New rules of the tax game.
The Statistics of Income (SOI) division of the Internal Revenue Service recently published results of a 15-year study of nonprofit organizations. The study, "Tax-Based Research and Data on Nonprofit Organizations, 1975-1990," confirms amazing across-the-board growth in all types of nonprofit organizations, which likely underlies the increased IRS enforcement efforts targeting the nonprofit community.
In addition to this general study, in the mid-1980s SOI began studying tax-exempt organizations' unrelated business income. The first such study reported on Form 990-T (Exempt Organization Business Income Tax Return for unrelated income) data for the 1987 tax year. As this article goes to print, SOI has just released a second study, "Exempt Organization Business Income Tax Returns, 1991," based on the 1991 tax year. The results of this study confirm significant growth in nonprofit organizations' unrelated business activities and income in the past several years.
These SOI studies use statistical sampling techniques and definitions that open specific results to differing interpretations. However, the IRS interpretation seems to be that nonprofit organizations have become big business. And that interpretation has implications for IRS enforcement strategy.
SOI finds fivefold growth in
The "Tax-based Research and Data on Nonprofit Organizations, 1975-1990" study results offer insight into why the IRS has stepped up enforcement efforts.
According to the study, more than 1 million nonprofit organizations are registered with the IRS. Of registered tax-exempt groups, 501(c)(3) organizations represent more than 50 percent, with combined assets of more than $600 billion. Assets of 501(c)(6) organizations, the category of most associations as of tax year 1990, were more than $19 billion (see table, "Growth in 501(c)(6) Organizations"). Total assets and revenues of 501(c)(6) entities are more than five times what they were in 1975, and the revenue generated by all tax-exempt organizations represents more than 10 percent of the U.S. Gross Domestic Product.
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Unrelated income up 32
SOI's first study on unrelated business income reported on the 1987 Form 990-T data of tax-exempt organizations. In 1987, 22,758 Form 990-T returns were filed, reporting total unrelated business income of $2.5 billion (see table, "Unrelated Business Income: Form 990-T Data of All Tax-Exempt Organizations").
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After offsetting deductions, nonprofit organizations reported a total tax liability of $83 million. The largest share of taxes (35 percent) was borne by 501(c)(9) voluntary employees beneficiary associations, while 501(c)(6) business leagues, chambers of commerce, and real estate boards and 501(c)(7) social and recreational clubs accounted for 29 percent of all unrelated business income and 30 percent of the resulting tax liability. Finally, 501(c)(3) organizations accounted for 46 percent of all unrelated business income reported and 25 percent of the resulting tax liability.
The just-published 1991 study reveals a 32 percent increase since 1987 in unrelated business income reported by all tax-exempt groups ($3.3 billion) and a 41 percent increase in the resulting tax liability ($117 million). While the proportions of unrelated business income attributed to various sources remained relatively constant between study years, 501(c)(6) organizations' reported tax liability actually dropped 10 percent from 1987 to 1991. This may have resulted from more aggressive offsetting cost-allocation methods, an area of continuing interest to the IRS.
SOI reports upcoming projects include a study to improve the classification of analyzed data to allow more targeted identification of groups the IRS believes require "better education and improved compliance," as well as a more detailed study of the commercial income of nonprofits.
The host of examinations challenging nonprofit organizations in recent years is a direct result of the phenomenal growth in the nonprofit industry, as SOI's studies demonstrate. Other contributing factors include continued pressure from the business community to put nonprofit organizations offering business services on an equal footing with for-profit businesses, the constant search for revenues to reduce the federal budget deficit, and the IRS's improved ability to collect and analyze exempt-organization data.
The IRS Exempt Organizations Division recently established an information-sharing library system for use by tax auditors in seven key IRS districts. The library's purpose is to capture information by market segment -- for instance, 501(c)(6) "associate member" dues cases -- to coordinate examinations. Data such as the findings and results of district-level cases were previously unknown or inaccessible to other districts or the national office. These cases now will be available throughout the IRS for conducting audits and coordinating enforcement.
IRS officials have determined statistically through their examinations that for every dollar of reported unrelated business income, many more dollars go unreported. Therefore, the growth in unrelated business income expressed in the studies actually represents a fraction of the true amount that is subject to examination. At a recent industry forum, an Exempt Organizations Division official indicated that the IRS does not audit in the tax-exempt area to raise money, but rather to monitor organizations' compliance with tax laws and regulations. It is clear, however, that IRS enforcement efforts are designed to be cost-effective and that raising money is a nice byproduct for an entity whose parent company (the U.S. government) is $4 trillion in debt.
The following sections describe areas in which the IRS has or will concentrate enforcement efforts.
Lobby tax law
The lobby tax provisions and implementing regulations of the 1993 Omnibus Budget Reconciliation Act are the most vexing of the 1993 tax law changes affecting associations. Although the IRS can legitimately blame Congress for creating this ill-conceived law, the IRS has done little through the regulatory process to make it easier to administer or comply with. An extremely broad definition of lobbying, in particular, promises to cause scores of association government affairs and finance specialists alike their share of headaches -- not to mention needless and unproductive paperwork. Both the statute and regulations are flawed and deserving of repeal. In fact, ASAE has been tireless in its efforts for repeal and/or relief on the judicial, legislative, and regulatory fronts.
In the interim, however, until the law is repealed by Congress or overturned by the courts, the IRS will police compliance. And even though regulations have not vet answered many questions, this has not stopped the IRS from assessing penalties on associations. In short, the lobby tax appears destined to plague the association community for the foreseeable future.
Associate member dues
The issuance of two 1993 technical advice memoranda in which the IRS recharacterized dues paid by associate members as unrelated business income, resulting in crippling taxes, interest, and penalties, has sent shock waves through the association community. IRS has put associations on notice that where a class of members has access to certain unrelated benefits (e.g., advertising, insurance) yet has no significant ties to the association's tax-exempt purpose (e.g., voting rights, board and committee representation), this previously exempt dues income may be taxed as unrelated business income. Threatened assessments in two cases now before the U.S. Tax Court may easily wipe out these associations' reserves and in one case threatens the organization's very existence. At press time, the IRS was awaiting the outcome of these key Tax Court cases before finalizing and issuing formal guidance to the public. Once again ASAE has played an active role in this area.
Royalties: name and logo
licensing, mailing list rentals,
Notwithstanding two favorable Tax Court rulings in the Sierra Club case (which the IRS is appealing) holding that proceeds from mailing list rentals and an affinity credit card program are not unrelated business income but rather tax-exempt royalties, the IRS doggedly continues to pursue taxing association revenue earned under such arrangements. In fact, the nation's second-largest nonprofit organization, the American Association of Retired Persons, Washington, D.C., recently paid the IRS $135 million to settle a dispute over royalty income it derived from sponsoring insurance programs for years 1985 through 1993. The IRS continues to issue private late rulings and technical advice memoranda taxing revenue from association sponsorship of vendor products and services, as well as from the rental of association mailing lists. This issue will likely remain unresolved until the U.S. Supreme Court is able and willing to address it.
403(b) retirement plans
More than $200 billion is invested in the plan assets of 403(b) retirement plans, primarily sponsored by 501(c)(3) organizations. Many of these plans are not subject to the Employee Retirement Income Security Act (ERISA) and do not have to file an annual Form 550 pension plan tax return. This, coupled with the fact that tax-exempt groups are not generally concerned with supporting a tax deduction for plan contributions, has contributed to lax enforcement by sponsoring organizations monitoring eligibility requirements, mandatory distribution, investment counseling, and funding and accumulation limits. At a recent industry forum, Marcus S. Owens, IRS Exempt Organizations Division director, revealed that 403(b) plan taxation is a major area of IRS enforcement and one where the IRS has yet to examine a plan that was 100 percent in compliance.
It should also be noted that the standard three-year statute of limitations is not available as a defense in this area.
In the now-famous 1991 Cotton Bowl ruling and resulting audit guidelines, the IRS established unrelated business income tax criteria for corporate sponsorship income that focused on a corporate sponsor's intent to receive a "substantial return benefit" in return for payment. With the proposed regulations in 1993, the IRS dropped this approach and instead adopted the Federal Communication Commission's concept (used in the public broadcasting context) of distinguishing between "acknowledgment" (resulting in tax-exempt income) and "advertising" (resulting in taxable income). The proposed rules provide specific criteria to consider in such a determination. The proposed regulations have been generally well-received by the association community (except for a proposed "tainting" rule), but unfortunately the IRS has not formally issued them in final form, saying they have been put on the back burner behind more pressing issues.
Where a tax-exempt entity receives rents and/or sales proceeds from property (e.g., a headquarters building) that is in some portion debt-financed, section 514 of the Internal Revenue Code calls this "unrelated debt-financed income." A portion of this amount, based on a complex formula, is then added to the organization's annual unrelated business income. Even where rental income received by an organization is considered related to its tax-exempt function, a portion of the income will be treated as unrelated business income if the association performs special services (more than basic maintenance) for tenants, or where it receives rent based on a percentage.
Several exemptions to this form of unrelated business income do exist, however, including cases in which 15 percent or less of the property is leased, the income is produced by an enterprise engaged in certain research activities, or the property is used in a trade or business where substantially all the work is performed without compensation.
These are but a few examples of areas in which the IRS is concentrating its enforcement efforts on nonprofits. The IRS'S increased enforcement in the tax-exempt area and improved ability to track and share data clearly demonstrate that the rules of the game are changing. Nonprofit entities must realistically and effectively identify and address their potential tax exposure to survive.
Although each area of unrelated business income tax risk discussed here has its own nuances, several general protective measures may help shield associations from the reach of the Tax Man. 1. Establish and maintain a clear document trail to support your exempt and nonexempt activities and resulting income and expenses. 2. Develop and maintain a reasonable and consistently applied system for allocating costs between exempt and nonexempt functional activities (e.g., between lobbying and nonlobbying activity, related and unrelated programs, and tax-exempt parent and for-profit subsidiary). 3. Scrutinize what is emphasized and de-emphasized in your association's financial and tax reporting (e.g., disclosing a large percentage of associate member dues on your financial statements and Form 990 may lead to IRS unrelated business income scrutiny in this area). 4. Be consistent with regard to organizational documents and operational characteristics. In particular, pay special attention to legal, tax, and other documents (e.g., application for exemption, articles of incorporation, bylaws, minutes, and member solicitation materials) to ensure that they reflect the reality of an association's services and activities. 5. Consider carefully the need to disclose potential unrelated-business-income-generating activities in order to avail your association of the three-year statute of limitations. Be sure to weigh the benefits of such disclosure against the IRS attention this could draw to your association. 6. With regard to name and logo licensing, mailing list rentals, and sponsorship of vendor products and services, enter into one independent contract for use of the association's name, logo, and/or membership list only, and into a separate stand-alone contract for any services, however minimal, provided by the association. Also, if possible, limit such services to "quality control" and other "passive" activites. 7. With regard to unrelated business income tax exposure for associate member dues, discriminate as little as possible in the rights and benefits of different classes of membership, and ensure as much documented participation as possible by associate members in the association's tax-exempt functions. 8. Review 403(b) and 457(b) plans to ensure compliance with eligibility, nondiscrimination, investment counseling, deferral, and payout rules. 9. Ensure that corporate sponsorship arrangements do not cross the line from "acknowledgment" to "advertising." 10. Establish and monitor strong internal control policies that include clear guidance with regard to procurement, travel and entertainment, conflicts of interest, and acceptance of gifts to protect against a claim of private inurement.
* Assets and revenues of 501(c)(6) organizations increased by a factor of five from 1975 to 1990.
* Examinations of unrelated income will become more intense, and the IRS will continue to tax more and more association income.
* Use a 10-point checklist to help protect your association from tax trouble.
General Findings: SOI Study of
Charities and Other Tax-Exempt
* The growth of the tax-exempt sector substantially exceeded the growth of the national economy from 1975 through 1990.
* There are 1.4 million tax-exempt organizations in the United States, and approximately 1 million must file returns with the Internal Revenue Service. About half of these organizations are 501(c)(3) charitable organizations; the remainder fall primarily under sections 501(c)(4)-501(c)(9) of the Internal Revenue Code.
* Tax-exempt organization revenues and expenses represent 10 percent of the U.S. Gross Domestic Product, a 4 percent increase in nonprofit activity as a percentage of GDP from 1975 to 1990.
* Overall, tax-exempt organization assets increased 150 percent from 1975 to 1990 and now exceed $1 trillion.
* Overall, tax-exempt organization revenue increased 227 percent from 1975 to 1990, compared to 51 percent growth in real GDP.
Study Finds Dramatic Growth in Trade and
A new General Accounting Office (GAO) study of organizations exempt from tax under sections 501(c)(4), (c)(5), and (c)(6) of the Tax Code provides an illuminating picture of the state of noncharitable tax-exempt organizations. The report based on this study is titled Tax Exempt Organizations: Information on Selected Types of Organizations.
The study, requested by two senators, found that between 1975 and 1990, 501(c)(6) business leagues experienced dramatic growth in their numbers, assets, revenues, and expenses, while 501(c)(4) social welfare and (c)(5) labor and agricultural organizations experienced far less growth in these areas -- in some cases undergoing significant declines. The changes during this period are illustrated as follows:
* The number of business leagues increased about 45 percent to 65,869, while the number of social welfare groups increased about 14 percent to 142,473. Conversely, the number of labor and agricultural organizations declined about 18 percent to 71,653.
* The assets (in 1990 dollars) of all three types of organizations increased. Business leagues' assets increased more than 140 percent to more than $19 billion, while those of labor and agricultural groups increased about 47 percent to nearly $14 billion, and those of social welfare organizations increased about 20 percent to more than $35 billion.
* The change in revenue (in 1990 dollars) varied for these three types of organizations. While revenues for business leagues increased nearly 144 percent to $18 billion and revenue for labor and agricultural groups increased about 13 percent to more than $12 billion, the revenue for social welfare organizations declined almost 47 percent to $18 billion.
* The change in expenses (in 1990 dollars) for these organizations also varied. The expenses of business leagues increased about 145 percent to just more than $18 billion and those of labor and agricultural groups increased nearly 19 percent to $12.7 billion. Meanwhile, the expenses of social welfare organizations declined about 48 percent to $17.7 billion.
The study analyzed the organizations' 1992 Forms 990 to determine the compensation for the five highest paid executives from 46 of each of the largest social welfare organizations, labor and agricultural groups, and business leagues, as measured by the organizations' assets. Of 673 executives identified, the study found that 100 executives (about 15 percent) received $200,000 or more in compensation for 1992. Conversely, 198 executives (about 29 percent) received no compensation for 1992.
The study found that, in general, between 1990 and 1994, audits of social welfare organizations, labor and agricultural organizations, and business leagues decreased about 30 percent, while the amount of taxes and penalties resulting from these audits increased about 200 percent. The IRS also revoked the tax-exempt status of 67 of these types of organizations between 1992 and 1994.
This reports can be ordered by contacting GAO by telephone at (202) 512-6000, by fax at (301) 258-4066, or by mail at GAO, P.O. Box 6015, Gaithersburg, MD, 20884-6015. Be sure to reference report #GAO/GGD-95-84BR. The first copy is free; additional copies are $2 each. Make out checks or money orders to the Superintendent of Documents.
For more information on issues related to the Internal Revenue Service's focus on the unrelated business activities and income of nonprofit organizations, you may want to turn to the following resources, available from ASAE's Association Management Press. To order any of these articles or papers, call (202) 626-2748; fax: (202) 408-9634; text telephone for people with hearing impairments: (202) 626-2803.
* "Common Sense for Royalty Income," by George D. Webster (Association Management, September 1991), 1 page; $3 for members, $5 for nonmembers. Product 126029.
* "Figuring Unrelated Business Income Tax the IRS Way," by David M. Duren and Andrew S. Lang (Association Management, June 1993), 13 pages; $3 for members, $5 for nonmembers. Product 126291.
* "Taxing Associate Member Dues," by Jeffrey S. Tenenbaum (Special report, Association Management, July 1994), 10 pages; $3 for members, $5 for nonmembers. Product 126457.
* "Tax Issues for Exempt Organizations: A Primer," by Paula Cozzi Goedert and Jerald A. Jacobs (Association Management, January 1990), 8 pages; $3 for members, $5 for nonmembers. Product 125784.
* "Unrelated Business Income Tax Issues," by George D. Webster (Association Management, July 1994), 2 pages; $3 for members, $5 for nonmembers. Product 126462.
A number of ASAE Government Affairs issue papers on nonprofit tax issues are available free via ASAE's fax-on-demand line. Call (800) 622-ASAE (from outside the United States: (402) 271-9293) to request the following documents:
* "IRS Rules on Associate Member Dues," document 30103;
* "New IRS Rules on Spouse Travel, Business," document 30501;
* "Spouse Travel Comments to the IRS," document 30503;
* "UBIT: Taxing Associate Member Dues," document 30101; and
* "UBIT: Taxing Corporate Sponsorships," document 30102.
John P. Langan is president of Langan Associates, Washington, D.C., a certified public accounting and consulting firm exclusively servicing the nonprofit community.
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|Title Annotation:||Special Report; includes related articles|
|Author:||Langan, John P.|
|Date:||Jun 1, 1995|
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