The tax reform signed into law in December 2017 will have a significant impact on tax-exempt organizations nationwide, substantially increasing the amount of income that may be subject to tax.  It is important that organizations are acutely aware of the changes in the law and, more importantly, the changes in the amount of income that may be subject to tax.  Planning for these changes now can help organizations mitigate the potential impact of the new law and help management prepare for the impact of increased tax liability, or even the impact of having to pay taxes for the first time.  The Internal Revenue Service (“IRS” or “Service”) recently published the first significant guidance relating to exempt organizations impacted by the new tax law which can be used by organizations to prepare for, and possibly limit, the adverse impact of the new law.

Notice 2018-67 (“Notice”), issued by the Service on August 21, 2018, interprets and provides administrative guidance about new Internal Revenue Code (“Code”) § 512(a)(6).  Below is a brief summary of the interpretations and guidance provided in the Notice that may be applicable to, and useful for, most exempt organizations impacted by section 512(a)(6).

Background

New Code § 512(a)(6) drastically changes the calculation of unrelated business taxable income (“UBTI”).  Previously, exempt organizations with more than one line of unrelated trade or businesses were required to pay tax on the net unrelated business income (“UBI”) determined by deducting the aggregated amounts of income and expenses from all unrelated business activities.  However, under section 512(a)(6), for each tax year beginning on or after January 1, 2018, exempt organizations with more than one trade or business are required to calculate the net UBI separately with respect to each trade or business.

Under new Code § 512(a)(6), for purposes of calculating an exempt organization’s UBTI:

• the amount of UBTI, including the calculation of any net operating loss (“NOL”) deductions, shall be computed separately for each trade or business;
• the organization’s UBTI shall be the sum of the UBTI for each respective trade or business, less the specific deduction provided by the Code (currently $1,000); and
• the amount of UBTI for any single trade or business shall not be less than zero.

As a result of this change, exempt organizations will no longer be allowed to net the losses of a single loss activity against the gains from other profitable business activities.  Additionally, organization’s will no longer be allowed to use NOLs accumulated from significant loss activities to reduce the future income derived from other unrelated trades or businesses.

Notice 2018-67 General Guidance for Identifying each Unrelated Trade or Business

Throughout the Notice, the Service repeatedly acknowledged the lack of appropriate guidance defining a single unrelated trade or business and the substantial burdens, on both exempt organizations and the Service, that would result from certain interpretations of Code § 512(a)(6).  The Notice indicates that, pending the issuance of regulations interpreting section 512(a)(6), exempt organizations may rely on any “reasonable, good-faith interpretation of §§ 511 through 514, considering all of the facts and circumstances, when determining whether an exempt organization has more than one unrelated trade or business for purposes of § 512(a)(6).”

It is significant that the Notice specifically provides that organization’s “may rely” on any reasonable interpretation made in good faith.  By repeatedly focusing on the ability of exempt organizations to rely upon their own reasonable interpretations, the Notice is essentially providing a safe harbor from any adverse decision regarding Code § 512(a)(6) to every exempt organization that merely undertakes the effort to determine whether they are engaged in multiple unrelated trades or businesses and, as such, are subject to the provisions of section 512(a)(6).

The “reasonable, good faith interpretation” standard is quite broad, and the Notice provides some specific guidance as to what the IRS will consider a basis for a “reasonable, good-faith interpretation,” including:

• An analysis taking into account all facts and circumstances;
• Classification of business activities through use of the North American Industry Classification System (“NAICS”), which can be found at https://www.census.gov/eos/www/naics/2017NAICS/2017_NAICS_Manual.pdf;
• An analysis using the fragmentation principle as provided in Code § 513(c) and Treasury Regulations (“Treas. Reg.”) § 1.513-1(b); and
• An analysis of other sections of the Code that provide various factors for determining whether an organization is engaged in a trade or business, including: sections 132, 162, 183, 414, and 469.

Until the Service publishes proposed regulations interpreting Code § 512(a)(6), an exempt organization may rely on any of the methods described above to aggregate or identify separate trades or businesses.

Specific Guidance

In addition to the general guidance pertaining to whether an exempt organization is engaged in more than one unrelated trade or business, the Notice provides guidance for specific situations that present unique factors or are potentially overburdensome, including: (a) the use of NOLs; (b) partnership income; and (c) fringe benefits characterized as UBI pursuant to section 512(a)(7).

• NOLs

Prior to the creation of Code § 512(a)(6), organizations were allowed to carry over their aggregate NOLs and deduct such losses from future or prior year gains as the law permitted.  While the new provision continues to allow organizations to use NOLs, section 512(a)(6)(A) only allows an NOL deduction “with respect to a trade or business from which the loss arose.”  As such, for tax years beginning on or after January 1, 2018, organizations will need to track their NOLs for each unrelated trade or business, only deducting NOLs from future gains within the same unrelated trade or business activity.

While tracking and using future NOLs may be a difficult process, the Notice clarifies that the NOL limitation does not apply to NOLs accumulated before 2018.  As such, exempt organizations that accumulated NOLs before 2018 may continue to deduct such NOLs from the aggregate amount of their UBTI until such NOLs expire.  It is unclear how the pre-2018 NOLs may be used in conjunction with the post-2018 NOLs in future tax years.  However, the transitional rule permitting the use of aggregate NOLs as a deduction against the total amount of an organization’s UBI should be helpful to many organizations with prior year tax losses.

• Partnership income

Under Code § 512(a)(6), calculating the UBTI of exempt organization income derived from partnership activities, especially investment partnerships, may be nearly impossible.  Generally, when an exempt organization participates in a partnership, the organization is treated as though it is directly engaged in each of the activities of the partnership.  As such, a determination as to whether the organization is engaged in an unrelated trade or business through its partnership interests will be based on an analysis of the activities of the partnership itself. 

By itself, analyzing the activities of a separate entity to determine whether income derived from that entity is UBTI seems like a difficult and burdensome process for determining an organization’s tax liability.  However, the process becomes exponentially more difficult in situations where the partnership is itself invested in one or more partnerships which may have invested in one or more partnerships.  Under the plain text of Code § 512(a)(6), it is possible that exempt organizations would be required to analyze the activities of each partnership in an ownership chain to determine whether each entity engaged in an unrelated trade or business and, if so, the amount of UBTI that the organization derived from the entity’s activities.  Fortunately, the Notice saves exempt organizations from this nightmare by creating transition rules which permit the aggregation of gross income and deductions from certain investment activities.

The Notice provides that any proposed regulations will likely treat activities in the nature of an investment (“investment activities”) as one trade or business which will permit organizations to aggregate gross income and deductions from all such investment activities.  Under the transitional rules, an organization will be permitted to aggregate a partnership investment with its other investment activities if it meets either a de minimis test or the control test.

An exempt organization’s partnership interest will satisfy the de minimis test if the organization holds no more than a 2 percent profits interest and no more than a 2 percent capital interest.  An exempt organization’s partnership interest will satisfy the control test if the organization does not hold more than 20 percent of the capital interest in the partnership and the exempt organization does not have control or influence over the partnership’s operations.  Where an organization satisfies either the de minimis or the control test, the organization may treat all such partnerships interests as a single trade or business for purpose of Code § 512(a)(6).

• Fringe benefits characterized as UBI under Code § 512(a)(7)

Code § 512(a)(7) increases an organization’s UBTI by the amount of certain fringe benefit expenses for which a deduction is not allowed under section 274.  However, the Notice provides that such additions to UBTI are not subject to section 512(a)(6) because the increase in taxable income under section 512(a)(7) is not the result of an item of gross income derived from an unrelated trade or business.

Next Steps

Notice 2018-67 is very important to exempt organizations preparing themselves for the impact of the recent tax reform.  The greatest significance of the Notice is that it essentially provides a safe harbor to all organization’s that undertake the effort to make a “reasonable, good-faith” determination as to whether they are engaged in more than one unrelated trade or business, allowing organizations to rely on such internal determinations until the Service publishes proposed regulations.  The protection that this affords organizations in light of the uncertainty of Code § 512(a)(6) is significant, and the benefit of such protections definitely will outweigh the time and resources required to develop such a reasonable, good faith basis for an organization’s positions.  It is strongly advised that exempt organizations impacted by section 512(a)(6) take the steps necessary to avail themselves of the safe harbor that the Service has created.

In the age of internet banking, hackers accessing online banking accounts is a widespread problem.  One common fraud scheme involves obtaining a business’s bank account login information and then replacing intended beneficiary account numbers with account numbers belonging to the hacker or his or her accomplice.  The account numbers could be swapped on scheduled outgoing payments or templates for frequently paid vendors.  Whether the login information is obtained through a “phishing” attack or malware, unauthorized bank account access can cause the loss of hundreds of thousands or even millions of dollars for which banks often disclaim responsibility.

In the past, parties perpetrating banking fraud often needed to forge payment instructions and/or trick bank employees by phone or in-person.  Today, any scammer with unauthorized access to an online bank account can steal funds without needing to forge documents and without even needing to speak to anyone.  The fact that a bank offers internet account access for convenience does not allow it to ignore online security risks for its customers.  Banks confirm a customer’s identity by photographic ID when he or she visits a branch to access an account, and for the same reason, banks need security procedures in place to ensure authorized persons are requesting access to online accounts.

Widespread fraud schemes are one of the primary reasons that commercially reasonable standards in the banking industry require banks to use multi-factor authentication, i.e., to ensure that a single set of user logins cannot enable fraudulent activity.  It is also why banks use monitoring and reporting software to detect suspicious and unauthorized activity or compromised user passwords.  Banks sometimes fail to utilize such procedures but nonetheless deny responsibility for a customer’s resulting losses, relying upon disclaimers contained in the bank’s boilerplate contracts.   

Such contractual defenses may be overcome by relying upon Federal Financial Institutions Examination Council (“FFIEC”) Guidance which spell out minimum elements that should be part of a financial institutions security procedures.  Courts frequently hold that failure to comply with FFIEC Guidelines reflects that the banking institution has not complied with commercially reasonable banking standards.  

GKG Law would be happy to consult with victims of such banking frauds in order to address whether they have rights arising therefrom.  Please contact Brendan Collins or Oliver Krischik, attorneys in the firm's Litigation Practice, if you would like to discuss any issues in this regard.  Brendan may be reached by telephone at (202) 342-6793 or by email at bcollins@gkglaw.com.  Oliver may be reached by telephone at (202) 342-5266 or by email at okrischik@gkglaw.com.

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GKG Law frequently represents aircraft owners in contesting the validity of notices of liens filed with the FAA relating to their aircraft.  Many aircraft owners face issues relating to FAA lien filings that create a “cloud” on the title to their aircraft.  Often, such a cloud arises when vendors that have provided services relating to the aircraft file a notice of lien with the FAA due to alleged unpaid sums that the vendor is owed.  These clouds are often discovered by aircraft owners when a title search is performed in connection with the sale of their aircraft, by a commercial lessor of the aircraft, or by a lender seeking to perfect its lien on the aircraft in connection with making a loan to the owner.

Many states have statutes permitting persons who provide storage, repairs, maintenance or other services relating to an aircraft the ability to create a lien on the aircraft for amounts owed, provided that they have met the requirements of the statute permitting the lien.  Federal law permits those persons to file notices of the existence of such liens with the FAA aircraft registry.  Although, under appropriate circumstances, such liens serve a valid purpose such as ensuring that mechanics and other aircraft service providers are compensated for services they performed at the request of an aircraft owner or operator, the ability to file such liens can pose a threat to aircraft owners and lessees.

In filing a mechanics’ lien on an aircraft, a mechanic or other service provider creates a cloud on the aircraft’s title, thereby impeding the aircraft owners’ ability to sell (or in some cases refinance) the aircraft until the lien has been released.  Such liens also may cause an aircraft lessee to be in default under its lease of the aircraft.  Recognizing the tremendous leverage that such liens afford them, some service providers file liens in excess of the amount validly owed, or file liens that do not comply with the requirements of state lien laws, knowing that an aircraft owner may feel compelled to pay to release the lien in order to permit an aircraft sale or loan to move forward, even though the lien is invalid. 

An aircraft owner or lessee has several defenses that it may assert against such liens.  Among the possible defenses that may be asserted by an aircraft owner or lessee are the fact that: 1) the vendor did not provide services that fall within the scope of the state lien statute under which the vendor asserts the existence of the lien; 2) the vendor did not provide the aircraft related services in the state where the liens are being asserted; 3) the lienholder has not complied with the state’s possessory lien requirements; and/or 4) the services were not provided with the aircraft owner’s consent.

In addition, an aircraft owner or operator can take certain precautionary measures to minimize the risk posed by such liens.  These include ensuring that there is a written agreement with the service provider specifying the exact nature and costs of the services to be provided.  Such written communications should preclude the service provider from later submitting an invoice, and asserting a lien, for an amount in excess of the amount that the aircraft owner or operator agreed in writing to pay to the vendor.  

Private aircraft ownership and operations periodically result in commercial disputes.  These disputes may arise in connection with the purchase or sale of an aircraft, the lease of the aircraft, the adequacy of repairs performed on the aircraft, and/or disputes regarding who has assumed responsibility for such maintenance and repairs.  GKG Law’s extensive experience in all aspects of the business aviation marketplace makes it particularly suited to authoritatively protect your rights in such commercial disputes.  Please contact Brendan Collins at GKG Law if you would like to discuss any potential aircraft related disputes.  Brendan may be reached by telephone at (202) 342-6793 or by email at bcollins@gkglaw.com.  

Risks to Private Aircraft Owners Posed by Service Providers

Over the past year, GKG Law has witnessed successful results for clients that are good reminders that non-profit organizations and associations should continually re-evaluate their tax positions and be cognizant of potential errors by the IRS.

Successfully Challenging Outdated UBI Determinations

In June 2018, a non-profit association (the “Association”) received a refund of nearly $2 million in taxes paid on revenue that the IRS improperly deemed to be Unrelated Business Income (“UBI”).  This turn of events occurred after the Association initially questioned whether the amount of its UBI was substantial enough to jeopardize its tax-exempt status.  In analyzing this issue, the Association’s legal counsel determined that an earlier IRS determination regarding the Association’s income was incorrect and that the organization was entitled to a large refund.

Over 30 years ago, the Association was examined by the IRS and received a determination that the income derived from administering certain purchasing programs for its members was taxable as UBI.  In the decades since that examination, the Association paid annual taxes on all revenue derived from those programs never questioning the IRS position.

Upon seeking guidance about its exempt status, the Association was surprised to learn that the prior IRS determination was incorrect and that the income was not UBI.  On the advice of counsel, the Association filed amended returns seeking refunds for all taxes paid in each open year.  Once filed, the IRS examined the Association’s returns before approving a refund of all taxes paid in prior years.  In addition to the $2 million refund, the IRS now recognizes that these programs are related to the Association’s exempt mission, negating the erroneous determination and saving the Association hundreds of thousands in taxes each year going forward.

Successfully Challenging Inconsistent UBI Determinations

GKG Law also oversaw the reversal of a proposed adverse IRS determination which reflected regional inconsistencies with respect to the ruling.  On the advice of Counsel, the association requested a technical advice memorandum from the IRS national office which provided an official and binding IRS position regarding the law in respect to this tax issue.  This resulted in saving the association almost $400,000 in proposed taxes and penalties while avoiding the risk and expense associated with litigation.

What Could These Results Mean for You?

These successful results are a reminder to all associations that adverse IRS determinations relating to programs and activities deemed to be unrelated, should be reevaluated over time.  Circumstances and IRS positions change, and those activities may no longer be the type of activities characterized as unrelated trade or business activities.  This is especially true in circumstances where the IRS is issuing uneven determinations to similar organizations.

Further information on this topic can be found here https://www.gkglaw.com/publications/503-recent-successes-challenging-irs-ubi-determinations-showcase-importance-of.

The District of Columbia Office of Tax and Revenue (“OTR”) has become aggressive in challenging Taxpayer’s self-determinations that they are Qualified High Technology Companies (“QHTCs”) and thus exempt from the District of Columbia’s corporate franchise tax.  GKG Law recently represented a Taxpayer who received a Notice of Proposed Assessment of Tax Deficiency (“Proposed Assessment”) against it, pursuant to which the OTR was seeking approximately a million dollars in corporate franchise taxes over the life of the exemption.  In our experience, a vigorous defense of such assessments is necessary to prevail in reversing such an assessment.

In 2001, the District of Columbia enacted the “New E-Conomy Transformation Act,” D.C. Law 13-256, D.C. Code §47-1818.01 et seq. (2001) (the “Act”).  The Act, which is designed to make the District of Columbia an attractive location for high technology companies, grants certain high technology companies a five-year exemption from the District of Columbia’s corporate franchise tax.  In order to qualify for the exemption, a company must, among other things, derive at least 51% of its gross revenues from specified high technology activities.  These activities include internet-related marketing and promotion services, and the development of internet-related application and digital content.

GKG Law recently handled a case in which, as outlined in the Proposed Assessment, the OTR determined that the Taxpayer was not a QHTC because it had not established that its internet-related service and sales were performed with regard to the internet and not simply over the internet.  The OTR also challenged whether the Taxpayer derived 51% of its income from specified high technology activities.  GKG Law filed a Protest of the Proposed Assessment with the Office of Administrative Hearings (OAH) in which it asserted that the Taxpayer was a QHTC based upon the fact that the Taxpayer was not merely placing advertising on its website but instead was deriving revenue from its own high technology activities, which included designing, developing and operating internet-based services.  GKG Law also argued that the Taxpayer’s revenue was primarily derived from the high technology specified activities. 

Addressing these types of tax assessments requires not only tax expertise, but also a willingness to aggressively challenge OTR’s positions.  Please contact us if you would like to discuss these or similar tax issues you may have.  Brendan Collins may be reached by telephone at 202.342.6793 or by email at bcollins@gkglaw.com.  Chris Younger may be reached by telephone at 202.342.5295 or by email at cyounger@gkglaw.com.

Recently, GKG Law successfully assisted two clients with navigating challenges to adverse Unrelated Business Income (“UBI”) determinations made by the Internal Revenue Service (“IRS”).  Combined, these saved our clients’ almost $2.4 million in taxes in 2018 alone.  The first resulted in a nearly $2 million tax refund and future tax savings of hundreds of thousands of dollars in each future tax year, and the second resulted in the IRS overruling a proposed tax deficiency of approximately $400,000. 

Successfully Challenging Outdated UBI Determinations

The first successful result occurred in May 2018 when GKG Law’s non-profit organization client (the “Organization”) received notification from the IRS that it would receive a refund of nearly $2 million in taxes paid on income that the IRS improperly deemed to be UBI.  This result came after the Organization initially questioned whether its UBI was substantial enough to jeopardize its exempt status and sought counsel from GKG Law’s tax law experts who immediately recognized the Organization’s income was incorrectly characterized as UBI and that it was entitled to a refund.

The initial IRS determination was made more than 30 years ago, after an examination determined that the Organization’s income derived from administering certain purchasing programs for its members was UBI subject to federal income tax.  In each year since, the Organization paid tax on all its net revenue derived from the purchasing programs, regularly exceeding $1 million.  Under the guidance of members of GKG Law’s Association Practice Group, the Organization filed amended returns seeking refunds for taxes paid in all open years.  Subsequently, the IRS opened an examination which resulted in the approval of the full amount of the refund request for each tax year. The IRS now recognizes these programs as related to the Organization’s tax exempt mission, solidifying its status and saving hundreds of thousands of dollars in taxes each year going forward.

Successfully Challenging Inconsistent UBI Determinations

The second successful result also occurred in May 2018, when a GKG Law non-profit association client (the “Association”) received a no change letter from the IRS Appeals Division, overturning a prior proposed determination of a substantial tax deficiency issued by the IRS Examinations Division.  During an examination of the Association’s operations, the IRS determined that the Association received more than $800,000 of UBI from the sale of journal advertising space during the tax years examined and that all such income should be reported as taxable UBI in future tax returns.  Following word that the IRS Appeals Division intended to uphold the proposed determination, the Association sought the expertise of GKG Law’s tax attorneys and hired the firm to assist the Association’s tax counsel in achieving a favorable resolution to the dispute.
 
The IRS determined that under an agreement with an independent publisher, which gave the publisher exclusive control of and right to retain all income from advertising sales, the Association had too much control over the substantive content of its journal to characterize any portion of the advertising income as a non-taxable royalty.  As such, the IRS attributed a portion of the publisher’s advertising income to the Association as UBI and proposed the assessment of tax on that amount.
 
Instead of seeking to resolve the matter though litigation against the IRS, GKG Law recognized regional inconsistencies in IRS rulings on this issue and recommended that the Association request a technical advice memorandum (“TAM”) from the IRS national office to determine whether the IRS could attribute taxable UBI to the Association in this situation.  This TAM would provide an official and binding IRS position regarding the application of the law in respect to this issue and the Association.  Upon consideration of the TAM, the IRS national office ruled that advertising income earned by the publisher could not be attributed to the Association as UBI.  Subsequently the IRS appeals office was required to overturn the position taken in its examination and, as a result, the Association was not required to pay tax on the proposed amount of UBI, approximately $800,000, or on the amount of such income received in future years, approximately $200,000 per year.

What Could These Results Mean for You?

GKG’s recent successes are good reminders that organizations should occasionally reevaluate their programs and activities previously deemed to be unrelated, even activities which the IRS has determined to be unrelated.  Circumstances and IRS positions change, and those activities may no longer be characterized as unrelated trades or business activities.  These outcomes also highlight that organizations need to be aware of IRS enforcement efforts in their industry and should not merely accept the IRS position in an examination.  This is especially true in circumstances where the IRS is issuing uneven determinations to similar organizations.  As a rule, organizations should be cognizant of potential administrative remedies to disputes with the IRS before accepting the inevitability of an IRS determination or seeking a judicial remedy through litigation.