Back in 2013, the IRS released the final report of the College and University Compliance Project and one of the important takeaways for institutions of higher education was that they needed to pay closer attention to whether they are conducting any unrelated businesses at a loss on a consistent basis, and if so, then they are at risk of greater tax liability due to what are called the “hobby loss” rules. A recent Tax Court case gave us a further example of how those rules could impact tax exempt organizations and their operations.
Reminder regarding unrelated business taxable income:
First, a mini-primer on a complicated topic: Unrelated business taxable income (UBTI) is income resulting from an activity that is:
1. A trade or business,
2. Regularly carried on,
3. Not substantially related to the exempt purposes of the organization (outside of simply providing a source of revenue)
Income from such an activity is taxable, after deducting expenses directly connected to the activity. There are a host of exceptions and exclusions, and exceptions to the exceptions. The purpose of UBTI is to create an even playing field where tax exempt organizations are subject to tax when engaging in the same business as the taxable sector.
What did we learn about hobby losses from the College and University Compliance Project?
During the College and University Compliance Project, 90% of the organizations audited as a result of the project saw increases in their UBTI, totaling about $90 million. One of the drivers was the IRS determination that if an activity conducted by one of these organizations had a pattern of losing money and generating losses, then the organization does not have a profit motive for that activity. If there is no profit motive, then the “hobby loss” rule comes into play which limits your deductions to your revenue in the activity and doesn’t allow you to generate losses, which then means that you can’t use those losses to offset other taxable activities. So, if an organization has one activity that is very profitable, but another that is regularly conducted at a loss and may now constitute a hobby instead of a business – even though they have potentially significant taxable income, it can still result in zero tax. This wasn’t exactly new law, but still came as a surprise to many.
Hobby loss rule strikes again!
In a recent ruling issued by the Tax Court, the Losantiville Country Club, a Section 501(c)(7) social club, learned the hard way about running an unrelated business at a loss and was assessed taxes and penalties.
The Country Club operates a golf course, swimming pool, dining room, and other similar types of amenities you would typically see at a country club. Much of its revenue comes from member dues and charges, but nonmembers also pay to use the facilities. The nonmember revenue is considered to be an unrelated business with respect to the Country Club’s activities and is subject to tax, as is its investment income. During the audited years, the Country Club’s nonmember revenue was not more than the costs related to earning that revenue, and the Country Club used the losses to offset its investment income and reported no taxable income during those years. The IRS argued, and the Tax Court agreed, that the Country Club didn’t operate this activity at a profit and therefore it couldn’t use the losses to offset other potentially taxable income. Not only did the Country Club have to pay the taxes for prior years, but it was also assessed accuracy-related penalties for those years because they were assisted by a tax preparer and the preparer should have known better (*there is another lesson there*).
Takeaway
If your organization is regularly generating losses in an unrelated business and using those to reduce your taxable income from another unrelated business – you should seek professional advice!