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IRS Report on Colleges and Universities Identifies Significant Compliance Issues
Posted in Tax and Finance

On April 25, the IRS released a much-anticipated final report on its compliance study of colleges and universities. The study was initiated in October 2008, when the IRS sent questionnaires to 400 randomly-selected public and private colleges and universities. In May 2010, the IRS issued an interim report, which presented summary data on the preliminary feedback from 344 institutions—177 private and 167 public colleges and universities. Out of the 400 colleges and universities receiving questionnaires, the IRS selected 34 schools (both public and private) for examination because their questionnaire responses and Form 990 reporting indicated potential noncompliance in the areas of unrelated business income (“UBI”) and executive compensation. As of the release date of the final report, 31 of the 34 audits have been closed and “the overwhelming majority of examinations closed with adjustments to returns.” The audits primarily covered the tax years from 2006 to 2008. Based on public statements and releases, the schools examined by the IRS include Cornell University, Harvard University, Suffolk University, the University of Texas at Austin, Texas A&M University, Lamar University, the University of Central Florida, the University of Florida, the University of Miami, the University of Georgia, the University of North Carolina, the University of Notre Dame, Purdue University, Kansas City University of Medicine and Biosciences and Yeshiva University.

Unlike the interim report, which presented statistical summaries of the responses to the questionnaires based on the size of the organizations, the final report focuses more on what the IRS discovered in the examinations, particularly on noncompliance issues in the areas of UBI and executive compensation.

The original goal of the project was to help the IRS and public better understand colleges and universities and (1) their conduct and reporting of exempt or other activities that may generate unrelated business taxable income (“UBTI”); (2) investment, management and use of endowment funds; (3) executive compensation practices; and (4) governance practices. As reflected in the final report, the IRS took a much narrower focus and concentrated on underreporting of UBTI and payments of unreasonable executive compensation.

Unrelated Business Taxable Income Findings

When a tax-exempt organization engages in activity that is not sufficiently related to its tax-exempt purpose, it generates UBI, which is subject to tax. The tax is reported on Form 990-T. In general, an activity giving rise to UBTI has three characteristics: (1) it is a trade or business; (2) it is regularly carried on; and (3) it is not substantially related to furthering the exempt purpose of the organization. The law provides for a number of exceptions to the general rule with respect to certain types of revenue streams. For example, dividends, interest, royalties and certain rental income are excluded from the definition of UBTI. Also, significant to the final report, expenses or losses directly connected to an organization’s unrelated trade or business reduces the overall amount of the organization’s UBTI.

In the interim report, the IRS categorized four areas of activities, which could be viewed as potential generators of UBTI: (1) advertising, (2) corporate sponsorship, (3) rentals, and (4) other activities, such as logo usage, bookstores, and commercial research. In the final report, the IRS identified the following five activities as being connected with more than half of the 180-plus audit adjustments from underreported UBTI: (1) fitness and recreation centers and sports camps, (2) advertising, (3) facility rentals, (4) arenas, and (5) golf courses. Tax compliance officers for colleges and universities generating significant income from the above activities should consider taking appropriate measures to ensure proper characterization of such income since these activities are clearly on the IRS’s radar.

The final report indicated:

  • Increases to UBTI for 90% of colleges and universities examined totaling about $90 million;
  • over 180 changes to the amounts of UBTI reported by colleges and universities on Form 990-T; and
  • disallowance of more than $170 million in losses and net operating losses (NOLs), which could result in more than $60 million in assessed taxes.

In the final report, the IRS identified four primary reasons for increases to UBTI in the completed exams:

(1) The IRS disallowed claimed losses from activities that it determined lacked a profit motive and therefore were not connected to unrelated business activities. The IRS found that organizations were claiming losses from activities that did not qualify as a “trade or business” due to a lack of intent to make a profit. According to the IRS, a pattern of recurring losses indicates such a lack of profit motive. Nearly 70% of examined colleges and universities reported losses from activities for which expenses had consistently exceeded UBI for many years. 

(2) Additional expenses used to reduce UBI were disallowed as being improper expense allocations. Organizations are permitted to allocate expenses that are used to carry on both exempt and unrelated business activities, but they must do so on a reasonable basis. The IRS determined that on nearly 60% of the Form 990-Ts examined, colleges and universities had misallocated expenses to offset UBI for specific activities.

(3) NOLs were either improperly calculated or unsubstantiated on more than a third of returns examined, resulting in the disallowance of nearly $19 million in NOLs.

(4) Nearly 40% of colleges and universities examined had misclassified certain activities as exempt or otherwise not reportable on Form 990-T. Fewer than 20% of these activities generated a loss. Nearly $4 million of income was reclassified as unrelated, subjecting those activities to tax.

The IRS was also interested in whether the examined institutions sought outside advice about the treatment of potentially unrelated activities. About 20% of those organizations examined sought an opinion from outside professionals. In about 40% of those cases, the IRS did not agree with the outside opinion when the issue was raised on examination. As a result of these findings, the IRS indicated it plans to look at UBI reporting more broadly, particularly at activities creating recurring losses and the allocation of expenses for activities involving both related and unrelated business, noting that these issues may be present elsewhere across the tax-exempt sector.

Executive Compensation Findings

The executive compensation portion of the examinations focused on private colleges and universities and their compliance with section 4958 of the Internal Revenue Code of 1986, as amended (“Code”). This provision generally does not apply to public institutions. Under section 4958 of the Code, if a tax-exempt organization pays more than reasonable compensation to their disqualified persons (i.e., their officers, directors, trustees and key employees (“ODTKEs”)), then excise taxes are imposed on the ODTKEs who received payment of unreasonable compensation and on those persons who approved it. An organization may shift the burden of proving unreasonable compensation to the IRS by: (1) using an independent body to review and determine compensation amounts; (2) relying on appropriate comparability data; and (3) contemporaneously documenting the compensation-setting process.

Although most private colleges and universities examined attempted to meet the rebuttable presumption standard, about 20% of them failed to do so because of problems with their comparability data, including:

  • Reliance on data of institutions that were not similarly situated, based on location, endowment size, revenues, total net assets, number of students, and selectivity;
  • use of compensation studies that failed to document the selection criteria for the schools included or to explain why such schools were deemed comparable to the school relying on the study; and
  • compensation surveys that failed to specify whether amounts reported included only salary or also other types of compensation (a requirement of section 4958 of the Code).

The final report also contains a summary of the compensation amounts paid to ODTKEs and other highly-compensated individuals of both public and private colleges and universities. The IRS found that the average base salary for the top management official of colleges and universities (identified as the president or chancellor in most cases) was $452,883, with a median base salary of $376,018. The average total compensation was $623,267, with a median total compensation of $499,527.

The IRS also looked at the average compensation paid to the six highest-paid non-ODTKEs of the colleges and universities with closed examinations. These included investment managers ($894,214), sports coaches ($884,746), administrative/managerial ($381,745), department heads ($279,770), and faculty ($215,854). (The above figures are for non-ODTKEs who are not medical doctors. The figures for the 30% non-ODTKEs who hold positions at medical schools are significantly higher.)

The IRS examined the employment tax returns for about a third of the colleges and universities under audit, and found that all such exams resulted in adjustments in wages, leading to assessment of tax and, in some cases, penalties. Wage adjustments totaled almost $36 million, while employment taxes and penalties amounted to over $7.2 million. Among the reasons for adjustments were failures to include in employee income the value of the personal use of automobiles, housing, social club memberships and travel.

The IRS looked at retirement plan reporting at eight of the colleges and universities examined and found problems with half of them. These exams resulted in increases in wages from failure to report deferred compensation-related wages of more than $1 million and the assessment of more than $200,000 in taxes and penalties. One of the primary reasons for these adjustments is that contributions to plans were required to be taken into income in current years because the payments were not condition upon the future performance of substantial services sufficient to create a substantial risk of forfeiture under section 457(f)(3)(B) of the Code.

Observations

In the wake of the final report, it is important for not only academic organizations, but all tax-exempt organizations, to reevaluate their tax compliance measures. In particular, the lessons learned from the 31 closed examinations described in the final report should serve as a reminder of the significance of proper characterization of income and expenses as arising from related or unrelated business activities, as well as the importance of using appropriate comparability data in setting compensation amounts so as to satisfy the rebuttable presumption for reasonableness. At a minimum, the report’s focus on UBI and executive compensation should put all tax-exempt organizations, particularly colleges and universities, on high alert that the IRS is paying close attention to these areas. If you are not confident in the compliance practices of your organization, any concerns should be addressed sooner rather than later.

For more information, please feel free to contact Ross Cohen at RCohen@bgdlegal.com or a member of Bingham Greenebaum Doll’s Tax and Finance Practice Group.

DISCLOSURE REQUIRED BY CIRCULAR 230.  This Disclosure may be required by Circular 230 issued by the Department of Treasury and the Internal Revenue Service.  If this e-mail, including any attachments, contains any federal tax advice, such advice is not intended or written by the practitioner to be used, and it may not be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.  Furthermore, any federal tax advice herein (including any attachment hereto) may not be used or referred to in promoting, marketing or recommending a transaction or arrangement to another party.  Further information concerning this disclosure, and the reasons for such disclosure, may be obtained upon request from the author of this e-mail. Thank you.

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    Ross D. Cohen serves as Co-Leader of the Federal Tax Team and concentrates his practice on federal tax transactional and planning issues of partnerships, joint ventures, limited liability companies and S and C corporations.

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