The recent Tax Cuts and Jobs Act has garnered much attention for its individual and business-focused provisions, but it also contains some potential game-changers for exempt organizations. In the upcoming weeks, we will explore a number of these provisions—starting today with changes to the unrelated business income taxation (“UBIT”) landscape.

As background, exempt organizations (including 501(c)(3) organizations) generally are exempt from federal taxation on their income. However, UBIT subjects these organizations to tax on their net unrelated business taxable income—which in most cases is income from an unrelated trade or business that is regularly carried on, less any allowable deductions. Breaking that down further:

• An “unrelated trade or business” is any trade or business which is not substantially related (aside from the need of the organization for funds or the use it makes of the profits derived) to the exercise of the organization’s exempt purposes or functions.
• A “trade or business” has the same meaning it has in Section 162, and generally includes any activity carried on for the production of income from the sale of goods or the performance of services.
• In determining whether a trade or business is “regularly carried on,” analysis focuses on the frequency and continuity with which the activities producing the income are conducted and the manner in which they are pursued.
• To be considered “substantially related,” a trade or business must contribute importantly to the accomplishment of the organization’s exempt purposes.

However, exceptions or modifications can shift taxation implications. Some common exceptions and modifications are the exclusion of passive income like rent and royalties from unrelated business taxable income in many cases, and the exception for a trade or business run entirely by volunteers.

Currently, unrelated business taxable income is calculated on an aggregate basis—in other words, even if an organization has a number of different unrelated trade or business activities, they can group the revenue in total, and apply aggregated deductions to that total, for the ultimate net tax due (or loss).

This changes under the new law, however. Instead, each unrelated trade or business activity must be looked at separately, with deductions from a particular activity applied only to the revenue from that same activity. So if an organization has an excess of expenses in Activity A, it cannot use those to offset income from Activity B. This could result in taxable income for organizations going forward that typically haven’t had any in the past. However, an organization can carry forward a loss from Activity A to offset income from Activity A in subsequent years.

Another change that impacts UBIT is a shift in corporate tax rates, with the graduated brackets replaced with a flat 21 percent rate. Some larger exempt organizations may pay less tax than in the past, since the maximum rate is down from 35 percent. However, the smallest organizations will see their tax rate rise from 15 percent to 21 percent and pay more tax.

In addition, unrelated business taxable income will be increased in some cases by the amount of disallowed fringe benefits (e.g., paid transportation, parking, and athletic facility fringe benefits) it provides to its employees. This is meant to bring exempts in line with for-profit counterparts, which typically cannot deduct these expenses.