April 3, 2008 | Read Time: 4 minutes
The Internal Revenue Service will be paying increased attention to nonprofit organizations that raise money through business activities to make sure that the law requiring them to pay tax on the income is working as Congress intended, said a key official of the tax agency.
The revenue service wants to make sure that some charities are not overly aggressive and thus avoiding paying tax that the law requires them to pay, says Ronald J. Schultz, a senior adviser to the commissioner of the IRS’s Tax Exempt and Government Entities Division.
Mr. Schultz noted in an interview that a recent analysis by the agency’s Statistics of Income Division showed that more than half of tax-exempt organizations that file tax forms on unrelated-business activities report overall losses or zero taxable income. A review of large charities by The Chronicle (February 7) reached a similar conclusion.
Nonprofit groups must pay unrelated-business income tax, known as UBIT, on retail sales, magazine publishing, and other commercial operations that are not directly related to their tax-exempt purposes.
Mr. Schultz said the federal government enacted the tax in part so that charities could make money from unrelated enterprises while paying an appropriate tax.
“When you see losses, it’s fair to ask whether they are doing that,” he said. “Folks should expect us at the Internal Revenue Service to look for reasons why they are losing money.”
Many charities could have “a number of very legitimate reasons” why they might lose money on an unrelated business even though they sought to do well, he said.
“It could be that they just started it, and, just like for-profits, it takes awhile to get it off the ground and make money on it,” he said. “Or it could be that they fully intended to make money on it but the budget didn’t work or the business plan wasn’t very good and they guessed wrong. Or they were inefficient and they need to work on it.”
But some nonprofit organizations may wind up showing losses or zero income because they could be “misallocating” some expenses when they fill out their Form 990-T, Mr. Schultz said.
Deductible Expenses
Charities are allowed to deduct direct expenses for the business — those costs organizations incur only because they are involved in an unrelated business, such as the salary of someone working solely for the business, to reduce the amount of their unrelated-business income.
They are also allowed to deduct indirect expenses, which groups would incur even if they weren’t involved in a business — such as the salary of the chief executive officer of the organization, rent, and utilities. Organizations are allowed to apportion or “allocate” these indirect costs between their tax-exempt work and their unrelated-business activities.
“There clearly is an incentive for organizations to make sure on the 990-T that they allocate every appropriate cost or expense to minimize their tax burden. And what that means is they might look to become creative in the expenses that they allocate,” said Mr. Schultz.
“It may be that there are some allocations going on that are inappropriate,” he said, “and that there is excessive allocation of indirect costs to the unrelated-business activity to either reduce the unrelated-business income or in fact create a loss.”
Mr. Schultz said the IRS increasingly “is going to be looking at the indirect expenses to see how organizations are allocating, what methods they are using, and how much of the loss or how much of the reduction in the income is attributable to this allocation of indirect expenses.”
‘Arms-Length Constraint’
Mr. Schultz said the IRS is also concerned that some nonprofit organizations might not be fairly counting costs that they share with nonprofit or for-profit organizations with which they are related, such as having board members in common.
“They could do tax planning to figure out how much they are going to pay a related organization without an arm’s-length constraint” on the calculation, Mr. Schultz said, “to improperly reduce their unrelated-business tax liability.”
Mr. Schultz said that on UBIT matters, he does not “mean to be saying that because we are seeing all these losses that it means there is widespread abuse and the system has to be fixed. What it signals to me is that we should be looking at it. And we might very well find that there is a little bit of abuse but it’s mostly compliant and consistent with the structure that Congress built.”
Mr. Schultz said he expects that some nonprofit groups will pay more attention to the way they fill out the Form 990-T because of a recent change in tax law.
Until 2006, nonprofit organizations did not have to make the forms public, but in that year Congress passed legislation requiring organizations to disclose the returns.
“Because of the public nature of the 990-Ts going forward — and because you can reasonably expect the media and others to pay attention to these things — organizations are going to think more about them,” Mr. Schultz said.
“Increasingly,” he added, “you are going to see reports in the media about a particular organization that filed a 990-T that say, Here’s what it reported. Does this make sense?”
