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Form 990-T and Losses: IRS ViewpointThe IRS is taking a close look at tax exempt organizations that engage in unrelated business activity but rather than reporting taxable income, are instead reporting large loss carryforwards. The IRS has already begun to look at this issue with the release of its compliance questionnaire that was sent out to 400 colleges and universities. The IRS noted that many of the colleges and universities’ Forms 990-T were showing large losses after expense allocations.
In this article, we will discuss three areas of particular interest to the IRS when looking at losses on Form 990-T: 1. Profit motive of the activity 2. Dual use facility expense allocations 3. Exploited activities Profit Motive of the Activity One of the areas that the IRS is looking at when examining the large losses is 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, this test eliminates deductions for losses from activities that lack 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.” This section of the Code allows organizations to offset the income and gains from one unrelated activity against the losses generated by another unrelated activity. However, as noted in the definition, the losses must be generated by a trade or business, which is defined as an activity that is 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 their Form 990-T are at risk of IRS applying the profit motive test to their activities. This may result in the losses from the activity 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 these losses, the IRS has adopted a facts and circumstances approach to determine whether or not an activity is a trade or business. Various areas that might indicate to the IRS that an activity does not have a profit motive include: 1. No formal business plan or contracts for the activity. 2. Expenses almost always exceed any income from the activity. 3. Many years of losses. 4. 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 approach to look at each one of these activities as its own separate trade or business and make the determination on whether or not each one of these has or does not have a profit motive. Using this methodology, the IRS has taxed profitable activities while disallowing the ones with losses. Dual Use of Facilities Another area of focus by the IRS 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 is allowed to deduct an expense that is directly connected to an unrelated trade or business if it has a “proximate and primary relationship” to that unrelated trade or business. The Regulations further discuss this relationship regarding expenses directly related to unrelated business activities and expenses from the dual use of facilities or personnel. The Regulations state that the expense allocation between the dual uses must be “reasonable.” However, “reasonable” has been subject to interpretation and litigation. Some guidance may be found in Rensselaer Polytechnic Institute (RPI) v. Commissioner of Internal Revenue (1983/1984). In this case, RPI interpreted “reasonable” to mean that fixed costs as well as depreciation and overhead expenses that could not be associated directly with exempt student uses nor nonexempt commercial for-profit uses should be allocated based on percentage of total use, ignoring periods when the facility was idle. RPI prevailed. However, the Commissioner, to this day, 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. With 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 regarding such matters 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. These types of 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 of these types of activities discussed in the IRS regulations include advertising income from an educational organization’s journal or a scientific organization’s endorsement of laboratory equipment. For these types of activities, the IRS requires that organizations report and complete two separate calculations of net income from the activities – one from the taxable activity, and one from the exploited activity. Under 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. However, if the taxable activity shows a loss, 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 are putting excess expenses on page 1 of Form 990-T under deductions not taken elsewhere on Form 990-T. Conclusion With the increasing scrutiny by the IRS in this area, organizations with unrelated business activities generating losses on their Form 990- T should look closely at the following areas:
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