"Exempt and Nonprofit Organizations Alert: IRS Addresses UBTI and Executive Compensation Issues"

by Skadden, Arps, Slate, Meagher & Flom LLP

IRS Addresses Issues of Unrelated Business Taxable Income and Executive Compensation in Colleges and Universities Compliance Project Report

On April 25, 2013, the Internal Revenue Service (IRS) released its Final Report for the Colleges and Universities Compliance Project, a multiyear analysis of tax-exempt colleges and universities.1 In 2008, the IRS distributed questionnaires to 400 randomly selected colleges and universities and selected 34 for examination. The Final Report focuses predominantly on two areas of concern that are equally relevant to all Section 501(c)(3) public charities: unrelated business taxable income (UBTI) and executive compensation.

Unrelated Business Taxable Income

As a result of the study, the IRS increased UBTI for 90 percent of colleges and universities examined, making more than 180 adjustments totaling about $90 million. Advertising and facility rentals resulted in adjustments to UBTI for almost half of colleges and universities examined; fitness and recreation centers, sports camps, arenas and golf courses resulted in UBTI adjustments for about a third of the organizations.

The most common reason the IRS adjusted a school's UBTI was that the school incorrectly claimed losses from activities that the IRS did not consider to constitute a "trade or business." An organization only generates unrelated business income from a "trade or business," and an activity only qualifies as a trade or business if the organization engaged in the activity is intending to make a profit. The IRS' view is that if a school sustains continuous losses from a single activity, this pattern is sufficient to show a lack of profit motive. Accordingly, a school cannot claim losses against UBTI from such an activity because, not being operated for profit, it cannot be a "business" activity. For this reason, the IRS disallowed losses at 70 percent of schools examined. More than $170 million in losses were disallowed, resulting in additional tax liability of $60 million for impacted organizations.

The validity of these losses is of particular interest to the IRS because losses from a single activity can offset gains from other trade or business activities not only in the year of the loss but also in future and past years. This allows organizations to continue to conduct an unrelated business activity operating at a loss while taking deductions from that activity against the aggregate income of other unrelated business activities.

The IRS also disallowed expense deductions on more than 60 percent of IRS Forms 990-T because they were based on incorrect allocations between exempt and unrelated business activities. Too frequently, schools took deductions on expenses related to an activity in furtherance of an exempt purpose, which may not be deducted from UBTI.

The IRS also found that almost 40 percent of colleges and universities examined had misclassified certain activities as exempt or otherwise not reportable on Form 990-T. As a result, the IRS reclassified nearly $4 million in income as unrelated, subjecting those activities to tax.

Executive Compensation

The Compliance Project also focused on Internal Revenue Code (the Code) Section 4958, which provides that organizations may pay no more than reasonable compensation to their disqualified persons. Section 4958, which applies to all Section 501(c)(3) public charities, imposes an excise tax on disqualified persons who received payment of unreasonable compensation and, in certain cases, on those persons who approved it. At the colleges and universities examined, the officers, directors, trustees, and key employees (ODTKEs) were disqualified persons subject to the reasonable compensation requirements of Section 4958. The burden of proving unreasonable compensation shifts to the IRS if an organization follows the three step rebuttable presumption process. To obtain the presumption, an organization must: 

  • use an independent body to review and determine the amount of compensation;
  • rely on appropriate comparability data to set compensation; and
  • contemporaneously document the process used to set the compensation amount.

While most private colleges and universities examined attempted to meet the rebuttable presumption standard, weaknesses were found in the comparability data of about 20 percent of them, including: 

  • using data from institutions not similarly situated to the school;
  • using compensation studies that did not document the selection criteria for the schools in the surveys and did not provide an explanation as to why those schools were deemed comparable to the school relying on the study;
  • relying on surveys in which the school's own compensation data was included but the survey was not limited to schools that could be considered comparable to each other. Some schools used such surveys with no adjustments while others removed schools that were not comparable; and
  • using compensation surveys that did not specify whether compensation amounts provided included only salary or also other types of compensation to equal total compensation, as required by Code Section 4958.

The IRS opened employment tax exams for 11 of the colleges and universities examined, all of which resulted in adjustments. These adjustments included an increase in taxable wages of more than $35 million generating more than $7 million in employment taxes and almost $170,000 in penalties. The wage adjustments were made for a variety of reasons, including the failure to include in income the value of the personal use of automobiles, housing, social club memberships and travel; the misclassification of employees as independent contractors; the failure to withhold taxes for wages paid to non-resident aliens; and the failure to include in income the value of certain graduate tuition waivers and reimbursements. The IRS opened retirement plan examinations for eight of the colleges and universities examined, resulting in deferred compensation-related wage adjustments of more than $1.1 million generating more than $200,000 in taxes and more than $12,000 in penalties.

The IRS makes it clear that the 34 selected colleges and universities are not a representative sample as they were selected for examination because their returns and questionnaires indicated potential noncompliance. Still, the IRS plans to look at UBTI reporting more broadly, especially at recurring losses and the allocation of expenses, and to use educational tools and examinations to ensure that organizations understand the need to use appropriate comparability data when setting compensation. The IRS further notes that the examinations raised issues surrounding compensation and unrelated business taxable income "that may well be present elsewhere across the tax-exempt sector."

Congressman Charles W. Boustany, Jr., M.D., (R-LA), chairman of the Subcommittee on Oversight of the Committee on Ways and Means, called the Report's findings "alarming" and announced that the subcommittee will hold a hearing on the Final Report on Wednesday, May 8 to examine the causes for the "widespread noncompliance" found.

We would be happy to assist you should you have any questions regarding the impact of the IRS' findings on your organization.

1 The IRS released on May 7, 2010, an interim report summarizing initial responses to its questionnaire.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Skadden, Arps, Slate, Meagher & Flom LLP | Attorney Advertising

Written by:

Skadden, Arps, Slate, Meagher & Flom LLP

Skadden, Arps, Slate, Meagher & Flom LLP on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.


JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.