When A Good Cause Is Not Enough

Let’s talk about the tax issues of tax-exempt entities. It sounds like a contradiction, doesn’t it?

It actually is its own area of practice. Several years ago I was elbow-deep working with nonprofits, and I attended a seminar presented by a specialist from Washington, D.C. All he did was nonprofits. At least he was in the right town for it.

There are the big-picture tax-exempt issues. For example, a 501(c)(3) has to be publicly-supported. You know there is a tractor-trailer load of rules as to what “publicly supported” means.

Then there are more specialized issues. One of them is the unrelated business income tax. The concept here is that a nonprofit cannot conduct an ongoing business and avoid tax because of its exemption. A museum may be a great charitable cause, for example, but one cannot avoid tax on a chain of chili restaurants by having the museum own them.

That is not what museums do. It is unrelated to “museum-ness,” and as such the chili restaurants will be taxed as unrelated business income.

Sometimes it can get tricky. Say that you have a culinary program at a community college. As part of the program, culinary students prepare meals, which are in turn sold on premises to the students, faculty and visitors. A very good argument can be made that this activity should not be taxed.  

What is the difference? In the community college’s case, the activity represents an expansion of the underlying (and exempt) culinary education program. The museum cannot make this argument with its chili restaurants.

However, what if the museum charges admission to view its collection of blue baby boots from Botswana? We are now closer to the example of culinary students preparing meals for sale. Exhibiting collections is what museums do.

I am looking a technical advice memorandum (TAM) on unrelated business income. This is internal IRS paperwork, and it means that an IRS high-level presented an issue to the National Office for review.

Let’s set it up.

There is a community college.

The community college has an alumni association. The association has one voting member, which is a political subdivision of the state.

The alumni association has a weekly farmers market, with arts and crafts and music and food vendors. It sounds like quite the event. It uses the parking areas of the community college, as well as campus rest rooms and utilities. Sometimes the college charges the alumni association; sometimes it does not.

The alumni association in turn rents parking lot space to vendors at the market.

All the money from the event goes to the college. Monies are used to fund scholarships and maintain facilities, such as purchasing a computer room for the library and maintaining the football field.

OBSERVATION: The tax Code does not care that any monies raised are to be used for a charitable purpose. The Code instead focuses on the activity itself. Get too close to a day-in-and-day-out business and you will be taxed as a business. Granted, you may get a charitable deduction for giving it away, but that is a different issue.

From surveys, the majority of visitors to the farmers market are age 55 and above.

There was an IRS audit. The revenue agent thought he spotted an unrelated business activity. The file moved up a notch or two at the IRS and a bigwig requested a TAM.

The association immediately conceded that the event was a trade or business regularly carried on. It had to: it was a highly-organized weekly activity.

The association argued instead that the event was its version of “museum-ness,” meaning the event furthered the association’s exempt purpose. It presented three arguments:

(1) The farmers market contributed to the exempt purpose of the college by drawing potential students and donors to campus, helping to develop civic support.

(2) The farmers market lessened the burden of government (that is, the college).

(3) The farmers market relieved the distress of the elderly.

The IRS saw these arguments differently:

(1) Can you provide any evidence to back that up? A mere assertion is neither persuasive nor dispositive.

COMMENT: The association should have taken active steps – year-after-year – to obtain and accumulate supporting data. It may have been worth hiring someone who does these things. Not doing so made it easy for the IRS to dismiss the argument as self-serving.

(2) At no time did the community college take on the responsibility for a farmers market, and the college is the closest thing to a government in this conversation. Granted, the college benefited from the proceeds, but that is not the test. The test is whether the association is (1) taking on a governmental burden and (2) actually lessening the burden on the government thereby.  As the government (that is, the college) never took on the burden, there can be no lessening of said burden.

COMMENT: This argument is interesting, as perhaps – with planning – something could have been arranged. For example, what if the college sponsored the weekly event, but contracted out event planning, organization and execution to the alumni association? 

(3) While the market did provide a venue for the elderly to gather and socialize, that is not the same as showing that the market was organized and worked with the intent of addressing the special needs of the elderly. 

COMMENT: Perhaps if the association had done things specifically for the elderly – transportation to/from retirement homes or free drink or meal tickets, for example – there would have been an argument. As it was, the high percentage of elderly was a happenstance and not a goal of the event.

There was no “museum-ness” there.

And then the association presented what I consider to be its best argument:

(4) We charged rent. Rent is specifically excluded as unrelated business income, unless special circumstances are present – which are not.

Generally speaking, rent is not taxable as unrelated business income unless there is debt on the property. The question is whether the payments the association received were rent or were something else.

What do I mean?

We would probably agree that leasing space at a strip mall is a textbook definition of rent. Let’s move the needle a bit. What would you call payment received for a hospital room? That doesn’t feel like rent, does it? What has changed? Your principal objective while in a hospital is medical attention; provision of the room is ancillary. The provision of space went from being the principal purpose of the transaction to being incidental.

The IRS saw the farmers’ market/arts and craft/et cetera as something more than a parking lot. The vendors were not so much interested in renting space as they were in participating (and profiting) from a well-organized destination and entertainment event. Landlords provide space. Landlords do not provide events. 

The IRS decided this was not rent.  

You ask why I thought this was the association’s best argument? Be fair, I did not say it was a winning argument, only that it was the best available.

The alumni association still has alternatives. Examination requested the TAM, so there will be no mercy there. That leaves Appeals and then possibly going to Court. A Court may view things differently.

And I am unhappy with the alumni association. I suspect that the farmers’ market went from humble origins to a well-organized, varied and profitable event. As a practitioner, however, I have to question whether they ever sought professional advice when this thing started generating pallet-loads of cash. Granted, the activity may have evolved to the point that no tax planning could save it, but we do not know that. What we do know is that little – if any – planning occurred. 

What Are The New Individual Income Taxes?

Congress has given us a new tax bill – the American Taxpayer Relief Act of 2012. It was passed by the Senate at approximately 2 a.m. on January 1 and ….. Actually, that fact alone tells you about the quality of this tax bill.

Let’s take a look at some individual tax measures.

(1)   The 2% social security tax reduction is gone. Everybody with a paycheck will immediately see their take-home pay go down.

(2)   The previous tax rates of 10/15/25/28/33/35 percent still exist, but ….

a.      There is a new 39.6% tax rate.

NOTE: The new rate starts at $400,000 for singles and $450,000 for marrieds.

(3)   The qualified dividends and capital gains rates do not change UNLESS…

a.      … you make more than $400,000 for singles and $450,000 for marrieds.

b.      If this is you, your NEW qualified dividends and capital gains tax rate will be 20%.

OBSERVATION:  Let’s be fair: 20% is not a bad tax rate.

You may have noticed that the above three changes pivot on $400,000/$450,000.

QUESTION: Can we rely on this throughout the new law?  

ANSWER: Silly you. Of course not.

(4)   Phaseout of your personal exemptions

Tax pros call this the “PEP,” and it is the brilliant idea to reduce (if not eliminate) your exemptions for yourself, your spouse, your kids and anyone else – once you go past a certain income.

QUESTION: What is that income level?

ANSWER: $250,000 for singles and $300,000 for marrieds.

(5)   Phaseout of your itemized deductions

You have the same reasoning as (4), but this time we are talking about reducing your itemized deductions. These are your mortgage, real estate taxes, contributions and so on.

QUESTION: What is that income level?

ANSWER:  $250,000 for singles and $300,000 for marrieds.

(6)   Alternative Minimum tax

Congress reset the exemption amounts to $50,600 for singles and $78,750 for marrieds – about in line with 2011.

This is good news because – if Congress did nothing – the exemption amounts were scheduled to decrease drastically. This would have pulled millions more people into the AMT, even with the same income as 2011 and would have made for some stressful client conversations.

Congress has also linked the AMT exemption and phaseout levels to an inflation factor. Finally and thank goodness.

Frankly, in my opinion the AMT may be the most important thing Congress did with individual taxes in this legislation.

(7)   Coverdell IRAs

a.      Remain at $2,000 rather than reverting to $500

b.      As an FYI, these are the “education” IRAs

(8)   Employer provided education

a.      The exclusion from income is renewed at $5,250.

NOTE: This will make a Tax Guy’s wife happy as she returns for her Master’s.

(9)   Student loan interest

a.      Remains deductible up to $2,500

(10)  The American Opportunity tax credit     

a.      Is renewed up to $2,500

NOTE: Good news for a Tax Guy with a daughter in college

(11)    The $250 supplies deduction for elementary and secondary school teachers

a.      Is renewed

(12)    Mortgage debt exclusion from income

a.      Up to $2 million is renewed but for 2013 ONLY

(13)    The sales tax deduction in lieu of income tax deduction

a.      Is renewed

b.      Good news if you live in Florida, which does not have an income tax

(14)    Above-the-line deduction for higher education

a.      Up to $4,000 – if you can meet the income limits

(15)    Child credit

a.      Stays at $1,000 per child rather than dropping to $500

Let’s go back a moment to the 39.6% tax rate (income of $400,000/450,000) and the PEP/Pease (income of $250,000/300,000).  In addition to this spaghetti, there are two NEW taxes in 2013. They are NOT in this bill because they already existed and were waiting to hatch, like something in the movie Aliens. They are ADDITIONAL taxes on top of the above. They are:

(1)   If your income goes above $200,000 for singles and $250,000 for marrieds, there will be a new 3.8% tax rate on your interest, dividends, capital gains and investment income of that type. This was courtesy of ObamaCare.

(2)   If your income goes above $200,000 for singles and $250,000 for marrieds, there will be a new 0.9% tax on your salary for additional Medicare. This too is courtesy of ObamaCare.

Did you see what Congress did here? Look at the income thresholds on some of these taxes:

               $200,000/$250,000

               $250,000/$300,000

               $400,000/$450,000

Try remembering all that and doing the math in your head whenever you get a client phone call.

Notice what the “true” top federal tax rate is: 39.6% plus 3.8% plus 0.9% plus 1.2% (approximate PEP/Pease effect) equaling 45.5%. This is Congress' thing now: sneaking taxes on you through the back door.

We will go over the business tax provisions with another blog.