ELITE ADVISOR BEST PRACTICES
Safeguarding UBI Deductions - Part two
The IRS is taking a tougher stance on the unrelated business income activities of tax-exempt organizations. Advisors can take these steps to help exempt clients minimize their tax exposure.
By Dennis Walsh, CPA
- 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 businesslike manner pursuant to a business plan and about documenting in organization minutes the decisions designed to improve profitability.
Portions of this article were first published by The Planned Giving Design Center, the world’s largest community of planned giving professionals.
As we discussed last time, more and more tax-exempt organizations are paying higher taxes on their unrelated business income. For an organization to be engaged in an unrelated trade or business activity as defined in IRC § 513, the activity must (a) qualify as a trade or business; (b) be carried on regularly; and (c) not be substantially related to exempt purposes.
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 are 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 that 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 cause its loss of 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 cause loss of 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 § 183 regulations, along with regulations under IRC § 469 regarding the grouping of trade or business activities for purposes of the passive loss rules, provide helpful insight as to the types of factors the IRS might use in evaluating whether an activity consisting 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), including:
- 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
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 businesslike manner pursuant to a business plan and about documenting decisions (in organization minutes) that are designed to improve profitability. Accurate records supporting reasonable cost allocation and NOL-related computations must be maintained. Taken together, these actions will reduce the likelihood of disallowance of business deductions resulting in costly assessments of taxes and interest.