With the United States officially in a recession, state and federal funding sources on which charitable organizations rely are drying up. In addition to funding cuts, charities are struggling with across-the-board expense increases while trying to serve a broader charitable population. Colleges and universities are seeing a marked increase in requests for financial aid, while hospitals are challenged by having to provide more charity care. These financial struggles have led many organizations to seek alternative revenue sources that are outside their charitable mission and, therefore, are taxable.
Despite charitable organizations’ struggles, questions have been raised as to the appropriateness of granting these organizations tax-exempt status. In certain instances, the media have portrayed charitable organizations as entities with ballooning endowments that fail to carry out the charitable mission for which they receive tax exemption. In response, Congress and the IRS have begun to question not only the types of organizations that deserve tax exemption, but also whether those charitable organizations that currently have tax-exempt status are appropriately paying tax on income from their noncharitable activities.
In October, the IRS released a college and university Compliance Questionnaire focused on compensation, endowment and the classification of activities as tax-exempt or taxable. Regarding the questionnaire, Sen. Charles Grassley, R-Iowa, the Senate Finance Committee ranking Republican, stated, “Colleges and universities should be much more transparent about their activities, just as tax-exempt hospitals are being asked to do. … They need to show they’re making good use of the tax exemption and other federal subsidies they receive.” While colleges and universities are the target of this IRS compliance check, all tax-exempt organizations should be aware of this initiative and be ready if the IRS asks questions about their activities. This article will focus on tax-exempt organizations’ classification of revenue as “unrelated business income” (UBI).
IS IT UBI?
Revenue from activities that are related to a tax-exempt organization’s charitable purpose is not considered UBI and, consequently, not taxed. However, revenue generated by a tax-exempt organization from activities outside its charitable mission generally is taxable as UBI. Tax-exempt organizations can generate UBI directly, by performing the activity themselves, or indirectly through partnership investments.
Congress added UBI tax provisions to the Internal Revenue Code in 1950 in an attempt to eliminate “unfair competition” between for-profit businesses and tax-exempt organizations conducting similar activities. If not subject to tax on net income derived from business ventures unrelated to its exempt purpose or functions, an exempt organization would have a financial advantage over a for-profit entity carrying on a competing enterprise. The UBI rules generally impose an income tax at corporate rates (or at trust rates for exempt organizations that are created as trusts) on an exempt organization’s net income derived from unrelated business activities.
IRC § 512(a)(1) defines UBI as the gross income an organization derives from any “unrelated trade or business” it regularly carries on, less allowable deductions directly connected with the carrying on of such a trade or business. Section 513(a) defines the term “unrelated trade or business” as any trade or business that is not substantially related to an exempt organization’s exercise or performance of its exempt function. Treas. Reg. § 1.513-1 sets forth and provides examples of the three mandatory criteria to define an unrelated trade or business:
1. The activity is a trade or business that is engaged in for profit;
2. The activity is regularly carried on by the organization; and
3. The conduct of the trade or business is not substantially related (other than through the production of funds) to the organization’s performance of its exempt functions.
Certain types of income that could be considered UBI pursuant to the preceding definition are specifically excluded from UBI by IRC § 512(b). UBI generally does not include passive income such as dividends, rent, royalties, interest and capital gains. However, if the activity that generates the passive income is debt-financed, IRC § 514 brings the income back under the UBI classification (with an exception for schools and pension trusts that generate passive income from debt-financed real property, which is beyond the scope of this article).
IF IT’S UBI, ARE THERE OFFSETTING EXPENSES?
Identifying the income associated with an unrelated trade or business is only the first step. The more difficult step is identifying directly connected expenses that are allowable as deductions to arrive at net UBI. Directly connected expenses are allowable if they have a proximate and primary relationship to carrying on the unrelated trade or business. It can be particularly challenging to determine the directly connected expenses when dealing with “dual-use facilities” that are used both for the exempt function and for commercial purposes.
An allocation of expenses between the exempt and commercial use is necessary to determine the expenses that may offset the UBI. Treas. Reg. § 1.512(a)-1(c) provides that an organization with dual use of facilities or personnel must allocate expenses related to such facilities “between the two uses on a reasonable basis.” Rensselaer Polytechnic Institute v. Commissioner (732 F.2d 1058 (2nd Cir. 1983)) is often cited as authority for an organization’s reasonable allocation of expenses to dual-use facilities. The Institute allocated fixed expenses based on a ratio of commercial use time over the total time the facility was in actual use. The IRS challenged the methodology and argued that the denominator of the ratio should be total time available for use, not total actual use. Therefore, the IRS’s methodology would result in a smaller ratio and less expense allocated to the commercial use. While the court decided in favor of the Institute, concluding that its expense allocation methodology was reasonable, the IRS subsequently disagreed with the court decision. This inconsistency indicates that tax-exempt organizations must be prepared to support and defend their methodology for allocating expenses.
Government officials, including members of Congress, Treasury and IRS officials, and state attorneys general, have focused attention on income-producing exempt organization activities.
Expense allocations perceived to be excessive. Steven T. Miller, IRS commissioner of the Tax Exempt and Government Entities Division, said in congressional testimony in 2007 that he was concerned about the increasing overlap of activities between commercial and exempt organizations and the amount of flexibility, which he called excessive, that exempt organizations may have in allocating expenses associated with commercial activities to reduce UBI.
Use of blocker corporations and hedge funds questioned. In 2007 and 2008, congressional tax writers considered organizations’ use of offshore “blocker” corporations, corporations domiciled in low-tax jurisdictions and established to block UBI from going to exempt organizations. To address such tax avoidance, congressional proposals have ranged from disallowing exempt organizations from using blocker corporations to allowing exempt organizations to invest in U.S.-based hedge funds without incurring UBI. To date, no proposals have moved forward in the legislative process, but the Senate Finance Committee staff circulated a discussion draft in August 2008 that reintroduced the idea of eliminating exempt organizations’ use of offshore blocker corporations. The discussion draft was targeted at reducing oil speculation to control the price of gasoline, but one section focused on UBI blocker corporations in the exempt organization context. For the moment, the discussion draft has been put aside as the government has focused on the crises on Wall Street and in the economy.
College athletics draw scrutiny. In April 2007, Grassley asked the Congressional Budget Office (CBO) to analyze college athletics, including commercial activities, the tax treatment of programs in the UBI context, and the impact of corporate sponsorship payments on college athletics. To date, no CBO analysis of these topics has been released.
IRS research suggests inaccurate reporting. The IRS Statistics of Income Division (SOI) compiled studies using data from Form 990, Return of Organization Exempt From Income Tax, and Form 990-T, Exempt Organization Business Income Tax Return. The studies found that gross UBI increased 99% between 2002 and 2004, primarily due to improved investment performance. Tax-exempt organizations’ deductions, however, were almost equal to revenue in 2004, with $9.5 billion of gross UBI and $9 billion in deductions. Consequently, exempt organizations paid little unrelated business income tax due to offsetting deductions. This has led the IRS to question the accuracy of UBI reporting on Form 990 and Form 990-T. The IRS believes its studies illuminate a variety of issues for lawmakers.
The IRS looks at college and university UBI. The IRS sent a college and university Compliance Questionnaire in October 2008 to a cross section of 400 public and private colleges and universities. In addition to sections on endowments and executive compensation, the questionnaire focused on organizational activities and whether colleges and universities are treating certain activities as unrelated and reporting them on Form 990-T. The IRS anticipates that the responses to the 33-page questionnaire will provide it with a better understanding of how colleges and universities:
Report revenues and expenses from trade or business activities.
Classify activities as exempt or taxable.
Calculate and report income or losses on Form 990-T.
Allocate revenues and expenses between exempt and taxable activities.
The IRS said it will report on its findings later this year.
PUBLIC INSPECTION OF FORM 990-T REQUIRES CONSIDERATION
Tax-exempt organizations have long been required to make Form 990 available for public inspection. But since August 2006, section 501(c)(3) charitable organizations also are required to make their Form 990-T available for public inspection. Under IRS guidance, public disclosure is required only for information on Form 990-T, including attachments and schedules, that is associated with UBI. Consequently, various forms and schedules that exempt organizations attach to Form 990-T but which have no bearing on the calculation of UBI or the tax paid thereon are not subject to public inspection. These may include Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, and Form 8886, Reportable Transaction Disclosure Statement.
Because the public now has access to Form 990-T, the same practices developed by organizations to review disclosures made on Form 990 should be applied to the preparation of Form 990-T. While an organization must include complete and accurate information in full compliance with the law, consideration should be given to the format, wording and extent of disclosures made on Form 990-T to avoid embarrassing mistakes and disclosure of superfluous information.
PREPARING FOR UBI SCRUTINY
If an exempt organization has concerns about UBI reporting or wants to increase its comfort level with its UBI position, it should review the position and take corrective action as necessary. The following list of questions is intended to start a discussion at your organization about UBI and assist in a review of previous positions taken on Form 990-T.
1. Have all sources of UBI been identified? A complex, decentralized organization may be at risk of omitting revenue from Form 990-T. The risk often is not what is reported on the return but what is left off. A good resource is Part II of the IRS’s college and university Compliance Questionnaire (www.irs.gov/pub/irs-tege/sample_cucp_questionnaire.pdf). While not comprehensive for all exempt organizations, the questionnaire provides a long list of activities that could be unrelated.
2. Has your organization acquired interests in alternative investments, such as private equity, limited partnerships or foreign corporations? Consider obtaining a list of alternative investments from investment managers and gathering Schedules K-1 from partnerships in a central location. The individual responsible for preparing the organization’s Form 990-T should work with the investment managers to ensure these investments are considered for UBI purposes.
3. How reasonable is your organization’s allocation of expenses to unrelated business activities? Deductions included on Form 990-T must be supported with well-documented work papers. Could you explain the expense allocation methodology to the IRS?
4. Do unrelated business activities reported on Form 990-T have a history of generating tax losses? Repeated years of tax losses (assuming a proper allocation of deductions) could indicate the lack of a profit motive, one requirement for establishing the existence of a trade or business.
5. If your organization is in a taxpaying position, does it calculate and make timely quarterly deposits of estimated UBI tax? Organizations can avoid estimated tax penalties only by depositing estimated taxes on time. Calculating estimated tax liabilities quarterly can be challenging, particularly if the organization has alternative investments generating income that tends to vary substantially from year to year.
6. Does your organization have a net operating loss (NOL) carryforward? How comfortable are you that the NOLs generated in prior years were calculated correctly? Generally, the statute of limitations expires three years after filing Form 990-T. However, to the extent that an NOL carryforward is deducted on a current-year return, the IRS can open a loss year return to confirm the accuracy of the NOL carryforward, even if the statute of limitations otherwise would have barred review.
7. Is your organization complying with record-retention requirements related to UBI documents? Records should support all numbers included on Form 990-T, including NOL deductions. Records also should be retained to explain why income omitted from Form 990-T is not considered UBI.
8. Are your organization’s federal and state income tax accounts up to date, and do the IRS and state records of tax deposits and assessments agree with your records? Periodic requests for and review of your organization’s federal and state income tax account transcripts will help identify discrepancies.
By no means is this list exhaustive. More investigation may be needed, depending on the complexity of your organization and its operations.
PRACTICE MAKES PERFECT
Congressional and IRS attention to UBI reporting is not new. As organizations consider alternative income sources, including those that may be taxable, it is particularly important to prepare Form 990-T and review UBI practices carefully. These are crucial steps to ensure that if the IRS contacts your organization, it will be able to show accurate reporting of UBI and appropriate allocation of related expenses.
Increased congressional and IRS scrutiny of exempt organizations includes looking at unrelated business income (UBI).
UBI is taxed to prevent unfair competition between taxexempt and taxable organizations. It can be generated either directly or indirectly. Determining expenses directly connected to UBI can be a challenge.
Although the current IRS Compliance Questionnaire targets colleges and universities, all exempt organizations should be aware of the issues regarding UBI and address them accordingly.
Careful preparation of Form 990-T and review of UBI practices are crucial steps in preparing for the possibility that the IRS could contact your organization regarding UBI.
Travis Patton, CPA, director, and Jocelyn Bishop, Esq., manager, work in the Exempt Organization Tax Services group within National Tax Services at PricewaterhouseCoopers. Their e-mail addresses, respectively, are email@example.com and firstname.lastname@example.org.
Nonprofit Organizations: Guide to Advanced Tax Planning, a CPE self-study course (#736790)
AICPA National Not-For-Profit Industry Conference, June 11–12, Washington
For more information or to place an order or register, go to www.cpa2biz.com or call 888-777-7077.
The Tax Section provides tools, technologies and peer interaction to CPAs with tax practices. The Section keeps members up to date on tax legislative and regulatory developments. Visit the Tax Center at www.aicpa.org/TAX.
IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations
Form 990-T, Exempt Organization Business Income Tax Return, and instructions
Form 14018, Compliance Questionnaire—Colleges and Universities, and instructions