To support their unrelated business income (UBI) expense allocations in the face of IRS scrutiny, tax-exempt healthcare systems should take a fresh look at their expense-tracking methods. These organizations may benefit from reconsidering how they identify and document the primary components of unrelated business taxable income (UBTI) expenses.
Recent IRS examinations of tax-exempt healthcare systems have confirmed that the IRS appears to be taking a much more aggressive approach in challenging the manner in which hospitals allocate expenses to unrelated business activities. In some instances, the IRS is recomputing expenses reported on Form 990-T, “Exempt Organization Business Income Tax Return,” and converting losses into taxable income. Reductions in allowable expenses can have a significant impact, even on a single unrelated business activity reported on Form 990-T.
The fact that many organizations report large amounts of gross UBI on Form 990-T but minimal taxable income or, in some cases, significant losses has been a long-standing concern of the IRS. Now that the gross and net UBTI amounts are reported on page 1 of Form 990 in addition to Form 990-T, the legitimacy of expenses swiftly may be brought into question by the IRS. In fact, it is apparent that the IRS’ concern has increased and that it has stepped up its efforts to question and challenge the expenses that are reported on Form 990-T.
IRS Expense Allocation Standards
The IRS has five broad and somewhat overlapping standards for tax-exempt organizations to use when developing cost-allocation methods for determining UBTI:
- The method must allocate to the unrelated business activity only that portion of any item of deduction that is proximately and primarily related to the business activity, and only to the extent provided by IRC Section 162, Section 167, or other relevant provisions of the code.1
- The expense allocation method used by tax-exempt organizations must be reasonable.2
- The burden of proof with respect to the deductibility of expenses rests with the exempt organization.
- Once adopted, a reasonable method of allocation must be used consistently.3
- The method must clearly reflect income.4
What Tax-Exempt Healthcare Organizations Can Do
Notwithstanding the broad principles that have been developed, published, and applied in rulings and court cases, tax-exempt organizations continue to come up short in the eyes of the IRS. In the past two or three years, the IRS systematically has reduced or eliminated the expenses reported by tax-exempt healthcare organizations on their Form 990-T.
Expense allocation, or “misallocation of expenses” as the IRS describes it,5 requires organizations to apply only those expenses that have a primary and proximate relationship to the unrelated business activity identified. Of course, the concept is easier to articulate than it is to actually accomplish. One approach that tax-exempt healthcare organizations should consider is to focus on the primary expense components that constitute UBTI expenses – people, space, equipment, and overhead.
People – The first expense category to address is people. The initial step in this process is to identify the people who actually are conducting the unrelated activity in some way. The next step is to determine how much of their time is devoted to the unrelated activity and develop substantive documentation of that time, such as time sheets. If a determination is made that an employee was directly involved in conducting an unrelated activity, the organization should ensure that it has documentation that identifies the time spent on the activity and how that time was determined. Rough approximations of employees’ time as a percentage of the workday or workweek without some type of substantive support are likely to be questioned and challenged.
Space – The next expense category that should be documented is the space used to conduct the unrelated activities. The organization should have square footage allocations, time studies, and other sorts of documentation that show the connection between the amount of square footage and the amount of time the space is used for the unrelated activities. The organization also should determine whether the space is used exclusively for unrelated activities or whether it is dual-use property. Part of this analysis requires a determination of how many hours in a given day the specific space is used for both exempt and nonexempt activities. Any analysis should be conducted with the knowledge that the IRS has not accepted the reasoning of Rensselaer Polytechnic Institute v. Commissioner of Internal Revenue,6 which maximizes the expenses allocable to unrelated business activities by using the ratio of days a facility is used for unrelated business activities during the tax year (numerator) versus the total days the facility is used for all purposes during the year (denominator). The IRS would attribute to exempt purposes any time the space is not used, thus increasing the denominator (and minimizing allocable expenses) by using the total number of days the facility is available for use during the year rather than actual usage.
Equipment – In addition, the equipment and supplies used for performing the unrelated activities need to be identified and documented. If the equipment is used for both exempt and nonexempt activities, a breakdown similar to the space or real property analysis mentioned earlier will need to be performed. At each step of this expense analysis, the organization should ask the question, “How do we know that?” In other words, what substantiation does the organization have that this is an appropriate expense to allocate to the unrelated business activity?
Overhead – After these first three major expense components have been identified and documented, the organization should allocate the overhead expenses that are incurred to support the respective employees, personal property, and equipment used in the unrelated activities; the square footage of space that was used; the amount of utilities consumed; the allocation of interest expense of any borrowings related to that space or equipment; and all other categories of expenses that support the unrelated activity – ideally tracking and documenting the causal connection between such expenses and the activity.
Over the years, some healthcare organizations – especially very large organizations with many internal departments – have developed elaborate tracking systems to support the allocation of expenses to unrelated business activities. Some such systems were developed by firms or individuals no longer connected with the organization, which sometimes leaves the current finance and accounting staff to make assumptions about the rationale employed. Organizations dealing with such situations may benefit from taking a fresh look at expense-tracking methods and establishing annual procedures to review those methods for ongoing and new activities. With increased IRS scrutiny of unrelated business activities, now is the time for healthcare systems to verify that their methods are current, understandable, and defensible.
1 See Reg. 1.512(a)-1(a).
2 See Reg. 1.512(a)-1(c).
3 See Reg. 1.512(a)-1(f)(6)(i).
4 See Reg. 1.446-1(a)(2).
5 See IRS, “Colleges and Universities Compliance Project Final Report,” available at www.irs.gov/pub/irs-tege/CUCP_FinalRpt_042513.pdf. The Final Report states, “The IRS also found that on nearly 60% of the Form 990-Ts we examined, colleges and universities had misallocated expenses to offset UBI for specific activities.”
6 Rensselaer Polytechnic Institute v. Commissioner of Internal Revenue, 53 AFTR 2d 84-1167 732 F2d 1058 84-1 USTC ¶9397 (CA-2, 1984).