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.

 Section 501 expressly recognizes that concept of tax-exempt organizations being subject to taxation. Exemption from taxation is provided under §501(a) for organizations described in §501(c), §501(d), and §401(a). These organizations are charities and 28 other categories of organizations described in §501(c), religious and apostolic organizations described in §501(d), and qualified retirement plans described in §401(a).

 Section 501(b) states that an organization exempt from taxation under §501(a) is subject to tax as provided in parts II (taxes on private foundations), III (the UBIT), and VI (taxes on political organizations) of subchapter F. Notwithstanding parts II, III, and VI of subchapter F, however, such an organization is “considered an organization exempt from income taxes for purposes of any law referring to organizations exempt from income taxes.”

 The Tax Court recently considered this seemingly straightforward Code provision in Research Corporation v. Commissioner, 138 T.C. No. 7 (2012). 

Research Corporation, founded in 1912, was an exempt charitable organization that had paid UBIT for five years of its existence. The organization established a qualified retirement plan for its employees in 1961 and terminated the plan in 2002. Part of the fund was transferred to a successor fund and the balance was distributed to the organization. The IRS gave the organization a private ruling stating that the reversion did not constitute UBTI. The question addressed by the Tax court was whether the organization was liable for a 20% excise tax under §4980(a) on the qualified plan assets distributed to itself. Section 4980(c)(1)(A) expressly provides that the excise tax does not apply if the employer “has, at all times, been exempt from tax under subtitle A…” Because subtitle A of the Code contains the income taxes provisions, the reference in §501(b) to “organizations exempt from income taxes” is the same as the reference in §4980(c)(1)(A) to “exempt from tax under subtitle A.”

 Research Corporation muddied the waters by paying a portion of the excise tax equal to the percentage of the UBTI it received during its existence over its total income. Thus, on a distribution of $4,411,395, the organization calculated a proportionate distribution of $14,055 and paid an excise tax of $2,811. The IRS sought to collect $879,468 in additional tax and a penalty on the entire amount distributed to the organization.

 Given the language of §501(b) and §4980(c)(1)(A), there does not appear to be an issue here. Both the Research Corporation and the Commissioner were in error. In fact, because the organization has always been exempt from income taxes, its plan was excluded from the scope of qualified plans subject to the excise tax. Seemingly grasping at straws, the IRS argued that, because the UBIT is imposed under subtitle A and further because the organization had paid the tax on five occasions during its existence, then the organization was not exempt from tax under subtitle A. The Tax Court held that §501(b) was clear and unambiguous and that the organization did not owe the excise tax.

 For a detailed discussion of the Tax Court’s opinion in Research Corporation, see Pension Plan Terminations for Exempt Organizations with Unrelated Business Income by James R. Malone, Jr.

It is no surprise that the IRS has identified UBIT compliance as a priority for 2012. With government funding and private donations decreasing during the recession years, exempt organizations reportedly stepped up unrealted business activities to supply needed revenues. Also, the redesigned Form 990, Return of Organization Exempt from Income Tax, effective in 2008, now provides the IRS with information it can use to identify exempt organizations which are engaging in activities that may generate UBTI. Form 990-T, Exempt Organization Business Income Tax Return, is used to report the UBIT.

 In its 2011 Annual Report & 2012 Work Plan, released on February 8, 2012, the Exempt Organizations section of Tax Exempt and Government Entities announced that it would use the information on Form 990 for UBIT compliance to identify organizations that reported unrelated business activities on Form 990 but did not file a Form 990-T. In addition,the IRS proposes to analyze Form 990-T data to develop risk models to identify organizations that consistently report significant gross receipts from unrelated businesses but also report no tax due. Cryptically, the Work Plan also states that the IRS will use its analyses of the Forms 990 and 990-T “in connection with a coming UBIT project.” 

 How Can the IRS Use Information Reported on Form 990 to Enforce the UBIT?

 Section VIII of Form 990 requires an exempt organization to list all sources of revenue for the taxable year. Line 2 is for program service revenue, which is revenue received by the organization in carrying out its exempt purposes. The top five largest sources of program service revenue are identified in lines 2a through 2e; all other program services revenue are lumped together on line 2f. Lines 6 through 10 refer to specific income-producing activities, such as rentals, sales, fundraising, and sales of non-inventory assets. Miscellaneous revenues are entered on line 11.

 Entries on lines 2a through 2f and lines 11a through 11d must be accompanied by a business code. Common business codes are found in Appendix J to the Instructions for Form 990. A more detailed list of business codes is set forth on the North American Industry Classification System (NAICS) website. For example, a museum that operates a gift shop would list the gross receipts from the gift shop and specify a business code of 453220 — Gift, novelty, and souvenir stores.

Furthermore, Form 990 requires an exempt organization to indicate the extent to which the amount of each business income entry is:

 ● Related or exempt function revenue

● Unrelated business revenue

● Revenue excluded from tax under §§512, 513, or 514

 Part IX of Form 990 requires a statement of functional expenses. For each category of expenses, an organization must indicate how much represents program service expenses, management and general expenses, or fundraising expenses. Somewhat unexpectedly, at least some expenses associated with unrelated business activities are reported under the column for program service expenses.

 By examining an exempt organization’s Form 990, the IRS can easily tell whether the organization reported receiving income subject to the UBIT by looking at column (C) of Part VIII. The IRS can also identify by column (D) the amount of income that the organization believes is excluded from the tax under §§512, 513, or 514. In contrast, in the Statement of Expenses in Part IX, expenses attributable to unrelated business activities are not specifically delineated. If an organization reports substantial income from unrelated business activities on Form 990 but does not file a Form 990-T, or files a Form 990-T but reports no tax due, the inconsistency will likely raise a red flag if the IRS follows the 2012 Work Plan.

For a discussion of other IRS priorities for 2012 involving exempt organizations, see Ellis Carter, IRS 2012 Work Plan — What’s New for Nonprofits.

• Education about the UBIT in general
• Specific direction on business activities the organization already conducts
• Contact person to consult before engaging in new business activities
• Policy to notify the organization’s attorney or accountant regarding proposed new business activities that might generate UBTI  

Awareness. As with so many other things, the first step in UBIT compliance is awareness. In this regard, the term “tax-exempt” organization is misleading. Particularly with smaller exempt organizations, trustees and employees may interpret “tax-exempt” literally to mean that their organization does not have to pay taxes — ever. This notion may be reinforced if the organization is exempt from state income, sales, and property taxes. Unless they are aware of the UBIT, exempt organization personnel have no reason to examine or report particular income-generating activities.

Education about the UBIT starts at the top. All trustees, directors, officers, and managers should be aware of the tax and its basic elements. Those who manage the organization in its day-to-day activities generally require more familiarity with the specifics of the tax. Responsibility for UBIT compliance may be delegated to a tax department or controller.

Example: At New York University, the Controller’s Division provides tax services, including tax compliance. In an Office of General Counsel Memorandum entitled Unrelated Business Income Tax, dated February 15, 2012, NYU’s general counsel explains the UBIT and common sources of UBIT in an understandable three-page document. The memorandum encourages employees to seek advice from the General Counsel’s Office and to report all UBTI to the Tax Division of the Controller.

Example: The Tax Compliance Office of Southern Illinois University maintains a Tax Guide for Academic and Administrative Departments. The Guide contains a lengthy discussion of the UBIT, including the basic requirements, exceptions, common activities that raise UBIT concern in the university context, special rules for corporate sponsorships, computation of the UBIT, and filing requirements. The UBIT discussion concludes by stating that it is “critical” for university departments to conduct a “methodical and comprehensive review” of all their income-generating activities and giving names of university contact persons.

Guidance to personnel. If an exempt organization already conducts unrelated business activities, specific guidance on how the tax applies to those activities should be accessible to those involved. One of the most common unrelated business activities is the sale of advertising. Many exempt organizations publish newsletters containing paid advertising. Advertising income is almost always taxable. Thus, employees who prepare a newsletter need to be aware of the treatment of advertising income so they can keep accurate records of the expenses and employee time expended for soliciting and publishing advertising.

Example: A good example of providing specific information about existing or potential unrelated business activities is an information document on Baylor University’s website entitled Unrelated Business Taxable Income (UBTI). The Tax & Compliance Accounting department explains that activities which are “in line with” the university’s exempt purposes are not taxed, but that activities which are not related to its exempt purposes may be subject to the UBIT. Then the document lists the three basic requirements for operation of the UBIT: trade or business; regularly carried on; and not substantially related. Following are links to various activities that might generate UBTI in the university setting, including Advertising Income, Bookstore Operations, Concession Sales, Participation in Partnerships, Professional Entertainment Events, and Use of Facilities by the General Public. For each topic, the university provides succinct explanations about how the UBIT applies, including relevant case law and IRS rulings. Under Advertising Income, for example, the document explains how income from advertising in student publications may not be subject to the tax, citing both a treasury regulation and a technical advice memorandum.

Advisors’ Role. Advisors to exempt organizations need to familiarize themselves with the UBIT and specifically about UBIT issues that have arisen in the activities of organizations similar to the ones they advise. For example, the UBIT applies more leniently to churches. Thus, advisors to churches (including temples, mosques, and the like) need to be familiar not only with UBIT basics but also with the special rules for churches. Similarly, special rules apply to social clubs and voluntary employees’ beneficiary associations (VEBAs) under which they are exempt from the UBIT only on income from members and income set aside for charitable purposes. Advisors to social clubs and VEBAs need to make the organizations aware that they are taxed on their investment income and income from nonmembers.

Best compliance results can be obtained when exempt organization employees are trained to run any new income-producing activities by the UBIT contact person.

Example: In a web page entitled Unrelated Business Income Tax, Oakland University explains that new activities at the university are reviewed by the Tax Compliance section of the Controller’s Office. Employees are warned that UBIT issues are highly dependent on the particular facts and circumstances and encouraged to contact the Tax Compliance section with any questions.

Although the exempt organizations discussed in the examples are universities with administrative resources to handle UBIT issues, even smaller exempt organizations can formulate an effective UBIT compliance plan. With help from their advisors, exempt organizations can educate their personnel and establish procedures for examining and reporting income-producing activities.