Laura Kalick is an attorney and consultant to nonprofit organizations at Kalick Law, LLC, in Washington, DC.
Current tax law lets you offset your unrelated business income if your non-mission-related business activities result in a loss. But if you write off those losses, document them carefully: The IRS is watching.
An important part of associations' annual tax-filing ritual is reporting their income from business activities unrelated to their tax-exempt purpose. That income is subject to unrelated business income tax (UBIT). Under current tax law, when those business activities result in a financial loss, associations can use those losses to offset other unrelated business income, reducing their tax liability. However, if a business generates a loss year after year, the IRS may say that there is not a profit motive, and therefore the losses are not legitimate trade or business losses that may be used to offset trade or business income.
Recently, the IRS has started paying more attention to such offsets. Associations that report large amounts of gross unrelated business income but do not pay any UBIT—information that's easily found on the first page of the Form 990—have drawn increased IRS scrutiny. This is particularly true of larger organizations.
Even though the reach of an IRS examination to assess taxes usually extends back only three years, the agency may examine the legitimacy of a net operating loss that has been carried forward and used to offset other unrelated business income for up to 20 years after the loss first arose.
Of course, there may be valid reasons for losses: For example, the business was in startup phase, actual costs were significantly greater than anticipated or budgeted, competitive pressures prevented pricing to allow for full recovery of costs, or demand for the product or service was less than projected. Whatever the reason, in order to preserve those losses as offsets, the association should document the reasons for claiming them, and that documentation should be maintained. It is much easier to build your case supporting the offsets if you have contemporaneous written records.
Tax reform proposals in Congress would reduce the offset benefits that the current tax code allows. A new provision would require that losses from an unrelated trade or business activity could only be used to offset the income from that particular unrelated activity. If such proposals are enacted, they will bring their own set of problems for many organizations. In the meantime, associations should make sure the validity of any net operating loss is well-documented.