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Figuring unrelated business income tax the IRS way.

Do you see eye-to-eye with the IRS? Two experts in nonprofit tax accounting procedures reveal insider information that will help you allocate costs the way the Internal Revenue Service would do it.

The chief executive officer of a Washington, D.C., trade association was informed recently by the controller that the Internal Revenue Service was assessing nearly a million dollars worth of tax, penalties, and interest on unrelated business income the association had "failed to report" in prior years. The executive's first thought was, "This is not in the budget." The second was, "This is going to be difficult to explain to the board."

The IRS has discovered that when it audits unrelated business income of a nonprofit organization, it collects, on average, twice the tax the nonprofit entity originally reported. And the IRS has determined that trade and professional associations underreport their tax more than most other nonprofit groups. Thus, it is not surprising that, on February 16, IRS Exempt Organizations Technical Division Director Marc Owens announced a special emphasis this year on auditing 501(c)(6) trade associations.

In a recent series of meetings between Lang + Associates, a consulting and certified public accounting firm in Bethesda, Maryland, and IRS officials, the red-hot tax issue of cost allocation against unrelated business income was discussed. During the discussions, a considerable gap was exposed between unrelated business income tax (UBIT) cost-allocation methods that the IRS considers reasonable and methods that most associations use.

This gap spells trouble. When examining unrelated business income, the IRS measures the reasonableness of an association's cost-allocation methods against certain facts and circumstances. If the IRS deems an association's methods unreasonable, it can recompute taxable income using allocation methods it considers reasonable. This may result in back taxes, penalties, and interest that can deal quite a blow to the association's budget.

This article was developed to help executives avoid this outcome by clarifying the tax rules. The information provided can be used by all associations to align their cost-allocation methods with IRS expectations.

Clarifying the process of cost allocation

Cost allocation is the process by which costs are applied to a particular activity; in other words, what did it cost to produce this activity? Allocation of costs is a much more critical tax issue for nonprofit organizations than it is in the for-profit sector. This is because a nonprofit group's exempt-purpose revenues are not subject to tax, while its unrelated business income revenues are. Thus, how costs are allocated between nontaxable and taxable revenues can make a significant difference.

Two fundamental axioms explain why cost allocation is controversial and likely to remain so. First, cost allocation is an inexact science for which there is no one correct method. Second, cost allocation is complex if done correctly. Thus, errors in logic and other traps lurk, and the consequent distortions in results often are not readily detectable. A clear corollary is that opportunities abound for associations to manipulate costs.

Manipulation spurred by recession

Only during the past five years or so has UBIT cost allocation emerged as a major issue. The applicable tax law has changed very little since the 1970s. What has changed are the economic climate facing associations and the collection pressure facing the Internal Revenue Service.

The recession has caused trade and professional associations to look harder than ever for nondues income sources. Many of the sources they target are unrelated to their exempt purposes and, therefore, subject to the unrelated business income tax. In an effort not to lose any of this income through taxes, many associations assert that their unrelated business income revenues are more than offset by the expenses the associations choose to allocate against the revenues. Revenues may be reduced either by direct costs, such as the cost of printing an advertisement in an exempt periodical, or by indirect costs, such as a receptionist's time in handling phone calls that include request to place the advertisement. The term cost allocation refers most precisely to indirect costs, ones that relate to a variety of activities and thus must be "allocated" among them. Many associations are aggressive in allocating indirect costs to offset unrelated business income revenues and thus pay no tax.

As associations have sought allocation opportunities, Congress and the executive branch have placed considerable pressure on the IRS to collect additional revenue under existing tax law as an alternative to imposing new taxes. The Pickle Subcommittee hearings on UBIT, launched in the summer of 1987, operated on the premise that nonprofit organizations were an inviting source of additional tax revenue. However, the nonprofit sector proved to be a powerful opponent of new UBIT provisions in the tax law, and no meaningful changes were enacted. What did result from the hearings were instructions to the IRS to determine the potential for additional UBIT collections.

IRS audits revealed additional tax amounts that, while insignificant in terms of the overall federal budget deficit, were nonetheless significant to the associations being taxed. In addition to finding much unrelated business income going unreported, the examiners found valid reasons to greatly reduce or entirely disallow associations' cost allocations against the reported unrelated business income. The result of these audits was higher taxes for the associations, plus penalties and interest, not only for the year under examination but usually for one or more prior years as well.

Particularly vexing to audited associations has been the fact that the cost-allocation rules are poorly defined. How can associations be expected to follow the rules of a process that is an art form at best?

Tough-to-follow rules and regs

What are the IRS rules and regulations for allocating costs? The regulations say that to be deductible against unrelated business income, expenses must be "directly connected" with the revenue source in question and have a "proximate and primary" relationship to it. Neither of these concepts is defined by the regulations, except that they are used to define each other. The regulations also require that any allocation of expenses among related and unrelated activities be done on a "reasonable" basis and be "consistently" followed. The regulations contain no "safe-harbor" methods or clear-cut tests and few concrete examples. As mentioned before, the determination of what is reasonable depends on the facts and circumstances of the case in question.

Little additional guidance is found in the Form 990-T instructions or in the IRS's Exempt Organizations Examination Guidelines Handbook. Insights relevant to certain situations may be gained from several key court cases (see sidebar, "Key Cases"), but these decisions provide few final answers on what is "reasonable" and the IRS actively disputes the outcome of one of the cases (Rensselaer Polytechnic Institute).

As is true in almost all tax matters, the burden of proof is on the taxpayer. IRS examiners merely must establish that the taxpayer has failed to prove that the cost-allocation method used is reasonable. An examiner might decide that a method lacks adequate documentation, or contains an internal contradiction, or simply lacks credibility based on the facts and circumstances.

Once establishing that the taxpayer has failed to prove use of a reasonable method, an examiner generally constructs a method that is reasonable from the perspective of the Internal Revenue Service, then recalculates the tax liability on that basis.

Interestingly, few associations undergoing an IRS audit have complained of examiners overstepping rules or taking cost-allocation principles to unreasonable extremes. Instead, the unfortunate phenomenon associations have encountered is that the typical examiner actually enjoys the mathematical intricacies of cost allocation and is good at the process. The most common result of these calculations is a substantial increase in UBIT owed.

Discussions with the IRS

The series of meetings between Lang + Associates and the IRS on these issues took place this past January and February. The purpose was to elicit informal advice as to what cost-allocation methods might be considered reasonable in a given set of circumstances. The meetings were held with two distinct groups of IRS representatives. Members of the IRS Exempt Organizations Division's operational arm supplied most of the insights about specific methods. Members of the IRS Technical Division offered a perspective on possible revisions to the regulations and addressed certain procedural points.

It bears repeating that the advice sought was strictly informal. At no time would any IRS official commit to a given position without at least some qualification, such as "it seems reasonable given the limited facts" or "it would still depend on all the facts and circumstances." This reticence was understandable due to the nature of the regulations and the numerous cases currently under audit.

Several valuable principles emerged during the dialogue. One IRS official raised anew the rule of thumb put forward by Howard Schoenfeld, a prominent official of the IRS Exempt Organizations Division, which he labeled "the Washington Post test": If you as an association executive would be embarrassed by seeing your method of cost allocation described in The Washington Post, then it probably is not a reasonable method. A more pedestrian expression of the same point is to ask whether an impartial third party would view the method as reasonable.

Another principle is that you should not allocate costs in such a way that shows a significant unrelated business income loss year after year. A third party might easily ask, "If you're really losing money and it's not related to your exempt purpose, why are you doing it?" The IRS is armed with a court precedent that makes this same point, namely the West Virginia State Medical Association case, cited in the sidebar. Losses may still be justifiable, such as in the case of renting out an unused portion of a large, debt-financed headquarters building, but the justification should be considered before reporting the loss.

Beyond these principles, IRS representatives described what they would consider a good method of cost allocation. As indicated, the methods used by the vast majority of associations are not nearly thorough enough in the eyes of the Internal Revenue Service.

What the IRS "prefers"

The IRS prefers to see a method that distributes all association expenses to the various program activities, whether they are related or unrelated and whether or not they produce revenue. In other words, methods that allocate indirect costs only to unrelated business income activities and not to other cost centers are seen as particularly suspect.

Further, the IRS clearly prefers a "multiple-base" method of allocation. Such a method, for example, allocates some costs on the basis of salaries, others on labor hours, others on square footage, and so on.

Finally, the IRS prefers to see a "step-down" method in place. A step-down method is one that recognizes that some indirect costs benefit other indirect cost centers as well as direct cost centers. (Further explanation of this method appears in the question-and-answer section of this article.)

Developing an acceptable method

The officials from the IRS discussed the development of an acceptable cost-allocation method. In doing so, they also pointed out instances in which associations typically "go wrong."

A key discussion point was that, for an expense to be deductible against unrelated business income, it must first meet the Internal Revenue Code's general criteria as an "ordinary and necessary" trade or business expense. If depreciation is deducted, it must be on a basis accepted for tax purposes, such as the Modified Accelerated Cost Recovery System (MACRS), or straight line for debt-financed realty. Any special UBIT rules contained in the code or regulations must also be met, such as the rules for deducting mechanical and distribution costs against advertising in exempt periodicals.

The officials went to great lengths to point out that the expenses listed in an association's financial statements might well be different from those allowable against unrelated business income. Financial statements are commonly prepared based on generally accepted accounting principles (GAAP), which differ--sometimes significantly--from income-tax-based accounting principles.

Following is a partial list of potential differences between GAAP financial statement expenses and expenses that are tax-deductible.

* The depreciation method used for financial statements may not be allowable for tax purposes.

* Twenty percent of expenses for meals and entertainment is not deductible.

* Allowance for bad debt is not deductible--only direct write-off of bad debt.

* Federal income taxes are not considered deductible.

* Excise taxes, such as qualified pension plan excise taxes (Chapter 43 of the code), are not deductible.

* Fines and penalties are not deductible; nor are illegal payments or bribes.

* Key-man life insurance premiums are not deductible unless they are considered compensation to the employee.

* Expenses required to be handled differently by various audit guidelines--such as management and general expenses under the health and welfare audit guide--may or may not be considered deductible.

Another frequent source of errors IRS officials encounter involves associations that receive government grants. Having completed a long and detailed negotiation of a method of cost allocation acceptable to the granting federal agency, associations are sometimes inclined to use the same method in relation to their UBIT sources. The officials specifically cautioned that costs reimbursable under government grants might not meet tax code criteria. For instance, some meal and entertainment expenses might be fully reimbursable under the grant, but only 80 percent of the expenses would be deductible for tax purposes. Cost-allocation methods developed for federal grants may still be used for UBIT purposes, but they require tailoring to meet tax code rules.

The officials emphasized the need for associations to identify, segregate, and distribute all direct costs. A cost cannot be left in an indirect cost "pool" and allocated to UBIT if it is specific to some other activity. The following reality test applies: A cost is indirect only if it cannot possibly be allocated directly. Thus, consultant fees can be indirect, but only after every effort is made to try to identify them as directly related to a particular project or program. Certain costs are specified as nonallocable by the UBIT regulations because the costs are directly allocable to exempt activities. For example, membership development and fund-raising costs are deemed specific to exempt purposes and are not allocable against UBIT activities that these costs might appear to benefit (see Reg. Sec. 1.512(a)-1(e)).

There are other categories of costs most likely to be classified as indirect. The following costs would most often be left as indirect but might be considered direct under some circumstances:

* board meeting expenses;

* interest on general-purpose borrowing; and

* licenses and taxes.

One common fallacy pointed out by the officials is failing to segregate costs that have been reimbursed or will be reimbursed by third parties. Obviously, such costs should not be allocated either directly or indirectly; nor should they form part of the basis on which other costs are allocated.

Once all direct costs are distributed, the indirect costs may be allocated. (By strict definition of the word, "allocation" refers only to indirect costs.)

During the segment of the discussions that focused on method development, several critical issues surrounding cost allocation were clarified. Following are key questions raised and the answers given.

Q: What kinds of costs may be considered indirect? When is an indirect cost actually direct?

A: Salaries and benefits of the following staff are generally considered indirect: accounting staff, receptionist, janitors, and, in most circumstances, the executive director/president and people charged primarily with board relations. Likewise, board meeting and governance expenses are generally considered indirect; it depends on what the executive director and the board are doing. For example, if most of their activity consists of pursuing a legislative agenda, then salary and other expenses would not be indirect. Similarly, if 90 percent of the receptionist's time and attention is engaged in taking sales orders, then his or her salary and related expenses would not be indirect, at least not for that 90 percent.

Q. Could a partial-allocation method, one that allocates indirect costs only to a single activity (a UBIT source) rather than allocating indirect costs entitywide, ever be considered acceptable? (An example of such a method, common among small to mid-sized associations, is to load a portion of all overhead expenses onto the advertising income after the end of the year for the purpose of completing the Form 990-T. No further allocation is done.)

A: An association could adopt partial-allocation methods but would do so at its own risk; the association should keep in mind that "rough methods produce rough results." To prove the accuracy of its method, the association would have to test the method year by year against another more thorough one. Hence, there would most likely be as great an effort involved in employing the "short-cut" method as in employing a more thorough one preferred by the IRS.

Partial-allocation methods can produce unexpected and unfortunate consequences under an IRS audit. For instance, if the method were carried through to allocate indirect costs to other activities, it might result in increasing a 501(c)(3) organization's reportable lobbying expenses above what the association actually reported. There might also be implications for the allocation of indirect costs to fund-raising expenses. By applying the partial-allocation method throughout the organization, an association could test for these implications early on.

Q: Could a "one-step" cost-allocation method, using a single allocation factor, be considered acceptable under some circumstances?

A: Before answering this question, the jargon of indirect cost allocation must be defined. Among entitywide cost-allocation methods are "one-step" and "step-down" methods, using either "single-factor" or "multiple-factor" bases for allocation.

A one-step method allocates all costs from all the overhead departments (or the indirect cost centers) to the program departments (or the direct cost centers), without any intermediate steps.

A step-down method recognizes that some indirect costs benefit other indirect cost centers as well as direct cost centers. This method starts by allocating one set of indirect costs (for example, occupancy costs) to overhead departments (for example, finance and administration) as well as program departments. In succeeding steps, the accumulated costs of each overhead department are eliminated by allocating them to the remaining overhead and program departments. This continues until all indirect costs have been allocated to the program departments, including those containing unrelated business income.

An allocation factor, or basis, is the independent variable on which an allocation is based. If it can best be said that certain indirect costs vary in proportion to employee time devoted to the ultimate programs, then employee time is the allocation factor of choice. If other indirect costs are more a function of square footage set aside for the various program departments, then square footage is the allocation factor of choice.

Smaller associations tend to use a single factor as a basis for allocating all indirect costs; larger associations tend to use multiple factors--one factor for certain indirect costs, another factor for others, and so forth.

Table 1 illustrates a one-step method using a single allocation factor. Would such a method be acceptable to the IRS for smaller, less complex associations?

Neither the technical nor the operational IRS representatives ruled out this possibility, but neither would acknowledge its acceptability beyond any but the simplest set of circumstances. With any complexity at all, or if large dollar amounts are involved, the IRS advises going to a multiple-factor, step-down method.

Q: On what allocation factors should an association rely?

A: These are some of the allocation factors currently used by associations:

* direct cost--a ratio of direct costs of the activity to total direct costs of the association (this method is followed under most government grants);

* salary--a ratio of direct salaries by activity to total salaries;

* labor hours;

* number of employees;

* budgeted salaries or labor hours;

* square footage;

* computer use measures;

* gross income; and

* estimates.

The operational officials commented on the perils inherent in using any one of these factors by itself. Consider as an example a small association whose annual convention is by far its largest "product." Use of a direct-cost ratio would be unreasonable if the convention was handled entirely by a third-party vendor, unless the direct-cost ratio was modified to discount or omit such costs. Alternatively, if the convention was handled entirely in-house, a direct-cost ratio might well be appropriate.

Salary is the most commonly used allocation method. However, it too can be "unreasonable" under some circumstances. For example, if personnel performing work for a magazine receive 20 percent of the organization's salaries but occupy only 10 percent of the building, use of salary to allocate occupancy costs would be clearly unreasonable.

The officials highlighted the fact that a salary ratio could be a big problem in certain cases where a 501(c)(6) organization leases a portion of its facilities at no charge to a related 501(c)(3) entity. In those situations, where little or no salary costs are assigned to the activity of leasing to the 501(c)(3) organization, a substantial allocation of appropriate indirect costs would not be done. Failure to allocate indirect costs to the 501(c)(3) leasing activity would incorrectly increase allocations to the 501(c)(6) organization's UBIT activities, if any, as well as underreport the 501(c)(6) group's support of the 501(c)(3) entity.

Generally speaking, salary ratio or labor hours are appropriate factors for allocating personnel-related expenses. However, budgeted salaries or labor hours are only considered reasonable if they agree closely with the actual year-end figures. The IRS considers budgets to be estimates before the fact and, thus, less acceptable than estimates made after that fact (which the IRS considers likely to be wrong in any case).

Square footage is considered a valid basis for allocating only certain selected costs, most notably occupancy. Where there is physical overlap (that is, more than one activity carried on in the same space), square-footage ratios become problematic, even for occupancy.

Gross income ratio is generally not considered reasonable (Reg. Sec. 1.512(a)-1(f)(6)(i)). The officials commented that gross income would be "worthless" as a basis for a single-factor allocation, probably even worse than estimates. In a multiple-factor allocation, gross income could be appropriate for certain expenses, such as costs of goods sold.
TABLE 1

One-Step, Single-Factor-Allocation Method

1. Summary schedule of direct and allocated costs

ALLOCATION FACTOR
 Salary Totals
 Financial ratio after
 statement (2, below) allocation

FUNCTIONAL GROUPINGS:

Overhead cost centers:

Occupancy costs 200,000 (200,000) 0
Executive director 100,000 (100,000) 0
Accounting and personnel 200,000 (200,000) 0
Data processing 100,000 (100,000) 0

Subtotal 600,000 (600,000) 0

Program cost centers:

Member services 50,000 60,000 110,000
Lobbying 50,000 90,000 140,000
Convention 100,000 150,000 250,000
Magazine:
Advertising 50,000 90,000 140,000
Nonadvertising 150,000 210,000 360,000

Subtotal 400,000 600,000 1,000,000

Total 1,000,000 0 1,000,000

2. Allocation based on direct labor dollars
(based on time sheets; could be based on effort reports)

 Salaries, Distribution
 benefits, to program
 and taxes Ratio cost centers

Member services 30,000 10% 60,000
Lobbying 45,000 15% 90,000
Convention 75,000 25% 150,000
Magazine:
Advertising 45,000 15% 90,000
Nonadvertising 105,000 35% 210,000

Total 300,000 100% 600,000


For an example of how an allocation based on gross income could distort reality, consider an association that leases a major portion of its building. Suppose the triple-net lease generates one third of the association's revenues, but lease maintenance requires no more than 100 hours a year of employee time. For an even more egregious result, consider the fact that some activities (lobbying, for instance) generate no revenue at all. In these circumstances, it would clearly be unreasonable to allocate overhead in direct proportion to the revenue generated.

Estimates are difficult to prove reasonable. To do so requires an inordinate amount of documentation and testing of the estimates against some actual figures. Estimates will be challenged, says the IRS.

For all of these reasons, the IRS prefers the use of different or "multiple" factors to allocate different kinds of indirect costs. As Table 2 illustrates, it is possible to employ multiple factors in a one-step allocation method. But having gone so far as to use multiple factors, using the IRS's preferred step-down method does not add much complexity.

When establishing a step-down method, care should be taken in determining the order in which overhead departments are allocated. Generally, the first costs allocated should be those with the broadest coverage (for example, occupancy costs or perhaps the salary and associated costs of the executive director). Whatever order is developed should be used consistently.

This is not the first time step-down methods have been recommended to the association community. Cost-allocation methods for associations, and step-down methods in particular, were described 22 years ago by certified public accountant Arthur F.M. Harris in ASSOCIATION MANAGEMENT (July 1971, pp. 36-41, "New Accounting Problems Ahead for Associations"). An example of a step-down method has been adapted from that article. The order of steps shown in the table reflects the IRS's preference in this instance. It is interesting to note in Table 4 that, of the various methods shown in Tables 1 through 3, the step-down method allows the least expense to be allocated against advertising income. Another scenario might produce a different result, however.

Documentation critical to success

During the Lang + Associates-IRS discussions of allocation methods, the IRS officials clearly indicated that if there is no substantiation, there may be no deductions allowed. IRS examiners have reached this conclusion in a number of cases, and the courts have tended to agree.

Remember that the burden of proof is on the taxpayer. Acceptable proof consists of documents the association actually has used, not documents and arguments generated in response to an upcoming IRS audit.

Essential documentation includes, among other things, the work sheets used to develop the allocation methods, as well as any other proof of how and from where the numbers were derived.

If an association uses salary or personnel hours as an allocation basis, then contemporaneous time records created by the employees themselves, or by contemporaneous interviews with employees, are essential. The officials emphasized the necessity for the records to be contemporaneous and defined that as no less frequent than the end of every month.

The officials did agree that if an employee works full time on only one activity and that role is supported by a job description, then time records would not be required. However, if any portion of an employee's salary is to be charged to a UBIT activity, a contemporaneous time record is highly desirable.

"Level-of-effort" reports may be allowed but also must be contemporaneous. In an effort report, an employee records the approximate percentages of each day devoted to his or her various tasks.

Regularly prepared time sheets are clearly the best evidence, but time sheets from sample periods may be allowed if the sample is truly representative. For example, if the association's main source of revenue is an annual meeting and an employee chooses to record the time periods immediately preceding and during that meeting, that's clearly not a representative sample. (Remember the Washington Post test.)

The consistency issue

The regulations state that a reasonable method of allocation, once adopted, must be followed consistently. The following series of questions and answers addresses essential consistency issues.

Q: Is consistency required among financial reports? For example, does the expense breakdown on an association's Form 990 need to match corresponding expenses shown on its 990-T? (In most associations, the 990 numbers are taken from the audited financial statements, which frequently do not allocate indirect costs to programs.)

A: The simple answer is that consistency, especially in the expense area, is not expected. The IRS reply was that for many associations it would be impossible for expenses related to advertising as shown on the 990-T to match those shown on the audited financials unless the audited financial statements were prepared on an unrelated business income tax basis.

The IRS officials noted that the business and depreciation deductions on the 990-T must follow the tax code requirements, which differ in many aspects from the requirements for preparing financial statements. These "book-tax" differences were enumerated earlier. The officials specifically noted that the tax code allows only the method of direct write-off for reporting bad debt, not the method of allowance for doubtful accounts. This issue frequently arises for advertising revenues and for sales of inventory items.

The officials did indicate that some consistency was expected. For example, 990s, especially in reporting management and general and fund-raising expenses, should track closely with audited financial statements. They also pointed out that unrelated business income revenues shown on the 990 should match the 990-T.

Q: If expenses on the 990 or the audited financial statements do not need to match the 990-T, what are elements of a good connecting trail?

A: The IRS strongly prefers to establish a trail directly from the adjusted trial balance to the 990-T, rather than from the 990. A "statement of book-tax adjustments" attached to the 990-T filing is particularly desirable.

As discussed earlier, book-to-tax work papers are an important part of good documentation. If, however, they are created only after the year's end and do not follow a method already in place (as established by existing documents such as contemporaneous time sheets and square-footage measures taken earlier), the work papers will be suspect.

Q: If a "reasonable" allocation method is adopted with respect to one unrelated business income activity, must the same method be applied to future unrelated business income activities from different sources?

A: The IRS representatives replied that the obvious answer is no. A given method might be reasonable for one unrelated business income activity, and completely unreasonable for another.

Q: What about consistency over time?

A: The representatives have a real concern about the use of a consistent allocation method from one year to the next. This concern was evidenced in the National Association of Life Underwriters case, in which the IRS argued successfully that the taxpayer's newly adopted method was not applicable because the association previously had adopted a method that had been determined reasonable in an earlier IRS examination. The IRS asserted that, under the regulations, NALU could not abandon that reasonable method without prior IRS permission.

Q: Is an association locked into its existing allocation method?

A: When posed with the concern that change from one method to a better method was best in the long run for both the association and the IRS, the officials admitted that there were many scenarios in which a change could be undertaken successfully. But each such change has its own hurdles. For instance, an association could change to a better method and skirt the impact of the NALU case by claiming that its former method was unreasonable. The problem that arises here is that if the former method was unreasonable, the association would be required to file amended returns for the years in question.

The next scenario described an association that was unsure of the acceptability of the method it had been using; the association wanted to switch to a method favored by the IRS. The association asked if it would be able to do so without conceding that its old method was unreasonable, thus avoiding filing amended returns.

The IRS's operational department representatives suggested that such a change could be undertaken with confidence. TABULAR DATA OMITTED TABULAR DATA OMITTED The association would need to file a Form 3115 application for a change in accounting method within the first 180 days in the year of change, accompanied by a $200 user fee. The unfortunate aspects of this alternative are: 1) Form 3115 is eight pages long and is accompanied by four pages of instructions; and 2) as with filing amended returns, this alternative has the unattractive by-product of bringing the change directly to the IRS's attention.

Does a 3115 always have to be filed? For instance, would a 3115 filing be required for changing from a "reasonable" cost-allocation method to one that is "more reasonable"?

The IRS Technical Division representatives considered an example of an association using a one-step method with salary as the single factor, changing subsequently to the IRS-preferred step-down, multiple-factor method. Based on the example provided (see Tables 1 and 3), the representatives did not see the changes as involving a "change in accounting method" that would require Form 3115. However, associations wishing to make a change should seriously consider filing the 3115 to start the running of the statute of limitations.

In cases where a 3115 is not required, should the association report a change in method of allocation for UBIT? For instance, should a statement of disclosure, including results both under the old and new methods, be attached to the 990-T, or should the 3115 be filed anyway?

The IRS operational representatives indicated that merely attaching a disclosure statement to the 990-T would not have the advantage of starting a three-year statute of limitations, because there is no existing requirement to disclose this type of change. This means that associations wishing to change from any method that is not "unreasonable" are left with the choice of going through the expense and risk of filing the 3115 to be safe, or making the change without satisfactory disclosure to the IRS--thus running the risk of having the new method disallowed on audit.

Q: With all this uncertainty, what about making no change at all?

A: The IRS's response to this question is worth repeating verbatim: "Examiners are looking for allocation opportunities. Agents are doing allocation on an expense-by-expense basis. They are finding lots of unreasonable methods that are insupportable. The agents are leveling the playing field."

Q: When will better cost allocation guidance be available?

A: The IRS representatives expressed some doubt as to whether it made for good tax policy to have field examinations set the standards for cost-allocation methods. The representatives pointed out that the Exempt Organizations' business plan for 1993 calls for the Office of the Chief Counsel to develop proposed regulations for allocating costs of facilities used for both exempt and unrelated business income activities, either concurrently or alternately.

Q: Is there any guidance planned for the newer forms of unrelated business income?

A: Lang + Associates pointed out the complete absence of guidance for allocating costs against emerging new sources of UBIT--specifically, charges for access to on-line data bases and advertising in informational videos. The officials replied that the IRS is considering the addition of specific rules to the existing regulations. The rules would provide guidance in UBIT areas other than advertising in exempt periodicals, which is the only area where specific guidance is now provided. How such rules would be administered is a question being debated within the IRS itself. Until the guidance is provided, associations are left with the Washington Post test to guide the way.

Practical recommendations

No one should expect significant changes in the regulations anytime soon. The length of the process required of the IRS in either amending or issuing new regulations is generally measured in years.

For some time to come, being able to prove your method reasonable will remain the name of the game. No method seems completely safe from IRS attack.

In this uncertain climate, association executives should take some practical steps:

Alert your board. Overall, the number of 990-T's audited remains relatively low. However, the average increase in tax liability found on 990-T audits is high. You should apprise your board of these essential facts and explain why you can offer no guarantees that an IRS audit might not disallow your cost-allocation method and raise your association's tax bill substantially.

Weigh the stakes. What is your maximum potential tax bill, including interest and penalties, in the extreme event that all your cost allocations are disallowed? If it's an amount that won't endanger your association's security or yours, then it might not be worth the time involved to upgrade your cost-allocation method--the time might be better spent on other projects. Most associations will find it worth the time.
TABLE 4

Comparison of Results of Various Allocation Methods

 One-step, One-step, Step-down,
 single multiple multiple
 factor factors factors

Member services 110,000 110,000 138,194
Lobbying 140,000 140,000 120,689
Convention 250,000 250,000 232,234
Magazine:
Advertising 140,000 130,000 121,573
Nonadvertising 360,000 370,000 387,310

Total 1,000,000 1,000,000 1,000,000


Test your method periodically. Compare it to the method the IRS favors: an entitywide step-down method using multiple allocation bases. If you find no great differences in result, you will gain a substantial measure of comfort. If the results do differ (or even if they do not), you may find that, having thought through the full step-down process and having created the electronic spread-sheets, the work involved in maintaining and employing it on a regular basis will be far less than you thought it would be.

Improve your documentation. This may be the best protection that an association can provide for itself. If your association doesn't already keep contemporaneous time sheets, it should start. Time sheets should be supported by job descriptions that do not tell a conflicting story. Cost-allocation work papers should show consistency of method and should tie directly to time sheets, recorded square-footage measurements, and other records.

Reducing the uncertainty

Given the wording of the regulations and the lack of other guidance from the IRS, you are faced with considerable uncertainty as to whether your association's cost allocations will survive IRS scrutiny. More specific guidance must be offered by the IRS in the future in the form of regulations or other pronouncements. Until such time, follow the informal guidance gathered from the discussions--and you will reduce the uncertainty in figuring your association's unrelated business income tax.

Cost Allocation Do's and Don'ts

1. Do use a consistent method, but

2. Don't use the same allocation percentage(s) year after year. The number underlying the percentage will change from one year to the next.

3. Do charge as direct costs all expenses that can possibly be identified with specific activities. Reduce the pool of indirect costs as much as possible.

4. Don't allocate on ratio of gross income under most circumstances.

5. Don't allocate membership development/fund-raising costs (see Reg. Sec. 1.512(a)-1(e)). These generally should be direct costs to ultimate functions, not left as indirect costs.

6. Don't allocate legislative or lobbying costs. These generally should be direct costs to ultimate functions, not left as indirect costs.

7. Do maintain contemporaneous time records.

8. Do use floor plans and leases for square-footage allocations.

9. Do keep all work sheets and records used to develop cost allocations.

10. Do address the allocability of

* interest expense on general purpose borrowing;

* board of directors meeting expenses;

* legal and accounting fees;

* A-133 audit fees;

* other consultant fees;

* licenses and taxes; and

* off-site expenses, especially meeting expenses.

11. Don't tie your future to an allocation method you would not want to see described in The Washington Post.

Key Cases Providing Cost-Allocation Insights

* Rensselaer Polytechnic Institute v. Commissioner, 732 F.2d 1058 (2nd Cir. 1984). The issue centered on what is considered a "reasonable" allocation of expenses between exempt activities and unrelated trade or business activities of a facility owned and operated by a tax-exempt organization. The university used its field house for tax-exempt purposes and for the production of income through commercial activities and events unrelated to its tax-exempt purpose.

A dispute arose over Rensselaer's method of allocating fixed expenses in determining the amount of unrelated business taxable income resulting from the commercial activities and events.

The IRS argued that the appropriate method of allocation of fixed expenses between exempt and nonexempt purposes should be based on the total available time. The taxpayer asserted that fixed expenses should be allocated on the basis of actual use between exempt and taxable activities.

The court held that the organization's method of allocating expenses between exempt purposes and unrelated trade or business activities on the basis of hours of actual use of the facility, rather than the total time available for use, was "reasonable" within the meaning of Treas. Reg. 1.512(a)-1(c).

The IRS was extremely unhappy and, in an Action on Decision (CC-1987-014), stated the following: "We continue to believe that fixed expenses should not be allocated on the basis of actual usage. The proper method of allocation of the fixed expenses should be allocated between exempt and unrelated use on the basis of a 24-hour-a-day, 12-month-a-year period, with an allocation of hours used for unrelated activities over the total number of hours in the year.

"However, we now believe that this issue should not be litigated until the allocation rules of section 1.512(a)-1(c) of the Income Tax Regulations are amended. As long as the language permits an allocation between exempt and unrelated uses on a "reasonable" basis, it may be difficult for the Service to prevail on this issue in another circuit."

Although there has been no amendment to the allocation rules of Treas. Reg. 1.512(a)-1(c), the IRS's position remains directly contrary to the court's decision according to 1) IRS Letter Ruling #9149006, Aug. 12, 1991; and 2) IRS General Counsel Memorandum #39863, Nov. 26, 1991.

* National Association of Life Underwriters, Inc. v. Commissioner, T.C. Memo 1992-442, August 5, 1992. The cost-allocation aspect of the case revolved around two lines in the tax regulations concerning advertising in exempt periodicals and so-called dual-use expenses:

"Where items are attributable both to an exempt organization periodical and to other activities ..., the allocation of such items must be made on a reasonable basis which fairly reflects the portion of such item properly attributable to each such activity. The method of allocation will vary with the nature of the item, but once adopted a reasonable method of allocation ... must be used consistently." (Reg. Sec. 1.512(a)-1(f)(6)(i)) |Emphasis added~

Despite NALU's effort to show that it had used a reasonable method for allocating dual-use expenses for its 990-T filings, the court agreed with the IRS that the association had previously adopted another "reasonable" method (on its earlier 990-T filings) and it could not change methods because of the regulation's requirement that a method be used consistently. From NALU's standpoint, the IRS had found another method in use in previous years and the court had then required NALU to prove that method unreasonable.

As a result of this logic, the association had to allocate some of its indirect costs on a less advantageous basis and was completely unable to allocate any costs connected with its convention, conferences, or legislative expenses. The court found that these costs had not been allocated to the magazine under the previous "reasonable" method, and the fact that the magazine reported on those activities did not provide any reason to alter the pattern.

The NALU case can be misleading in that the consistency standard could be interpreted to mean use of a consistent percentage (27 percent). The percentage should be recalculated each year.

* West Virginia State Medical Association v. Commissioner, 882 F.2d 123 (4th Cir. 1989). On its Form 990-T, the association had been reporting a loss on advertising in its exempt periodical. The loss was used to offset positive unrelated business income from marketing the services of a collection agency, with the result that taxable income reported on the 990-T was negative.

The court found that the advertising was not an activity conducted for profit and, therefore, did not constitute unrelated business income; hence, it disallowed the loss. In doing so, the court observed that although advertising in general did constitute unrelated business income, the issue was whether the West Virginia State Medical Association conducted its advertising operation with the intention of making a profit. Since it had sustained an advertising loss for 21 consecutive years and failed to explain why it did not simply discontinue the advertising, the association's advertising losses were determined to be voluntary and, therefore, not a trade or business subject to the unrelated business income tax.

* United Cancer Council, Inc. (UCC), IRS Technical Advice Memorandum. The basic issues of concern to the IRS in this case (addressed in an IRS National Office Technical Advice Memorandum and petitioned before the U.S. Tax Court in early 1991) are as follows:

1. An organization whose principal activity consists of fund-raising must carry on a charitable program commensurate in scope with its financial resources in order to qualify for exemption under Section 501(c)(3). (According to the IRS, approximately 4 percent of total funds expended by UCC were for "charitable" purposes; more than 90 percent of the expenses were classified by the IRS as fund-raising expenses. Thus the benefit to the public was incidental; the primary benefit was to the fund-raiser.)

2. The IRS proposed revocation of UCC's tax-exempt status because fund-raising costs were too high; in effect, this was a for-profit direct-mail fund-raising entity.

UCC had allocated a considerable portion (40 percent to 50 percent) of its substantial mailing expenses to charitable purposes. The IRS concluded that UCC was not entitled to allocate any.

3. In the technical advice memorandum, the IRS acknowledged that "reasonable allocations of mixed programs are allowed, but that the allocation between fund-raising and program-related activities depends on the facts and circumstances of each case."

4. In this case, the IRS measured the mailings and determined that on both the linear and square-inch methods, more than 90 percent of the content was not educational. The IRS concluded that the major thrust of UCC fund-raising literature was soliciting "readers to participate in sweepstakes in an effort to raise funds rather than educate the public."

Andrew S. Lang is president and David M. Duren is one of the nonprofit tax managers at Lang + Associates, Bethesda, Maryland, a consulting and certified public accounting firm specializing in nonprofit organizations. Lang is an associate member fellow of ASAE; both Lang and Duren are members of ASAE's Finance and Administration Section.
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Title Annotation:includes related articles
Author:Duren, David M.
Publication:Association Management
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Date:Jun 1, 1993
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