The Internal Revenue Service recently issued its Final
Report on the Colleges and Universities Compliance Project,
marking the conclusion of a five-year study of one of the largest
segments of the nonprofit sector. The Report summarizes the
Service's analysis of questionnaire responses and focuses on
the results of the examinations completed to date. On
May 8, 2013, IRS Exempt Organizations Director Lois Lerner
summarized the origins, process and results of the Project in testimony
before the House Ways & Means Committee, Subcommittee on
Oversight.
The Final Report is based on examinations of only 34
organizations—a number that the IRS acknowledges is too small
to provide a statistically valid sample. Thus, the IRS
cautions against drawing any broad conclusions from the Report
regarding the compliance practices of colleges and
universities.
However, the results of these audits—including, in
particular, significant adjustments and assessments of unrelated
business income (UBI) and employment taxes and
penalties—provide useful data points regarding compliance and
reporting practices in the areas of unrelated business activities
and executive compensation. Indeed, the Report confirms that
the IRS will apply the lessons learned from these examinations in
future unrelated business income tax (UBIT) and executive
compensation audits, stating:
the IRS plans to look at UBI reporting more broadly, especially at recurring losses and the allocation of expenses, and to ensure, through education and examinations, that tax-exempt organizations are aware of the importance of using appropriate comparability data when setting compensation.1 |
Background
In 2008, the IRS Exempt Organizations Division sent detailed
"compliance check" questionnaires to 400 randomly
selected colleges and universities in order to better understand
these institutions and their practices involving endowments,
executive compensation, and unrelated business activities.
The IRS provided a preliminary overview of the questionnaire
responses in an Interim
Report released in May 2010.
According to the Final Report, 34 colleges and universities were
selected for examination because their questionnaires and Form 990
information returns suggested the "greatest potential for
compliance issues with respect to UBI or compensation."
The group was evenly divided between public and private
institutions, and about two- thirds were classified as
"large," with at least 15,000 students. The ensuing
audits covered all returns related to the institution, including
Form 990, Form 990-T, employee plan returns, excise tax returns
(Form 4720) and employment tax returns. The tax years under
examination ranged primarily from 2006 to 2008.
Highlights of the Report
1. Unrelated Business Taxable Income
One of the Service's primary areas of focus in the college and
university examinations was the institutions' reporting of
"business activities, including the characterization of
activities as exempt or unrelated, the methodology for allocating
expenses, the significance of recurring losses on specific
activities, the calculation of net operating losses, and the
application of exceptions and modifications." In the
end, the Service determined that 90% of the colleges and
universities examined underreported their UBI, and made upward
adjustments to UBI for this group of approximately $90
million. More than half of the adjustments were connected to
the schools' operation of fitness and recreation centers,
sports camps, advertising, facility rentals, arenas, and golf
courses. The Service also disallowed more than $170 million
in losses and net operating losses (NOLs) on 75% of the
returns examined.
The IRS reported four primary reasons for these adjustments.
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What this means...
Not surprisingly, we expect that UBIT issues will remain a major
issue for IRS education and enforcement (i.e., examinations).
So now would be a good time to work with counsel to review your
organization's UBIT compliance and reporting practices with the
following issues and filters in mind:
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2. Executive Compensation
The compensation segment of the Report focuses on compliance
issues arising under the intermediate sanctions rules of section
4958 of the Code. Those rules mandate that charities pay their
"disqualified persons" reasonable (i.e., not excessive)
compensation, and impose penalties if compensation is not
reasonable. A charity's disqualified persons include not
only its officers, directors, trustees, and family members of these
individuals, but also any other individual who is in a position to
exert "substantial influence" over the organization's
affairs. Some individuals who qualify as "key
employees" for Form 990 reporting purposes may also be
"disqualified persons."
The Report notes that most of the private colleges and
universities examined by the Service attempted to satisfy the
procedures prescribed in the Regulations under section 4958 for
securing the "rebuttable presumption" that compensation
is reasonable, i.e., by (1) having an independent body review and
set the compensation; (2) using "appropriate comparability
data" to set the compensation; and (3) keeping contemporaneous
documentation regarding the compensation setting process.
However, the IRS concluded that approximately 20% of the examined
institutions—including ones that engaged compensation
consultants to assist in the compensation-setting
process—failed to secure the rebuttable presumption because
of shortcomings in their comparability data.
The Report documents the IRS's first large-scale effort to
look not only at whether comparability data was used but whether
the data was "appropriate." The section 4958
Regulations explain that comparability data is
"appropriate" if it provides the board or compensation
committee with "information sufficient to determine whether
... the compensation arrangement in its entirety is
reasonable." Relevant information includes, but is not
limited to, "compensation levels paid by similarly situated
organizations, both taxable and tax-exempt, for functionally
comparable positions" and "current compensation surveys
compiled by independent firms," among other
things.
In its examinations of colleges and universities, the IRS found
that the comparability data used by some institutions was not
"appropriate" because:
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What this means...
Based on the clear language in the Report, we expect that
executive compensation will remain a focus for future IRS education
and enforcement efforts—with the IRS taking a hard look at
the comparability data used to justify the compensation amount. As
a result, organizations and their counsel should review their
procedures for setting executive compensation with the following
issues in mind:
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This article is designed to give general information on the developments covered, not to serve as legal advice related to specific situations or as a legal opinion. Counsel should be consulted for legal advice.