Keeping Your Balance: IRS scrutinizes Form 990-T and losses

Listen to this article

The IRS is taking a close look at tax exempt organizations that engage in unrelated business activity but rather than reporting taxable income instead report large loss carryforwards.

The IRS already has started to look at the issue with the release of its compliance questionnaire, sent out to 400 colleges and universities. The IRS noted that many of the schools’ Forms 990-T showed large losses after expense allocations.

There are three areas of particular interest to the IRS when looking at losses on Form 990-T:

• Profit motive of the activity;
• Dual use facility expense allocations; and 
• Exploited activities.

Profit motive of the activity

One of the areas the IRS is examining is th the profit motive of the activity. The “Profit Motive Test” came from rulings and case law that occurred in the 1980s and 1990s. When applied, the test eliminates deductions for losses from activities lacing a profit motive.

IRS Code Section 512(a(1) defines unrelated business taxable income as “gross income derived by an organization from any unrelated trade or business regularly carried on by it, less the deductions which are directly connected with the carrying on of such trade or business.”

The section allows organizations to offset the income and gains from one unrelated activity against the losses generated by another unrelated activity.

As noted in the definition, the losses must be generated by a trade or business, defined as an activity carried on for the production of income, and has the other traits of a for profit organization. In other words, an organization must engage in the activity with the primary goal of generating a profit.

Organizations reporting large losses on Form 990-T are at risk of the IRS applying the profit motive test to their activities. That may result in the activity’s losses being disallowed due to the IRS assertion that the organization did not engage in the activity with the primary purpose of generating income or profit.

In looking at the losses, the IRS has adopted a facts and circumstances approach to determine whether an activity is a trade or business. Various areas that might indicate an activity does not have a profit motive include:

• No formal business plan or contracts for the activity;
• Expenses almost always exceed any income from the activity;
• Many years of losses; and
• No adjustments to cost, expenses or pricing to lower the losses.

Another item to be aware of is the IRS treatment of offsetting losses from one set of unrelated activities against the income from other unrelated activities. It has been the IRS’s approach to look at each one of those activities as its own separate trade or business, and determine whether each one has or does not have a profit motive. Using that methodology, the IRS has taxed profitable activities while disallowing those with losses.

Dual use of facilities

Another area of focus regarding losses reported on Form 990-T involves the expense allocation and deductions for the dual use of facilities and personnel. Under IRS Regulations 1.512(a)-(1)(a), an organization can deduct an expense directly connected to an unrelated trade or business if it has a “proximate and primary relationship” to the unrelated trade or business. The regulations further discuss the relationship regarding expenses directly related to unrelated business activities and expenses from dual use.

The regulations state that the expense allocation between the dual uses must be “reasonable”; however, “reasonable” has been subject to a variety of interpretations and litigation. Some guidance may be found in Rensselaer Polytechnic Institute v. Commissioner of Internal Revenue (1983/1984), in which RPI interpreted “reasonable” to mean that fixed costs as well as depreciation and overhead expenses that could not be directly associated with exempt student uses or non-exempt commercial for-profit uses should be allocated based on percentage of total use, ignoring periods when the facility was idle. RPI prevailed. To this day, however, the commissioner contends that the basis of allocation should have been all time the facility was available for use, which would substantially reduce the amount of expenses and losses that could be used to offset unrelated business income.

Given the lack of clarity on the issue, it is up to the organization and the IRS to come to some type of negotiated settlement on their own should the issue be brought to light during an audit.

Exploited activities

The third area of focus regarding loss reporting on Form 990-T involves the calculation and reporting of expenses from exploited exempt activities. Such activities occur when an organization generates intangible assets in performance of its exempt activity that are exploited in a commercial manner, and does not contribute to an organization’s exempt purposes. Examples included within the IRS regulations are advertising income from an educational organization’s journal or a scientific organization’s endorsement of laboratory equipment.

For such activities, the IRS requires organizations to report and complete two separate calculations of net income from the activities — one from the taxable activity and one from the exploited activity.

Under the IRS regulations 1.512(a)-1(d), if the taxable activity has net income, any losses from the exploited activity can be used to offset the net income from the taxable activity to the extent of net income. The exploited activity is not allowed to create a net operating loss for the taxable activity. If the taxable activity shows a loss, however, that loss is what is required to be reported on Form 990-T.

The IRS is concerned that organizations are not observing the rules regarding the expense deduction limitations and putting excess expenses on page 1 of Form 990-T under deductions not taken elsewhere on Form 990-T.

Given the IRS’s increasing scrutiny in these areas, organizations with unrelated business activities generating losses on Form 990-T should look closely at:

• Each activities’ profit motive — document why the activity is generating losses (i.e., start up mode, meant to run a loss, etc.);
• Dual use of facilities expense allocations — look at and document the methodology used in the calculation. Is it reasonable? Is it consistent with relevant tax court rulings or the IRS’s interpretation?
• Exploited exempt activities — ensure the organization is in compliance with the expense limitation rules.

Raymond J. Jacobi, CPA is a partner with Mengel, Metzger, Barr & Co. LLP and can be reached at [email protected].