On April 25, 2013, the IRS released its Final Report on the tax law compliance activities of 400 colleges and universities across the country. In 2010, the IRS had released an Interim Report summarizing the responses to a questionnaire sent by the IRS to 400 randomly selected colleges and universities in October 2008. In that questionnaire, the 400 colleges and universities were asked to submit information in a number of areas based on their tax years ending in 2006. Based on the questionnaire responses, the IRS opened examinations of 34 colleges and universities and focused on issues of unrelated business taxable income, executive compensation and employment tax. The IRS has now completed 90 percent of those examinations and has published its Final Report, which provides a comprehensive view of both the questionnaire responses and the examinations.
On May 1, 2013, Congressman Charles W. Boustany, Jr., chairman of the Subcommittee on Oversight of the Committee on Ways and Means (Subcommittee), announced that the Subcommittee will hold a public hearing on the Final Report. The hearing will take place on Wednesday, May 8, 2013, in Room 1100 of the Longworth House Office Building, beginning at 2 p.m. Although oral testimony will only be heard from invited witnesses, any individual or organization may submit a written statement for consideration by the Subcommittee and for inclusion in the printed record of the hearing. For anyone considering the submission of a written statement, submission details and formatting requirements can be found here.
The Final Report highlights certain findings from the examinations of 34 colleges and universities in the areas of unrelated business taxable income, executive compensation, employment tax and retirement plans.
I. The IRS Found Significant Underreporting of Unrelated Business Taxable Income
The examinations resulted in more than 180 adjustments to the examined institutions’ returns, resulting in an aggregate increase to unrelated business taxable income (UBTI) of approximately $90 million, spread among 90 percent of the examined institutions. The primary reasons for this increase were (i) improper reporting of certain losses as connected to unrelated business activities when they were not; (ii) errors in computation or substantiation regarding net operating losses (resulting in the disallowance of nearly $19 million in NOLs); and (iii) misclassification of certain activities as exempt or otherwise not reportable that the IRS found to be unrelated activities.
The improper reporting of certain losses as connected to unrelated business activities occurred in two ways. First, the IRS found that institutions were claiming losses from activities that did not qualify as a “trade or business” because the institutions failed to show a profit motive for the activities. Because of this issue, the IRS disallowed losses on 75 percent of the returns examined, resulting in the aggregate disallowance of more than $150 million in losses and NOLs. Second, the IRS found that approximately 60 percent of the examined institutions had misallocated expenses between exempt and unrelated business activities, resulting in claimed expenses that were not connected to the unrelated business activity.
More than 30 different activities were connected to the more than 180 adjustments made to the UBTI reporting of the examined institutions. In order of frequency, the following activities accounted for more than half of the adjustments: (i) fitness and recreation centers and sports camps; (ii) advertising; (iii) facility rentals; (iv) arenas; and (v) golf courses. In particular, adjustments related to advertising and facility rentals resulted in changes in UBTI for almost half of the examined institutions. Adjustments related to fitness and recreation centers, sports camps, arenas and golf courses resulted in changes to UBTI for about one-third of the examined institutions.
II. Flaws Found in Comparability Data Establishing Reasonable Compensation
Section 4958 of the Internal Revenue Code provides that private colleges and universities may pay no more than reasonable compensation to their officers, directors, trustees and key employees. On examination, an organization may shift the burden of proving unreasonable compensation to the IRS if the organization establishes a rebuttable presumption of reasonableness. To establish this presumption, an organization must use an independent body to review and determine the amount of compensation, use appropriate comparability data and contemporaneously document the compensation-setting process.
Approximately 20 percent of the examined private colleges and universities failed to establish the rebuttal presumption due to problems with their comparability data. One problem was selecting institutions that were not similarly situated to the college or university under examination, based on one or more of the following factors: location, endowment size, revenues, total net assets, number of students and selectivity. Another problem was the use of compensation studies that did not document the selection criteria for including schools or explain why included schools were deemed comparable.
Finally, some compensation surveys did not specify whether the reported compensation amounts consisted solely of salary amounts or included other types of compensation. The IRS examined total compensation by looking at individuals’ gross income and by examining whether fringe benefits or deferred compensation were properly included or excluded from wages.
III. Employment Tax and Retirement Plan Issues
In addition to examining Forms 990 and 990-T, the IRS also reviewed employment tax and employee plan returns. All the completed examinations resulted in adjustments in wages, totaling about $36 million, leading to the assessment of additional taxes and penalties in an amount over $7 million. Wages were adjusted for several reasons, including (i) the failure to include in income the value of personal use of automobiles, housing, social club memberships and travel; (ii) misclassification of employees as independent contractors; (iii) failure to withhold taxes for wages paid to nonresident aliens; and (iv) failure to include in income the value of certain graduate tuition waivers and reimbursements.
The IRS examined retirement plan reporting for one-fourth of the 34 examined educational institutions and found problems in about half of these examinations, resulting in wage increases of more than $1 million and the assessment of more than $200,000 in taxes and penalties. The wage increases were primarily due to (i) contributions that had to be taken into income in current years, because the payments were not subject to a substantial risk of forfeiture under section 457(f)(3)(B); (ii) loans from 403(b) plans in excess of the 72(p) limits; (iii) deferrals for 403(b) plans in excess of 402(g) limits; and (iv) additions to 403(b) plans in excess of 415(c) limits.
IV. Future Focus of IRS Examinations
As a result of the examinations summarized in the Final Report, the IRS has stated that it plans to look at UBTI reporting “more broadly,” focusing on recurring losses and the allocation of expenses. Additionally, the IRS plans to use examinations and education resources to make tax-exempt organizations aware of the proper use of comparability data when setting executive compensation. This increased focus will have impact on the entire nonprofit sector and not just colleges and universities.
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