By The Book - August 2013: IRS Report Scrutinizes Unrelated Business Income Reporting by Tax-Exempt Organizations

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The Internal Revenue Service (IRS) has released a final report (the “Report”) summarizing its findings from a study focused on the level of compliance by tax-exempt colleges and universities with respect to unrelated business income (“UBI”) and executive compensation reporting. The Report provides that significant compliance issues exist and that the IRS will start to look at UBI reporting more broadly. It also provides that the IRS will seek to increase awareness amongst tax-exempt organizations of the importance of using appropriate comparability data in determining compensation amounts of disqualified persons.

The multi-year study began in 2008, when the IRS sent questionnaires to about 400 randomly selected tax-exempt colleges and universities. After examination of questionnaire responses and federal tax returns submitted by each of these organizations, the IRS subsequently chose 34 colleges and universities for audits.

The audits resulted in UBI tax (“UBIT”) increases for 90% of the colleges and universities examined; over 180 changes to the amounts of UBIT reported on Forms 990-T (Exempt Organization Business Income Tax Return); and disallowance of more than $170 million in losses and net operating losses. The majority of the adjustments to amounts of UBIT reported arose from the following activities:

  • (a) fitness, recreation centers and sports camps,
  • (b) advertising,
  • (c) facility rentals,
  • (d) arenas, and
  • (e) golf.

Reasons for adjustments included:

  • (a) misclassification of an activity as a trade or business,
  • (b) misallocation of expenses,
  • (c) errors in computation or substantiation, and
  • (d) misclassification of related activities.

The executive compensation aspect of the examinations focused mainly on compliance with section 4958 of the Internal Revenue Code (the “Code”), which imposes a tax in instances where certain tax-exempt organizations pay more than reasonable compensation to disqualified persons. Disqualified persons can potentially include, among others, officers, directors, trustees, and key employees. Most of the audited organizations that were subject to Code section 4958 attempted to meet the rebuttable presumption standard, under which the IRS presumes that the tax under Code section 4958 is inapplicable if certain requirements are met. About 20% of these organizations failed to meet the standard because of problems with their compensation comparability data.

The IRS also reviewed employment tax and employee plan issues for employees of the audited organizations. All of the completed audits thus far have resulted in adjustments in wages, which can lead to tax assessments and penalties. A quarter of the audited organizations were subject to retirement plan reporting review and half of such organizations were found to have reporting issues.

The release of the Report reinforces the continuing trend of increased nonprofit organization scrutiny by the IRS. While the Report focuses on compliance by tax-exempt colleges and universities, it should serve to caution all tax-exempt organizations with respect to UBI reporting and the other reporting issues addressed by the Report.