Industry Insights

IRS Focuses on Unrelated Business Income for 2012

August 2012

Treatment of unrelated business income (UBI) is a significant focus for the IRS, according to its 2012 Exempt Organization Work Plan. There are two red flags that will spawn reaction:

  • If unrelated business activities are reported on Form 990 and no Form 990-T is filed, the IRS will be looking for an explanation.
  • If the Form 990-T shows significant gross receipts from UBI activities but declares no tax due, the IRS will take a closer look.

UBI has long been an area of scrutiny for the IRS, but it has bubbled to the surface through the College and University Compliance Project of 2008. This compliance initiative had several focuses, one of which was UBI. The IRS uncovered varying treatment and approaches and, as a result, wants to examine UBI in all contexts.

UBI is income from a trade or business regularly conducted by an exempt organization and not substantially related to the performance by the organization of its exempt purpose or function, except that the organization uses the profits derived from this activity.

Common sources of UBI for higher education institutions include debt-financed rental, bookstore sales, restaurant operations and research grants. These operations may be a useful means of raising funds, recruiting or generally supplying activities for students, faculty, alumni and visitors. However, the IRS may view the activity as unrelated to the organization’s exempt purpose and engaged in for a profit.

Form 990-T is used to report UBI and assess taxes associated with these activities. This form should be filed if activities generate more than $1,000 in income. In addition, Form 990-T is granted an automatic six-month extension when Form 990 is granted a three-month automatic extension, with an extra three months available. It is possible, then, to file Form 990 before Form 990-T is due.

Part V of Form 990 asks two questions related to the filing of Form 990-T:  Did the organization generate more than $1,000 in UBI, and did it file Form 990-T? If the answers are yes and no, respectively, the IRS will want an explanation on Schedule O. Schedule O is deemed the overflow schedule by the IRS and can be used to provide additional information and clarification for answers on Form 990 or related schedules.

The explanation on Schedule O may be as simple as filing an extension for the Form 990-T, because the required information was not complete for the filing of the Form 990. However, if the IRS deems the explanation subpar, a questionnaire will be issued that could eventually lead to an audit. In addition, the IRS plans to develop a compliance project around its findings from the questionnaire and audit process.

According to the IRS Statistics of Income Division, which analyzes information reported on various tax forms, more than 50 percent of filing organizations reported zero net income or a loss on Form 990-T for the period January 1, 2009, to December 31, 2010. There are several reasons why an organization would report breakeven or a loss from UBI activities. The activity could have generated a loss even though there is intent to make a profit. Another factor to consider is the allocation of expenses; this is not a well-defined area, so allocations could be considered liberal. In addition, Form 990-T may report more than one activity. While one activity may be income-producing, another may be in a loss situation, effectively offsetting income. 

A history of losses from Form 990-T has been a compelling argument against profit motive for UBI activities during field audits. It has not been uncommon for losses to be disallowed as a result. In addition, the allocation of expenses has been a focus as the tax code is vague on what is “directly” attributable to an activity. The allocation of expenses must be made on a reasonable basis and can include both direct and indirect expenses. 

An annual review of programs and UBI calculation should be documented to support conclusions. If you have additional questions or need assistance in the review of your unrelated business activities, contact your BKD advisor or Paige Gerich.

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