*The work plan contains the IRS’s plans to look more closely at unrelated business income and, especially, at tax-exempt organizations that report unrelated business activities on Form 990 but do not file a Form 990-T. The IRS will also develop a model to help them identify organizations that report significant amounts of income from unrelated business activities but show no tax due, even if they are filing Form 990-T. Such organizations may be subject to audit by the IRS. In addition, the IRS has already begun its statutorily mandated task of reviewing the community benefit activities of hospital organizations at least once every three years. Although the reviews are not examinations and are not meant to search for unreported unrelated business income, the review will entail looking at the Forms 990, 990-T, and other accessible information. Therefore, it is a great possibility that a hospital’s unrelated business income and expense allocations will receive more scrutiny than usual.
The new Form 990 has put the unrelated business income tax (UBIT) issue front and center. A snapshot is provided on page 1 of the Form 990 by requiring information on gross unrelated business income (UBI) and net UBI reported on Form 990-T. Further back, on page 9 of the form, revenue is broken down into columns that show whether the income is being characterized as related, unrelated or not reported as UBI because it meets an exception or modification to UBI. Page 9 can be very revealing, especially where the same activity generates both related and unrelated income. For example, this applies to a hospital laboratory that serves both patients (related) and nonpatients (unrelated). Where the unrelated income is being offset by large expenses, this may call into question whether some of the expenses used to offset the unrelated business income are really expenses of the related activity.
The rule is that expenses relating solely to exempt purposes cannot be used to offset unrelated business income; expenses that relate solely to unrelated business activities can be used in full to offset unrelated business income and, when employees, equipment or a facility is used for both related and unrelated purposes (i.e., a dual use), the expenses are supposed to be allocated between the two uses on a reasonable basis. What constitutes a reasonable basis has generally been interpreted by the courts to favor the tax exempt organization, but the IRS believes that some organizations may go too far.
Another issue regarding the use of expenses to offset unrelated business income is whether the losses generated from an activity characterized as unrelated can be used to offset the profits of another unrelated activity. In order to be an unrelated trade or business there are three requirements:
(1) the activity must be regularly carried on;
(2) the activity must be a trade or business; and
(3) the activity must not be substantially related to exempt purposes.
All three requirements are necessary for a conclusion that an activity is an unrelated trade or business that generates unrelated trade or business income or loss. A profit motive is one of the key elements required in order for an activity to constitute a trade or business. If there are losses reported year after year, the requisite profit motive may be lacking. Of course, there could be reasons for generating losses for many years.
Such reasons could apply if the activity is in a start-up mode, actual costs were significantly greater than anticipated or there was less demand for a product or service than was projected. On the other hand, if the activity was budgeted to operate at break-even or a loss because doing so contributed to the organization’s exempt mission, it would appear that the profit motive is lacking or that the activity was actually in furtherance of exempt purposes. In this case, the losses generated cannot be used to offset other unrelated business income that the organization has generated from another activity.
How to prepare? If your organization has UBI and either does not file a Form 990-T or reports negative or no UBI on Form 990-T, you should review the basis of the losses that have been used to offset the unrelated business income and document their validity.
Remember, the rule is that any domestic or foreign organization that is exempt under Section 501(a) of the Internal Revenue Code and that has gross income of $1,000 or more from a regularly conducted unrelated trade or business is supposed to file a Form 990-T.
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*This article originally appeared in BDO USA, LLP’s “Nonprofit Standard (Winter 2012)“. Written by Laura Kalick, JD, LLM, BDO CPA. Copyright © 2013 BDO USA, LLP. All rights reserved. http://www.bdo.com