The IRS Exempt Organization Group issued its annual Workplan in February 2013, which provides a summary of the IRS initiatives for the current fiscal year. The Workplan indicates that the IRS will continue to scrutinize unrelated business income (“UBI”), particularly organizations that report a significant amount of gross income, but report a loss or no income tax due on the Form 990-T.
As most colleges and universities are aware, the IRS sent a compliance questionnaire to about 400 schools in 2008. Based on the responses, the IRS selected approximately 30 institutions for examination. Consistent with this year’s Workplan, one of the primary issues in those examinations was UBI activities that repeatedly generate an annual loss, especially when those losses are used to offset the profits of another unrelated activity.
One of the key elements of an unrelated business activity is that the activity be a trade or business, which is defined as an activity that is carried on for the production of income, similar to a commercial enterprise. In other words, an organization’s primary purpose in conducting the activity must be to generate a profit.
When examining substantial losses reported on a Form 990-T, the IRS applies a “profit motive” test. This test was derived from rulings and case law during the 1980’s and 1990’s in which the IRS disallowed a deduction for losses from activities lacking a profit motive. While the determination is based on the facts and circumstances, a history of losses will be unfavorable for a loss deduction. The activities of colleges and universities that often generate a loss include golf courses, summer camps, facility rental, and recreational centers.
An additional matter reviewed by the IRS in these examinations is expense allocations, which are allowable as deductions to arrive at net unrelated business taxable income. These expenses include both direct and indirect expenses. Direct expenses are permissible if they have a proximate and primary relationship, and thus, are “directly connected” to the unrelated business activity.
On the other hand, the determination of indirect expenses can be more challenging, especially when a facility is used by an institution to carry on both exempt functions and unrelated activities (i.e., dual use facilities). The Treasury Regulations provide that the expenses attributable to a dual use facility “shall be allocated between the two uses on a reasonable basis.” However, the term “reasonable basis” is not defined in the Internal Revenue Code. Thus, this issue of “reasonable basis” has often been the subject of IRS rulings and case law, and interpretations throughout the years have been somewhat inconsistent. Due to these inconsistencies, colleges and universities must not only document, but be prepared to support their expense allocation methodology.
With the increased scrutiny of UBI by the IRS, colleges and universities should consider a self-assessment of their UBI activities. Institutions that reflect losses on their Form 990-T, especially those with historic losses, may wish to take a fresh look to determine if there are compelling facts and circumstances to demonstrate that the motive for conducting the activity is to generate a profit. In addition, when deducting direct expenses and allocating indirect expenses for a dual use facility, the school should review its allocation methodology to ensure it is reasonable.
Finally, and most importantly, remember to document, this would include both the validity of the losses as well as the reasoning behind any allocations. It may also be helpful to seek the advice of a tax advisor with nonprofit expertise to assist in this assessment. If the IRS happens to contact your school in the future, these proactive steps can assist in supporting the accurate reporting of UBI.