October 30, 2014

By Karen Dunn, JD, LLM

The IRS has increased its focus on unrelated business income (UBI) reporting. Because of this, the Advisory Committee on Tax Exempt and Government Entities (ACT) released recommendations to the IRS for specific changes to UBI reporting and additional guidance. Although the IRS’s focus is in response to the findings of the IRS’ College and University Compliance Project issued in April 2013, this applies to all exempt organizations, not only colleges and universities.

Many organizations do not fully understand the UBI rules. They are likely to under-report UBI or fail to file a Form 990-T. This leads to more audit risk, and payment of back taxes, interest, and penalties. The ACT points out the Form 990-T instructions and IRS materials contain insufficient detail to provide adequate guidance and may even create confusion for organizations.

Simply put, UBI is taxable income from trades or businesses that are unrelated to the organizations’ exempt purposes. The rules are complex and an analysis of what is UBI is beyond the scope of this article. Not only may UBI create a tax liability, it can also cause an organization to lose its exempt status if it becomes a substantial part of the organization’s overall activities.

The ACT’s specific recommendations include:

  • Create regulations in line with the requirement that the organization have a charitable purpose and abandon the commerciality test for UBI.
  • Provide guidance for allocating indirect costs where facilities or personnel are used both for exempt and unrelated activities.
  • Publish a revenue ruling that provides comprehensive guidance on UBI issues. A sample ruling was included in the report.
  • Revise the Form 990-T. A draft redesigned Form 990-T was included in the report.
  • Continue to improve the IRS’s website, electronic communication, and education.

Rejecting the IRS focus on commerciality

The freshest thought expressed in the ACT report is its rejection of the IRS focus on commerciality in deciding what UBI is and whether an organization that engages in unrelated activities should qualify for exemption. The ACT proposes that new regulations support that profits from a substantial commercial activity should not jeopardize exemption as long as the organization’s income and its financial resources are used commensurate in scope with its charitable program. Basically, this means the test should compare the size of the unrelated activity to the size of the exempt activities. While the IRS and courts have used this “commensurate test” in certain limited cases, lately they have been relying more on comparisons of the unrelated activity to similar commercial businesses rather than looking at the exempt organization as a whole.

Safe harbor method for allocating indirect costs

Improper allocation of expenses was one of the primary reasons for underpayment found by the IRS in its College and University report. Thus, unsurprisingly, the ACT requests formal guidance on proper methods for allocating indirect costs where facilities or personnel are used for both exempt and unrelated activities. The IRS rules require that allocations be “reasonable” and appropriately put to the “proximate and primarily related” business activity. This is a fairly vague requirement. The ACT recommends the IRS clarify this by providing safe harbor methods that they will consider reasonable under most circumstances and methods that will be considered unreasonable per se. Examples of reasonable methods could be unit based, such as unrelated rounds of golf divided by related rounds of golf, or square footage calculations. Per se unreasonable methods might be inconsistently applied methods. This will allow the IRS to apply less scrutiny to organizations using the safe harbor methods consistently. Methods that don’t meet either the safe harbor or per se unreasonable criteria would be scrutinized under a facts and circumstances approach.

Sample Revenue Ruling

The suggested revenue ruling includes guidance on use of losses and scenarios of specific situations such as facility rentals, website publications, dual use facilities, and preparatory time. More on the sample revenue ruling will be discussed in Part III of this series of articles.

Redesigned Form 990-T

The draft redesigned Form 990-T included in the report has as its centerpiece a line by line checklist of activities that flow to the Form 990-T. More on the suggested redesigned Form 990-T will be discussed in Part II of this series of articles.

Website, electronic communication, and education

The IRS has been trying to educate and provide information to tax professionals, exempt organizations, and the general public on its website and via webinars and email updates. The ACT recommends the following to improve and enhance the
IRS’s web based resources:

  • Upgrade and modernize their technological capabilities by committing “human, financial, and technological” resources.
  • Enhance the email update listserv by requiring email addresses on Forms 1023 and 990s.
  • Establish a tax professional webpage which provides links to statutes, regulations, rulings, revenue procedures, CPE material, Internal Revenue Manual, and other IRS information.
  • Improve the website index and search capabilities.
  • Web pages and files should be downloadable, printable, and searchable pdf files, including its “Exempt Organization Participant text”, CPE material, and the Internal Revenue Manual.

The ACT’s recommendations are based on both the College and Universities Compliance Project Final Report and its own independent study of the UBI issue. Its findings clearly point to lack of guidance as a contributor to noncompliance. For more organizations to be tax compliant and also be able to enhance their financial planning, both exempt organizations and their tax advisors must have access to clear, understandable information and a simpler Form 990-T for reporting.

© Clark Nuber PS, 2014.  All Rights Reserved

This article contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.