The Impact of Continual Losses on Unrelated Business IncomeJanuary 16, 2014
A deeper look into the IRS report on the College and University Project.
As you know, tax-exempt entities must pay federal and state income tax on income generated from activities unrelated to their tax-exempt mission. In May I wrote a blog noting that the IRS had just completed its College and University Project and in that report they discussed the many errors they found in the reporting of unrelated business income and the calculation of the unrelated business income tax. In this blog, I would like to explore in more detail some of the concepts expressed in the report on the College and University Project.
In order for an activity to be subject to income tax, it must be (1) unrelated to the organization’s tax-exempt mission and (2) it must be a business. Since both of these conditions must be satisfied, I think of this as two ways to exclude an activity from being considered taxable. First I try to determine if the activity can be related to the organization’s tax-exempt mission. Failing to find a relationship between the activity and the tax-exempt mission, I next examine the activity to determine if it is one that is carried on in a business-like manner. Many completely unrelated activities fail to qualify as unrelated business activities because the organization does not operate them in a business-like manner.
For example, in one instance a nonprofit that uses its parking lot on Friday and Saturday evenings to generate revenue from theater goers attending performances across the street did not have to report the revenues earned as unrelated business income because a normal parking lot business operates for more than just a couple of hours on two nights of the week. An activity must qualify as a “trade or business” in order for its income to be considered unrelated business income.
In many organizations, there are a number of unrelated activities generating gross unrelated revenues. Some of these activities operate at a profit and some operate at a loss after allocating all related costs to the activity. In the College and University Project, the IRS found that many of the activities that were generating losses – losses that were used to offset other unrelated profits – were in fact activities that did not qualify as a “trade or business”. An activity qualifies as a “trade or business” if, among other things, the organization is engaged in the activity with the intention of making a profit. A pattern of repeated losses is generally sufficient to show a lack of a profit motive.
Without a profit motive, the activity is excluded from the unrelated business income activities and the loss is not available to offset taxable profits from other unrelated business activities. In the College and University Project, the IRS disallowed more than $170 million in losses which could eventually amount to more than $60 million in assessed taxes. The most common reason for dis-allowance of losses in these exams was that the claimed losses were connected with an activity for which the school lacked a profit motive, as evidenced by years of sustained losses.
We see a number of tax-exempt organizations annually reporting unrelated business activity but also reporting annual losses and large cumulative net operating losses carried forward to future years. We encourage everyone to take a hard second look at the activities that are generating the losses. If the activities have been reporting continual losses year after year, they probably do not qualify as a trade or business and should be removed from the calculation of unrelated business income. This may expose other unrelated activities that are profit making to the unrelated business income tax if their income is no longer going to be sheltered by the loss-generating activities. After the College and University Project, we expect that the IRS will increase their examination and compliance efforts in this area.
If you have multiple activities comprising your Form 990-T Unrelated Business Income reporting, we are happy to help review the activities and your return in more detail. For more information please contact any member of our not-for-profit services group at firstname.lastname@example.org