Tax Exempt Organizations Compliance Project Final Report
The IRS has completed approximately ninety percent of the project which was launched with 400 questionnaires sent to randomly selected colleges and universities. After review of the questionnaire responses and Form 990, Return of Organization Exempt From Tax, (“Form 990”), reporting; the IRS selected thirty four of the respondents for examination. The organizations chosen were equally divided between private and public institutions.
According to the IRS, the organizations selected indicated potential noncompliance in the areas of unrelated business income and executive compensation. “Because these issues may well be present elsewhere across the tax-exempt sector, all exempt organizations need to be aware of the importance of accurately reporting unrelated business income and providing appropriate executive compensation.”
In calculating unrelated business taxable income (“UBTI”), a tax-exempt organization should total the UBI from all activities less the total allowable expenses allocated to those activities.
Tax-exempt organizations need to report annually any unrelated business income (“UBI”) on Federal Form 990-T, Exempt Organization Business Income Tax Return. UBI is defined by the IRS as “the income from a trade or business regularly conducted by an exempt organization and not substantially related to its exempt purpose”. In calculating unrelated business taxable income (“UBTI”), a tax-exempt organization should total the UBI from all activities less the total allowable expenses allocated to those activities. It is important to keep in mind that losses from any UBI activities may be used to offset gains from other UBI activities.
The project has resulted in more than 180 adjustments. These adjustments increased unrelated business taxable income by roughly $90 million and disallowed over $170 million in losses and net operating losses (“NOLs”). The primary reasons for increases to UBTI related to:
- Improper reporting of expenses unrelated to business activities;
- Errors in computation or substantiation; and
- Misclassification of certain activities as exempt.
The IRS found that institutions were claiming losses from activities that did not qualify as a “trade or business” because these institutions failed to show a “profit motive.” In order for an activity to be considered a “trade or business” one of the criteria is that the taxpayer engages in the activity with the intent to make a profit. The IRS noted that a “pattern of recurring losses indicates a lack of profit motive”. Consequently, the institutions were offsetting actual UBI with losses from activities that were not actually generated from trades or businesses.
In addition to looking at which activities should be classified as UBI, the IRS also took a close look at the NOL’s reported on the organizations’ Forms 990-T. The IRS concluded that in approximately one-third of the tax returns examined that the NOLs were either improperly calculated or not substantiated. As a result, the IRS disallowed approximately $19 million in NOLs. Lastly, the IRS determined that nearly forty percent of the institutions examined had misclassified activities as exempt and not reportable on Form 990-T.
Included in the report are the five most frequently noted items which subjected the tax-exempt organizations to adjustments with respect to UBTI. The items noted are:
- Fitness and recreation centers and sports camps;
- Advertising;
- Facility rentals;
- Arenas; and
- Golf courses.
In addition to the aforementioned noted items, tax-exempt organizations should always carefully review all Forms K-1 received for UBI items. Both UBI items of profit and loss per Forms K-1 are reportable for tax-exempt organizations.
Establishing Reasonable Compensation
Another area the project focused on was executive compensation. The focus was on the reasonableness of compensation paid to officers, directors, trustees and key employees within the meaning of Internal Revenue Code Section 4958. Reasonable compensation is generally defined for these purposes as the value that would ordinarily be paid for like services by like enterprises under like circumstances. Organizations need to be aware that compensation includes all forms of cash and non-cash compensation, including salary, fees, bonuses, severance payments, and deferred compensation.
In order to ensure that the compensation is reasonable, organizations should undertake the following during their compensation process:
- Using an independent body to review, determine and approve compensation;
- Rely on appropriate comparability data when determining and approving compensation; and
- Documenting the compensation-setting and approval process.
The IRS found that while most of the institutions examined met the rebuttable presumption of reasonableness standard, twenty percent failed to do so due to issues noted with comparability data.
Organizations need to be aware that compensation includes all forms of cash and non-cash compensation, including salary, fees, bonuses, severance payments, and deferred compensation.
Employment Tax Issues
In addition to examining UBI and compensation, employment tax and retirement plan returns, respectively, were examined. Due to these additional examinations, adjustments were made to these particular returns totaling $36 million in additional taxes and resulting in excess of $7 million in penalties. Adjustments were made for several reasons, including but not limited to adjustments for:
- Failure to include the value for personal use of auto, housing, members and travel;
- Misclassification of employees and independent contractors;
- Failure to withhold taxes for wages paid to nonresident aliens; and
- Failure to include in income the value of certain graduate tuition waivers and reimbursements.
Conclusion
The Oversight Subcommittee of the House Committee on Ways and Means held a hearing on May 8th with respect to the IRS’s findings and widespread noncompliance noted. The Oversight Committee is chaired by Charles Boustany, a Republican Congressman from Louisiana. The results of this project have significance for all tax-exempt organizations, not just colleges and universities. Going forward, the IRS plans to take a much closer look at UBTI and specifically focus on those activities which show recurring losses. All organizations should be aware that they need to have well documented records and a secure basis as to the allocation of expenses. Additionally, this project demonstrates a tax-exempt organization’s need to be able to substantiate their comparability data when dealing with compensation issues. As noted in our tax tip on the Exempt Organization’s Annual Report and Work Plan, released on February 20, 2013, these are items the IRS will continue to be examining with respect to all tax-exempt organizations.
A complete copy of the Colleges and Universities Compliance Project Final Report may be accessed at the Not-for-Profit & Education Services section of our Firm’s website.
View Not-For-Profit and Education Services
To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.
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