IRS Examines Unrelated Business Income Tax Reporting for Nonprofits
posted Sep 25, 2015 by Sandy Ross, CPA, CFE in the Mission Matters Blog
Not-for-Profit organizations will want to pay attention to how they calculate the tax paid on unrelated business activities, since the IRS monitors this reporting very closely. After the IRS studied 400 public and private colleges and universities and had to perform 30 audits as a result, the IRS felt that a focus on the reporting of unrelated business income would be beneficial.
What is UBIT?
Let’s say your nonprofit’s mission is to end homelessness, and you run a bakery on the side (open to the general public) to raise additional funds. All income you raise from the bakery is considered unrelated business income, since it is not related to your exempt purpose. Any excess income over the allowable deductions for that income creates UBIT (Unrelated Business Income Tax).
Deductions allowed against unrelated income
There are certain expenses like bakery supplies, facility costs and staff costs which are allowed as deductions against unrelated income when it comes time to report. There are two types of expenses: directly connected and dual use.
Directly connected expenses
Directly connected expenses are deductions incurred entirely as a result of the unrelated business, meaning that if the bakery did not exist in the above example, these expenses would not be incurred (cost of maintaining the bakery building, for example).
Dual use expenses
Expenses incurred for both exempt functions and unrelated business are considered dual use expenses. Let’s say the president of the nonprofit mentioned above is paid $80,000 per year and spends 90% of her time on exempt activities, and 10% on helping the bakery. The organization can take a deduction of 10 percent of the $80,000 ($8,000) as a deductible expense of the unrelated activity when completing their Form 990-T.
In instances where the allocation of time is not as clear cut as this, the allocation of dual use expenses is a bit more complicated. When your organization uses a facility for both exempt and unrelated activities, the expenses, depreciation, etc. must be allocated between the two uses “on a reasonable basis.” Once the organization determines the expenses incurred for the dual purpose there are two methods that can be applied to allocate expenses (which might include repairs, maintenance, utilities and depreciation):
- The IRS Method- This method uses a ratio based on the number of days a facility is used for unrelated activities, compared to the number of days the facility is able to be used (365 days).
- The Rensselaer Method- This is another ratio based on the number of days a facility is used for the unrelated activities (numerator), related to the total days a facility is used for both unrelated and exempt purposes. This method is favored among nonprofits because more expense is allocated to the unrelated business.
It is crucial that you document, in detail, your reasoning behind all allocations. In light of the increased IRS scrutiny, it is a good idea to seek counsel from your accountant if you are having trouble allocating expenses. There are penalties if you inaccurately report unrelated business expenses.
For more information on unrelated business income, read our whitepaper, “Unrelated Business Income.”
Questions? Contact any member of our Not-for-Profit Services Team.