This article summarizes the highlights of the Final Report concerning the UBIT. Succeeding posts will examine in greater detail the most common compliance errors made by colleges and universities in determining UBTI.

Of the 34 institutions selected for audit, a whopping 90% had increases to UBTI, including more than 180 adjustments representing about $90 million in unpaid taxes. More than one half of the adjustments involved the following activities:

• Fitness and recreation centers and sports camps
• Advertising
• Facility rentals
• Arenas
• Golf courses

The adjustments related not only to the underreporting of income from unrelated trades or businesses but also to excessive losses and net operating losses. Over $600 million losses and NOLs were disallowed on 75% of the examined returns.

 Note: The colleges and universities were selected for examination because responses to their questionnaires indicated potential noncompliance on UBIT issues. Thus, the institutions audited are not a representative sample of all colleges and universities. The Final Report cautions that the results apply only to the institutions examined and should not be generalized as representative of other colleges and universities.

 The most common adjustments made in the examinations involved the following issues:

• Misclassification as a trade or business due to lack of profit motive
• Misallocation of expenses between exempt and nonexempt activities
• Errors in computation or substantiation of NOLs
• Misclassification of unrelated activities as related activities
• Failure to seek professional advice about the treatment of potentially unrelated activities

In Part 2 of this article, we will discuss how an exempt organization might underreport UBTI as a result of misclassifying an activity lacking a profit motive as a business activity subject to the UBIT.

Speaking for the Obama administration today, Treasury Secretary Timothy Geithner proposed reducing the highest corporate tax rate from 35% to 28% (25% for manufacturing). The proposal would also do away with some corporate tax deductions and subsidies to compensate for the lost tax revenues. Leading Republican presidential candidates have called for even lower corporate tax rates. Mitt Romney has proposed a 25% top corporate tax rate. Rick Santorum’s plan would reduce the top rate to 17.5%.

 How is the possibility of corporate tax reform relevant to exempt organizations? 

 For exempt organizations other than trusts, unrelated business taxable income is subject to the same tax rates as business corporations under §11. Using the corporate tax rates is consistent with the underlying basis for the UBIT, which is to prevent tax-exempt organizations from competing unfairly with taxable corporations when engaging in similar business activities.

 If any of the proposals for lower corporate tax rates are enacted, exempt organizations will pay less tax on UBTI. Exempt organizations may step up the level of their unrelated business activities if they become more profitable due to lower tax rates. Any organization that increases its unrelated business activities should exercise caution, however, because engaging in excessive unrelated activities may result in loss of tax exemption.

 For exempt organizations organized as trusts, UBTI is taxed at the rate for non-exempt trusts and estates under §1(e). The highest tax rate is 39.6% of taxable income exceeding $7,500. This is the same as the highest tax rates for individuals, although for most individuals the 39.6% rate does not kick in until their taxable income exceeds $250,000. If income tax rates for individuals are also lowered and the reductions are applied to trusts and estates, unrelated business activities of exempt trusts will also become more profitable.

Resources: Obama corporate plan cuts tax rate, shuts loopholes, Reuters (Feb. 22, 2012); §511(a), (b).

How significant is the UBIT? From the perspective of the national budget and the national debt, $594 million in UBIT is a drop in the bucket. From the standpoint of individual exempt organizations, however, whether they are subject to the UBIT is highly significant.

 ● Penalties for ignorance. If the managers of an exempt organization are not aware of the UBIT, they risk bringing in untaxed UBTI over a period of years that may ultimately subject the organization to paying back taxes, interest, and penalties for the noncompliance. Even worse, an organization that carries on excessive unrelated business activities may have it exemption revoked.

 ● Need for professional advice. If an exempt organization sells any product or provides any service to its members or to the public, the organization must determine whether the income from the sales or services constitutes UBTI. The UBIT is packed with terminology, exceptions, modifications, and other matters that make it difficult for management or board members to decide if there is UBTI. Thus, many exempt organizations that engage in business activities need to make their accountants or attorneys aware of the activities and how much income they derive from them.

● Economic pressures. The economic downturn has put pressure on many exempt organizations to finds funds to carry on their exempt activities. Donations have slowed because donors have less disposable income. Moreover, exempt organizations which served the poor are finding increased needs in their communities because of layoffs and other economic factors. In the quest to find funds for their operations, some exempt organizations may be commencing business activities or expanding existing business activities. 

 It is imperative that an exempt organization and its advisors evaluate whether any of the organization’s activities generate UBTI.

See Jael Jackson, Unrelated Business Income Tax Returns, 2007, Statistics of Income Bulletin (Winter 2011).