Goin’ Fishin’ with the IRS: Observations on the Compliance Questionnaire for Colleges and Universities

January 21, 2009

Over the past few months, McGuireWoods has advised a number of colleges and universities that received the Form 14018, “Compliance Questionnaire — Colleges and Universities,” from the IRS. During our representation of these higher education institutions, it has become apparent that the IRS anticipates that the responses it receives from the 400 selected institutions will serve as the basis for future IRS inquiries into whether and how higher education institutions comply with the tax laws applicable to tax-exempt entities.

Colleges and universities that received the questionnaire have until February 6, 2008 to reply to the IRS and should be well into the response process at this time. Moreover, even though only a fraction of higher education institutions nationwide received the IRS questionnaire, all colleges and universities should consider the long-term ramifications of the IRS’s anticipated compliance and enforcement efforts in the areas addressed by the questionnaire.

From the questionnaire, several important trends appear in both the nature of the questions and the way the IRS has framed the questions. Both current and future responders to the questionnaire, and similar IRS initiatives in the future, should note the following:

  1. The questions are very specific, relate only to 2006 information, and require a thorough reading of the entire questionnaire, as well as the attached “definitions, references and additional instructions.” The responding institution should also carefully review the statements in the IRS cover letter and the IRS responses to “frequently asked questions,” which it has posted on its web site, before answering any questions. Because the questionnaire covers four different overlapping areas, it is vital to obtain a full understanding of the information being sought before attempting to answer any questions in order to prevent inaccurate answers and unnecessary revisions.
  2. The responding institution should limit its responses to the questions asked by the IRS. The questions are nuanced, and “over-answering” poses the risk of raising unintended issues. Before answering any question, the responding institution should confirm the definition of the terms used in the question. For example, Question 61(c) requests the amount of the contributions to “employee benefit plans.” For purposes of Question 61(c), however, the question relates only to contributions to welfare benefit plans, and does not include retirement plan contributions.
  3. Part II of the questionnaire reflects the IRS’s continued interest in “unrelated business income.” This portion of the questionnaire solicits answers on questions related to unrelated business income, regardless of whether the responding institution reports the activities on Form 990, the annual information return most tax-exempt organizations must file. These questions signal the IRS’s intent to cross-reference the questionnaire with annual information returns, with a specific and heightened interest in unrelated business income. All responding institutions should be aware of information in prior information returns in order to anticipate any answers on the questionnaire which are inconsistent with previously reported activities.
  4. Part III of the questionnaire address endowments and their income, and includes detailed questions regarding classification of endowments, the organization of each related endowment, the employment and compensation of investment advisors, and the spending policies of endowment funds. The IRS has indicated its particular concern with the proper distribution and use of endowment funds, and responding institutions should answer the questions with clear statements of their position and administration of endowment fund distributions.
  5. Sections of Part I (highest paid employees) and Part IV (officers, directors, trustees and key employees) require detailed information regarding compensation. The two groups are covered separately, and the responding organization should make certain that the individuals it intends to include on the questionnaire are within the scope of the requested response. Part IV of the questionnaire asks detailed questions about fringe benefits, such as housing and life insurance, as well as deferred compensation plans for key employees. The IRS has increased enforcement of “excess compensation” paid to employees of nonprofit entities, and the questionnaire answers could trigger unwarranted attention if answered incorrectly.

Although the questions are set forth in a rigid format, the IRS has suggested that responding institutions may attach additional information to explain answers where necessary. Because of the unique nature of each institution’s responses, we recommend that each responding institution prepare an Addendum containing at least three primary explanations. First, where the questionnaire is unclear or the answer or the nature of the answer is uncertain, the responding institution should identify the assumptions upon which it is basing its answer. Second, where multiple endowments or activities are covered, the responding institution should describe the method of separating the responses. Third, the Addendum should contain information which clarifies or supports any answers as needed.

Higher education institutions that have received the questionnaire should now be working with counsel and their advisors in order to meet the February 6, 2008 deadline (which the IRS already extended one time). However, all other higher education institutions should review the IRS questionnaire, in case (as we expect) the responses from the initial group will form the basis for future IRS compliance and enforcement actions within all colleges and universities. McGuireWoods will be happy to assist any colleges and universities in this process and will continue to work closely with our clients and the IRS through this process.