United States: IRS Advisory Committee Releases Recommendations On UBTI Compliance

Instead of relying exclusively on donations and grants to fund their missions, more tax-exempt organizations are engaging in commercial activities to raise revenues. Common activities include organizing travel tours, publishing magazines, selling insurance products, selling advertisements and operating businesses that are unrelated to the organization's charitable purpose. Tax-exempt organizations generally are required to pay federal income tax on any unrelated business taxable income (UBTI).

UBTI is defined as the gross income derived from any unrelated trade or business regularly carried on by an exempt organization that is not substantially related to the organization's performance of its exempt function, less allowable deductions that are directly connected with the carrying on of the trade or business. 1 Unfortunately, many tax-exempt organizations do not fully understand this definition and repeatedly underreport and underpay taxes on their UBTI – and the IRS has taken notice.

In April 2013, the IRS released its final report summarizing the responses to a questionnaire sent to 400 randomly selected colleges and universities, including questions about 47 activities that could result in UBTI. As part of the same project, the IRS audited 34 of the colleges and universities, which resulted in more than 180 adjustments to the audited returns and an aggregate increase of approximately $90 million in UBTI among the audited institutions. 2 The audits also resulted in the disallowance of more than $170 million in losses and net operating losses, which could amount to more than $60 million in assessed taxes based on the IRS's calculations. 3

Given the IRS's recent focus on UBTI and its concerns about the underreporting of UBTI, the Advisory Committee on Tax Exempt and Governmental Entities (ACT) 4 released a report on June 11, 2014, making recommendations to improve the UBTI compliance of tax-exempt organizations (the "Report"). A summary of these recommendations is provided below.

Adopt the Commensurate Test. Section 1.501(c)(3)-1(c)(1) of the Treasury Regulations provides that an organization will not qualify for tax exemption if more than an insubstantial part of its activities are not in furtherance of an exempt purpose. However, section 1.501(c)(3)-1(e) of the Treasury Regulations provides that an organization may qualify for tax exemption even if it operates a trade or business as a substantial part of its activities if such operation is in furtherance of its exempt purpose and it is not organized and operated for the "primary purpose" of carrying on a trade or business.

Some courts and IRS agents apply a "commerciality test" to determine: (1) what constitutes unrelated business generating taxable income and (2) when certain commercial activity will preclude tax exemption under Internal Revenue Code (the Code) section 501(c)(3). The "commerciality test" disqualifies from exemption an organization that is operating in a commercial manner, for example, by engaging in activities that compete with for-profit entities. The Report recommends that the IRS establish a regulation project to promulgate its long-held position that the "commensurate test," as articulated in Revenue Ruling 64-182, is the appropriate measure.

Under the commensurate test, an organization would not lose its exemption under section 501(c)(3) because it engages in substantial commercial activity as long as the organization's charitable programs are commensurate in scope to its income and financial resources. As support for this recommendation, ACT points to the Corporation Excise Tax Act of 1909, from which the present income tax exemptions are derived, and argues that the statute does not indicate any intention to limit the tax exemption of charities that are engaged in business or to limit the quantum of business activity. Rather, ACT suggests the statute indicates an intention to assure the exemption of charities engaged in businesses.

Issue Formal Guidance. The Report acknowledges that misallocated expenses offsetting unrelated business income is one of the primary reasons for underpayment of UBTI by colleges and universities. For example, nearly 60 percent of the audited Form 990-Ts had misallocated expenses to offset UBTI. 5 Accordingly, the Report recommends that the IRS issue clear guidance on proper methods of cost allocation. Specifically, the Report recommends that the IRS publish a comprehensive revenue ruling that:

  • identifies allocation methods that will be given safe harbor treatment;
  • identifies allocation methods that are per se unreasonable;
  • provides categories of activities that will be considered related and unrelated; and
  • provides scenarios involving activities frequently reported on the college and university questionnaires, such as facility rentals and dual-use properties.

Adopt a New Form 990-T. Based on interviews with various tax-exempt organizations, the Report recommends that the IRS redesign the Form 990-T to achieve the following goals:

  • Heighten education and outreach in the UBTI arena via expanded, detailed instructions.
  • Simplify Form 990-T by including an unrelated business activities checklist that operates as a decision tree, walking organizations through the steps for determining if an activity is an unrelated business.
  • Shorten the length of the return to two or three pages.
  • Provide Yes/No questions to report overall UBTI data.

Additionally, the Report recommends that the new Form 990-T include a web-based interactive worksheet, which would allow organizations to (1) calculate revenues and expenses, and (2) identify reportable unrelated business income per activity. This worksheet would be filed electronically with the IRS, but would not be publicly disclosed.

Enhance Communication, Education and Training. The Report recommends that the IRS continue to improve, update and enhance access to the materials and information available on its website. Specific recommendations include:

  • requiring each tax-exempt organization to submit an email address on IRS Forms 1023 and 990;
  • establishing an online mailbox tool as a primary means of communicating with and disseminating information to tax-exempt organizations; and
  • establishing a webpage for tax professionals with direct links to the relevant statutes, regulations, revenue rulings and procedures, private letter rulings, CPE texts, EO-related IRM, and other IRS information.

Conclusion. In light of the findings contained in the Report, the IRS has stated that it plans to look at UBTI reporting "more broadly," focusing on the misallocation of recurring losses and expenses. This increased focus on UBTI will require tax-exempt organizations and their advisors to understand the rules to avoid an underpayment of tax and the imposition of interest and penalties. The Report's recommendations that the IRS issue formal guidance on UBTI, redesign the Form 990-T, and enhance communication, education and training are steps in the right direction. If adopted, these recommendations would promote greater understanding of and compliance with the UBTI rules and reporting requirements.

Footnotes

1. See IRC §§ 512(a) and 513(a).

2. The Internal Revenue Service, Colleges and Universities Compliance Project Final Report, Apr. 23, 2013 at 11.

3. Id. at 12.

4. ACT is a group of volunteer practitioners, appointed by the Department of Treasury, who advise the IRS on the development and implementation of policy concerning exempt organizations.

5. The Advisory Committee on Tax Exempt and Governmental Entities, supra at 3.

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