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IRS Inspects Reporting of Unrelated Business Income

December 19, 2014

Pay close attention to how you calculate tax on unrelated business activities, the IRS is watching!

As a result of IRS speculation that many nonprofits may be improperly reporting losses concerned with unrelated business activities and accordingly, might not be paying unrelated business income tax (UBIT), the IRS has recently conducted 30 audits.

Unrelated Business Income Tax

Here’s an example of what is considered unrelated business income. If the purpose of your nonprofit is dedicated to providing tutoring services to children with disabilities, and you also run a bakery open to the public to acquire additional funds, the bakery is considered unrelated. The unrelated business income that exceeds over the allowable deductions is subject to UBIT.

Directly connected expenses- These expenses are costs that would be nonexistent if the side business did not exist, and they are allowed as deductions against unrelated income.

“Dual use” expenses- Costs used to both further the overall nonprofit mission, and run an unrelated business or activity are called dual use expenses. So, let’s say that the nonprofit president of tutoring/bakery organization gets paid $80,000 per year, and he spends 90% of his time on the nonprofit mission, and 10% on the bakery.

The nonprofit can take a 10% deduction of the $80,000 ($8,000) - a deductible cost of unrelated activity on form 990-T.

For situations where the allocation is not as clear as this example, the nonprofit has to pinpoint the specific expenses the business incurs for the dual purpose. Two methods can be applied to allocate these expenses- two ratios known as the Rensselaer and IRS methods.

  • Rensselaer Method- This figure is based on the number of days the unrelated business takes up the facility (numerator) in relation to the number of days for all business purposes (denominator). This is generally favored among nonprofits because more costs are allocated to unrelated business.
  • IRS Method- This figure relates the number of days the facility is used for the unrelated business activity (numerator) to the number of days the facility is open for use.

Documentation is crucial!

It is vital to document all business activities in any situation, but be sure to produce support for all deductions you are making. Time sheets are useful for tracking the percentage of an employee’s salary that is able to be allocated to unrelated business. You need logic and support behind every allocation. If expenses are inaccurately reported, the IRS may charge penalties (20% of underpaid tax). In addition, keep in mind that the form 990 will note any inconsistencies and is a public documents so be sure all of the information included is accurate and complete.

Questions? Contact any member of our Not-for-profit Services Team.

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