State-chartered credit unions (SCCU) are exempt under Internal Revenue Code (IRC) Section 501(c)(14)(A) from income taxes on their net exempt income. As exempt organizations, they must file a Form 990 each year to report their activity. SCCUs also need to consider whether they need to file a Form 990-T to report unrelated business income (UBI). The IRS has been scrutinizing the activities of tax-exempt organizations lately, especially in the area of unrelated business income tax (UBIT).
SCCUs not currently reporting any UBI on Form 990-T and applicable state tax return(s) are at risk of incurring penalties from the IRS and applicable states for all prior taxable years as well as potentially failing to report any uncertain tax positions on the audited financial statements.
UBI is defined in Regulation §1.513-1(a) as gross income derived by an organization from any unrelated trade or business the organization regularly carries on, less the deductions.
When looking at income, there are three criteria that must be met for UBI:
- Income must be from a trade or business
- Such trade or business must be regularly carried on
- Conduct of such trade or business must not be substantially related to the organization’s performance of its exempt purpose, other than through the production of funds
When looking at income-producing activities, each activity—and all the facts and circumstances surrounding the activity—must be examined to determine the activity’s relation to the organization’s exempt purpose.
On March 24, 2015, the IRS Tax Exempt and Government Entities Division issued a memorandum outlining the applicability of UBI to SCCUs.
The memorandum includes four main points to consider when looking at UBI.
- Income from the following income-producing activities is considered substantially related and not subject to UBIT:
- Sale of checks/fees from a check printing company
- Debit card program’s interchange fees
- Credit card program’s interchange fees
- Interest from credit card loans
- Sale of collateral protection insurance
- Income from marketing the following products and ATM fees is subject to UBIT:
- Automobile warranties
- Dental insurance
- Cancer insurance
- Accidental death and dismemberment
- Life insurance
- Health insurance
- ATM “per-transaction” fees from nonmembers
- Income from these products is subject to UBIT, if sold to nonmembers:
- Credit life and credit disability insurance
- GAP auto insurance
- All other insurance products, unless there’s a royalty agreement, are generally subject to UBIT.
Bellco Credit Union v. U.S. also should be considered when reviewing income-producing activities for UBI. This case is one of the key reasons the abovementioned memorandum was released—it provides more insight to IRS examiners when reviewing the SCCU activity. The case provides more support for additional investment advisory services to members not being subject to UBIT.
Another UBI area to be aware of is debt-financed income. IRC §512(b)(4) notes income derived from debt-financed property, which is defined in IRC §514, shall be included in UBI. Under IRC §514 (b)(1), debt-financed property means any property that’s held to produce income and with respect to which there’s an acquisition indebtedness any time during the taxable year. It does provide an exception for property substantially related to the performance of an organization’s exempt purpose.
In Alabama Central Credit Union v. U.S., interest income a credit union earned on bonds it purchased on margin and with borrowed funds was considered to generate UBI.
The court rejected the argument that the purchase on margin was related to the credit union’s tax-exempt function. It said the purchase of securities on margin and with borrowed funds to maximize the yield or income therefrom doesn’t constitute a purchase of property substantially related to the debtor’s tax-exempt function.
In most cases, SCCUs have some income-producing activities that give rise to UBI. The most likely source is from nonmember ATM fees. A review of income-producing activities and documentation on whether the income should be classified as UBI is an important next step.
Once an SCCU has determined it has UBI to report, it also should look at the deductions directly connected with carrying out a specific UBI activity that can be reported to offset this income. In general, for a deduction to be directly connected with the conduct of an unrelated business activity, an item of deduction must have a proximate and primary relationship to the carrying on of that business.
Per Reg. §1.512(a)-(1)(c), when facilities are used both to carry on exempt activities and to conduct unrelated trade or business activities, expenses, depreciation and similar items attributable to such facilities—for example, items of overhead—shall be allocated between the two uses on a reasonable basis. Similarly, where personnel are used to carry on exempt activities and conduct unrelated trade or business activities, expenses and similar items attributable to such personnel—for example, items of salary—shall be allocated between the two uses on a reasonable basis. The portion of any such item so allocated to the unrelated trade or business activity is proximately and primarily related to that business activity and shall be allowable as a deduction in computing UBI.
Per Reg. §1.512(a)-1(f)(6)(i), the method of allocation will vary with the nature of the item, but once adopted, a reasonable method of allocation with respect to an item must be used consistently. Thus, for example, salaries may generally be allocated among various activities on the basis of the time devoted to each activity; occupancy costs such as rent, heat and electricity may be allocated on the basis of the portion of space devoted to each activity; and depreciation may be allocated on the basis of space occupied and the portion of the particular asset used in each activity. Allocations based on dollar receipts from various exempt activities generally won’t be reasonable since such receipts usually aren’t an accurate reflection of the costs associated with activities carried on by exempt organizations. Proper documentation of the methodology used for allocation of indirect costs should be considered.
State treatment of UBI varies, including some states that don’t tax UBI. We recommend you evaluate each state where UBI is earned and look at the filing requirements for those specific states.
New Items to Consider with the Tax Cuts and Jobs Act
There are several additional items SCCUs should watch out for due to the passage of the Tax Cuts and Jobs Act.
First, taxable UBI will now be taxed at the corporate income tax rate of 21 percent, instead of the previous graduated rates that topped off at 35 percent. Any future net operating losses only will be able to offset 80 percent of taxable income and can be carried forward indefinitely.
Second, SCCUs will need to look at each UBI activity separately for reporting purposes. Activities that produce losses won’t be able to offset activities that produce income. If an SCCU has mainly been reporting losses, but has any activities with income, it will now have to pay tax on those income-producing activities. If there are income-producing activities, the SCCU should consider making estimated tax payments for 2018 to avoid underpayment penalties and interest.
Third, an SCCU will be required to pay a 21 percent excise tax on compensation exceeding $1 million paid to one of the organization’s five highest-compensated employees. This tax also will apply to parachute payments three times greater than the average of the last five years of the person’s salary.
SCCUs should review income-producing activities and document their conclusions to support reasons for not reporting income as UBI. If the SCCU has nonmember income, there’s a possibility this income should be reported as UBI.
If the SCCU has UBI to report, it should file a Form 990-T to report this income and applicable expenses. If the organization has an activity that continues to produce UBI losses, the SCCU should periodically review the expense allocation for reasonability.
Contact your trusted BKD advisor with questions or for more information.