The U.S. Internal Revenue Service has released its final report following a multi-year study of tax-exempt compliance by nonprofit universities and colleges. Colleges and Universities Compliance Project Final Report (Apr. 25, 2013). The IRS study, which began in 2008, included a comprehensive questionnaire sent to approximately 400 U.S. institutions of higher learning, followed by detailed audits of 34 institutions whose questionnaire responses and Form 990 information returns indicated possible noncompliance with regard to unrelated business taxable income and executive compensation.
UNRELATED BUSINESS TAXABLE INCOME. Entities recognized as charities under Section 501(c)(3) of the Internal Revenue Code are exempt from U.S. federal income tax on income that is derived from activities that are substantially related to the entity’s exempt purpose. However, with limited exceptions, charities are subject to unrelated business income tax (UBIT) on income that is not substantially related. In its universities report, the IRS disclosed that 90 percent of the institutions that were audited had understated the amount of UBIT for which they were liable, amounting to a total of US$90 million in unpaid taxes. The IRS attributed the understatements to a variety of errors by the universities, including (a) improperly reducing their net taxable income by net operating “losses” from activities that were, in fact, tax-exempt–a fact that rendered the losses ineligible to offset profits derived from unrelated business activities; (b) incorrectly deducting from their profits expenses incurred in activities that were not directly connected with the unrelated business activities; (c) errors in computation and substantiation; and (d) erroneously classifying as exempt or not reportable income that was actually subject to UBIT. The IRS identified the following as the revenue sources most often incorrectly characterized by the universities:
- Fitness, recreation centers and sports camps;
- Facility rentals;
- Arenas; and
EXECUTIVE COMPENSATION. Section 4958 of the Internal Revenue Code imposes “intermediate sanctions” in the form of punitive excise taxes on charities and their top management personnel if the organization on pays more than reasonable compensation to its “disqualified” persons–defined broadly as persons who, during the five year period leading up to the transaction, were in a position to exercise substantial influence over the affairs of an exempt organization.
By regulation, the Treasury Department has established a “safe harbor” procedure for determining executive compensation, which, if followed by the tax-exempt entity, entitles the entity to a rebuttable presumption that the compensation is reasonable.
To come within the safe harbor, the entity must–
- Use an independent body to review and determine the amount of compensation;
- Rely on appropriate comparability data to set the compensation; and
- Contemporaneously document the compensation-setting process in writing.
In its report, the IRS observed that, “[a]lthough most private colleges and universities examined attempted to meet the rebuttable presumption standard, about 20% of them failed to do so because of problems with their comparability data.” In particular, the report concludes that many universities used inappropriate comparability data for the following reasons:
Institutions that were not similarly situated to the school relying on the data, based on at least one of the following factors: location, endowment size, revenues, total net assets, number of students, and selectivity. Compensation studies neither documented the selection criteria for the schools included nor explained why those schools were deemed comparable to the school relying on the study. Compensation surveys that did not specify whether amounts reported included only salary or included total other types of compensation, as required by section 4958.
The report also notes that the IRS examined the audited institutions’ employee tax and employee returns. The Service identified multiple errors resulting in total assessments for unpaid taxes and penalties in excess of US$7.2 million.
Note: the photographs accompanying this article–of Hoover Tower at Stanford University, the McLauren Building at Massachusetts Institute of Technology, and the Duke University chapel–are used for illustrative purposes only, and are not meant to imply any involvement by Stanford, MIT, or Duke in the events described in the article. The IRS report does not refer by name to any specific universities or colleges.