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Where Do You Stand with UBIT?

Dave Moja, PartnerProfessional Practice Leader - Tax9.22.16

Recent UBIT Developments

• Catalog Sales

• University Foundation LLC Buys a Mall!

• Cause-related Marketing

• 2014 ACT Report – Appendix A

• IRS Colleges & Universities Compliance Project

• Boutique Hotel Case

• Labor Organization Periodical Case

• Margin Purchases – Debt-financed Investments

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Catalog Sales

• TAM 201633032

• 1979 EO CPE Text – “Museum Retailing - UBIT Issues”

• ISSUE(S)Whether Organization’s sale of * * * through its online store, printed catalog, and at various unrelated retail outlets is an unrelated trade or business within the meaning of § 513 of the Internal Revenue Code.

• CONCLUSION(S)Organization’s sale of * * * through its online store, printed catalog, and at various unrelated retail outlets is an unrelated trade or business within the meaning of § 513.

Cause-related Marketing

• What does this look like?

• A business/commercial entity agrees to use your name and/or logo in its advertisements, with promise to remit, say, a portion of purchase price to you

• What is in it for you?

• Potential for greater contribution revenue

• Expected increased awareness for your organization

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Cause-related Marketing, continued

• What might go wrong?

• Control over where advertisements are displayed

• Possible state reporting requirements

• Does the business and/or their products align with your organization? FUTURE?!

• Endorsements?

Case Study #1

• Marathon Bible College (MBC) is a public charity and a school under I.R.C. sections 501(c)(3) and 170(b)(1)(A)(ii). They set up “Marathon Bible College Night” with participating Aunt Paula’s All-American Pancake house restaurants across Florida. MBC promotes the event by sending flyers that offer 20% off pancakes on a given day and state that “a portion of the proceeds goes to support the MBC Cross Country program.” They call us to ask, “Is this revenue subject to UBIT?”

• Although a review of the corporate sponsorship regulations under Treasury Regulation 1.513-4 would suggest that the wording on these communications would constitute “advertising” and thus be subject to UBIT, our answer – based on the narrative below – is “probably not.”

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Case Study #1, continued

From IRS Exempt Organizations and UBI Webcast Q&A (June 24, 2014):

3. If an organization sends out an email stating to go eat at an unrelated, taxable entity fast food restaurant, get a discount, and have a portion go to the exempt organization, is this UBI? The emails do appear to be advertisements due to language in the ad.

IRS ANSWER: This would depend on the specific facts and circumstances of the case. However, if the business activity (the sale of food) is conducted by the restaurant rather than the exempt organization, the business activity (and the income resulting from it) would likely not be imputed to the exempt organization.

College Buys a Mall!

In PLR 201444043, Sole membership LLC/exempt supporting organization’s ownership of retail center adjacent to university’s campus won’t be treated as UBTI or cause revocation of organization’s exempt status.

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Final Report on the Examination of 34 Colleges and Universities

100%

90%

70%

40%

40%

60%

90%

990T

Under-reported UBI

Disallowed Non-Operating Loss Deduction

Misclassification of Reported Related Activities

Improper Calculation or Unsubstantiated NOLs

Misclassification of Expenses

Increases to UBIT of $90M Across 90% ofOrganizations Examined

Form 990-T: Public Disclosure

• Pension Protection Act of 2006

• Extended IRC §6104 disclosure requirements to Form 990-T

• Tax Technical Corrections Act of 2007

• Requires IRS to make Forms 990-T publicly available

• (Notices 2008-49, 2007-45)

• Expect to see your Form 990-T on Guidestar

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Unrelated Business Activities Overview

Where Can UBI Hide?

• Property Rentals

• Services

• Websites (banner ads & “click-thru”)

• Goods/Products

• Facilities

• Catering

• Advertising

• Trade Shows (Virtual)

• Cell Phone Towers

• Sports Sponsorships*

• Shops, Bookstores

• Cafeterias, Coffee Shops

• Stadiums, Gyms, Arenas, Chapels, Theatres

• Health/Recreational Facilities

• Golf Courses (Frisbee)

• Storage Facilities

• Parking Lots/Garages

• Farms, Groves, Orchards

• “Boutique Hotel”

• “Commerciality”

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Unrelated Business Income

• Foundational Principle:

• Key is how the money is earned, not how it’s used

• Unrelated business income takes away the potential advantage for nonprofits

Three-part Test

• Key is to FAIL one of the tests

• Is the income…

1• A trade or business?

2• Regularly carried on?

3• Not substantially related to the

exempt purpose?

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Specifically Excluded?

Exclusions

• Certain activities are statutorily excluded from the unrelated business income (UBI) rules, although they may meet the definition of an unrelated trade or business

• In addition, case law provides various other exclusions for specific activities

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The Most Common Exclusions

• Volunteer labor

• Member’s convenience

• Donated merchandise

• Conventions and trade shows

• Games of chance

• Distribution of low-cost items for donations

• Qualified corporate sponsorship income

The Most Common Exclusions (cont.)

• Interest, dividends, and similar income

• Royalties

• Real property rental income

• Gains and losses from the disposition of property

• Neighborhood land rule

• Debt-financed – 15% rule

• “Schools” – I.R.C. Section 514(c)(9)

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Volunteer Labor

• Any activity in which substantially all of the work is performed by unpaid volunteers is not an unrelated trade or business [IRC Sec. 513(a)(1)]

• An organization’s paid staff may be directly involved with an activity that is exempt under this exception, provided sufficient volunteer effort is also present

• Substantially generally > 85%

Member’s Convenience

• An activity carried on by a Section 501(c)(3) entity or by a governmental college or university primarily for the convenience of its members, students, patients, officers, or employees is not an unrelated trade or business [Rev. Rul. 81-19; IRC Sec. 513(a)(2)]

• Many times difficult to distinguish from “related to exempt purpose”

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Donated Merchandise

• The sale of merchandise, substantially all of which has been received by the organization as a gift or contribution, is not an unrelated trade or business [IRC Sec. 513(a)(3)]

• “Thrift Shop Exception”

• Substantially generally > 85%

Games of Chance

• Exempt organizations frequently conduct games of chance such as bingo, pull tabs, raffles, video games, poker, and lotteries

• To avoid having the conduct of such games classified as an unrelated trade or business, an organization typically operates the games with unpaid volunteers or conducts the games in such a manner as to qualify them as bingo [IRC Secs. 513(a)(1) and (2)]

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Treasury Regulation 1.513-5(d)

• As used in this section, the term “bingo game” means any game of bingo of the type described above in which wagers are placed, winners are determined, and prizes or other property is distributed in the presence of all persons placing wagers in that game. The term “bingo game” does not refer to any game of chance (including, but not limited to, keno games, dice games, card games, and lotteries) other than the type of game described in this paragraph.

Treasury Regulation 1.513-5(d)

• Bingo game defined. A bingo game is a game of chance played with cards that are generally printed with five rows of five squares each. Participants place markers over randomly called numbers on the cards in an attempt to form a preselected pattern such as a horizontal, vertical, or diagonal line, or all four corners. The first participant to form the preselected pattern wins the game.

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Corporate Sponsorships

Six Acceptable Actions

1. Listing the name, logo, or product line of sponsor

2. Awarding exclusive sponsorship award (e.g., via industry: one to airline, one to hotel industry)

3. Providing logos or slogans that do not contain any qualitative language or comparative description of the products

4. Listing of payor’s locations, addresses, phone numbers, and Internet addresses

5. Providing value-neutral descriptions of the sponsor’s product display

6. Listing sponsor’s brands or trade names

Advertising

There are four items that cannot be done:

1. Advertising

2. Designating a sponsor as an exclusive provider

3. Providing facilities, services, or other privileges to the sponsor unless they are of “insubstantial value”

4. Granting of either exclusive or nonexclusive rights to use college’s intangible asset (e.g., name or logo)

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Dividends, Interest, Annuities, etc.

The following are excluded in computing unrelated business taxable income:

• All dividends, interest, annuities, payments with respect to securities loans, income from notional principal contracts, and

• Other income from an exempt organization’s ordinary and routine investments that the IRS determines are substantially similar to these types of income

Royalties

• Payment for use of a valuable right

• Payments for trademarks, trade names, or copyrights

• Certain licensee payments

• Mailing lists (no services)

• Mineral royalties (not “working interests”)

• Royalties do not include payments for personal services

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Real Property Rental Income

• Real property generally excluded

• Except – debt-financed property**

• Personal property (equipment)

• Less than 10% of real property rental = no UBI

• If between 10% – 50%, pro rata share of income is UBI

• If personal property included in real property is over 50%

= 100%

Debt-Financed Property

• When an exempt organization uses debt to acquire or

improve investment property

• Income earned on that investment is included in UBIT

• Proportionate to the ratio of debt on the property to the

property’s tax basis

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I.R.C. Section 514(c)(9) Exclusion

• 514(c)(9)(A) In General

• Except as provided in subparagraph (B), the term “acquisition indebtedness” does not, for purposes of this section, include indebtedness incurred by a qualified organization in acquiring or improving any real property

• For purposes of this paragraph, an interest in a mortgage shall in no event be treated as real property

“Qualified Organization”

• 514(c)(9)(C) Qualified Organization

• For purposes of this paragraph, the term “qualified organization” means:

• 514(c)(9)(C)(i) an organization described in section 170(b)(1)(A)(ii) and its affiliated support organizations described in section 509(a)(3)

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I.R.C. Section 170(b)(1)(A)(ii)

• (ii) “an educational organization which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on”

Neighborhood Land Rule

• “If an organization acquires real property with the intention of using the land for exempt purposes within 10 years, it will not be treated as debt-financed property if it is in the neighborhood of other property that the organization uses for exempt purposes.

• “This rule applies only if the intent to demolish any existing structures and use the land for exempt purposes within 10 years is not abandoned.”

• ** Church = 15 years

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Property Related to Exempt Purpose

• If substantially all (85% or more) of the use of any property is substantially related to an organization’s exempt purposes, the property is not treated as debt-financed property

• Related use does not include a use related solely to the organization’s need for income, or its use of the profits

• The extent to which property is used for a particular purpose is determined on the basis of all the facts

Property Related to Exempt Purpose

• They may include:

• A comparison of the time the property is used for exempt purposes with the total time the property is used;

• A comparison of the part of the property that is used for exempt purposes with the part used for all purposes; or

• Both of these comparisons

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Property Related to Exempt Purpose

• If less than 85% of the use of any property is devoted to an organization’s exempt purposes, only that part of the property used to further the organization’s exempt purposes is not treated as debt-financed property

Cost Allocation Issues

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Methods of Allocation

• Reasonable given all facts/circumstances

• Space-based methods

• Time-based methods

• Unit-based methods

Audit Procedures – Audit Risk Alert

• Obtain or update an understanding of the allocation methodology of expenses by functional classification

• If payroll and related costs are a significant part of total expenses, then specifically review the NFP’s methodology for allocating payroll and related costs to the functional classifications

• Verify the consistent application of the allocation methodology

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Cost Allocations – Space-based

• University E owns a 10,800 square-foot, four-story office building. Three of the floors are occupied by professors and other employees of E whose work is part of the exempt purpose of E. One of the floors is rented out to a software company, Q, who does not do any work with E.

• E provides significant cleaning services for Q. Each floor is 2,500 square feet with a common-space 800-square-foot entryway on the first floor.

Cost Allocations – Space-based

• E allocates its dual-use expenses on a “square footage” allocation method as follows:

• Unrelated = 2,700 sq. ft. (including 200 sq. ft. of common space) = 25%

• Related = 8,100 sq. ft. (including 600 sq. ft. of common space) = 75%

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Cost Allocations – Time-based

• University P has a computer repair department, W, that employees three people. W provides computer services to W’s various campus departments, faculty, and students. On a limited basis, W provides computer repair services to the outside public.

• The three employees of W track their total time spent on repairs and their time spent on outside public repair projects.

Cost Allocations – Unit-based

• College Y operates a golf course that is used by students, faculty, their golf teams, alumni, and the general public. Fees charged to alumni are higher than students/faculty/teams, but 10% less than general public fees.

• Y notes that fees paid by alumni and general public are unrelated business income.

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Cost Allocations – Unit-based

Y has allocated expenses to the unrelated business income on a “unit-based” allocation method as follows:

Number of unrelated (alumni and general public) rounds of golf (numerator) /

Total number of rounds of golf (denominator)

Cost Allocations – Unit-based

= % of expenses allocable to unrelated / business income from golf fees

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Case Study #2

• Denali Christian College (DCC) in Alaska is a public charity in accordance with Internal Revenue Code sections 501(c)(3) and 170(b)(1)(A)(ii). In the past year, a donor gave DCC a golf course. So now, DCC runs a golf operation that is used by students, faculty, alumni, and the general public. Fees charged are as follows:

• General public $30

• Alumni $25

• Faculty $10

• Students $10

Case Study #2

• The accounting team at DCC knows that they have unrelated business income for the greens fees paid by the general public and alumni (but not students and faculty). They have allocated expenses to the unrelated business income on a “gross-to-gross” (gross revenue for unrelated golfers over total gross revenue). So, for example, if each of the four “types” of golfers above accounted for 250 rounds per year, the expense allocation would look as follows:

($30 x 250 = 7,500) + ($25 x 250 = 6,250) = 13,750 / 18,750 = 73.33%

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Case Study #2

• In the Colleges and Universities Compliance Project (Final Report 2013), the IRS found this NOT to be a reasonable allocation method –inherently because it misrepresented the expenses because unrelated golfers paid more per round. Thus, the numerator in the cost allocation equation was skewed upward.

• The IRS EO Examinations team prescribed a “unit-based” allocation method modeled after NUMBER OF ROUNDS as follows:

Number of unrelated (alumni and general public) rounds of golf (numerator) / Total number of rounds of golf (denominator)

= % of expenses allocable to unrelated business income from golf fees

This would result in a much lower expense allocation percentage at:

500 rounds / 1,000 total rounds = 50.00%

Form 990-T: A History

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History

• Appeared in 1951

• Has changed little in 64 years

• Widely criticized as “confusing” and “not providing enough information”

• Lack of consistent reporting

• Education and outreach?!

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Current Form 990-T

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Purpose of Form

Use Form 990-T to:

• Report unrelated business income,

• Figure and report unrelated business income tax liability,

• Report proxy tax liability,

• Claim a refund of income tax paid by a regulated investment company (RIC) or a real estate investment trust (REIT), on undistributed long-term capital gain,

• Request a credit for certain federal excise taxes paid or for small employer health insurance premiums paid, and

• Report unrelated business income tax on reinsurance entities.

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Form 990-T – Current Issues

• Profit Motive?

• Losses (NOLs) From Specific Activities

• Election to Forego Carryback

• Charitable Contributions Deduction

• Domestic Production Activities Deduction

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Case Study #3

• Saltwater Christian College (SCC) is a higher education institution that is exempt under Internal Revenue Code section 501(c)(3) and 170(b)(1)(A)(ii). SCC produces (MPGE) and sells a monthly magazine, entitled Baylight, within the United States.

• SCC’s gross receipts from the magazines include gross receipts derived from the sale of magazines to customers and payments from advertisers to publish display advertising or classified advertisements in Baylight.

Case Study #3, continued

• We meet with their CFO and accounting team to work on completing Form 990-T. As we accumulate and allocate expenses, their CFO asks about any “weird” deductions that might be available. We answer that SCC’s income described above are “domestic production gross receipts” (DPGR) derived from the sale of Baylight magazine. Thus, Bay University should be able to take advantage of the “Domestic Production Activities Deduction” on their Form 990-T.

• The Domestic Production Activities Deduction is calculated on Form 8903, Domestic Production Activities Deduction and then reported on Form 990-T, Line 28.

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Form 990-T Redesign

Form 990-T: Redesign!

New Form 990-T Vision

• The vision of the redesigned form would be to:

A. Heighten education and outreach in the UBIT arena

B. Simplify Form 990-T for those organizations required to file

C. Minimize the size of the return – if possible

D. Provide IRS-requested Yes/No questions to provide overall UBIT data

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Form 990-T: Redesign!

• Unrelated Business Activities Checklist

• Guide sheets

• Form 990-T (new)

• Part I – Revenues and Expenses

• Part II – Signature

• Part III – Tax Computation & Payments

• Part IV – Other Information Regarding Unrelated Business Activities

• Worksheets

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UBIT Issues

• The “Tax Gap”

• #2 - The Exempt Organizations Division should work with Chief Counsel and the Treasury Department to provide formal guidance to the field regarding proper methods for allocating indirect costs where facilities and/or personnel are used to carry on exempt activities and to conduct unrelated trade or business.

• Priority Guidance Plan: “Guidance under section 512 regarding methods of allocating expenses relating to dual use facilities.”

• Know the “Exceptions!”

How Do We Proceed?

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What To Do at Your Organization…

• Training

• “UBIT Study”

• Communication

• Point person

• Qualified outside advisors

What To Do at Your Organization…

• Identify potential unrelated business activities

• CUCP Questionnaire

• Form 990, Part III and Part VIII

• Revenue Section of your Trial Balance

• Develop procedures for monitoring

• Training

• Forms/Formats/Updates?

• Report questions to the point person

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Resources

• IRS Publication 598

• Form 990-T Instructions

• IRS College & University Compliance Project Final Report (April 26, 2013)

• www.irs.gov/pub/irs-tege/CUCP_FinalRpt_050213.pdf

• 2014 ACT report (EO section)

• www.irs.gov/pub/irs-tege/tege_act_rpt13.pdf

• Other

Questions?

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Follow Dave Moja on Twitter:

@Nonprofittax

Thank you.

Dave Moja, PartnerCapinCrouse LLP

dmoja@capincrouse.com

407.883.4671