As we fast approach tax filing deadlines, like the IRS Form 990’s May 15 deadline for tax-exempt organizations operating on a calendar fiscal year, the time is ripe for focusing on the joys and perils of tax reporting compliance. Some key lessons emerge from the U.S. Tax Court’s 2017 decision, which addressed the Losantiville Country Club’s Form 990-T tax returns. This Club learned some painful tax lessons particularly about unrelated business income for nonprofits. So watch and learn – and put off thoughts of suntans and golf swings, at least for now.
Background – Taxable Income
Losantiville Country Club is a typical Section 501(c)(7) tax-exempt social club, with golf, swim, tennis, and children’s activities, as well as a dining room and spaces for wedding receptions. (Losantiville is also the original name for Cincinnati, Ohio, roughly indicating “across from the Licking River.”) The Club regularly filed IRS Form 990s and Form 990-Ts. Form 990-T is used to report and pay taxable income derived from “unrelated business” income such as a social club’s sale of goods or services to nonmembers, as required under federal income tax provisions associated with an exempt organization. For a brief primer on the unrelated business income tax, see our blog post, When Are Nonprofit Revenues Taxable- UBIT Basics.
The Club relied on accountants to prepare its Form 990 and Form 990-Ts. In the years in question, the Club’s expenses associated with nonmember sales exceeded the income creating a loss. The accountants utilized the loss from nonmember sales to offset the taxable income the Club had received from certain investment income. The result of this accounting was that the Club owed no unrelated business tax liability. The accountants’ reporting methods were contrary, however, to a 20-year old U.S. Supreme Court ruling that the offset could be made only if nonmember sales were entered into by the social club for profit.
The IRS challenged the Club’s position that the losses from the nonmember sales could offset the investment income, in light of the U.S. Supreme Court’s prior ruling. The IRS first issued a “notice of deficiency” to the Club, and the case then proceeded to U.S. Tax Court. Accompanying each notice was an accuracy-related fine for understating income tax due to alleged “negligence or disregard of rules or regulations.” The Tax Court upheld the IRS findings and penalties, and the case is now on appeal to the federal Sixth Circuit Court of Appeals. (T.C. Memo 2017-158; Docket No. 6105-15)
Getting Tax Reporting Right
Where did the Club go wrong, and what lessons can responsible nonprofits learn – whether as tax-exempt social clubs or other tax-exempt organizations? In a nutshell, it all matters, and acutely so: keeping track of the details, following the law, appreciating how others will handle the details and the law, and ultimately getting it all together.
Lesson One: Unrelated business income is a big deal to the IRS. The Internal Revenue consistently and strictly enforces the area of “unrelated business income taxation” (UBIT). The applicable definitions of “unrelated” vary for different types of organizations under Section 501(c) of the Tax Code. Many UBIT exceptions and related reporting procedures are incredibly complex and a challenge, without good counsel, to apply to a nonprofit’s specific circumstances. But, across the board, the Internal Revenue Service strictly enforces the tax against organizations that under-report such tax liability. So especially if a nonprofit is seeking creative income-producing opportunities through selling goods or services, it is essential to get the UBIT analysis right.
Lesson Two: Get tax compliance right the first time around. Notably, the Club filed amended Form 990-Ts to assert its position on nonmember sales losses offsetting investment income. The fact that the Club filed amended tax returns may have triggered the IRS scrutiny. And who wants the IRS to come knocking?
Lesson Three: The IRS’s application of tax requirements can sometimes seem not only inconsistent but illogical, making tax compliance difficult to proactively address. The IRS’ enforcement of so many tax issues for exempt organizations is based on the application of a “facts and circumstances” test. For example, facts and circumstances tests are utilized in tax questions for private inurement, private benefit, political speech-related matters, and whether an organization’s activities are substantially further exempt purposes under the unrelated business income tax. Counsel for Losantiville asked that this similar “facts and circumstances” analysis be used to determine whether the Club’s sales to nonmembers were entered into with an intent to profit. The IRS argued against applying the facts and circumstances test. The IRS focused instead on just one factor - actual profitability - in determining whether the organization had the requisite “intent to profit.” Since the Club experienced losses from nonmember revenues, there could not have been any intent to profit – at least according to the IRS. The Tax Court agreed with the IRS and rejected the Club’s offset for UBIT purposes.
Lesson Four: Watch out for IRS penalties, which can come all too easily. At first blush, the Club hardly seemed negligent, with dedicated staff reviewing its financial statements each month and a third-party accounting firm assisting the Club in preparing its annual IRS returns. But the details mattered! It was not enough just to complete IRS reports; the Club needed to do them right, preferably the first time, and in light of applicable law like the controlling Supreme Court case on offsetting income. Notably, the Tax Court found that there was “no evidence” that the accountants had sufficient expertise or that the Club provided them with “necessary and accurate” information.
Bottom line? Simply paying lip service to the IRS reporting requirements is not sufficient, especially in the risk-laden area of unrelated business income. So to reduce the risk of the IRS knocking at your nonprofit door, keep track of all the financial details, hire (and inform) high quality professionals experienced with nonprofit nuances, and file your Form 990 and 990-T returns correctly the first time around.
