Service Will Not Litigate Conflict Over Allocation of Tax-Exempt and Unrelated Expenses on the Basis Of Property's Actual Use

UIL Number(s) 0512.08-00

CC:TL distributed: CC-1987-014

What is the proper method of allocating the fixed expenses of a dual-use facility between exempt and unrelated uses in determining the unrelated business taxable income of a tax-exempt organization?

DISCUSSION:

IRC 512(a)(1) generally provides that the term "unrelated business taxable income" (UBTI) means gross income derived from an unrelated trade or business less any deductions which are "directly connected" with the carrying on of such trade or business. Treas. Reg. 1.512(a)-1(b) provides that to be directly connected with the carrying on of an unrelated trade or business, an item of deduction must have "a proximate and primary relationship" to the carrying on of that business activity. Section 1.512(a)-1(c) of the regulations, in effect, provides that where facilities are used to carry on both exempt and unrelated activities, expenses, depreciation and similar items attributable to such facilities "shall be allocated on a reasonable basis" between the uses, and the portion of any such item so allocated to the unrelated trade or business "is proximately and primarily related" to that business activity, and is allowable as a deduction in computing UBTI.

Rensselaer Polytechnic Institute (RPI), a tax-exempt educational organization, uses one of its facilities -- a field house -- for tax- exempt purposes and for the production of unrelated business income. The issue on appeal involved the allocation of fixed expenses (including depreciation) which do not vary in proportion to actual use of the facility. The Tax Court agreed with RPI's method of allocating on the basis of actual use, finding it to be "reasonable" within the meaning of the regulation. 79 T.C. 967 (1982).

The Second Circuit affirmed, finding that apportioning the indirect expenses on the basis of actual usage "sensibly distributes the cost of a facility among the activities that benefit from its use." 732 F.2d at 1061-1062. In response to the argument that this method of allocation was inconsistent with the statutory "directly connected with" requirement, the court stated that the Government's position would involve a more stringent interpretation of "directly connected with" for purposes of section 512 than generally was applied with respect to the deductibility of ordinary and necessary business expenses. Additionally, the court stated its belief that the Government's position would place exempt organizations at a competitive disadvantage with respect to taxable business, insofar as they could not allocate any of the indirect expenses to those periods in which the facility was not used at all. This was seen as contrary to Congressional purpose in enacting the UBTI provisions which was to place private enterprise on an equal level with competing businesses run by tax-exempt institutions.

Judge Mansfield issued a dissenting opinion, 731 F.2d at 1063, and argued that the court's holding placed exempt organizations at a competitive advantage insofar as they could use expenses incurred in furtherance of exempt purposes to offset nonexempt income, even though these expenses were not directly connected with the organization's unrelated business activities. The majority assumed that the same standards should govern deductibility for tax-exempt organizations as taxable businesses. The dissent stated this assumption was a fundamental error which conflicted with "legislative intent, economic reality, and the express wording of the pertinent statute and regulations." Id.

The dissent noted that when Congress initially passed the UBTI provisions, it was concerned with producing a fair amount of revenue as well as with removing the unfair competitive advantage exempt organizations enjoyed. Furthermore, Congress "was confronted with inherent differences between a regular taxable business and a non- profit university" only partially engaged in income-producing commercial activity which precluded the "wholesale transfer and application to a university of the deduction principles governing regular commercial businesses." 762 F.2d at 1063-64. Unlike a commercial business, part of a university's income was exempt and, therefore, an incentive existed to minimize the allocation of expenses to exempt activities which didn't exist for commercial businesses. This incentive required a stricter standard of deductibility for tax- exempt organizations. Id. at 1064.

The dissent also concluded that the majority's holding would not produce parity between taxable businesses and exempt organizations. Even though an identical rule of deductibility applied, it would be applied to organizations having different characteristics and, therefore, would be affected differently by the same rule. After tax, the tax-exempt organization would continue to be in a more advantageous position. Id. at 1064.

We continue to believe that fixed expenses should not be allocated on the basis of actual usage. The proper method of allocation of the fixed expenses should be to allocate between exempt and unrelated use on the basis of a 24-hour-a-day, 12-month-a-year period, with an allocation ratio of hours used for unrelated activities over the total number of hours in the year.

However, we now believe that this issue should not be litigated until the allocation rules of section 1.512(a)-1(c) of the Income Tax Regulations are amended. As long as the language permits an allocation between exempt and unrelated uses on a "reasonable" basis, it may be difficult for the Service to prevail on this issue in another circuit.

While the issue has considerable administrative importance, in the absence of a conflict in the Circuits petition for a writ of certiorari is not recommended.

RECOMMENDATION:

That certiorari not be recommended.

REVIEWERS: