On April 25, 2013, the Internal Revenue Service (IRS) issued its final report regarding its Colleges and Universities Compliance Project (the “Project”), which began in 2008. The initial stage of the Project involved sending questionnaires to 400 randomly-selected public and private institutions. Based on responses to these questionnaires, the IRS audited 34 of the 400 institutions. The report identifies two main issues: (i) a failure by some colleges and universities to adequately follow procedures recommended by the IRS for use in setting compensation levels of officers, directors, trustees and key employees; and (ii) significant under-reporting of unrelated business income (UBI). Importantly, the report indicates that because the audited institutions were not randomly selected, “no assumptions should be drawn about the compensation and UBI practices of other colleges and universities based on the examination results.” Nonetheless, the report indicates that the IRS will continue to focus on compliance efforts with respect to these issues across the tax-exempt sector.
Compensation and Comparability Data
Like all public charities, colleges and universities may pay no more than reasonable compensation to officers, directors, trustees, and key employees. Private colleges and universities may shift the burden to the IRS to prove that compensation is not reasonable by following a procedure that establishes a rebuttable presumption of reasonableness. The three elements of the rebuttable presumption require the institution to: (i) use an independent body to set compensation; (ii) rely on appropriate comparability data when setting compensation levels; and (iii) contemporaneously document the compensation-setting process.
While most audited colleges and universities attempted to meet the rebuttable presumption, 20 percent of the audited institutions failed to sufficiently meet the standard because of problems with comparability data, including the following:
- Comparable institutions were not similarly situated in location, endowment size, revenues, total net assets, number of students, and selectivity;
- Selection criteria for the comparable institutions were not properly documented or explained; and
- Compensation surveys did not specify whether compensation amounts included only salary or other types of compensation as well.
Under-Reporting of Unrelated Business Taxable Income
UBI is income from a trade or business regularly conducted by a tax-exempt organization and not substantially related to its exempt purpose. Unrelated Business Taxable Income (UBTI) is the UBI that is taxable after deducting expenses directly connected to an unrelated trade or business. During the course of the audits, the IRS made more than 180 changes to UBTI reported for specific activities, resulting in increased UBTI for 90 percent of the audited colleges and universities. The primary reasons for increases to UBTI were:
- Disallowing expenses not connected to unrelated business activities;
- Errors in computation or substantiation; and
- Reclassifying exempt activities as unrelated.
The IRS noted that the majority of adjustments to UBTI came from activities involving the operation of fitness centers and sports camps, advertising, facility rentals, arenas, and golf.