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Disallowed losses: Is your organization at risk?

In recent years, congress and the IRS have increased scrutiny of exempt organizations, particularly regarding those organizations’ unrelated business incomes – otherwise known as UBI.

In 2014, the IRS concluded its College and University Compliance Project, which focused on UBI reported by tax-exempt colleges and universities. Findings led the IRS to disallow $170 million in net operating losses claimed on previously filed tax returns. Based on this result, tax-exempt organizations need to reevaluate the methods they use for calculating and reporting UBI. Unrelated business expenses are historically overreported, a truth that provided some of the impetus for the enhanced focus. 

Among the considerations for organizations trying to determine what constitutes unrelated business are the following:

  • In order for an activity to be considered an “unrelated business,” it must be a trade or business – i.e., operating with a profit motive – regularly carried on and unrelated to an organization’s exempt functions.
  • In cases in which an activity for which a profit motive is lacking, the IRS may rule it disallowed.
  • While there may be legitimate reasons for an activity to have a history of losses, if the activity is not expected to generate a profit in future years, a tax-exempt organization ought to consider whether it should cease reporting the losses on Form 990-T.
  • If the activity is expected to become profitable in the coming years, the reasoning to support such a belief should be documented and disclosed.

Improper Expense Allocations
The IRS is taking a closer look at the methods used to allocate expenses between different activities. Organizations, therefore, should establish reasonable allocation methodologies to ensure that expenses are properly allocated between activities. Any expenses incurred in support of both related and unrelated programs need to be divided between the different activities on a reasonable basis.

The misclassification of certain activities as exempt or otherwise not reportable on Form 990-T poses another issue altogether. Activities that are related for one organization may be considered unrelated for another. With this in mind, tax-exempt entities need to evaluate whether certain activities are related or unrelated by referring to their mission statements and should document their rationale for classifying an activity as related

To learn more about this or any other UBI issues, contact LaPorte CPAs & Business Advisors Tax Senior Manager Sean O’Neill at [email protected]