A recent report of the IRS’ Exempt Organizations (EO) division provides the results of a multi-year audit of tax-exempt colleges and universities regarding their compliance with IRS reporting requirements. The report focuses on three areas of concern for EO: underreporting of unrelated business income; executive compensation; and employment tax and retirement plan returns.
On April 25, 2013, Exempt Organizations Director Lois G. Lerner announced the release of the IRS’ Colleges and Universities Compliance Project Final Report at an annual conference in Washington, D.C. sponsored by Georgetown University. In 2008, the IRS’ EO division launched a multi-year project with the distribution of detailed questionnaires to 400 colleges and universities and the subsequent audit of 34 selected institutions.
In 2010, EO released an Interim Report with a preliminary overview of the questionnaire responses. The Final Report focuses on the exam results and provides additional analysis of the questionnaire responses. Lerner cited the study as an example of the long-term compliance projects EO will undertake, and her remarks focused on three primary areas of concern: (1) underreporting of unrelated business income (UBI), (2) executive compensation, and (3) employment tax and retirement plan returns.
Unrelated Business Income
IRS staff “routinely find that exempt organizations offset most of their UBI with deductions, and that only about half of organizations required to file a 990-T report any tax liability,” Lerner said in her remarks. According to the Final Report, UBI was underreported at 90 percent of the colleges and universities examined, with underreported amounts totaling over $90 million. The majority of audit adjustments resulted from five types of unrelated business activities:
fitness and recreation centers and sports camps
In total, the IRS disallowed more than $170 million in losses and net operating losses (NOLs), which could result in more than $60 million in tax liability for the impacted organizations.
The Final Report attributes underreporting of UBI to several recurring practices -- the most common practice, by far, is claiming losses from activities that do not qualify as a trade or business. “Nearly 70% of examined colleges and universities reported losses from activities where for many successive years the expenses exceeded income,” Lerner reported. Lerner further explained that continual losses from an activity for a protracted period indicates a lack of profit motive required for an activity to qualify as a trade or business. Because the examined activities did not qualify as a trade or business, the losses claimed for those activities could no longer be used to offset profits from other unrelated activities in current or future years. Accordingly, EO disallowed more than $150 million in losses and NOLs reported by the institutions under examination. Lerner also attributed underreporting of UBI to misallocated expenses (where expenses did not have the proximate and primary connection to the unrelated business activity); misclassification of certain income producing activities as exempt activities; and to erroneously calculated or unsubstantiated NOLs.
With respect to compensation, the examinations focused mainly on compliance with Internal Revenue Code § 4958, which prohibits private colleges and universities from paying unreasonable compensation to their officers, directors, trustees and key employees. An organization can shift the burden of proving unreasonable compensation to the IRS by adhering to the rebuttable presumption process, as follows:
using an independent body to review and determine the amount of compensation;
relying on appropriate comparability data to set the compensation amount; and
contemporaneously documenting the compensation-setting process.
“Experts found that, in about 20% of the examined schools, the comparability data used to set compensation was not appropriate data, which means the schools failed to meet the requirements of rebuttable presumption of reasonableness,” according to Lerner. Problems with compensation data included:
use of information from schools that were not similarly situated;
compensation studies that neither specified the selection criteria for the supposed comparable schools nor explained how those schools were like the school relying on the study; and
compensation surveys that did not specify whether amounts reported included only salary or included other types of compensation, as required by Code § 4958.
“I want to stress the need for organizations to review and question the data provided by consultants or others before relying on it to determine compensation amounts. Otherwise, an organization may find itself outside of the rebuttable presumption, and be required to prove to the IRS that the compensation in question is reasonable,” Lerner emphasized.
Employment Tax and Retirement Plans
In addition to looking at Forms 990 and Form 990-T, EO reviewed employment tax returns for about a third of the colleges and universities examined and found issues at all of them, resulting in about $36 million in increased wages and over $7 million in taxes and penalties. On the retirement plan front, EO looked at reporting of about a quarter of the colleges and universities examined and found problems at about half of them. Examinations resulted in increases in wages of more than $1 million and the assessment of more than $200,000 in taxes and penalties.
The full text of EO Director Lerner’s remarks are available here.
The Final Report is available here.
Members of Saul Ewing’s Tax Practice can help you determine what this report means for you and your organization. For more information, contact the authors or the Saul Ewing attorney with whom your normally work.