ELITE ADVISOR BEST PRACTICES
Safeguarding UBI Deductions - Part One
Here are steps that advisors can take to help exempt clients minimize their tax exposure.
By Dennis Walsh, CPA
- Exempt organizations frequently operate income-producing activities unrelated to their exempt purposes.
- Not all unrelated activities demonstrate profit motive required for unrelated business income (UBI) treatment, limiting an organization’s ability to apply operating losses against net income from qualifying trades or businesses.
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 exempt organizations work plans and resultant audit risks.
If you have clients that are exempt organizations, keep in mind that certain UBI audit deficiencies 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 last year’s Internal Revenue Service multiyear Colleges and Universities Compliance Project (CUCP) final report, UBI examinations resulted in:
- Increases to unrelated business taxable income (UBTI) for 90 percent of the colleges and universities examined
- Losses reported by nearly 70 percent of examined organizations 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 constitute businesses for the purposes of certain other provisions of the Internal Revenue 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 that 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 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 two 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 that 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.
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 organization 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 three of the five 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.
- There was less demand for product or service than projected.
- Business was in business cycle downturn.
- Business was budgeted to operate at breakeven or a loss, because doing so contributed to the organization’s exempt mission.
- Business was in winding-up phase.
Organizations were also asked whether, for each loss activity, they had 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 three of the five previous years as a benchmark for asking for the predominant reason for the losses and whether 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 three years out of a consecutive five-year period.
While this IRC 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.
Exempt organizations should define and group their activities carefully and should be able to defend the aggregation of their undertakings as a single trade or business where appropriate. Management should also be intentional about operating UBI activities in a businesslike manner pursuant to a business plan and about documenting decisions (in organization minutes) that are designed to improve profitability. In the next part of this series, we’ll look at how smart organizations define their activities and distinguish interdependence.