The American Institute of CPAs (AICPA) has sent the IRS a letter setting forth proposed guidelines on how a tax-exempt organization should allocate expenses attributable to facilities and/or personnel that are used for both tax-exempt and unrelated business activities (dual-use facilities/personnel). The letter is an updated version of a comment letter sent in 2016.

Each year, the IRS releases its Priority Guidance Plan identifying priority tax issues to be addressed through regulations, revenue rulings, revenue procedures, notices and other published administrative guidance during the IRS fiscal year (July-June). For the past several years (including the 2016-2017 Plan), the IRS has included in its priority guidance list "Guidance under Section 512 regarding methods of allocating expenses relating to [dual-use] facilities."

The letter from the AICPA timely responds to the need for IRS guidance in this area. Specifically, for the IRS's consideration, the letter proposes seven guidelines for allocating unrelated business income (UBI) expenses for dual-use facilities/personnel:

1. Deductible expenses must bear a proximate and primary relationship to the conduct of the activity.

2. Deductible expenses include both direct costs and indirect costs.

3. Indirect costs include fixed expenses (those which do not change when the unrelated activity is conducted or not conducted) and variable expenses (those which increase or decrease when the unrelated activity is conducted or not conducted).

4. The methodology for allocating expenses relating to dual-use facilities/personnel is reasonable and consistently followed from year to year, and should not cause the double-counting of any expense.

5. The methodology for allocating expenses relating to dual-use facilities/personnel is based on the character of the expense involved.

a. Facility costs (rent, mortgage interest, insurance, taxes, security, and utilities) are apportioned based on the portion of the facility used (square footage and time) for each activity.

b. Personnel costs (salary, benefits, and taxes) are apportioned based on time spent on each activity.

c. Information technology costs (software, computer services and internet) are apportioned based on the allocation of personnel to the activity.

d. Office expenses (supplies, printing, postage, and subscriptions) are apportioned based on the allocation of personnel to the activity.

6. The AICPA recommends that the IRS permit the use of gross revenue, from each respective activity, to allocate direct and/or indirect expenses if there is no difference in the prices charged to earn unrelated versus related revenue. This provision is intended for use by organizations that are unable, or for which it is administratively impractical, to maintain or create records for activities in which dual-use facilities/personnel are used and the associated expenses are clearly distinguished as related or unrelated.

7. The AICPA recommends that the IRS provide a simplified method for small businesses to determine expenses which are deductible against unrelated business income. Small organizations lack the resources to adequately document the information needed to identify expenses pertaining to dual-use facilities/personnel used in related and unrelated activities.

The letter also includes six examples illustrating the application of these guidelines.

Implications

The AICPA is offering the IRS much-needed guidelines for allocating indirect costs in dual-use facilities, which are facilities that operate to serve both related exempt function activities and activities that generate unrelated business income. Current regulations require that an organization with dual use of facilities/personnel must allocate expenses "between the two uses on a reasonable basis" (see Reg. Section 1.512(a)-1(c)), provided that the expense is an otherwise allowable income tax deduction (e.g., allowable under Section 162 or Section 167). The lack of guidance regarding dual-use facility/personnel expenses has created varying methods for allocating costs, differing among industries and organizations. Expense allocations are commonly reviewed and oftentimes challenged by the IRS during its examinations of organizations' UBI calculations. The AICPA hopes the IRS will alleviate speculation within the industry by adopting these guidelines of how to fairly and appropriately allocate different indirect costs, based on a methodology that fairly represents the character of the expense, the unrelated use, and the administrative abilities of the organization.

In past years, the IRS has been receptive and has welcomed comments and proposals related to tax-exempt organizations so it would not be surprising if some of the AICPA's recommendations are eventually incorporated in official IRS guidance. These guidelines have not been adopted by the IRS, however, so organizations should continue to monitor their own allocation practices and policies regarding dual-use facility/personnel expenses to make sure that they are reasonable and supportable.

Please contact your Ernst & Young LLP tax professional with any questions.

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RELATED RESOURCES

— For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg.

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