Don’t Let This Happen to You: Disallowed Losses on Form 990-T
If you’re in the college and university sector, we have a critical tip: know what the IRS wants.
The agency just finished a multiyear project in which it examined the treatment of losses used to offset unrelated business income (UBI), and it found that numerous institutions had incorrectly classified UBI expenses on their Form 990-T, resulting in reversals of reported losses.
Given the findings, we would all benefit from a more careful approach when determining our organization’s losses on the 990-T. As a start, keep in mind these three critical focus areas:
Profit Motive of the Activity
This is chief among the IRS’s new 990-T focuses. Essentially, the “Profit Motive Test” eliminates deductions for losses from activities that lack a profit motive.
IRS code 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, the losses must be generated by a trade or business—i.e. an activity that is carried on for the production of income and has the other traits of a business activity.
Organizations reporting large losses on their 990-T are at risk of the IRS applying the profit motive test. This may result in 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 determines whether or not an activity is a trade or business. Some areas that might indicate no 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
Also, be aware of the IRS’ treatment of offsetting losses from one unrelated activity against the income from other unrelated activities. Currently, it considers each of these activities its own separate trade or business, and makes its determination on whether or not each has a profit motive.
Characterization of Expenses
When looking at expenses to offset unrelated business income, the expenses should be put into three baskets:
1. Expenses related solely to exempt activity, which cannot be used at all to offset UBI
2. Expenses related solely to unrelated activity, which can be used in full (e.g., an individual whose only job is to procure advertising customers)
3. Expenses involving related and unrelated activities (i.e., “dual use expenses”)
Dual Use Facility Expense Allocations
Under IRS 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.
Currently, regulations state that expense allocation between dual uses must be “reasonable.” But “reasonable” is open for interpretation and litigation. Though still controversial, several legal cases highlight the issue, including RPI v. Commissioner of Internal Revenue (1983/1984).
With the current lack of clarity, if and when this issue is brought to light during an audit, the organization and the IRS have to negotiate a settlement.
What’s the takeaway? With this increased scrutiny, if your organization has unrelated business activities generating losses on its Form 990-T, carefully consider the following:
- Your activities’ profit motive. Document why the activity is generating losses (i.e. startup mode, meant to run a loss, etc.).
- Dual use of facilities expense allocations. Review and document the methodology used in the calculation. Is it reasonable? Is it consistent with relevant tax court rulings and the IRS’ interpretation?
- Documentation. Keep good records in case the IRS comes knocking.
Sandra Feinsmith, CPA is a tax senior director in BDO’s Nonprofit & Education practice and serves as a member of BDO’s Institute for Nonprofit Excellence. To reach Sandra, email firstname.lastname@example.org.