© Grant Thornton LLP. All rights reserved. TACCBO Conference June 13, 2013 UBI – How Does It Impact/Effect Community Colleges Kimberly Schrant, Managing Director Grant Thornton LLP

© Grant Thornton LLP. All rights reserved. Agenda UBI Introduction and Overview IRS College and University Compliance Project –characterization of income –expense allocations –significant losses –exclusions/modifications –review of returns

© Grant Thornton LLP. All rights reserved. A little humor to get started

© Grant Thornton LLP. All rights reserved. Unrelated business income Does this include state-run schools? From the instructions to the Form 990-T, one of the types of entities that must file [if they have UBI] is: Colleges and universities of states and other governmental units, and subsidiary corporations wholly owned by such colleges and universities.

© Grant Thornton LLP. All rights reserved. UBI Introduction and Overview UBI [unrelated business income] is income from a regularly- carried-on trade or business that is not substantially related to the organization’s exempt purpose. 3 Prong Test: –A trade or business –Regularly carried on –Not substantially related

© Grant Thornton LLP. All rights reserved. Start with the last part first: Is the activity not substantially related? When looking at UBI, start with determining whether the activity is related or not first. It can save you time with the other two parts. That being said: Any income-producing activity that does not directly further your organization’s exempt purpose could generate UBI. Sometimes, activities that ARE related to exempt purposes can still generate UBI if they are conducted on a larger scale than is reasonably necessary to perform an exempt function. In this instance, the portion that is more than needed is considered an unrelated trade or business.

© Grant Thornton LLP. All rights reserved. If the activity is not "substantially related", is it a trade or business? Example: –A tax-exempt college solicits, sells, and publishes advertisements from commercial vendors in its student publication. Even though the publication contains content related to the college’s exempt purpose, the publishing of advertising is still an unrelated trade or business. Any activity carried on for the production of income: that involves the sale of goods or performance of services, and otherwise has the characteristics of a business enterprise is considered a "trade or business" for purposes of the UBIT rules.

© Grant Thornton LLP. All rights reserved. Is the activity engaged in for profit? As will we soon see from our review of the IRS compliance report, this is an important aspect of determining "trade or business" status. To be a trade or business, the activity must be engaged in to generate a profit.

© Grant Thornton LLP. All rights reserved. And, finally, is your activity regularly carried on? Point to remember: IRS may not agree with frequency and continuity issue if the length of planning and preparation time for an annual event is more than two months. In most cases, if the activity shows frequency and continuity and is conducted the same way that a non-exempt organization would run a similar business, it is regularly carried on.

© Grant Thornton LLP. All rights reserved. IRS College and University Compliance Report (IRS Report) Issued April 26 th, 2013 Gives important insight into IRS positions regarding UBI topic: –Characterization of activities as exempt or unrelated –Methodologies for allocating expenses –Significance of losses on specific activities –Calculation of net operating losses (NOLs) –Application of exceptions/modifications –Review of UBI reporting

© Grant Thornton LLP. All rights reserved. IRS Report - characterization of activities as exempt or unrelated At more than 40 percent of institutions examined, activities that were effectively treated as related were determined to be unrelated What is the message here? –Take a harder look at your revenue streams and subject them to the tests for UBI. –Look at the IRS data on most missed items: Bookstores – 50 to 65% of institutions engaged in, 5% reported Food service – up to 64% of institutions engaged in, as low as 1% reported

© Grant Thornton LLP. All rights reserved. Bookstore operations Operated in different ways by different schools: Lease facilities to for-profit entity and receive rental income in return Retain for-profit management company to manage bookstore under management contract Operate directly by school or through NFP controlled by school

© Grant Thornton LLP. All rights reserved. Bookstore operations Issues with lease of facilities to for-profit entity with receipt of rental income in return Question as to whether: –Bona fide lease –For-profit entity simply acting as agent for college in exchange for a management fee

© Grant Thornton LLP. All rights reserved. Bookstore operations Need to make sure that a lease is in place and not just a license What is the difference? Lease – gives tenant exclusive possession of the premises – transfer of property for a given time License – permits only general possession of the premises - owner typically controls such things as lighting, heating, cleaning, repairing, and opening and closing the premises.

© Grant Thornton LLP. All rights reserved. Bookstore operations Retention of for-profit company to manage bookstore under management contract Look for terms in contract that indicate: acting on institution's behalf ability of institution to exercise significant control over for-profit company's activities under the agreement

© Grant Thornton LLP. All rights reserved. Bookstore operations Directly by school or through NFP controlled by school Fragmentation rule – all bookstore sales are taxable unless items fall under one of following categories: Sales to students/faculty/other employees items related to educational purposes Sales to students/faculty/other employees items unrelated but for convenience of same

© Grant Thornton LLP. All rights reserved. IRS Report - methodologies for allocating expenses Expense deductions were disallowed on more than 60 percent of Form 990-Ts examined because they were based on improper allocations between exempt and unrelated business activities. What is the message here? Make sure the expenses: are allowable under the Code, are "directly connected" with the conduct of the business, and

© Grant Thornton LLP. All rights reserved. IRS Report - methodologies for allocating expenses If expenses are for both related and unrelated activities, then a proper allocation of expenses should be determined: –expense must be allocated on a "reasonable basis" –various methods reasonably close to facts could be based on hours or gross receipts, depending on type of expense and how incurred document why it is "reasonable"

© Grant Thornton LLP. All rights reserved. IRS Report - significance of losses on specific activities 70% of institutions were that were disallowed losses and NOLs were due to such items being connected with an activity that lacked a profit motive, as evidenced by years of sustained losses. What is the message here? Be sure to thoroughly document how it was determined that an activity is engaged in for profit, especially if it is has incurred years of losses.

© Grant Thornton LLP. All rights reserved. Documenting profit motive – facts and circumstances Items to consider: Business plan – e.g., showing how future profits to be derived Efficiencies in operations – are steps being taken to increase efficiencies to minimize losses? Sales increases – What is being done to surge sales to increase the opportunities for turning a profit? Other items that prove the operation is in place to turn a profit

© Grant Thornton LLP. All rights reserved. IRS Report - calculation of net operating losses (NOLs) For more than 33% of returns examined, NOLs were either improperly calculated or unsubstantiated What is the message here? Be sure to maintain sufficient records, including those that document how the claimed NOLs were derived.

© Grant Thornton LLP. All rights reserved. Documenting an NOL deduction Items to be sure to save: Copy of return for each year generating an included loss Copy of workpapers reconciling return to books and records Copy of general ledger for year Bank statements/cancelled checks Consider keeping substantiation of deductions

© Grant Thornton LLP. All rights reserved. IRS Report - application of exceptions/modifications IRC Section 512 allows for exclusions from UBI. Here again, IRS found issues and made adjustments to approximately 50% of returns with the classification of such income. What is the message here? Be sure to understand the rules on the exclusion being used and document facts and analysis.

© Grant Thornton LLP. All rights reserved. Application of exception - royalties Common sources of income, such as from mailing lists and affinity credit card programs can be treated as royalties if properly structured. Items to consider here: –licensor is not required to perform any services for licensee –"quality control" activities by institution are allowed, e.g., to preserve college's reputation

© Grant Thornton LLP. All rights reserved. IRS Report – review of UBI reporting IRS found that about 20 percent of institutions examined sought outside advice about the tax treatment of specific potentially unrelated business activities and half of the Forms 990-T were reviewed by the board or board committee.

© Grant Thornton LLP. All rights reserved. IRS Report – review of UBI reporting What is the message here? IRS has been indicating, through its examination and revamp of Form 990, that boards, as part of their governance responsibilities should be reviewing such returns before filing. That review process should also extend to the Form 990-T, especially in light of the findings in the IRS study.

© Grant Thornton LLP. All rights reserved. A little more humor

© Grant Thornton LLP. All rights reserved. Conclusion What does all this mean?

© Grant Thornton LLP. All rights reserved. Questions?

© Grant Thornton LLP. All rights reserved. Tax Professional Standards Statement This document supports Grant Thornton LLP’s marketing of professional services, and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the subject of this document we encourage you to contact us or an independent tax advisor to discuss the potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this document may be considered to contain written tax advice, any written advice contained in, forwarded with, or attached to this document is not intended by Grant Thornton to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. © 2008 Grant Thornton LLP, the U.S. member firm of Grant Thornton International. All rights reserved. Printed in the U.S.A. This proposal is the work of Grant Thornton LLP, the U.S. member firm of Grant Thornton International, and is in all respects subject to negotiation, agreement and signing of specific contracts. The information contained within this document is intended only for the entity or person to which it is addressed and contains confidential and/or privileged material. Dissemination to third-parties, copying or use of this information is strictly prohibited without the prior consent of Grant Thornton LLP.