2015-Issue 26—These weekly commentaries typically deal with corporate and for-profit business issues, but this week we are changing it up and showing some love to the tax-exempt community. Specifically, we discuss the mechanism by which tax-exempt entities are transformed into actual taxpayers, the Unrelated Business Income Tax (UBIT).
First, a brief background on the history of the UBIT, which we suspect many of our readers who are involved with tax-exempt entities are aware of. Prior to 1950, when the UBIT was first introduced, the tax landscape was drastically different, something akin to the Wild West, with tax-exempt entities having the ability to engage in any activity or business operation they selected (related or unrelated), with the only caveat being that the earnings were used for exempt purposes, all the while enjoying full exemption from the federal income tax. As you can imagine, this did not sit well with for-profit businesses, as tax-exempt entities were free to expand their businesses using tax-free profits, whereas their non-exempt competitors were limited to after-tax profits, creating an unfair competition for market share and capital between tax-exempt entities and commercial enterprises.
In 1950, Congress held hearings regarding unfair competition by exempt organizations. One reported abuse involved the ownership of a spaghetti factory by a prominent tax-exempt university. While for-profit pasta makers were subject to the corporate income tax, the university sold spaghetti to the general public free of any tax burden. (Both the prestigious university and prodigious pasta purveyor remain in existence today, but have long since severed their business relationship (C.F. Mueller Co. v. Commissioner, 190 F.2d 120 (3d Cir. 1951).)
Congress wisely realized the inequity to spaghetti makers (and other for-profit businesses) and also saw an opportunity to increase federal income tax revenue, and in so doing enacted the Revenue Act of 1950, the provisions of which levied a tax on “the excess of an organization’s unrelated business net income over $1,000.” Interestingly enough (even as other for-profit taxpayer exemptions have been adjusted for inflation), the $1,000 exemption amount can still be found, 65 years later, on the current IRS Form 990-T, the reporting and filing mechanism for tax-exempt organizations subject to the UBIT. Minor tweaks and refinements to the initial provisions have been made over the years, beginning with the Tax Reform Act of 1969 and continuing with subsequent tax acts, but the underlying principles set forth in the initial legislation remain largely intact. Currently, unrelated business taxable income is governed by IRC Sections 511-513.
As defined in IRC Section 512(a)(1), unrelated business taxable income (UBTI) is equal to:
- The gross income derived from any trade or business regularly carried on (discussed in further detail below);
- Minus the allowable deductions that are directly connected with the carrying on of the trade or business; and
- Computed with the modifications set forth in IRC Section 512(b):
- Items of income that are not associated with a trade or business such as interest, dividends, royalties, rents, and proceeds from the sale of certain property are generally excluded from the tax on UBTI unless such income is derived from debt financing, which is addressed in IRC Section 514.
To constitute an unrelated trade or business, an activity must meet three requirements, as follows (classification of related v. unrelated activities is a hot-button issue for the IRS, and this determination should be well documented):
- The activity must constitute a trade or business: a trade or business includes any activity carried on for the production of income from the sale of goods or the performance of services with the intent to earn a profit.
- The activity must be regularly carried on: whether a trade or business is regularly carried on is determined by reference to the frequency and continuity with which the activities productive of the income are conducted and the manner in which they are pursued. Relevant factors include the typical time span of the activities and whether the activities are engaged in only discontinuously or periodically without the competitive and promotional efforts typical of commercial endeavors.
- The activity must not be substantially related to the organization’s exempt purpose: this requirement is largely based on facts and circumstances of each case, but generally, an “unrelated” trade or business is not substantially related to the exercise or performance of the purpose or function constituting the basis for the organization’s exemption.
A tax-exempt organization may have multiple activities that it considers businesses. For purposes of calculating net taxable unrelated business taxable income, an exempt organization is allowed to aggregate income from one activity with loss from another. However, if the loss activity consistently produces losses year after year, the IRS will likely take the position that the activity is not a business because of the absence of a profit motive, and disallow the loss deduction.
Looking to build on the momentum of the findings from its study of colleges and universities in 2013, which documented the results of 34 college and university audits, the IRS has indicated its plans to continue its focus on UBTI, placing an emphasis on expense allocations, aggregation of multiple unrelated business activities, and partnership investments. In this study, 90 percent of the exams ended with increases to UBTI that included more than 180 adjustments totaling about $90 million.
The Internal Revenue Code allows deduction of expenses from UBTI for all ordinary and necessary expenses incurred in carrying out the unrelated trade or business if the expense is an allowable deduction and directly connected with carrying out the business. Where the tax rules become somewhat subjective is when dealing with “dual use expenses,” which are expenses incurred for both related and unrelated activities (for example, an exempt organization or university renting out facilities to the public). Treasury Regulation Section 1.512(a)-(1)(c) provides that if assets or personnel of an exempt organization are employed both in an unrelated trade or business and in an exempt activity, there must be a “reasonable allocation” with regard to the deduction attributable to such assets or personnel between the two uses. What constitutes a “reasonable allocation” method has been widely debated, and the determination depends on the facts and circumstances of each individual case.
In 2014, the IRS’s Advisory Committee on Tax Exempt and Government Entities (ACT) recommended that the IRS provide formal guidance regarding allocation of indirect costs between exempt activities and unrelated business activities that includes the incorporation of a safe harbor element and clearly identifies allocation methods deemed to be “unreasonable.” (The IRS recently announced that providing further guidance regarding the allocation of expenses for dual use facilities under IRC Section 512 would be a priority for 2015-2016. In addition, the IRS is seeking public comments and suggestions from taxpayers and practitioners. SeeDepartment of Treasury 2015-2016 Priority Guidance Plan, released July 31, 2015.)
Aggregation of Multiple Unrelated Activities
As stated previously, exempt organizations are currently able to offset their net income and “occasional” losses from unrelated activities. One of the more recent proposals, the Tax Reform Act of 2014, sponsored by Rep. Dave Camp, then chairman of the House Ways and Means Committee, eliminates the exempt organization’s ability to offset income and losses from multiple unrelated activities. Organizations would no longer be able to aggregate multiple unrelated trades or businesses and would have to compute their unrelated business taxable income separately for each activity, with only the activities with net income being reported currently. Loss activities would be carried forward for future offset against income from only the activity from which the loss was originally generated, similar to the rules governing publically traded partnerships and master limited partnerships. If ever enacted, this could drastically alter the UBTI and UBIT calculations of organizations engaging in multiple unrelated activities.
This area is not only important for the exempt organization itself, but also for any partnership with institutional or tax-exempt investors. According to the 2014 Instructions for Schedule K-1, Line 20, Code V, if the partner notifies the partnership of its tax-exempt status, “the partnership will report any information necessary to figure unrelated business taxable income under IRC Section 512(a)(1) (but excluding any modifications required by paragraphs (8) through (15) of Section 512(b)).”
In our experience, the methodology used by partnerships to report UBTI to their exempt partners varies greatly. Some partnerships report a single amount on line 20V, while others include separate schedules and data, often requiring additional calculations depending on the determination of whether the organization is “qualified” or “non-qualified” under IRC Section 514(c)(9).
In addition, depending on the nature of the organization’s exemption, the percentage ownership in the partnership and the partnership’s foreign investment activity, the organization may be subject to certain foreign disclosure filing requirements, most notably Forms 926, 8865, 8621 and 5471, which carry significant monetary penalties for noncompliance.
Outside of the IRS standardizing the reporting of partnership K-1’s and the related disclosures, exempt organizations are going to have to rely heavily on their tax department and/or tax advisors to navigate the intricacies of accurately reporting UBTI and any additional filing obligations.
Common Errors and IRS Adjustments
In reviewing exempt organization returns or defending organizations being audited by the IRS, we frequently find these common errors and adjustments:
- UBTI from partnership income is often calculated incorrectly. Many exempt organizations make errors in calculating UBTI from partnerships. This is not surprising since some knowledge of foreign tax credits, oil and gas taxation, and many other complex areas of tax law are needed to calculate UBTI properly. In addition, the Schedule K-1 many not supply all the information needed, necessitating further follow-up with the partnership return preparer.
- Activities are often reclassified as UBTI in IRS audits. Large exempt organizations may have thousands of activities that require a determination of whether the activity is related to the organization’s exempt purpose. The exempt organization’s tax department may not be aware of all activities, or the IRS may disagree with a classification as related or unrelated.
- The Alternative Minimum Tax is often calculated incorrectly. Tax preference items related to UBTI may be difficult to obtain or calculate. In addition, exempt organizations often fail to realize the limitations on usage of net operating loss carryforwards for AMT purposes.
- Activities producing consistent losses are often removed from the UBTI pot, since the IRS will argue that these activities lack profit intent. This may result in the disallowance of many years of net operating loss carryforwards, since the statute of limitations starts when the loss is used, not when it is created.
- The IRS may disallow the expenses allocated to UBTI unless the taxpayer can show a direct relationship to the gross income and a reasonable allocation methodology. Ironically, overly aggressive allocation of expenses with consistent losses often results in complete reclassification of the activity due to a perceived lack of profit intent, while a less aggressive methodology that produces occasional profits may produce carryforward losses.
Alvarez & Marsal Taxand Says:
The determination of whether an activity constitutes UBTI and how expenses are allocated continues to be a source of confusion and controversy, with both exempt taxpayers and the IRS, 65 years after the law was enacted. In addition, charges of unfair advantage are still leveled against tax-exempt organizations in the press or via informants to the IRS. With no clarifying legislation on the horizon, the battle will likely continue at the audit level, with inconsistencies in reporting practices among both exempt organizations and partnerships with exempt partners.
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the US., and serves the U.K. from its base in London. Alvarez & Marsal Taxand is a founder of Taxand, the world's largest independent tax organization, which provides high quality, integrated tax advice worldwide. Taxand professionals, including almost 400 partners and more than 2,000 advisors in nearly 50 countries, grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business.