The IRS recently issued its final report for the Colleges and Universities Compliance Project, which it kicked off in 2008 with the distributions of questionnaires to 400 randomly selected higher-education institutions. The IRS then selected 34 of those organizations for examination, given their responses on the questionnaires and Form 990 reporting. The results focus in on compliance in two core areas, unrelated business income (“UBI”) and executive compensation, that have important implications for the broader tax-exempt sector. This post will examine UBI findings, and in an upcoming post we’ll go into executive compensation.
As background, organizations that are exempt from income tax (including but not limited to 501(c)(3) organizations) nonetheless can be subject to taxation on income from trade or business activity that that is regularly carried on and is not substantially related to an exempt purpose. There are different modifications and exceptions that can apply in this regime and take income outside the definition of UBI. In addition, organizations that have gross income from unrelated business activities can take certain related deductions that can reduce or eliminate the tax owed.
The IRS examinations of the 34 organizations resulted in an increase in UBTI of about $90 million—and almost all of the selected organizations required adjustments. The reasons for adjustments are as follows:
- Misclassification as a trade or business: the existence of a trade or business is required for income to be unrelated business income, and this requires a profit motive. Here, the IRS used lack of a profit motive to disallow more than $150 million in losses for activities that were being claimed on Form 990-T to offset other income.
- Misallocation of expenses: a trade of business often serves both exempt and unrelated purposes, which means that income and expenses need to be allocated between the two purposes. Here, the IRS found that expenses were being deducted against unrelated business income that properly should have been allocated to exempt purposes (and not deducted).
- Errors in computation or substantiation: this one is fairly self-explanatory; here, the IRS determined that more than $19 million in net operating losses were improperly calculated or substantiated.
- Misclassification of activities: the IRS looked at activities not reported on the 990-T to determine whether they should be classified as unrelated or nonexempt. It ended up reclassifying activities at 40 percent of the examined colleges and universities, resulting in about $4 million in additional taxable income.
Also, in close to half of cases where colleges and universities had sought an outside opinion related to the UBTI issue, the IRS did not agree with the opinion when the issue came up during examination.
Of course, given the implications for increased revenue to the federal fisc, the IRS interest in UBI goes far beyond colleges and universities, and the IRS has already begun to apply findings from its multi-year effort to the broader sector. In the FY 2012 Exempt Organization work plan, the IRS had announced a broader focus on UBI, particularly with respect to organizations that report unrelated business activities but don’t file a Form 990-T, or that do file a 990-T with significant activities but show no tax due. The FY 2013 work plan shows that the IRS efforts in this area already secured about 140 delinquent returns and more than $260,000 in tax payments from organizations that that were examined. Further, the IRS plans to examine a statistically valid sample of exempt organizations reporting substantial gross UBI for three consecutive years but haven’t reported tax—the concern here, as with the colleges and universities discussed above, is that activities may be misclassified, or that expenses may not be properly allocated and deducted.
Organizations should consider taking a step back at this point and looking closely at their activities. If they have unrelated business activities and file 990-T, are they properly figuring expenses and deductions? If they have activities that toe the line of unrelated and are currently not filing a 990-T, should they re-evaluate that activity? All in all, this area has proved to be something of a cash cow for the IRS, and increased scrutiny around UBI is likely the new reality.
Check back next week for our post on the executive compensation findings of the IRS report.