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

The Internal Revenue Service recently released a much-anticipated final report on its compliance study of colleges and universities, which may have implications for other nonprofits. The final report pinpoints several areas of noncompliance that could affect many tax-exempt organizations. Specifically, in its audit of over 30 schools as part of this report, the IRS identified noncompliance issues with the reporting of unrelated business income and executive compensation.

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Unrelated business income

When a tax-exempt organization engages in activity that is not sufficiently related to its tax-exempt purpose, it generates unrelated business income (UBI), which is subject to tax despite a nonprofit’s tax exempt status. In general, an activity is considered an unrelated business if it is (1) a trade or business; (2) regularly carried on by the organization; and (3) not substantially related to furthering the exempt purpose of the organization. Expenses or losses connected to a nonprofit’s unrelated businesses reduce the amount of the organization’s net UBI that is subject to tax (typically referred to as unrelated business taxable income or UBTI) and can result in the reporting of net unrelated business losses. This point is key for many nonprofits trying to reduce or eliminate tax on their UBI and the IRS knows it.

In the final report, the IRS identified the following five activities as being connected with most of the audit adjustments from underreported UBTI:

  • Fitness and recreation centers and sports camps
  • Advertising
  • Facility rentals
  • Arenas
  • Golf courses

Nonprofits generating significant income from the above activities should consider taking appropriate measures to ensure that this income is correctly identified. Income from these activities is clearly on the IRS’s radar.

The IRS also identified four primary reporting issues resulting in additional UBTI in the completed audits:

  • Improper deductions taken against UBI for losses that were not connected to unrelated business activities, frequently due to a lack of profit motive.
  • Misallocation of expenses between exempt and unrelated business activities in order to offset UBI.
  • Errors in calculations of losses or lack of documentation to substantiate losses.
  • Misclassification of certain activities as being either related to the institution’s exempt purpose or otherwise excluded from the UBTI calculation.

These issues point out the importance of properly documenting the business purpose and profit motive for activities producing recurring losses, and maintaining records of expense allocations between related and unrelated activities. The IRS has 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. The IRS specifically noted that these issues may be present elsewhere across the tax-exempt sector.

Executive compensation

The executive compensation portion of the audits described in the report focused on private colleges and universities and their compliance with the Internal Revenue Code’s provisions imposing excise taxes on certain “excess benefit transactions.” One such transaction occurs where an organization pays more than reasonable compensation to its disqualified persons. This provision applies to private, but not public, colleges and universities, and imposes a significant excise tax on disqualified persons receiving unreasonable compensation and on those persons who approved it. With respect to a college and university, disqualified persons are generally its officers, directors, trustees and key employees (ODTKEs).

The rules permit an organization to shift the burden of proving unreasonable compensation to the IRS by following a three step process to create a “rebuttable presumption of reasonableness”:

  • Using an independent body to review and determine compensation amounts;
  • relying on appropriate comparability data in setting the compensation amount; and
  • contemporaneously documenting the compensation-setting process.

Noted problems with comparability data (which resulted in audit adjustments) include:

  • Relying on data of institutions that were not similarly situated, based on location, endowment size, revenues, total net assets, number of students, and selectivity;
  • using 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 studies; and
  • using compensation surveys that failed to specify whether amounts reported included only salary or included other types of compensation.

Despite engaging independent compensation consultants to establish reasonable compensation, a number of institutions failed to qualify for the rebuttable presumption of reasonableness. 

Observations

In the wake of the final report, it is important for all tax-exempt organizations to reevaluate their tax compliance measures. In particular, the proper characterization of income and expenses from related or unrelated business activities, as well as the importance of using appropriate comparability data in setting compensation amounts.  Appropriate documentation and record-keeping are a key factor in this regard.

At a minimum, the final 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.

Congress, too, is taking notice of the noncompliance issues raised in the final report. The U.S. House of Representatives Ways and Means Subcommittee on Oversight held a hearing on the findings in the report on May 8, 2013. The opening statements of Charles Boustany, Jr. (R-La.), the Subcommittee’s chairman, can be found here.

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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