Laura Kalick, JD, LLM, is director of nonprofit tax consulting at BDO in Bethesda, Maryland.
Do you know what expenses can used to offset unrelated business income? You should.
Q: What expenses can be used to offset unrelated business income?
A: Expenses, depreciation, and similar items attributable solely to the conduct of unrelated trade or business are considered "proximately and primarily" related to that business activity. Therefore, such expenses are deductible in full in computing the unrelated business taxable income (UBTI) of an association. Other expenses are incurred solely in furtherance of exempt purposes—such as expenses related to an educational program—and cannot be used at all to offset unrelated business income. Where expenses, such as personnel or facilities, are incurred in both related and unrelated businesses, a reasonable allocation of the expenses must be made so that unrelated business income is not being offset by expenses that are incurred to further the exempt purposes of the organization.
The IRS has been focusing on the allocation of expenses to unrelated business income. For the first time, page one of the new Form 990 provides a quick comparison of gross unrelated business income reported on the form and the net UBTI reported on Form 990-T. The IRS is concerned that tax-exempt organizations, including associations, have underreported taxable income by allocating expenses from related activities and activities that constantly generate losses or deducting items that are not deductible for tax purposes. For example, only 50 percent of business meals are deductible for tax purposes, and nonqualified deferred compensation is not deductible for tax purposes.
For an expense to be considered an unrelated trade or business expense, it must be from an activity that is unrelated to the association's exempt purposes and from an activity that is regularly carried on and constitutes a trade or business. The IRS and the courts take the position that in order to be a "trade or business," there must be a profit motive. (See Portland Golf Club, 497 US 154.) If there are losses from the activity on a continual basis, the IRS and the courts have taken the position that there is no profit motive and therefore the trade or business requirement has not been met. For instance, if an association manages related associations and generates losses from the activity year after year, there may not be a profit-making objective for the activity. However, if those losses are used to offset unrelated trade or business income from a profitable activity, the IRS may disallow the use of these offsetting losses.
There may be a legitimate reason for the losses, such as the business being in a start-up phase, actual costs were significantly greater than anticipated or budgeted, the business was in business-cycle downturn, or the business was in winding-up phase. As part of the IRS Colleges and University Compliance Project (See IRS Form 14018 [9-2008]), the IRS is studying unrelated business income and expenses. The survey attempts to identify various situations where these institutions have losses from activities for three of the five previous years. Also, the survey asks what the basis is for the allocation of expenses between related and unrelated uses. For example, was it based on gross receipts from a facility, actual time used, time available, or other?
The Income Tax Regulations provide that more than one allocation method may be reasonable and may not have to be the best. Until this regulation has been changed, the IRS has taken the position that it will not litigate to prove that a particular method is not unreasonable since it lost a major battle on this issue (See Rennselaer Polytechnic [1987-014, 6/29/1987]). If an organization is a 501(c)(3) organization with tax-exempt bond-financed facilities, the allocation issue can be especially problematic. IRC 145 provides that an IRC 513 unrelated trade or business use is not a qualified use for purposes of the private-activity bond rules. If an organization allocates a portion of a building to unrelated business activity, that is documentation on the tax return regarding the use of the proceeds that may be inconsistent with the bond documents.
Not only is it important to accurately account for unrelated business income, but it is just as important to accurately account for unrelated trade or business expenses.
Laura Kalick is director, nonprofit tax consulting, at BDO in Bethesda, Maryland. Email: firstname.lastname@example.org