Are You Entitled To Deduct Your UBIT Losses?
This fall, the IRS intends to roll out a compliance check to colleges and universities. One of the areas of focus will be unrelated business income tax (UBIT), and specifically, assessing how institutions determine and allocate UBIT revenue and expenses. This article will discuss the impact of the "profit motive test." This test, which was developed in case law and rulings during the 1980's and 1990's, effectively eliminates a UBIT deduction for losses if the activity that produces them lacks a profit motive.
Code Section 512(a)(1) states that the term "unrelated business taxable income" means the 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 Code Section authorizes an institution to offset the gains from one unrelated trade or business against the losses attributable to another unrelated trade or business.[1]
However, the losses must be attributable to a "trade or business" which is defined as an activity that is carried on for the production of income and that exhibits the other characteristics of a commercial enterprise.[2] In other words, a "trade or business" exists where an institution engages in an activity for the primary purpose of generating income or profit.[3]
The obvious risk to an institution in connection with the application of the profit motive test is that the IRS will disallow losses from an activity on the grounds that the institution did not engage in the activity for the predominant purpose of generating income or profit.
The Fourth Circuit Court of Appeals did precisely that in 1989 in a case involving the West Virginia State Medical Association.[4]
In this case, the association sought to offset commissions it received from a bill collection agency against losses it had sustained on advertising. The court disallowed the advertising losses and accepted the IRS' argument that the advertising did not constitute a "trade or business". In reaching its conclusion, the court stated that the association had "incurred direct advertising costs resulting in substantial losses for twenty-one consecutive years" and had "failed to explain why it consistently incurred losses that could have been avoided by simply discontinuing the advertising activity."[5]
For these reasons, the court concluded that "the association's long-standing policy of voluntarily incurring losses evidenced a lack of profit objective underlying the loss-generating activity."[6]
In reaching a similar result, the United States Supreme Court clarified that the profit motive test requires that a taxpayer demonstrate that it "intended to earn gross income ... in excess of its total (fixed plus variable) costs."[7] In other words, in order to satisfy the profit motive test, an institution must consider both its variable and its fixed costs attributable to the loss producing activity.
Following in the footsteps of the courts, the IRS has adopted a facts and circumstances approach to determine whether an activity constitutes a trade or business. In PLR 9719002, the IRS weighed the facts and ruled that an organization was not entitled to deduct losses from the provision of meals to an unrelated party. The IRS concluded that the organization did not have a profit motive for engaging in the activity based upon the following facts: (a) it had no business plan for the activity; (b) the activity was temporary (i.e., conducted over a 6-7 month period); (c) there was no contract with the third party that
received the service; (d) the organization made no effort to solicit additional customers; and (e) the organization took no steps to make the activity profitable. Despite the facts and circumstances approach, our practical experience reveals that, if there is a history of losses, the IRS will disallow the loss deduction even in the face of numerous other favorable facts and circumstances.
As an example of the IRS' approach to this issue, consider the experience of a fellow university.[8]
The school booked fifteen different professional entertainment events during an academic year. Some earned a profit, while others did not. The school offset the gains from the profitable events against the losses from the unprofitable ones, producing a net loss for UBIT purposes. In contrast, the IRS treated each event as a separate "trade or business" and ruled that the school had no profit motive for the unprofitable events. Applying this logic, the IRS taxed the profitable events and denied the offsetting losses from the unprofitable events.
In sum, the following facts may demonstrate a lack of profit motive, and may cause the IRS to disallow losses from an activity:
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Successive years without a profit;
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Variable and fixed expenses routinely exceed income from the activity;
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Continuing losses without adjusting price or discontinuing activity;
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Activity directed towards a single recipient with no effort to solicit additional sales or customers; and
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Informal operations (e.g., no business plan, no contract, temporary or intermittent provision of services).
While no single fact is determinative, a history of losses will weigh heavily against a deduction. In addition, a pattern of these facts indicates that an institution is not engaged in an activity for the primary purpose of generating income or profit. Since this issue impacts each institution's Form 990-T and will likely be a component of the IRS compliance check, it is prudent to self assess your institution's vulnerability for activities that have been producing a loss and take a fresh look at whether your institution is entitled to offset these losses against its unrelated business taxable income.
[1] Treas. Reg. § 1.512(a)-1(a).
[2] Treas. Reg. § 1.513-1(b).
[3] Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987); American Bar Endowment v. United States Supreme Court, 477 U.S. 105 (1986); and Brannen v. Commissioner, 722 F.2d 695 (11th Cir. 1984).
[4]
West Virginia State Medical Association v. Commissioner, 882 F.2d 123 (4th Cir. 1989).
[5] Id. at 125.
[6] Id.
[7] Portland Golf Club v. Commissioner, 497 U.S. 154 (1990).
[8]
Bertrand M. Harding, Jr., The Tax Law Of Colleges And Universities, 14-15 (John Wiley & Sons, Inc., 3rd ed. 2008). | 
