Nonprofit Accounting Basics

IRS Unrelated Business Income Findings from the Colleges and Universities Compliance Project

As noted in an earlier article, the Internal Revenue Service (IRS) recently issued the Colleges and Universities Compliance Project Final Report. This project started with the completion of approximately 400 questionnaires. Based upon the results obtained from the questionnaires and from previously filed Forms 990, 34 colleges and universities were selected for examination. The findings from the project focused on two issues: compensation and unrelated business income. The compensation findings were addressed in the earlier article.

When determining whether the income from an activity should be considered unrelated business income, three criteria must be met:

  • The activity is a trade or business. A trade or business generally includes activities that generate income from the sale of goods or the performance of services.
  • The activity is regularly carried on. This means the business activity is conducted in a manner with a level of frequency and continuity to be comparable to that of a commercial enterprise.
  • The business activity is not substantially related to the exempt purpose, or the accomplishment of the exempt purpose, of the organization.

There are exceptions and modifications that may apply to these criteria, so care should be taken when making a determination as to whether an activity generates unrelated business income.

The extent of the underreporting of unrelated business taxable income identified during the 34 examinations was extensive. The amount of taxable income was increased for 90% of the colleges and universities examined, totaling $90 million. Over 180 changes were made to the amounts of unrelated business taxable income, and more than $170 million of losses and net operating losses (NOL) were disallowed.

The reasons for the increases to the unrelated business taxable income included:

  • Misclassification as a trade or business due to a lack of a profit motive. An activity qualifies as a trade or business only if is operated with the intention of making a profit. If the activity generates continuous losses beyond the period necessary to bring the operation to a profitable status not due to customary risks, then the activity is not considered to be operated with profit in mind. When filing Form 990T, the losses from a single activity can offset the gains from other activities. If there is an NOL, which allows for a loss carry back of two years and a carry forward of 20 years, a current year loss can also affect the amount due in other years. If a loss is generated by an activity that does not reflect a profit motive, then the netting of these losses against gains from other activities, in both the current year and others if allowed, is not appropriate.
  • Misallocation of expenses. Very often a business activity will serve both exempt and unrelated purposes. In these cases, the income and the expenses generated by the activity must be allocated between the two purposes on a reasonable basis. The IRS concluded expenses related to exempt purposes were used to reduce taxable income in more than 60% of the Forms 990T examined.
  • Errors in computation and substantiation. When the IRS recalculated the computations for the NOLs reported on the Forms 990T examined, more than a third were improperly calculated or unsubstantiated.
  • Misclassification of related activities. During the examinations, the IRS looked at the activities not reported on the Forms 990T to verify the filings were complete. Adjustments were made to the returns of more than 40% of the colleges and universities examined due to the treatment of unrelated activities as related.

The IRS was also interested in the use of outside consultants when determining the treatment of a potentially unrelated business activity. The IRS disagreed with the opinion that an activity was related in about 40% of the cases where an outside opinion was obtained. In these cases, the activity was reclassified as unrelated.

While colleges and universities often engage in certain unique activities, many of the findings in the IRS report related to activities, such as advertising and facilities rentals, which are shared by a wide spectrum of nonprofit organizations. The IRS is placing emphasis on unrelated business income in both its educational and examination processes, so a reevaluation of all activities and the way they are reported in light of these findings should be considered by all nonprofits.