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Legal Watch: Can You Take a Call from the IRS?: Making Sure You’re Complying with Unrelated Business Income Rules

10/8/2013

 

By Ada Meloy

Colleges and universities, like many organizations, generate income from multiple sources, and in most instances they are exempt from paying taxes on this income, thanks to their nonprofit or governmental status. Colleges and universities are not exempt, however, from paying taxes on unrelated business income (UBI). A college or university creates UBI when it engages in (and makes a profit from) regularly conducted activities that are not substantially related to its exempt purposes, and must pay taxes on the net revenue derived from those activities. Bookstores, sports arenas, and on-campus convenience stores are all examples of activities that often create UBI.

A recently published report by the Internal Revenue Service (IRS), resulting from a compliance project that began with a questionnaire directed to 400 colleges and universities, provides some interesting commentary: After reviewing the responses to the questionnaire, the IRS decided to conduct examinations of only 34 institutions—fewer than 10 percent of the respondents. Of that select group examined, the IRS found that 90 percent had underreported their total amount of UBI.1 This resulted in significant additional tax liabilities for some of the affected institutions, and should serve as a warning to others to revisit their own compliance with the UBI statute and regulations. To avoid paying significant back taxes, a thoughtful plan with respect to classifying activities and the income and losses derived from them is recommended.

Ways to Approach Unrelated Business Income at Your Institution

While at first glance it might seem that the best way to avoid running into UBI trouble is to avoid engaging in any unrelated activity, this is not necessarily a desirable or feasible way to proceed. UBI can result from activities that improve the quality of life and overall experience on campus. There are, however, several things to keep in mind when dealing with possible UBI activities.

It is first important to distinguish whether an activity is substantially related to the exempt purpose of the college or university or whether it is unrelated. For example, charging tuition is directly related to the purpose of providing students with an education, as is selling textbooks, but selling basic apparel in an off-campus store is not. UBI is found most frequently in the areas of fitness/recreation centers and sports camps, advertising, facility rentals, golf courses, and arenas. While each of these areas helps to offer an enriched experience for students and the campus community at a college or university, none is necessary or essential to the mission of higher education. Institutions should consider evaluating the costs and benefits associated with these and similar facilities or activities on campus and review, with expert advice, whether they serve a substantially related purpose or whether the income should be reported as UBI. Activities such as operating a sports arena or allowing facilities to be used for non-institution-related functions will generally be unrelated. Additionally, food services on campus outside of the cafeteria, or any stores selling mainly to the public, should likely be carefully reviewed. An area that may provide basis for argument is the establishment of a business school venture capital fund that is set up either as an educational exercise or to provide start-up funds. Also, facilities that are intended as community benefit operations but not limited strictly to university uses may be supportable as related.

Critical Details

Once an institution generates $1,000 or more in UBI, it must file a Form 990-T, so it is important to consider annually what could be thought of as unrelated to the exempt purpose. There are a number of exceptions specified in the statute that remove them from UBI classification, including royalties, rents, interest, dividends, sales of stocks, and other specified instances of income received by the institutions. Consulting with qualified legal and tax counsel is essential in areas of uncertainty with regard to UBI. The IRS determinations in this area are largely in private-letter rulings based on specific facts that can give some insight—but rarely clear answers—to a particular situation that a campus might be facing. Since virtually all colleges and universities undertake some activities unrelated to their exempt purpose, care in classifying income derived from each activity is essential. Moreover, only those expenses resulting from unrelated business can be deducted against UBI. Perhaps it is ironic that if an unrelated activity has never resulted in a profit, it will not be considered as a business the institution engaged in for profit, and its losses cannot be deducted against any UBI the institution may have generated from other activities. On the other hand, if a business were so successful as to become a major revenue source for the institution, it could jeopardize the institution’s tax exemption.

The findings in the IRS compliance review and subsequent examinations underscore the importance of evaluating activities carefully to determine what is “substantially” related to the college or university’s mission. Income from activities that are not related should be reported and taxes paid accordingly, lest an IRS audit bring the tax collector to campus.

NOTES

1 The Colleges and Universities Compliance Project Final Report, posted on April 25, 2013, is available at www.irs.gov/pub/irs-tege/CUCP_FinalRpt_042513.pdf.

 

Ada Meloy is the general counsel of the American Council on Education.

 

 


 

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