Providing administrative services for other organizations
- Durable medical equipment rental and/or sales
- Rental income
- Income generated by partnership and LLC interests
Per the IRS, “an activity is substantially related to your exempt purpose if the conduct of the activity has a substantial, direct, and causal relationship to the achievement of one or more exempt purposes.” This requirement must be considered individually in each situation based on your organization’s exempt purpose and the facts and circumstances involved.
Congress, the IRS, and the courts have created various modifications, exclusions, and exceptions that prevent certain items and/or activities from being considered in the computation of unrelated business taxable income. Examples include activities conducted by volunteers, passive income (interest, annuities, rents, and royalties), realized gains/losses from the sale of securities and fixed assets, and activities carried on for the convenience of your customers, employees, and volunteers. These special rules must also be considered when determining UBI.
Tax reform is changing UBI reporting
Tax reform has impacted UBI and Form 990-T in several ways, but one of the largest changes is the tax brackets and rates were simplified to a single flat 21 percent rate. Other major changes include reporting multiple unrelated business activities separately, reporting certain nontaxable employee fringe benefits as taxable, and creating and using net operating losses (NOLs).
Multiple unrelated business activities
If your organization has multiple unrelated business activities, you must separately calculate the net income or loss for each activity individually. Under the new guidance, a net loss from one activity cannot offset net income from another activity. Net UBI, therefore, is the total of only the profitable unrelated business activities.
Although the IRS is still creating the regulations to identify separate activities, Notice 2018-67 states that your organization may use a “reasonable, good-faith interpretation” of the current rules when making determinations. The notice further indicates that North American Industry Classification System (NAICS) codes — reported on Form 990-T (Block E) and Form 990 (Part VIII, Lines 2 and 11) — qualify as a reasonable method of making the distinction between activities. This implies that all activities that fit within a single NAICS code may still be aggregated and reported as a single unrelated business activity.
Nontaxable employee fringe benefits
If your organization provides employees with certain fringe benefits such as parking, transportation, or fitness facilities, and these benefits are excluded from employees’ taxable compensation under IRC section 274, then your organization’s net UBI is increased by the value of these fringe benefits. However, the IRS has not yet issued guidance on how to calculate the reportable amount on Form 990-T. Regardless, it is still important to determine whether your organization provides any applicable benefits. If so, you’ll need to determine whether such benefits are excluded from employees’ taxable compensation under IRC section 274 and calculate the amount to report on Form 990-T until the IRS issues clarifying guidance. Because this rule went into effect January 1, 2018, you may have a reporting requirement and liability for the period between January 1 and your fiscal year-end.
Net operating losses
The tax reform bill made several changes to the creation and use of NOLs.
First, because the net income and losses of activities are separately calculated, NOLs created in 2018 and after can only be used to offset the future net income of the activity that created it. However, NOLs created before 2017 can still be used to offset total UBI. The IRS is working on regulations to determine the ordering of NOL use. Until these regulations are provided, your organization should use any pre-2018 NOLs to the fullest extent possible, as they have a 20-year limit on their use.
An organization may have the following UBI to report for 2018:
Reference lab services — $10,000 net gain
Retail pharmacy — $12,000 net loss
Under the old tax rules, the organization would have a net loss of $2,000 for the year. Under the new tax rules, the organization must report $10,000 of net income from lab services and can carry forward the $12,000 loss from the retail pharmacy to offset future retail pharmacy net income.
Second, newly created NOLs can only be carried forward, as NOL carrybacks are no longer permitted. Since the 20-year limit was eliminated, these NOLs can be carried forward indefinitely.
Lastly, newly created NOLs can only be used to offset 80 percent of net UBI. This makes it impossible for your organization to completely avoid income taxes on a profitable unrelated activity, even if your NOL carryforward is much larger than your net taxable income.
The organization has $10,000 net income from its retail pharmacy in 2019. Although it has a $12,000 NOL carryforward related to its pharmacy, the NOL is limited to 80 percent of the pharmacy’s net income, or $8,000. The organization will report a taxable income of $2,000 and a remaining NOL carryforward of $4,000.
Reporting your organization’s UBI
Considerations for 2018 estimated tax payments:
- Are you using the flat 21 percent tax rate?
- Are you separately identifying and calculating expenses for each activity?
- Are you excluding all unrelated activities that have net losses?
- Are you including nontaxable employee transportation and parking fringe benefits?
Since most provisions of the tax reform bill became effective on January 1, 2018, it’s important that your organization answer the following questions:
- Have you properly accounted for and documented all UBI activities?
- Have you properly calculated any 2018 estimated taxes to cover your UBI liability?
While you are evaluating the impact of these changes, this may be the right time to conduct a thorough analysis of all of your organization’s activities to confirm that each activity is correctly classified and documented as program-related, unrelated, or excluded from taxation. Such documentation encourages accurate annual filings and can be useful when your organization’s activities are examined by the IRS or state department of revenue.
How we can help
At CLA, we combine our experience in the health care industry with our experience in nonprofit tax to help you navigate tax reform. We can help your organization complete a thorough UBI analysis so you can move forward knowing that you’ve accounted for all UBI activities.
Our professionals are closely watching changes to tax reform guidance. We will keep you updated as additional clarifications are released, and can help you implement these changes quickly. We encourage you to submit your comments on Notice 2018-67 to the IRS before the December 3 deadline.