The IRS recently completed a multiyear compliance project focusing on the college and university sector. (See the article on page 3 entitled “IRS Final Report on Colleges and Universities”.) As part of the project, the IRS examined the treatment of losses used to offset unrelated business income (UBI). The IRS found that numerous institutions had incorrectly classified expenses related to UBI on their Form-990-T, resulting in reversals of reported losses.
Based on the findings of the project, it would be beneficial to consider several areas of particular interest to the IRS when looking at losses on Form 990-T:
- Profit motive of the activity
- Characterization of expenses
- Dual use facility expense allocations
Profit Motive of the Activity
One of the areas that the IRS is looking at when examining the large losses reported on the 990-T is the profit motive of the activity. The “Profit Motive Test” came from rulings and case law that occurred in the 1980s and 1990s. When applied, this test eliminates deductions for losses from activities that lack a profit motive.
IRS Code Section 512(a)(1) defines unrelated business taxable income as “gross income derived by an organization from any unrelated trade or business regularly carried on by it, less the deductions which are directly connected with the carrying on of such trade or business.” This section of the Code allows organizations to offset the income and gains from one unrelated activity against the losses generated by another unrelated activity.
However, as noted in the definition, the losses must be generated by a trade or business, which is defined as an activity that is carried on for the production of income and has the other traits of a for-profit organization. In other words, an organization must engage in the activity with the primary goal of generating a profit.
Organizations reporting large losses on their Form 990-T are at risk of the IRS applying the profit motive test to their activities. This may result in the losses from the activity being disallowed due to the IRS’ assertion that the organization did not engage in the activity with the primary purpose of generating income or profit.
In looking at these losses, the IRS has adopted a facts and circumstances approach to determine whether or not an activity is a trade or business. Various areas that might indicate to the IRS that an activity does not have a profit motive include:
1. No formal business plan or contracts for the activity
2. Expenses almost always exceed any income from the activity
3. Many years of losses
4. No adjustments to cost, expenses or pricing to lower the losses
Another item to be aware of is the IRS’ treatment of offsetting losses from one set of unrelated activities against the income from other unrelated activities. It has been the IRS’ approach to look at each one of these activities as its own separate trade or business and make the determination whether or not each one of these has or does not have a profit motive. Using this methodology, the IRS has taxed profitable activities while disallowing the ones with losses.
Characterization of Expenses
When looking at expenses to offset unrelated business income, the expenses should be put into three baskets: the first basket is expenses that are related solely to the exempt activity and those cannot be used at all; the second basket has expenses that are solely related to the unrelated activity and those can be used in full. An example would be an individual whose only job is to procure advertising customers. The third basket has the expenses that involve both the related and the unrelated activities and those expenses are called “dual use expenses.”
Dual Use Facility Expense Allocations
Another area of focus by the IRS regarding losses reported on Form 990-T involves the expense allocation and deductions for the dual use of facilities and personnel. Under IRS Regulations 1.512(a) – (1)(a) (the Regulations), an organization is allowed to deduct an expense that is directly connected to an unrelated trade or business if it has a “proximate and primary relationship” to that unrelated trade or business. The Regulations further discuss this relationship regarding expenses directly related to unrelated business activities and expenses from the dual use of facilities or personnel.
The Regulations state that the expense allocation between the dual uses must be “reasonable”. However, “reasonable” has been subject to interpretation and litigation. Some guidance may be found in Rensselaer Polytechnic Institute (RPI) v. Commissioner of Internal Revenue (1983/1984). In this case, RPI interpreted “reasonable” to mean that fixed costs as well as depreciation and overhead expenses that could not be associated directly with exempt student uses nor non-exempt commercial for-profit uses should be allocated based on the percentage of total use, ignoring periods when the facility was idle. RPI prevailed. However, the Commissioner, to this day, contends that the basis of allocation should have been all time the facility was available for use, which would substantially reduce the amount of expenses and losses that could be used to offset unrelated business income.
With the lack of clarity on the issue, it is up to the organization and the IRS to come to some type of negotiated settlement on their own regarding such matters should the issue be brought to light during an audit.
With the marked increased level of scrutiny by the IRS in this area, organizations with unrelated business activities generating losses on their Form 990-T should look closely at the following areas:
Look at each of your activities’ profit motive. Document why the activity is generating losses (i.e., startup mode, meant to run a loss, etc.)
For dual use of facilities’ expense allocations, look at and document the methodology used in the calculation. Is it reasonable? Is it consistent with relevant tax court rulings or the IRS’ interpretation?
Documentation is key, so keep good records in case the IRS knocks on the door.
By: Sandra Feinsmith, CPA – BDO
This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Summer 2013). Copyright © 2013 BDO USA, LLP. All rights reserved. www.bdo.com