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As the IRS continues to focus attention and resources on the nonprofit sector, the Colleges and Universities Compliance Project report serves as a clear reminder to institutions that identifying unrelated business activities and properly accounting for income and related deductions should be a tax compliance priority.

IRS Report on Unrelated Business a Wake-Up Call for Colleges and Universities

  • 8/15/2013

IRS Report on Unrelated Business a Wake-Up Call for Colleges and Universities

Ninety percent of the colleges and universities examined by the IRS for its Colleges and Universities Compliance Project were found to have underreported their unrelated businesses income (UBI). As the IRS continues to focus attention and resources on the nonprofit sector, the project report serves as a clear reminder to institutions that identifying unrelated business activities and properly accounting for income and related deductions should be a tax compliance priority.

Released on April 25, 2013, the report is based on voluntary responses to compliance questionnaires sent to 400 colleges and universities. The survey asked about practices around UBI, executive compensation, and governance. The IRS’s subsequent review of these responses led to the examinations of 34 colleges and universities involving 117 separate Form 990 filings among them.

The examinations found:

  • More than 180 changes to the amounts of UBI reported by institutions on Form 990 and Form 990-T since the previous survey in 2008
  • Total increases in UBI of more than $90 million, with 90 percent of institutions examined having underreported UBI
  • Disallowance of more than $170 million in net operating losses (NOLs), with 75 percent of returns examined having disallowed losses

The primary reasons cited for these increases in UBI are:

  • Disallowance of NOLs on activities that lacked a profit motive and thus were not considered a trade or business
  • Disallowance of expense deductions that did not have primary and proximate relationship to the activity for which they were deducted
  • Unrelated business activities being misclassified as related activities

While the IRS’s final report covers everything from unrelated business income to compensation and employment taxes at colleges and universities, this article specifically explores the UBI adjustments in more detail, as well as implications for the entire nonprofit sector.

NOLs and the lack of a profit motive

In examining unrelated business activities that have sustained losses for several years, the IRS determined that those activities lacked sufficient profit motive to constitute a trade or business. After all, business activities are usually undertaken for a profit; continuous, sustained losses over time call into question whether the activity is indeed engaged in for profit.

Approximately 70 percent of the institutions examined had NOLs disallowed by the IRS due to lack of profit motive, totaling more than $150 million. In essence, institutions were deemed to have used losses from activities that were not a trade or business to offset income earned on activities that were.

One way for institutions to substantiate the business purpose of an activity is to have a business plan, including financial projections and accountability for meeting those projections. While this proactive approach may result in the activity actually generating taxable income, paying tax on unrelated business income may be worth the cost if the activity diversifies the institution’s revenue base.  

Allocation of expenses between business activities

When a trade or business activity serves both exempt and unrelated purposes, the income and expenses from the activity must be allocated between the two on a reasonable basis, based on whether the expenses have a proximate and primary relationship to the activities for which they are allocated. The IRS found that in cases where an activity served both an exempt and unrelated business purpose, more than 60 percent of the returns examined had misallocated expenses between the two, in effect deducting exempt function expenses against UBI.

To mitigate this issue, institutions should document the basis upon which they are allocating costs between related and unrelated activities. While direct costs of an unrelated business activity may be straightforward, allocation of costs such as salaries, depreciation, insurance, and facilities may be more difficult. Similar to how institutions document their functional expense allocation between program, administrative, and fundraising activities for financial reporting purposes, it may be helpful to further break down the allocation of these costs between exempt functions and unrelated business activities.

Classification of unrelated business activities

Organizations are exempt from taxes on income generated by activities that are substantially related to their exempt purpose. The exempt purpose of a college or university typically includes teaching and instruction, research, and public service. The IRS found that more than 40 percent of institutions examined had improperly classified unrelated business activities as related to their exempt purpose, resulting in nearly $4 million in adjustments. The majority of adjustments were related to fitness and recreation centers, sports camps, advertising, facility rentals, arenas, and golf courses.

The classification of activities as exempt and unrelated functions can be very subjective. IRS Publication 598 provides several examples of activities that were determined to be (or not to be) unrelated trades or businesses. Institutions should carefully evaluate each of their revenue-generating activities to decide whether any of them may qualify as unrelated business activities.

Implications for the nonprofit sector

In response to these findings, the House Ways and Means Oversight Subcommittee held a hearing on May 8, 2013, to discuss the IRS’s final report. Lois Lerner, director of the Exempt Organizations Division of the IRS, shared the results of the report with the subcommittee and indicated that a second IRS study of tax exempt organizations is underway. The new study is focused primarily on organizations that appear to have reporting discrepancies on Forms 990 and Form 990-T.

The fact that the second study includes all types of nonprofit organizations makes it more important than ever to identify unrelated business activities and to properly account for the income and related deductions these activities generate. As each organization’s situation is unique, it may be helpful to involve your tax professional in these discussions.