How could a change in the tax law passed in 2017 have a substantial impact on clubs today? Given the recent business disruptions caused by the coronavirus, unrelated business income might not seem like a big deal. However, after the IRS issued proposed regulations on April 24, 2020, unrelated business taxable income (UBTI) will be computed differently and potentially generate unrelated business income tax. All clubs and tax-exempt organizations will need to re-evaluate their accounting and tax strategies moving forward.
Background
Looking back to December 2017, the Tax Cuts and Jobs Act contained a piece of legislation, Section 512(a)(6), requiring tax-exempt organizations with more than one unrelated trade or business to calculate UBTI separately for each respective trade or business. Since then, the IRS accepted public comments on the law, which resulted in some modifications, most notably using the first two digits of the NAICS code to classify the unrelated business income.
Although the new, proposed regulations were issued on April 24, 2020, the IRS will accept comments and requests for a public hearing until June 23, 2020.
New UBTI for Clubs
There are two primary reasons why new regulations for unrelated business taxable income require the immediate attention of club owners and operators.
First, because the changes may make more of the unrelated business income a club has taxable. And second, because the generally accepted interpretation of the regulations is that clubs and other exempt organizations may be expected to comply with final regulations quickly – the first year after they’re published. This means that clubs may need to be in compliance as early as January 1, 2021.
If this timeline remains intact, clubs need to act now to review their current accounting and tax policies and method of allocation, assess the impact of this change, and to be ready for full implementation in a matter of months.
The new regulations apply to all exempt organizations; however, clubs have a unique tax treatment. Under the proposed rules, unrelated business taxable income covers all gross income, except for exempt function income. Unlike other exempt organizations, clubs cannot exclude investment income such as dividends, interest, or rents and must include this income as UBTI. So for clubs, UBTI is essentially all gross income, minus deductions directly connected with producing that income, and except for exempt function income.
Further, club losses from nonexempt activities cannot be used to offset investment income.
There is no de minimis rule, which means there is no threshold under which the new UBTI rules wouldn’t apply. During the initial commenting period, a de minimis rule was requested that would have exempted organizations from the new rules if their UBTI was less than $100,000. This comment was disregarded because the IRS considered its other changes, such as switching to a 2-digit NAICS code instead of a 6-digit one, to be less burdensome on smaller organizations to implement.
The NAICS code is how UBTI will be categorized. The first two digits of the NAICS code for the specific trade or business are used to determine its classification. This represents a change from the draft rule, which was the version released in the Tax Cuts and Jobs Act. In the original draft, the IRS suggested using the full six-digit NAICS code, but many stakeholders commented that this method would be too complicated and time-consuming to implement.
How to Calculate UBTI
Calculating unrelated business taxable income is not new; exempt organizations with different revenue streams are already accustomed to it. A big part of the change in the proposed regulations is how it’s calculated, though. Starting in 2021, clubs and other exempt organizations will need to calculate UBTI separately with respect to each trade or business. They are no longer allowed to aggregate income and deductions from all unrelated activities or use net operating losses (NOLs) from one activity to offset the gains of another.
To calculate UBTI:
- For each unrelated trade or business, assign a two-digit NAICS code.
- Add all unrelated business income from each trade or business.
- This amount should be calculated without regard to any deductions, such as NOL or charitable contributions.
- The total UBTI is reduced by qualifying deductions, explained below.
Additionally, taxable income from each trade or business cannot be less than $0.
In the current draft, unadjusted gross UBTI is specifically mentioned as not being a reasonable method to allocate indirect expenses because it is a revenue-based method that does not account for differences in the prices charged for an activity, such as higher pricing for non-members.
Clubs are permitted to deduct up to 10% of charitable contributions against total UBTI and may deduct certain net operating losses (NOL). Additionally, if the club sells property that was used directly in its exempt function, such as its fleet of golf carts, and then sells it, gain on the sale is only recognized if the proceeds are not reinvested in other property used in the exempt function of the club. New property must be purchased within one year of selling the old property, or within three years after the sale.
UBTI Regulations for Clubs
The new rules for unrelated business taxable income apply to all exempt organizations, but clubs were given a significant amount of attention in the rules. Club owners and operators need to be familiar with these rules and be prepared to implement them by the end of this year.
A potential troublesome spot in the regulations prohibit social clubs, such as golf courses and country clubs, from using the NAICS 2-digit code for arts, entertainment, and recreation.
However, clubs can use an exception to this rule for rounds of golf played by nonmembers, since in these situations the greens fees would constitute UBTI.
Other businesses specifically mentioned in the regulations include merchandise sales, food and beverage services, and rental property.
Another potential issue will arise because clubs are not permitted to combine all nonmember activity into one 2-digit NAICS code.
While clubs have always had to separate member and nonmember income, the new rules will require a further breakdown. If a club has a nonmember outing, it will be required to break down the income and expenses between the amount related to the use of the course and the food and beverage at the end of the day.
Finally, city clubs are not specifically addressed except as social clubs; in their cases, UBTI would typically come in the form of rooms, food and beverage, and spa and fitness.
Looking Ahead
The proposed regulations did not address exempt income such as non-recurring events like professional golf tournaments. While the final regulations could be slightly different, the general scope and extent of new UBTI calculations are likely to remain the same. Therefore, clubs can start planning for these changes now.
Although it may seem like another challenge on top of dealing with the financial fallouts due to coronavirus, this is a good opportunity to plan for the future, both in terms of operational changes and taxable income modifications. PBMares is here to assist your club with these changes. The regulations can be complicated but advance planning is key to successfully incorporating new unrelated business taxable income guidelines.
To submit a comment to the IRS, click here before June 23, 2020. To view the entire IRS Bulletin on Unrelated Business Income changes, click here.
