The IRS is turning its attention to the ways that nonprofit organizations calculate the tax they pay on unrelated business activities. In the wake of a recent IRS compliance study of 400 public and private colleges and universities, the agency has become concerned that nonprofits may be improperly reporting losses related to these activities and may not be paying unrelated business income tax (UBIT). After collecting statistical information on the ways these companies allocated expenses, the IRS launched 30 audits.
When is unrelated business income taxable?
Let’s say you’ve determined that an activity is unrelated to your exempt purpose. For example, your nonprofit’s exempt purpose is to coordinate foster care, and you also run a coffee shop open to the general public to raise additional funds. The coffee shop would be unrelated to your exempt purpose. The excess of unrelated business income over the allowable deductions for that income results in UBIT. When reporting unrelated income, certain expenses — such as staff costs, coffee inventory and related expenses — are allowed as deductions against that income. They’re categorized as directly connected expenses and dual use expenses.
What are “directly connected” expenses?
Deductions incurred solely because of the unrelated business are known as “directly connected” expenses. These are expenses that wouldn’t be incurred if the unrelated business didn’t exist.
In the above example, the costs of maintaining a building that’s used solely for the coffee shop (the unrelated business) are a directly connected expense, as are the salaries of personnel employed full-time to operate the unrelated business.
What are “dual use” expenses?
If expenses are incurred both to carry on exempt functions and to conduct an unrelated business, they are known as “dual use” expenses. For example, a nonprofit’s president is paid $100,000 per year. If he devotes 90% of his time to the exempt activities of the nonprofit, but 10% of his time to an unrelated business, the organization can take a deduction of $10,000 (10% of $100,000) as a deductible expense of the unrelated activity on Form 990-T.
The allocation of dual use expenses is more complex in situations where the allocation isn’t as apparent as in the above example. This is particularly true of dual use of facilities. According to U.S. Treasury regulations, when facilities are used both to carry on exempt activities and to conduct unrelated business, the expenses, depreciation and anything attributable to such facilities “shall be allocated between the two uses on a reasonable basis.”
In such a situation, the nonprofit must first identify the expenses that are incurred for the dual purpose, such as repairs and maintenance, utilities and depreciation. There are then two methods that can be applied to allocate those expenses:
- The Rensselaer method. This is a ratio based on the number of days that the facility is used for unrelated business (numerator) in relation to the total days used for all purposes (denominator). For example, 64 ÷ 253 (days), or 25.3%. This method was named after the court case upon which it was based.
- The IRS method. This is a ratio based on the number of days the facility is used for unrelated business (numerator) divided by the number of days the facility is available for use.For instance, 64 ÷ 365 (days), or 17.5 % of the calendar year.
The Rensselaer method is more favorable for the nonprofit because more expense is allocated to the unrelated business.
Document, document, document
Whether you’re deducting direct expenses or allocating dual use expenses, you must produce support for them. Use time sheets to document the percentage of an employee’s salary allocable to unrelated business, and keep facility use records for facilities allocations. Document your reasoning behind any allocations.
In its college/university compliance study, the IRS found that only 16% to 19% of participants relied on the advice of independent accountants or counsel for allocations of expenses between unrelated and exempt activities. With heightened IRS scrutiny, now is the time to revisit the issue with an accountant.
Why it matters
Here’s what nonprofits have to face if they inaccurately report expenses related to unrelated business activities:
Accuracy-related penalties. The IRS may assess penalties for negligence or disregard of rules or regulations, or for a significant understatement of income tax. The penalty is 20% of the underpaid tax.
Public access to Form 990-T, “Exempt Organization Business Income Tax Return.” Since 2006, 501(c)(3) organizations have been required to make their Form 990-T available to the public. So expect the form — including allocations of expenses — to be scrutinized by the public just as Form 990 has been in the past. Inaccuracies on the form could lead to substantially-lower donations and other public support.