- The Treasury Inspector General of Tax Administration wants to see the IRS improve examination procedures for unrelated business income.
- TIGTA determined six types of organizations with a higher likelihood of producing UBI, and private schools are among them.
- Your school must be reasonable when allocating expenses used to carry on exempt and unrelated business activities.
- A recent court case shines light on the low tolerance levels for claiming tax losses without a clear profit motive.
Need help reviewing your UBI tax positions?
Unrelated business income (UBI) is expected to get more attention in IRS examinations. So, schools and other exempt organizations should study their UBI tax positions before the IRS does.
The IRS Exempt Organization Division was recently given a report card that showed “needs improvement,” for not effectively identifying and auditing key tax areas such as UBI. A key function of this examination program is to identify any large, unusual, or questionable items — including revenue, expenses, or tax liabilities generated from unrelated business activities.
Likely exam targets
The Treasury Inspector General of Tax Administration (TIGTA) — the internal audit oversight branch of the IRS — recently recommended the IRS improve its UBI examination procedures. To include in this review project, TIGTA determined six types of organizations with a higher likelihood of producing UBI:
- Private schools
- Private foundations
- Hospitals and other health services
- Business leagues
- Pleasure, recreational, or social clubs
- Fraternal beneficiary associations and lodges
TIGTA recommended the IRS include UBI tax issues in future compliance projects to identify issues preventing taxpayers from being compliant with UBI reporting requirements. They also recommended the IRS require experienced senior-level exempt organization classifiers to review claims involving a net operating loss prior to accepting the claim as filed.
UBI tax positions are often a gray area, and your institution’s specific facts and circumstances may make a difference. Schools and other exempt organizations should understand and document their UBI tax positions to prepare for potential audits and help avoid unpleasant surprises.
Colleges and universities challenged
Tax issues for private schools are often similar to those of the higher education industry. In a previous exempt organization initiative, the IRS challenged UBI tax positions in exams of the multi-year Exempt Organization Colleges and Universities Compliance Project. As a result, a significant number of net loss carryovers were disallowed. The majority of these unrelated business activities were connected to:
- Fitness and recreation centers
- Sports camps
- Facility rentals
- Golf courses
The IRS found that the tax losses from many activities reported as unrelated business income either lacked the requisite profit motive or had expense allocations that were not deemed to be reasonable. An IRS challenge to your institution’s UBI prior tax losses or expense allocation could result in unexpected UBI tax liabilities or disallowance of your net operating losses.
In its final report, the IRS found that organizations were claiming losses from activities that did not qualify as a trade or business, by which UBI must be generated. An activity qualifies as a trade or business only if, among other things, the taxpayer engaged in the activity with the intent to make a profit. A pattern of recurring losses indicates a lack of profit motive.
The IRS disallowed reporting of activities for which the taxpayer failed to show a profit motive. Those losses no longer offset profits from other activities in the current year or in future years.
In many cases, the IRS found instances of improper expense allocation that claimed expenses, which generated losses, were not connected to the unrelated business activity. Organizations may allocate expenses used to carry on both exempt and unrelated business activities, but they must do so on a reasonable basis and the expenses offsetting UBI must be directly connected to the UBI activities.
Having trouble answering the motive question? A recent court case provides helpful factors to determine if an activity is a trade or business.
In Losantiville Country Club v. Commissioner, the U.S. Court of Appeals for the Sixth Circuit found that the exempt organization, which had a long history of unrelated business losses, provided no evidence that their “books and records were kept for the purpose of cutting expenses, increasing profits, and evaluating the overall performance of the operation,” and the organization “cited no concrete evidence that it adopted any new techniques or abandoned unprofitable methods in a manner consistent with an intent to improve profitability.”
And as indicated in the preamble of the final regulations for Section 512(a)(6) of the Internal Revenue Code (the UBI silo rules), “In determining the lack of a profit motive, greater weight is given to objective facts than to a taxpayer’s intent.” The preamble also confirmed that the Treasury Department and the IRS continue to consider and expect to publish additional proposed regulations for UBI regarding reasonable methods of expense allocations.
Talk with your tax advisor to strengthen your institution’s understanding of its UBI tax positions and make sure you’re following the rules.
How we can help
Our nonprofit professionals work with you to review your UBI tax positions, including technical analysis, documentation, and planning, so you can understand and mitigate potential tax risk. Let us help with your homework. Should your school receive an IRS examination, it may help you pass the test.