The IRS has issued a report that contains a stern warning for non-profit colleges and universities and which could resonate through the entire not-for-profit sector: watch out for how you treat unrelated business income and executive compensation if you want to protect your tax-exempt status.
On April 25, the IRS released a final report summarizing the results of its “Colleges and Universities Compliance Project,” which identifies several significant compliance issues in the higher-education sector. The report culminates a multi-year review originally launched by the IRS in 2008 following the distribution of a detailed questionnaire sent to 400 randomly selected colleges and universities.
The IRS then selected for examination a subset of 34 of those organizations whose questionnaire responses and Form 990 suggested potential non-compliance. The 37-page final report found that the most common areas of non-compliance are unrelated business income (UBI) 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,” said Lois Lerner, director of the IRS exempt organizations division.
Those in the higher-education sector say they are not surprised by the results. “The final report reveals the challenges faced by colleges and universities in understanding and uniformly applying the IRS's tax rules regarding unrelated business income, which is a challenge that is shared throughout the nonprofit sector,” says Mary Bachinger, director of tax policy for National Association of College and University Business Officers.
The regulations for UBI and executive compensation are “very complex and can be interpreted differently,” says Karin Johns, director of tax policy for the National Association of Independent Colleges and Universities. “Until we know more about the extent of the findings, we're not sure if this is a serious problem or an issue of differing tax advice or regulatory guidance among auditors.”
All large tax-exempt organizations—including hospitals and healthcare organizations—should carefully review the final report, as it provides clear insight into areas that the IRS will likely target next, says Yosef Ziffer, an associate in the tax and wealth planning group of law firm Venable.
During a May 8 hearing of the House Ways and Means Subcommittee on Oversight, Lerner said the IRS intends to look at these areas “more broadly” in future examinations within the entire non-profit sector, not just higher-education organizations.
Problem Areas
According to the report, the IRS found “significant underreporting” of UBI at more than 90 percent of colleges and universities examined. Such under-reporting primarily stemmed from four areas of non-compliance:
· Claiming losses from activities that did not qualify as a trade or business. An activity qualifies as a trade or business only if the taxpayer engages in the activity with the intent to make a profit. Nearly 70 percent of colleges and universities examined reported losses from activities where for many successive years the expenses exceeded income, indicating a lack of profit motive.
· Misallocation of expenses to offset UBTI for specific activities. Organizations may allocate expenses used to carry on both exempt and unrelated business activities, but they must do so on a reasonable basis, and the expenses offsetting UBI must have a proximate and primary relationship to the activities to which they are attributed. In nearly 60 percent of the Form 990-Ts examined, we found that claimed expenses, which generated losses, did not have the necessary proximate and primary connection to the unrelated business activity.
· Errors in computation or substantiation of net operating losses (NOL). NOLs are losses reported in one year that can be used to offset income in other years. On more than one third of returns examined, the schools had either improperly calculated the net operating losses, or the losses were not substantiated.
· Misclassification of activities. Nearly 40 percent of the schools examined improperly classified certain income-producing activities as exempt when the activities were unrelated and, in fact, subject to taxes. According to the IRS, the majority of mis-classifications resulted from five main activities: fitness, recreation centers, and sports camps; advertising; facility rentals; arenas; and golf courses.
Lerner cited a school's use of a golf course as a practical example of a potentially misclassified activity. If students use the course to train for the school's golf team, that then qualifies as a related activity. On the other hand, if the school allows both students and individuals not affiliated with the school to use the golf course, that is a taxable unrelated activity. “You can have both taxable and non-taxable activity, and you can allocate your expenses among those,” explained Lerner.
“Until we know more about the extent of the findings, we're not sure if this is a serious problem or an issue of differing tax advice or regulatory guidance among auditors.”
—Karin Johns,
Director of Tax Policy,
National Association of Independent Colleges and Universities
One common mistake the IRS observed is that many schools “didn't seem to have a thought-out reason for classifying things the way they classified them,” said Lerner.
If an organization believes an activity is related to its tax-exempt purposes, it's important to document the basis for that determination based on all pertinent facts and circumstances, says Ziffer.
“Practice strong recordkeeping to support allocation of expenses between related and unrelated activities,” says Bachinger. She also advises non-profits to adopt procedures to document business purposes and profit motives of unrelated activities via board minutes and business plans, and to periodically reexamine all income-producing activities with an eye toward identifying any unrelated activities.
Executive Compensation
The report also found deficiencies in reporting of executive compensation. Section 4958 of the Internal Revenue Code requires private colleges and universities to pay “reasonable compensation” to disqualified persons—officers, directors, trustees, key employees, and their families. Any disqualified person who receives unreasonable compensation, and on organizational managers who approve such compensation, will face an excise tax.
“We did not find rampant improper compensation, but we did see some areas that created issues for us,” said Lerner. Although most colleges and universities use the rebuttal presumption process to set the compensation, 20 percent of schools did not use appropriate comparability data to do so, “which means those schools failed to establish the rebuttal presumption,” she said.
Under the rebuttal presumption, organizations can shift the burden of proving unreasonable compensation onto the IRS through:
· Using an independent body to review and determine the amount of compensation;
· Relying on appropriate comparability data to set compensation levels, based on the size and scope of their organization; and
· Contemporaneously documenting the compensation-setting process.
Many organizations, however, do not follow these measures. In some cases, the schools relied on data from schools that were not comparable based on such factors as location, revenues, total net assets, and number of students.
COMPENSATION AND COMPARABLE DATA
Below is an excerpt from the IRS final report on colleges and universities.
The executive compensation component of the examinations focused mainly on compliance with section 4958 of the Code, which provides that organizations may pay no more than reasonable compensation to their disqualified persons. Section 4958 applies to private, but not public, colleges and universities, and imposes an excise tax on disqualified persons who received payment of unreasonable compensation and on those persons who approved it. At the private colleges and universities examined, the officers, directors, trustees and key employees (ODTKEs) were disqualified persons subject to the reasonable compensation requirements of section 4958.
An organization may shift the burden of proving unreasonable compensation to the IRS by following the three steps of the rebuttable presumption process:
Using an independent body to review and determine the amount of compensation;
Relying on appropriate comparability data to set the compensation amount; and
Contemporaneously documenting the compensation-setting process.
Although 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 including:
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.
Compensation Amounts
With few exceptions, each college or university examined identified its top management official, who was usually the president, as its highest-paid ODTKE.
Overall, the average and median base salary and total compensation for the top management official of the colleges and universities examined, both public and private, were as follows:
Average base salary: $452,883; median base salary, $376,018.
Average total compensation: $623,267; median total compensation, $499,527.
Source: IRS.
Another common error: many used compensation studies that neither specified the selection criteria for the supposed comparable schools nor explained the similarities between those schools and the school relying on the study.
It's pertinent that organizations review and question the data provided by consultants before relying on it to determine compensation amounts, said Lerner. “Otherwise, an organization may find itself outside of the rebuttable presumption and be required to prove to the IRS that the compensation in question is reasonable,” she said.
Alternatively, organizations that don't engage outside consultants should review their internal procedures for selecting comparability data to ensure it reflects the practices of similarly situated entities. “As long as organizations go through the process the IRS has laid out, then the compensation amounts they ultimately reward are presumed to be reasonable,” says Ziffer.
“That doesn't mean the IRS ultimately couldn't come back and challenge a particular compensation arrangement, but the burden of proof is on the IRS to affirmatively show that the amounts paid were in excess of what would otherwise be reasonable,” adds Ziffer.
When it comes to executive compensation, the IRS wants to see that adequate procedural mechanisms are in place. “The issues the IRS identified in the final report are focused less on the actual amount of compensation being paid by those colleges and universities, and more on the process that colleges and universities engage in when setting compensation for their most highly compensated individuals,” Ziffer says.
On the positive side, the report indicates “strong tax compliance in the higher education sector, particularly as far as following best practices for governance in the executive compensation area,” says Bachinger. “The very small number of institutions cited for falling short of the safe harbors in the IRS rules related to setting executive pay only means that they didn't meet the safe harbor, not that the compensation under review was inappropriate.”
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