Common IRS examination issues for tax-exempt organizations: Form 990-T developments

In recent years, the U.S. Internal Revenue Service (IRS) has increased its scrutiny of tax-exempt organizations. This is the first in a series of articles that will address common issues raised during the course of IRS Examinations of tax-exempt organizations over the past several years. This first article focuses on two frequent disputes involving Form 990-T, Exempt Organization Business Income Tax Return: (1) Dual Use Facility Expense Allocations; and (2) Hobby Loss Activities. Tax-exempt organizations that have risk in these areas should consult with their tax advisors and determine how best to minimize exposure to and risk upon IRS Examination. It should be noted that these same issues may also present tax planning opportunities for tax-exempt organizations that pay income tax.

I.  Dual Use Facility Expense Allocations  

A. UBTI Expenses, Generally

Under section 512 of the Internal Revenue Code1, an activity of a tax-exempt organization produces Unrelated Business Taxable Income (UBTI) if the income is derived from a trade or business that is regularly carried on and is not substantially related to the organization’s tax-exempt functions. UBTI is the gross income derived from any unrelated trade or business less the deductions directly connected with carrying on the trade or business.2 Allowable deductions when computing UBTI must be directly connected to the carrying on of an unrelated trade or business. Expenses that are directly connected to the unrelated trade or business are considered “proximately and primarily” related to the unrelated trade or business.3

Many exempt organizations have facilities, commonly referred to as “Dual Use Facilities,” that are used to conduct both exempt functions and an unrelated trade or business.4 An example of a Dual Use Facility is a university-owned building that is used for student activities, as well as commercial events.  Depreciation, overhead, and various other expenses attributable to the Dual Use Facility must be allocated between the exempt use and the unrelated business activity on a reasonable basis.5 “What” constitutes a reasonable basis is subject to dispute and often debated on audit. The Internal Revenue Code and Treasury Regulations do not provide clear guidance to allocate expenses associated with Dual Use Facilities. The regulations establish two requirements for allocating deductible expenses in Dual Use Facilities: (1) that the expense is allocated on a reasonable basis between exempt and unrelated activities and (2) the expense is an allowable deduction under relevant Code provisions. Given the lack of clarity in the Code and Regulations, three separate methods have developed from the IRS and the courts: 1) The “Actual Use” Method, 2) The “Available Use” Method, and 3) The “But For” Method.

B. Methods to Allocate Expenses

The Actual Use Method

Rensselaer Polytechnic Inst. v. Commissioner_6 established that indirect expenses can be apportioned in proportion to the actual hours that a facility is devoted to exempt and non-exempt uses. In _Rensselaer, the taxpayer (School) was a tax-exempt educational organization that owned and operated a field house.  The field house was devoted both to student and commercial uses. The IRS argued that the School understated its UBTI because the School improperly allocated expenses to UBTI. The School allocated indirect expenses in proportion to the actual hours that the field house was devoted to each use. The court found that this method of allocation met the reasonableness test because apportioning indirect expenses such as depreciation on the basis of the actual hours the facility was used sensibly distributes the cost of the facility among the activities that benefit from its use.

Under Rensselaer,if a field house is used for 600 and 400 hours for exempt and non-exempt purposes, respectively, then expenses are apportioned 60% to exempt use and 40% to non-exempt use. The field house’s owner is able to deduct the expenses allocated to non-exempt use from the income that was generated from the non-exempt use. The Rensselaer approach is beneficial to exempt organizations because the hours the building sits idle are not included in the apportionment of expenses.

Available Use Method

The Service argued in Rensselaer that the appropriate method to allocate fixed costs between exempt and non-exempt purposes should be based on the total time available for use. The Service argued that since fixed expense items, such as depreciation, occur during “idle time” for the Dual Use Facility, the denominator when allocating expenses should include available for use time. The Service’s argument is less favorable to the exempt organization because any idle time is allocated to exempt use, reducing total expenses allocable to UBTI.

Under the Available Use Method, if a school field house is used for 600 and 400 hours for exempt and non-exempt purposes, respectively, during the year, but also sat idle for 1000 hours during the year, then expenses are apportioned 80% to exempt use and 20% to non-exempt use. Note that an aggressive IRS Agent may argue that a Dual Use Facility is available for 24 hours each day, which would further reduce expenses allocable to UBTI.

“But For” Test

Baker Tilly has recently represented clients under IRS Examination where the IRS has proposed a third (and least favorable) method to allocate expenses associated with Dual Use Facilities. Under this third test, no expenses are allocable to UBTI unless the taxpayer only incurred the expense for UBTI purposes. This test essentially excludes fixed costs from the UBTI calculation altogether, and only allows for direct and variable expenses to be deducted. Expenses such as depreciation and overhead are disallowed if the exempt organization cannot demonstrate that these expenses would not have been incurred but for the unrelated business activity. The IRS cites the language from section 1.512(a)-1(b), which states that expenses, depreciation, and similar items attributable solely to the conduct of unrelated business activities are proximately and primarily related to that business, and therefore qualify for deduction. The IRS highlights the word “solely” to emphasize its position that fixed expenses cannot be allocated to non-exempt uses of a Dual Use Facility.

C. Challenges and Opportunities

The IRS does not agree with the Second Circuit’s taxpayer-friendly ruling in Rensselaer. Exempt organizations, therefore, should be prepared to defend expense allocations upon IRS Examination. To the extent that the Actual Use method is followed, exempt organizations should keep records, e.g., logs and calendars, to document the expense allocations used. Exempt organizations that have previously utilized the Available Use Method should consider filing amended Forms 990-T to apply the Actual Use Method and claim a refund. Baker Tilly has filed amended Form 990-T on behalf of clients that previously under-allocated expenses to Form 990-T. Where an exempt organization claims a refund on an amended Form 990-T, the IRS will generally either issue a refund or a denial letter that provides the exempt organization with Appeal rights. 

II.  Hobby Loss Activities

A. Section 183, Generally

In addition to challenges to Dual Use Facility Expense Allocations, the IRS may also challenge a UBTI-producing activity under the so-called hobby loss rules.  To constitute a trade or business, an activity must be carried on for profit.7 Section 183(a) provides that if an activity is not engaged in for profit, then no deduction attributable to such activity shall be allowed. In other words, if an activity is a hobby, deductions are limited to income and any net operating losses are disallowed. To avoid the hobby loss rules, a taxpayer must establish that it engaged in the activity with the primary purpose and intent of realizing an economic profit independent of tax savings.8

Section 1.183-2(b) provides a list of factors to be considered in the evaluation of a taxpayer's profit objective: (1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or taxpayer’s advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer's history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, from the activity; (8) the financial status of the taxpayer; and (9) elements of personal pleasure or recreation.

B. Section 183, Application to Exempt Organizations

Section 183 technically only applies to individuals and S corporations9 Section 183 does not mention tax-exempt organizations or unrelated business activities. However, the IRS takes the position that the hobby loss factors can be used to determine profit motive for UBTI-producing activities.

The IRS has challenged a UBTI-producing activity’s profit motive on numerous occasions. For instance, in Cleveland Athletic Club, Inc. v. United States,10 the Sixth Circuit Court of Appeals held that a tax-exempt social club could deduct a loss attributable to the sales of meals to nonmembers (“Food Sales Activity”). The IRS argued that the social club could not deduct a loss from the Food Sales Activity against other UBTI-producing activity because the Food Sales Activity produced losses annually and therefore, had no profit motive. The Sixth Circuit ruled that non-member business does not need to generate taxable income to demonstrate a profit motive. All indications showed the Food Sales Activity was a trade or business, regardless of the failure to generate a tax profit. The Sixth Circuit did not apply the nine hobby loss factors, but instead concluded that a for-profit motive existed without establishing how that conclusion was reached.

In Portland Golf Club,11 the United States Supreme Court ruled that an exempt organization’s UBTI-producing activity did not have a profit motive. Once again, the court’s opinion lacked specifics on why there was no profit motive. The court did note that total expenses significantly exceeded income from the activity.  Thus, while Portland Golf Club establishes that UBTI-producing activities must have a profit motive, the court declined to provide specific guidance on how to demonstrate such a profit motive.

While there is little guidance on how to determine if there is a profit motive, it stands to reason that courts will likely adopt the nine hobby loss factors to make this determination. Moreover, in April 2013, the IRS released a report that summarized the IRS’s Colleges and Universities Compliance Project, a multi-year study that identified significant compliance issues. The Questionnaire that was used to facilitate the Compliance Project requested information clearly targeted at identifying hobby loss activity. For instance, the Questionnaire requests: “check the box if the UBTI activity was managed or operated by an unrelated third party.” Another request states: “indicate whether your organization incurred a loss from the UBTI activity in at least three of the five previous years.” Based on the responses received from questions such as these, the Compliance Project identified hobby losses from UBTI-producing activities as a significant risk area.

C. Challenges and Opportunities

If a tax-exempt organization’s UBTI-producing activity is deemed a hobby, the tax-exempt organization cannot deduct any losses associated with the UBTI-producing activity. Like in Cleveland Golf Club, this may be relevant for tax-exempt organizations that have multiple UBTI-producing activities, some of which have taxable income while others have losses. If a loss activity is disallowed, the tax-exempt organization may find itself in a net taxable position, resulting in income tax due along with any associated interest and penalties.

Tax-exempt organizations can make a variety of changes to their UBTI-producing activities to reduce the chances that an activity will be characterized as a hobby. These changes include, but are not limited to, documented annual business plans, the maintenance of separate books and records, consultation with experts, and efforts to reduce expenses. These changes will be different for each organization and activity.

Baker Tilly stands ready to help, whether defending an IRS Examination, planning for a potential IRS Examination, or assisting with refund claims. 

Look for articles in the coming months providing tax risk mitigation recommendations for your organization in light of recent IRS audit activity.

1. All section references are to the Internal Revenue Code of 1986, as amended, and the Treasury Regulations issued thereunder.
2. Section 512(a)(1)
3. Section 1.512(a)-1(b)
4. Section 1.512(a)-1(c)
5. Section 1.512(a)-1(c)
6. 732 F.2d 1058 (2d Cir. 1984)
7. Section 1.513-1(b).
8. Westbrook v. Commissioner, 68 F.3d 868, 875 (5th Cir. 1995).
9. Section 183(a)
10. 779 F.2d 1160 (6th Cir. 1985).
11. 497 U.S. 154 (1990).