From the Archives: UBI Issues: Is Your Organization at Risk?

Update: We originally shared this post on risks related to Unrelated Business Income (UBI) back in 2014, and although time has passed, this topic should still be top-of-mind for many nonprofit organizations. As we covered in a recent blog, the IRS has issued its Tax Exempt and Government Entities FY 2017 Work Plan, focused on working smarter with fewer resources. This idea of “working smarter” includes targeted audit initiatives designed to let the IRS focus on organizations where they will be more likely to find noncompliance and revenue. The IRS identified five key areas, one of which is the “Tax Gap,” which includes UBI and employment taxes. The “gap” refers to the differences between what the organization reported and ultimately what the IRS can get them to pay. As noted in the 2017 Work Plan, in 90 percent of the examinations conducted in 2016, the IRS prevailed with its positions and examined organizations needed to change their returns, potentially resulting in owed taxes.

The targeting the IRS does is based on data gathered from Form 990, where data on unrelated business income and expenses abounds. For example, on the front page of Form 990, organizations must report the amount of gross unrelated business income for the year and how much net unrelated business income is reported on Form 990-T. A net loss could point to issues such as improper expense allocations or utilization of losses from activities that do not have profit motives. Page 9 of Form 990, Statement of Revenue, also holds clues about the allocation of expenses. If revenue from an activity is reported in both the related and unrelated columns, that could point to dual-use expenses that must be allocated on a reasonable basis. The IRS has indicated that it is especially looking at certain UBI issues including expense allocation issues and net operating loss adjustments.

Given the increased focus of the IRS on these issues, we wanted to resurface this post and remind readers of our key takeaway: the best defense against UBI risks is thorough documentation of your tax positions.

When the IRS completed its College and University Compliance Project (CUCP), the findings led to audits of 34 colleges and universities. The end result was disallowance of some $170 million in losses and net operating losses (NOLs) due to lack of profit motive, improper expense allocations and a variety of errors related to computation, substantiation and classification of unrelated activities.

These eye-opening discoveries grabbed the attention of Congress, and the IRS continues to hone in on the issues associated with UBI. As you may know, the IRS began an initiative in 2013 that examines large samples of organizations whose Form 990s share a specific characteristic: substantial gross unrelated business income (UBI) but zero taxable income over the past three years.

Taking a step back, the general rules for NOLs allow them to be carried back for three years and forward for twenty. The default option is to carry back the NOL first, and then carry it forward if it’s not used up, although an election can be made to carry the NOL forward only. States generally follow the federal NOL rules, though several states have modified them to a degree.  

With that in mind, in addition to understanding all state and federal regulations, there are several key principles that organizations should keep top of mind in order to maintain compliance and minimize the risk of errors:

Defining “Lack of Profit Motive”: To be “unrelated business,” an activity must be a trade or business that is regularly carried on and unrelated to exempt activities. For an activity to be a trade or business, it must operate with a profit motive. In the CUCP final report and other examinations, the IRS found many cases where there was no profit motive in a particular activity because of a history of continual losses. As a result, the IRS disallowed these losses.  If these disallowed losses are used to generate an NOL that is then used to offset income from a separate unrelated activity in an open year (generally the last three tax years), then that income is considered taxable.

There may well be legitimate reasons for an activity to have a history of losses and a very reasonable expectation for a turnaround in the future. An organization that is taking losses from an activity for several years should examine it carefully and either (1) cease reporting it on the 990-T and consider amending prior returns; or (2) document why it is reasonable to assume that the activity is going to turn around and become profitable.

Understanding Improper Expense Allocations: As a result of the CUCP, the IRS is taking a close look at allocations and proper expensing, so organizations need to establish reasonable allocations and document exactly what they are doing. When it comes to UBI, there are three different “baskets” of expenses:
  • Directly connected to the activity, proximate and primary: deductible in full (e.g., advertising commissions paid as part of a periodical advertising activity)
  • Exempt/related expenses: not deductible at all (e.g., development officer salary or fundraising expenses)
  • Dual use: must be allocated on a reasonable basis (e.g., the fixed expenses for a college gym that is used for student sports activities but also rented out to outside groups)
Additionally, expenses must be deductible for tax purposes. For example, some items must be capitalized instead of deducted. Nonqualified deferred compensation is not deductible and only 50 percent of business meals or entertainment is deductible.

Avoiding Errors in Computation or Substantiation of NOLs: Organizations need to carefully track NOLs and their use. To safeguard against error, it’s important to keep the schedule up to date, keep all tax returns, and attach the schedule to each 990-T. Keep in mind that, since an NOL can be carried forward for twenty years, an organization may be required to provide the IRS with documentation from up to two decades ago.   As many colleges found out the hard way, if the NOL can’t be supported and documented, it will be disallowed.

Correctly Classifying Unrelated Activities as Related or Excluded Activities: Activities that are related for one kind of nonprofit may be unrelated for another. For that reason, it’s imperative to analyze all activities in light of the particular organization and its mission. Certain types of income are not related to an exempt purpose, but are excluded from UBI by statute. The rules for exclusion are complex, so organizations need to be on firm footing when using an exception. Again, documentation is essential to show exactly why an activity is classified as being related or excluded. The CUCP final report did not cover several significant areas of concern surrounding UBI activity that arise quite frequently. These include income and loss from alternative investments, unrelated debt-financed income and income from controlled entities.

With the IRS looking harder at unrelated business income, organizations should pay attention to exactly what they’re reporting—or not reporting—on their Forms 990-T. A self-audit of your NOL and UBIT calculations may be a very timely project to help safeguard your assets, minimize your risks and facilitate compliance.