Approximately 400 U.S. colleges and universities have been receiving compliance questionnaires from the Internal Revenue Service over the past few days as part of a focused effort to study key areas in the tax-exempt community. On October 1, the IRS announced plans to send the 33-page questionnaire to 400 public and private colleges of all sizes (for a sample copy of the form, visit www. irs.gov/pub/irs-tege/sample_cucp_questionnaire. pdf). The college and university questionnaire focuses on unrelated business income, endowments and executive compensation practices during the 2006 tax year. Questionnaires have been sent (and still may be in the process of being sent) to a crosssection of small, mid-sized and large private and public four-year institutions. The IRS hopes the information gathered will help it identify issues and areas that may need more scrutiny.
The IRS’s targeting of colleges and universities is similar to that directed at hospitals just a few years ago. The focus follows several other initiatives that observers believe stem from congressional pressure, particularly from the Senate Finance Committee’s Charles Grassley, R-Iowa, and the House Ways and Means Committee. The Senate committee’s periodic hearings and Grassley’s public statements about tax-exempt entities’ lack of fiscal transparency likely have helped bring on this latest IRS scrutiny and the recent changes in reporting requirements for tax-exempt organizations.
Among other items, the questionnaire will gather information from the schools about how they report revenues and expenses from their trade or business activities, classify their activities as exempt or taxable activities and calculate and report income or losses on taxable activities. The questionnaire also will gather information regarding how the organization invests and uses its endowment funds and determines compensation of certain highly paid individuals. This most recent IRS investigation of schools is viewed largely as yet another step along the path of increased disclosures for nonprofit organizations.
Twenty-eight questions included in the questionnaire relate to endowment funds and must be responded to by institutions which have held endowment funds or have had institutional foundations hold such funds. The questions regard whether the institution had an investment policy for the funds, the management of the investments and whether and what type of investment committee was involved. Information is requested related to the investment managers, including whether such entities or persons were internal, external or related parties and what types of compensation arrangements were involved. Additional questions ask about the types of investments in which funds are invested. The IRS also requests information on the institution’s endowment assets per fulltime equivalent student. Endowments must be broken down into charitable gift annuities, charitable remainder trusts and pooled income funds, and information must be provided on the distribution of such endowment funds.
Unrelated Business Income
Private nonprofit universities are subject to unrelated business income tax. One concern for the universities is questions related to activities that may generate socalled unrelated business income, which falls outside the primary charitable or educational mission. The IRS’s definition of activities that produce unrelated business income is unclear, but the IRS could take the position that activities which consistently declare annual losses are actually nonbusiness activities because they are not intended to be profitable. The attention shown by the questionnaire to loss deductions may suggest a focus for future audits. One question in the questionnaire lists 47 activities which the IRS views as potential sources of unrelated business income, including the following: food service, golf courses, recreation and athletic facilities, catalog and internet sales and parking. The institution must disclose how income from each activity is treated and how management has operated such activities. Moreover, an explanation must be provided for any losses incurred. Joint venture activities must be disclosed, as well as the five largest revenue activities that have not been treated previously as unrelated business income.
Thirty-five questions relate to executive compensation, specifically on the six highest paid executives and key employees. In addition to information on loans to executives, fringe benefits must be disclosed. Private institutions are required to disclose in further detail their compensation review, approval, policy and consulting procedures.
While completion of the IRS’s questionnaire is entirely voluntary, a failure to respond could raise a red audit flag. Many of the questions, such as those related to compensation, require interpretation and analysis of what the IRS is actually seeking. Schools should ensure that the data reported on the questionnaire is consistent with what the school previously reported on the Form 990-T business income tax return for tax-exempt organizations or on Form 990. The IRS expects to receive most of the responses within the next several months, analyze the results of the compliance questionnaire and conduct examinations of a sample of the organizations. The IRS then plans to issue a report on the higher education sector next year. Tax attorneys and their clients are expecting an onslaught of IRS examinations and audits once the IRS collects and analyzes the information. Universities and colleges likely will need to consult with outside advisors and will be called upon to expend effort and money in gathering information and presenting it in the required format.