This section provides a general explanation of the appeals process for unrelated business taxable income related to employee benefit plans.
A. Types of Unrelated Business Income Related to Employee Benefit Plans
A trust that is qualified under Internal Revenue Code (IRC) section 401(a) is generally exempt from income tax under IRC 501(a). This means that the annual income derived from the trust is not taxed to the trust. Most of the common investment income a trust generally earns comes from dividends, interest, loan payments, as well as from gains and losses from the sale of stock. However, if the trust conducts an active trade or business, then that income is taxed as Unrelated Business Taxable Income per IRC section 513(b).
A trade or business, for purposes of IRC section 513, has the same meaning as in IRC section 162. IRC section 162 provides that a trade or business generally includes any activity carried on for the production of income from the sale of goods or from the performance of services. There are no definite rules on what is a trade or business. A determination based on the facts and circumstances of each case must be made to determine if the trust is actively involved in a trade or business.
Unrelated business income can occur when the trust is engaged in the same business activity as the plan sponsor. The management of the trust is, directly or indirectly, usually the same as that of the employer. Consequently, there is a tendency to apply the trade or business expertise of corporate management to the trust’s business activities. When the trust does engage in an activity which complements the employer’s business, the earnings attributable to that activity become taxable as unrelated business income. For instance, the employer may be engaged in the manufacture of a product and permit the trust to perform all or part of the marketing functions. Other examples of unrelated business income identified by the IRS include:
Sale of Lots - Corporations which are in the business of developing and improving real estate for sale to customers will often contribute land, which is adjacent to their own development projects, to their employee trusts. Or, they will contribute cash and require the trust to invest in such subdivisions. In this manner, the employer’s salespeople can promote and sell the trust’s subdivided and improved real property along with their own and escape taxation on the portion of the activity attributable to trust ownership.
Vending Machines - The operation of a vending machine route (large or small) is a trade or business. Trusts find this additional activity appealing as a revenue producer because little effort is required on their part to derive financial benefits.
Commissions and Fees - An employee trust may earn commissions or fees for services rendered. Income from these sources commonly stems from sales commissions (real estate as well as personal property) and finder’s or agency fees of various sorts.
Fruit Orchards and Citrus Groves - Some trusts own property and may operate the activity rather than lease the property.
Rental of Personal Property - The income derived from the lease or rental of personal property (other than that leased with real property) constitutes income from operation of a trade or business. Some examples include: tank cars, boats, automobiles, fishing and skiing equipment, signs and vending machines.
If the trust has unrelated business taxable income for a taxable year of $1,000 or more, the trustee (on behalf of the trust) is required to file a Form 990-T, Exempt Organization Business Income Tax Return (PDF). The expenses and depreciation allowable under IRC section 162, which are directly attributable to the trade or business, can be used to offset the unrelated business income. The trust is also allowed a specific deduction of $1,000 annually on top of those expenses directly attributed to the unrelated business income.
B. How does the IRS Propose an Unrelated Business Income Tax Assessment?
The revenue agent will initially propose the assessment by Letter 2005 (PDF) or by an individually designed letter. The letter will explain why the Service believes an additional tax liability is necessary and will advise the taxpayer of their appeal rights when they do not agree with the results of the examination. This letter will contain the following attachments:
Revenue Agent Report (RAR), which is used to support the contention that taxes and penalties have accrued, (summary of the facts pertinent to the case with the applicable tax law);
Form 870, Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment (PDF), serves as a delinquent return in the event you decide not to protest the preliminary notice agreeing to the assessment;
Letter 2005 generally gives the taxpayer 30 days to respond and advises the taxpayer of their Appeal rights if they do not agree. During the 30-day response period the taxpayer is free to present any documentation supporting the accuracy of the income tax return as filed or why an assessment should not be proposed. If no response is received within 30 days from the date of Letter 2005, the Service will assume that the proposed assessment is correct.
If agreement can be reached in one or more issue, the taxpayer should notify the revenue agent the agreed upon issues so a revised examination report can be issued. A typical situation might be where the taxpayer agrees to the unrelated business income tax assessment but does not agree to the penalty associated with the unrelated business income tax assessment.
C. Available Avenues If You Disagree With the Proposed Assessment
Initial Request for Review with the Revenue Agent’s Manager:
If the taxpayer does not agree with the revenue agent’s finding, a meeting with the revenue agent's supervisor to discuss the findings may be requested. Although requesting a meeting with the manager is not required, it is a valuable option for the taxpayer and should be considered before moving forward with the remainder of the Appeals Process or Court.
If it is subsequently decided to have a meeting with the revenue agent’s manager, all the facts previously presented to the revenue agent should be presented again for reconsideration. If the manager concurs that the Form 990-T as previously filed accurately reflects the correct income tax or that the assessment is not warranted, then no adjustment will be proposed. If a prior Form 990-T has been filed, the revenue agent will issue Letter 2085-A (PDF) acknowledging no change in the tax liability reported on the return(s). If there is further disagreement then the taxpayer is urged to appeal the case to an Appeals Office or directly to court.