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.

 1. Dues Paid to Agricultural or Horticultural Organizations

 Agricultural and horticultural organization described in §501(c)(5) are exempt organizations subject to the UBIT. Section 512(d) contains a special rule under which no portion of member dues paid to an agricultural or horticultural organization can be treated as UBTI by reason of benefits or privileges to which members are entitled. The exclusion applies for tax years beginning in 2012 so long as:

•  Payment of dues is a condition of membership; and
• The required annual dues do not exceed $151.

 When 512(d) was enacted in 1996, effective for tax years beginning after Dec. 31, 1986, the dollar limitation was $100. The limitation has been adjusted for inflation for taxable years beginning after 1995. Section 3.24 of Rev. Proc. 2011-52 provides that the inflation-adjusted amount for 2012 is $151. For tax years beginning in 2011, the §512(d)(1) limitation was $148.

 2) Limitation for Contributions Solicited Using Low Cost Articles

 Charitable organizations sometimes solicit contributions by mailing out low cost items to potential donors, hoping that receiving the items will spur the individual to make a contribution. Because the sale of goods constitutes a trade or business, contributions received in connection with mailings of low cost articles might be considered a taxable sale of the items by the organization to the extent of the value of the items. To prevent this result for inexpensive items, §513(h) provides that activities relating to the distribution of low cost articles are not an unrelated trade or business if the distribution is incidental to the solicitation of charitable contributions. For taxable years beginning in 2012, a low cost article is an item that cost the organization $9.90 or less.

 When §513(h) was enacted in 1986, the exception applied to low cost articles of $5.00 or less. That number has been indexed for inflation since 1988. Section 3.25(1) of Rev. Proc. 2011-52 provides that the inflation-adjusted amount for 2012 is $9.90. For tax years beginning in 2011, the §513(h) limitation was $9.70 or less.

 Resources: Rev. Proc. 2011-52, 2011-45 I.R.B. 70; Rev. Proc. 2010-40, 2010-2 C.B. 663.

 If an exempt organization earns income from the use or sale of debt-financed property, income or gain from the sale of the property is subject to the UBIT to the extent the property is financed. Under an exception called the neighborhood land rule, land acquired for future exempt use may be excepted from classification as debt-financed property for a10-year period (15 years for churches). The rule allows an exempt organization to use land purchased for prospective exempt use in a nonexempt activity pending conversion of the property to the exempt use. Meanwhile, income from the property, such as rents, is not subject to the UBIT.

 Note: The neighborhood land rule applies only when an exempt organization acquires property for future exempt use. Once the property is converted to an exempt use, it is not debt-financed property because of another exception for property used in an exempt purpose.

 The neighborhood land rule does not apply after the first five years from the acquisition date unless the organization shows that the property is reasonably expected to be used in an exempt function within the applicable period. Such a showing is made in a ruling request filed at least 90 days before the end of the fifth year. In PLR 201205018, the IRS ruled that the church was eligible to take advantage of the final 10 years in the 15-year period.

 The following factors convinced the IRS that the exempt use was reasonably expected before the termination of the 15-year period:

● The organization demolished structures that were on the land when acquired.

● The organization had incurred substantial expenses for engineering, design, construction, documentation, infrastructure, and more.

● Several new church facilities were already constructed on the land, including a worship center, a children’s facility, classrooms, and parking lots.

● The congregation was already using the completed facilities.

● Additional planned improvements were expected to take an additional (unspecified) time period not to exceed 10 years.

● The former church property was listed for sale.

See §514(b)(3); §1.514(b)-1(d).