While exempt organizations are, by definition, exempt from tax, they are subject to a tax on their income from unrelated businesses.
The Tax Cuts and Jobs Act makes significant technical changes to the computation of unrelated business income tax (UBIT). Specifically, if an organization has more than one unrelated trade or business, it provides that deductions from one business may not offset income from another business. This would increase tax on organizations who make money in one unrelated line of business but lose money in other unrelated lines of business.
One significant impact of this change will be on investment activity by non-profits. Larger non-profits with endowments often invest in alternative investments such as private equity funds. These funds can sometimes be organized as passthrough entities, giving rise to unrelated business taxable income. Inevitably, some funds will give rise to gains in a given year and other funds will give rise to losses.
It is not clear how the revised UBIT rules will apply in this situation. Will each fund be treated as its own bucket, such that an exempt organization will pay tax on gains even if its overall alternative investment portfolio has losses? Or will the IRS treat all funds together? Personally, I believe that the funds should be grouped in light of the economic interrelationship between the investments, the statutory language, and administrative considerations.
Similar questions arise with respect to how to group other activities. Many of these issues will arise in the context of colleges and universities. For example, take a university that sells membership in a fitness or recreation center to the public and also operates a sports camp for children. (Assume for the sake of discussion that these activities are subject to UBIT.)
Are these the same activity or a different activity for this purpose? What if the university also operates a golf course and allows the public to utilize it for a fee? Should this be its own bucket or is it the same as the recreation center?
Congress seems to have been focused on these sorts of activities, rather than investments. A 2013 report that the IRS issued on UBIT from business activities of colleges and universities was cited by the House Ways and Means Committee in its original consideration of this provision.
The IRS has issuing guidance on these topics in its priority guidance plan. However, in the interim, there are rules in other areas of the tax law that taxpayers may be able to use as a model in determining how to file, such as the rules relating to passive activities conducted by individuals.
Exempt organizations that have significant trades or businesses whose gains and losses offset each other may want to consider forming a taxable corporate subsidiary to hold these activities.
In a taxable corporation, gains and losses from one line of business can be offset against gains or losses from another line of business. So, by contributing their UBIT generating activities to a taxable corporation, exempt organizations can avoid the issues presented under the new law. However, there are disadvantages to the use of a taxable subsidiary as well. It may make sense to hold off on any action until after the IRS issues guidance.