Safeguarding UBI Deductions

Safeguarding UBI Deductions

Article posted in Compliance on 28 August 2013| comments
audience: National Publication, Dennis Walsh, CPA | last updated: 13 May 2014
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Summary

The Internal Revenue Service multi-year Colleges and Universities Compliance Project (CUCP) final report was issued in April 2013 and resulted in increases to unrelated business taxable income for 90% of the colleges and universities examined. In this article, PGDC contributing author Dennis Walsh, CPA continues his examination of this report by discussing the definition of a "trade or business" that gives rise to the unrelated business income tax along with steps organizations engaged in such activities should take to minimize their tax exposure.

By Dennis Walsh, CPA

The Internal Revenue Service multi-year Colleges and Universities Compliance Project (CUCP) final report was issued in April 2013. Findings regarding executive compensation and unrelated business income (UBI) practices from among the 400 institutions surveyed and 34 audited are useful from both a compliance and planning standpoint. 

Exempt organizations engaged in activities that generate income with current or potential UBI treatment may find it timely to review UBI characteristics and consider how the results might influence future IRS EO work plans and resultant audit risks.

Certain UBI audit deficiencies cited in the final report also provide valuable insight for preserving the income tax benefit available from business operating losses incurred in UBI activities.  Organizations that operate, or plan to operate, multiple activities may find this discussion particularly useful.

Key UBI findings

As summarized in the final report, UBI examinations resulted in:

  • Increases to unrelated business taxable income (UBTI) for 90% of the colleges and universities examined
  • Nearly 70 percent of examined organizations reporting losses from activities for which expenses had consistently exceeded UBI for many years and where the organization failed to show a profit motive
  • Disallowance of more than $170 million in Net Operating Losses (NOLs), including loss carryforwards, amounting to more than $60 million in assessed taxes

In addition, expense deductions were disallowed on more than 60 percent of the Form 990-Ts examined because they were based on improper allocations between exempt and unrelated business activities.  Although not the subject of this article, shared costs of conducting UBI activities, including costs of dual-use facilities, must be reasonably allocated among UBI activities and between related and unrelated activities.

For an organization to be engaged in an unrelated trade or business activity as defined in IRC § 513, the activity must:

  • Qualify as a trade or business
  • Be regularly carried on, and
  • Not be substantially related to exempt purposes

The remainder of this article focuses on issues attendant to the first of these three requirements. 

Trade or business

For purposes of IRC § 513, the term "trade or business" has the same meaning it has in IRC § 162, and generally includes any activity carried on for the production of income from the sale of goods or performance of services.  Thus, the term trade or business is not limited to integrated aggregates of assets, activities, and goodwill which comprise businesses for the purposes of certain other provisions of the Code.

Activities of producing or distributing goods or performing services from which a particular amount of gross income is derived do not lose identity as trade or business merely because they are carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purposes of the organization.  Treas. Reg. § 1.513–1(b).

Net operating loss

Unrelated business taxable income (UBTI) is the UBI that is taxable after deducting expenses directly connected to a trade or business.  Because UBTI is calculated by totaling the UBI from all activities and subtracting the total allowable deductions, losses from one activity can offset profits from another. 

Under IRC § 172, a net operating loss from a trade or business activity may normally be carried back 2 years and carried forward up to 20 years in order to offset net income realized in other years.  The NOL carryback or carryover from a taxable year for which the organization has UBTI is determined under IRC § 172 without taking into account any amount of income or deduction which is not included in computing UBTI.  Thus, a current or carryover NOL is not diminished by income from activities related to exempt purposes or other forms of income specifically excluded from UBI, such as investment income.

In determining the span of years for which a net operating loss may be carried back or forward, the intervening taxable years for which the organization is not subject to tax on UBI must be taken into account.  Treas. Reg. § 1.512(b)–1(e)().  Thus, the fact that an organization does not realize UBTI in one or more intervening years does not extend a carryover period.

In the CUCP audits, the IRS examined all NOLs reported on returns and found that on more than a third, NOLs were either improperly calculated or unsubstantiated. 

Profit motive

For deductions to be allowable under IRC § 162, an activity must be entered into with a profit motive.  The most common reason for disallowance of losses and NOLs in the CUCP audits was that claimed losses were connected with an activity for which the school lacked a profit motive, as evidenced by years of sustained losses.

Organizations were asked, for each income producing activity regardless of whether reported on Form 990-T, if they incurred a loss from the activity in at least 3 of the 5 previous years.  For activities with a “yes” answer, respondents were then asked to select from among the following as the predominant reason for the losses:

  • Business was in startup phase
  • Actual costs were significantly greater than anticipated
  • Competitive pressures prevented pricing to allow for full recovery of costs
  • Less demand for product or service than was projected
  • Business was in business cycle downturn
  • Budgeted to operate at breakeven or a loss because doing so contributed to the organization’s exempt mission
  • Business was in winding-up phase
  • Other

Organizations were also asked whether, for each loss activity, they have plans for making a profit.

Although the rules under IRC § 183, limiting deduction of losses from activities not engaged in for profit, are not applicable to exempt organizations with UBI activities, it is noteworthy that the IRS asked whether a particular activity incurred a loss in at least 3 of the 5 previous years as a benchmark for asking for the predominant reason for the losses and if there are plans for making a profit.  IRC § 183(d) provides a presumption that a trade or business is engaged in for profit if it reports a profit in at least 3 years out of a consecutive 5 year period.

While this Code Section applies to trades or businesses of individuals and S corporations, the accompanying regulations provide characteristics of an activity engaged in for profit that may be helpful in assessing an activity and substantiating profit motive.  The following items, summarized from Treas. Reg. § 1.183-2(b), are among the types of factors considered:

  • Activity carried on in businesslike manner
  • Accurate and complete books and records kept
  • Carried on in manner similar to like profitable activities
  • New methods to improve profitability are adopted
  • Taxpayer or advisors hold sufficient expertise
  • Advance study of activity was conducted
  • Significant time and effort is expended
  • Expectation of increase in asset value
  • Success in carrying on similar or dissimilar activities
  • Profit/loss history of activity, considering losses sustained for reasons beyond taxpayer’s control
  • Profits earned relative to cumulative losses and investment in activity
  • Dependence on income from the activity
  • Reasons for entering the activity indicate profit motive

Defining an activity

In order to determine whether a trade or business is carried on for profit, activities must be initially grouped in a reasonable manner representing appropriate economic units.  Whether multiple income-producing endeavors are viewed separately or aggregated and viewed as one or more activities affects whether deductions resulting from activities lacking profit motive and reporting losses may be offset against income from activities reporting net income. 

To the extent that individual undertakings form an appropriate basis for a single activity, net income will be measured for the activity as a whole.  The determination of whether an activity is engaged in for profit is then made without reference to the profitability of separate undertakings within the activity.  An undertaking is the smallest unit that can constitute an activity.

Careful analysis of income producing endeavors may also be required to carve trade or business activities from within core exempt functions.  As stated earlier, income derived from the sale of products or the performance of services does not lose identity as a trade or business because it is carried on within a larger aggregate of similar activities which may, or may not, be related to exempt purposes.

Thus, for example, the regular sale of pharmaceutical supplies to the general public by a hospital pharmacy does not lose identity as a trade or business merely because the pharmacy also furnishes supplies to the hospital and patients of the hospital in accordance with its exempt purposes.  Similarly, activities of soliciting, selling, and publishing commercial advertising do not lose identity as a trade or business even though the advertising is published in an exempt organization periodical.  Treas. Reg. § 1.513-1(b).

In defining a trade or business activity under IRC § 513, guidance provided in the IRC Sec. 183 Regulations, along with Regulations under IRC Sec. 469, regarding the grouping of trade or business activities for purposes of the passive loss rules, provides helpful insight as to the type of factors the IRS might use in evaluating whether an activity comprised of more than one undertaking may be appropriately classified as a single trade or business. 

Generally, the most significant factors in making this determination follow:  Treas. Reg. § 1.183-1(d)(1).

  • The degree of organizational and economic interrelationship of various undertakings
  • The business purpose which is (or might be) served by carrying on the various undertakings separately or together in a trade or business or in an investment setting
  • The similarity of various undertakings

The Regulation provides that the IRS will generally accept the characterization by the taxpayer of several undertakings either as a single activity or as separate activities, except where it appears that it is artificial and cannot be reasonably supported under the facts and circumstances.

The importance of defining a trade or business activity appropriately is further borne out by the following sentence from the Regulation:  "If the taxpayer engages in two or more separate activities, deductions and income from each separate activity are not aggregated either in determining whether a particular activity is engaged in for profit or in applying section 183.”  Note the more general application of this statement.

The following criteria from Treas. Reg. § 1.469-4(c)(2) are also helpful in sorting through facts and circumstances in grouping trade or business activities: 

  • Similarities and differences in types of trades or businesses
  • Extent of common control
  • Extent of common ownership
  • Geographical location
  • Interdependencies between or among activities

Examples of such interdependencies include the extent to which the activities:

  • Purchase or sell goods between or among themselves
  • Involve products or services that are normally provided together
  • Have the same customers
  • Have the same employees
  • Are accounted for with a single set of books and records

Takeaways

Exempt organizations frequently operate income producing activities unrelated to their exempt purposes. Management may consider such endeavors important to the success of other activities or to mission sustainability as funding sources. 

However, not all unrelated activities demonstrate profit motive required for UBI treatment, limiting an organization’s ability to apply operating losses against net income from qualifying trades or businesses. Accordingly, organizations should define and group activities carefully, and be able to defend aggregation of undertakings as a single trade or business where appropriate.

Management should also be intentional about operating UBI activities in a business-like manner pursuant to a business plan and documenting decisions designed to improve profitability in organization minutes. Accurate records supporting reasonable cost allocation and NOL related computations must be maintained. Taken together, these actions will help reduce the likelihood of disallowance of business deductions resulting in costly assessments of taxes and interest.


About the Author

Through The Micah Project, Dennis Walsh, CPA serves as a volunteer consultant to religious workers and exempt organizations, focusing on financial management, legal compliance, and organizational development. A graduate of the University of Wisconsin, he completed the Duke University certificate program in nonprofit management and is a member of the North Carolina Association of CPAs and the American Institute of CPAs.

Dennis is the author of “Legal & Tax Issues for North Carolina Nonprofits” and has written for various nonprofit publications. He actively volunteers with the Guilford Nonprofit Consortium, the Not-for-Profit Committee of the NCACPA, and for the accounting assistance program of the North Carolina Center for Nonprofits.

Mr. Walsh can be reached at nonprofitcpa365@gmail.com.

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