IRS Focus on Unrelated Business Income Tax
By Paul Hartog, HoganTaylor Assurance Partner
Beginning with the redesigned 2008 Form 990, the IRS has six years of comprehensive information filed by many exempt organizations. Expect the IRS to use this information to assess the likelihood of non-compliance by organizations and allow more effective use of examination resources to focus on the reporting of unrelated business income (UBI). The agency is concerned that many nonprofits may be reporting losses related to these activities and thus may not be paying unrelated business income tax (UBIT).
Background of Unrelated Business Income Tax
Nonprofit organizations (NFPs) are exempt from Federal income tax on revenue derived from the organization’s exempt purpose activities. However, many NFPs also engage in activities which do not directly relate to the exempt purpose. Revenue generated from these unrelated activities is subject to income tax under Section 511 of the Internal Revenue Code (IRC). This helps prevent tax exempt organizations from having an unfair advantage over for-profit businesses which pay tax on income from similar activities.
For most organizations, an activity is an unrelated business (and subject to unrelated business income tax) if it meets three criteria:
- It is a trade or business
- It is regularly carried on, and
- It is not substantially related to furthering the exempt purpose of the organization.
Certain types of income such as interest, dividends, royalties, rental income in some cases are generally not subject to UBIT. Space does not permit a detailed discussion of the exceptions but we would be happy to discuss individual situations in more detail.
Importance of the Revenue Source vs. Revenue Use
It is important to realize that it is the source of the revenue, not the use of the revenue which defines UBI. Thus, even though income obtained from an unrelated business activity is used for the NFP’s exempt purpose, such income is still subject to UBIT. It is also important to realize that an organization’s purpose is the reason why it exists and is the basis for qualification as a tax exempt entity. Activities are the organizations actions and undertakings.
Determining the Amount of Unrelated Business Income
In determining the amount of UBI that is subject to UBIT, certain expenses including “directly related” and “dual use” expenses are deductible. Deductions incurred solely because of the unrelated business are known as directly connected expenses. These are expenses that wouldn’t have been incurred if the unrelated business didn’t exist. If expenses are incurred to carry on exempt functions and to conduct an unrelated business, they’re known as dual use expenses. For example, a nonprofits executive director’s salary is $100,000. If he or she devotes 80% of his or her time to the organization’s exempt activities and 20% to an unrelated business, the organization can deduct $20,000 as a deductible expense of the unrelated activity on Form 990T.
The allocation of dual use expenses can become more complex – particularly when related to the dual use of facilities. According to U.S. Treasury regulations, when facilities are used both to carry on exempt activities and to conduct unrelated business, the expenses, depreciation, and anything attributable to such facilities “shall be allocated between the two uses on a reasonable basis.”
Whether you’re deducting direct expenses or allocating dual use expense, you must produce documentation. Use time sheets to document the percentage of an employee’s salary allocable to unrelated business activities. Additionally, document your reasoning behind allocations.
Potential Cost of Incorrectly Reporting UBIT
There are three main repercussions for nonprofits that inaccurately report expense related to unrelated business activities.
- Accuracy-related penalties. The IRS may assess penalties for negligence or disregard of regulations or for a substantial understatement of income tax. The penalty is 20% of the underpaid tax.
- Public access to Form 990T, “Exempt Organization Business Income Tax Return.” Since 2006, 501 (C) (3) organizations have been required to make their Form 990T available to the public. So expect the form – including allocations of expenses- to be scrutinized by the public just as Form 990 has been in the past.
- FASB ASC 740 (FIN48). For nonprofits required to disclose uncertain tax positions in their financial statement footnotes, an incorrect or overly aggressive allocation of expenses to unrelated business income could result in a disclosure under the interpretation. This disclosure is required to be reported on Form 990.
Consequences of Excessive UBI
NFPs can lose their tax-exempt status if the IRS determines that the percentage of their income that is derived from business activities unrelated to their specific exempt purpose is excessive. There is, however, no specific percentage of unrelated business income defined by the IRS as too large a percentage. The facts and circumstances of each unrelated business income situation would be considered.