As more nonprofit organizations look for multiple sources of revenue generation to fund their missions, reporting unrelated business income and net operating losses is getting a closer look by the IRS. A nonprofit organization that has unrelated business deductions that exceed its unrelated business income for a tax year has a net operating loss (NOL) equal to the amount of the excess.
An NOL can be carried back to the two proceeding years to offset unrelated business income in those years. If the NOL cannot be fully used in the prior years, the remainder can be carried forward for up to 20 years from the year of the loss to offset unrelated business income in those years.
The IRS completed a study in 2013 of the unrelated business income tax returns of 34 colleges and universities. The IRS concluded that the NOLs utilized on over 33% of the returns were either inadequately substantiated or calculated in error, which resulted in excess of $19,000,000 in NOLs being disallowed. A lack of a profit motive was the asserted significant reason for the dis-allowance as evidenced by annual losses over multiple years.
An activity conducted without a profit motive is not considered by the IRS to be a trade or business. The losses incurred by an activity without a profit motive cannot be deducted from the unrelated business income of other activities.
Determining whether an activity has a profit motive is very subjective. The IRS considers a number of factors when evaluating an activity including:
- Time and effort expanded. For example, were staff hired with specific specialized skills to operate the activity and were adequate resources devoted to it to make it successful?
- Prior profitability. Were there prior years that produced a profit even if the activity is currently being operated in the red?
- How the activity is carried on. Are the records maintained by the nonprofit organization so that they can evaluate the financial success of the activity in a business-like manner, and do they try to make operating changes to improve profitability?
There is no single factor that is used by the IRS in evaluating the profit motive of an activity. Other relevant factors can be considered.
Documentation can be key to defending the deductibility of losses if questioned by the IRS for a particular activity. Adequate records to support the expenses of the activity that are reported should be maintained. Just as important, an organization should document the steps taken to minimize current losses from the activity and facilitating the generation of future profits. If the activity incurs losses for several consecutive years, the organization should put in writing why it continues to operate the activity instead of shutting it down.
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