UBIT: It Applies to State Charters, but not Federal Charters

WASHINGTON – The IRS’ Unrelated Business Income Tax for non-profits is nothing new to credit unions, but a recent flurry of credit union audits for UBIT has raised concern in a handful of states, notably Connecticut, Alabama, and Colorado. According to the IRS Code, UBIT is income that is unrelated to an exempt entity’s purpose. Any exempt organization that has $1,000 or more gross income from an unrelated business must file IRS Form 990-T. The IRS has three criteria for determining if UBIT applies: (1) It is a trade or business, (2) it is regularly carried on, and (3) it is not substantially related to the furtherance of the exempt purpose of the organization. The third one is where some subjectivity can come in to play. The IRS says the activities that generate the income “must contribute importantly to the accomplishment of the organization’s exempt purposes to be substantially related.” UBIT does not affect federal-chartered credit unions as they are exempt from all federal taxes, so it’s also a state vs. federal charter issue. Fourteen state-chartered credit unions in Connecticut are currently being audited for UBIT. In Alabama credit unions are being audited for UBIT and Colorado IRS examiners are working with state regulators poring over credit union call reports to decide which CUs they’d like to audit for UBIT. Howard Pitkin, Director of Financial Institutions for Connecticut, says UBIT creates an unlevel playing field. “Under the current law, federal credit unions are considered to be an instrumentality of the federal government. The law’s the law, but I think it’s grossly unfair, even if you broke it down for all non-profit organizations,” said Pitkin. “We feel that this tax is discriminatory to levy on one credit union and not the other.” Pitkin offered up the example of a church making money on a bake sale. “Would you tax one kind of church and not the other? How long would that last?” Pitkin said UBIT has been around for a long time, but only now is it becoming an issue in Connecticut. He speculated if it wasn’t a way for the Administration to make up for budget shortfalls. None of the results of the Connecticut audits are in as of yet, said Pitkin. The audits are actually for the year 2000. “This issue should be a concern to state-chartered credit unions,” Pitkin said. While credit unions selling cakes obviously would be viewed as unrelated business income by the IRS, NASCUS President Doug Duerr said there are some products CUs would be surprised to learn that the IRS has challenged. For example, it has challenged credit unions offering credit insurance products, a venerable credit union product that 63% of CUs offer. NASCUS worked with CUNA Mutual back in 1997 to state the case to the IRS why credit insurance is related to a credit union’s business, but a ruling has not yet been handed down. CUNA Mutual said it is confident the ruling will be favorable. Alabama CUs are currently fighting the IRS on credit insurance. Vicki Williams, senior executive vice president for the Alabama League, said the IRS has audited six Alabama state charters and has found UBIT in five of them, with the sixth audit still pending. “This is something that apparently occurs every 20 years, but this time they’re more aggressive and assertive. If this goes forward, I think you’re going to see mass conversions to federal charters,” said Williams. She said Alabama IRS examiners have pegged credit insurance, sales of checks to members, GAP (Guaranteed Auto Protection) insurance and others as unrelated business income. The League quickly alerted its members of the situation so any UBIT challenges can be answered uniformly. CUNA Mutual attorneys and a CPA firm are working on behalf of Alabama CUs. Williams said back in November the lawyers and attorneys submitted a “request for technical advice” on behalf of the audited CUs to IRS headquarters to challenge the UBIT claims of the Alabama IRS examiners. There’s been no ruling as of yet. She said the examiners weren’t even aware of NCUA’s Incidental Powers rule, something they pointed out to them. So far the audits have been for 1999 and 2000, and Williams said one credit union’s UBIT bill would be as high as $600,000 if it goes through. “Our state charters already pay state excise taxes, and they can be significant. We know state-charters will convert if UBIT becomes another tax on them.” Williams said one former state charter, now a federal charter in the state that engages in arbitrage, conceded that any income related to that would be unrelated and would have willingly paid the tax. “We’ve heard a lot from Connecticut, and we’ve determined IRS examiners in different regions don’t talk much,” she said. Connecticut IRS examiners are even questioning ATM surcharge income. Duerr said one of the problems about UBIT is it’s really open to interpretation by different examiners at the IRS – what one IRS examiner thinks should fall under UBIT, another may not. On the facilities front, Duerr said federal credit unions can rent out much of their facility with no additional taxes, but rental income could be taxed for state-chartered credit unions. The IRS does state that certain rental income could be exempt from UBIT. Duerr said there are some cases where state-charters just lose out with the IRS. He said earnings state charters receive from repurchase agreements, commonly known as repos, are taxed under the code, but not for federal charters. “Through the years we’ve had differences of opinion with the IRS. We’ve had some situations where the examiner has determined an activity is not related and the credit union looks at it and says, `you’re right’. Other times they don’t see it,” said Duerr. Duerr said disagreements can be fought on the technical level, with a credit union challenging the IRS through technical letters on the disputed activity. Sometimes rulings are overturned at that level. “You have an appeal process to the regional office and you have an appeal process where ultimately you can take your appeal to tax court, and if it’s a big enough issue you can got to the federal level,” said Duerr. Duerr said NASCUS is concerned about this issue and believes there may have to be a precedent-setting ruling on a high judicial level. “Maybe the courts need to look at this and the disparity we have.” “The problem is if there are two credit unions across the street from each other and they’re doing the same thing, it is possible of the state-chartered credit union has to pay taxes and the federal doesn’t,” said Duerr. State charters have an advantage and a disadvantage when it comes to UBIT said Duerr. The disadvantage as already stated is FCUs are not subject to UBIT, while state-charters are. The advantage is if a state-charter is engaging in something unrelated to its business and earning income it can run the income through the credit union and just pay taxes on it, while a federal charter has to start a for-profit CUSO. CUNA Associate General Counsel Mary Dunn said CUNA and CUNA Mutual met with IRS several weeks ago to get a better idea of what they’re looking for with UBIT. Dunn said she doesn’t think this is an area where the IRS should be making judgment calls because there are rules on the books about what CUs can do from the state and federal regulators. “It seems to us logical that the IRS would look to that,” said Dunn. On the federal level, NCUA’s 721 dictates what activities federal credit unions can engage in. “I do believe they understand our position, however the IRS is its own entity and you know they feel they’re the ones who should be deciding what would be related to UBIT. When you have the primary regulator deciding what is a primary activity, it doesn’t seem appropriate that the IRS would take a different approach.” Dunn said credit unions shouldn’t be overly concerned if the IRS comes knocking. “Just because you’re contacted by the IRS doesn’t mean you’re engaging in unrelated business income,” said Dunn. There have been numerous debates over UBIT through the years, particularly with non-profit associations. Chris Vest, Assistant Director of Public Relations for the American Society of Association Executives, said ASAE has battled the IRS many times on UBIT. “Although most associations are non-profit and tax-exempt under the IRS tax code, anything that is deemed unrelated to the mission of the organization is taxable. These days most associations are not reliant on dues alone or one source of revenue for their operations, so you have a lot of non-dues activity that is potentially taxable,” said Vest. “Where you get into the problem is when you tax organizations on these revenue sources, you force them to scale back their educational program or whatever good they are doing for the community. In order to pay the tax bill you end up hurting the mission of that organization,” said Vest. CUNA Mutual recommends that credit unions contact their tax advisors on any challenges and offered itself as a resource as well. “Our position on UBIT is that most products offered by credit unions are related to exempt functions of credit unions as those functions have evolved over time. Credit unions should continue to keep accurate expense records. The better expenses are tracked, the easier it is for a credit union to accurately show how its expenses offset income that may be subject to UBIT,” said CUNA Spokesperson Sydney Lindner. [email protected]