The Internal Revenue Service recently issued its Final Report on the Colleges and Universities Compliance Project, marking the conclusion of a five-year study of one of the largest segments of the nonprofit sector. The Report summarizes the Service's analysis of questionnaire responses and focuses on the results of the examinations completed to date. On May 8, 2013, IRS Exempt Organizations Director Lois Lerner summarized the origins, process and results of the Project in testimony before the House Ways & Means Committee, Subcommittee on Oversight.
The Final Report is based on examinations of only 34 organizations—a number that the IRS acknowledges is too small to provide a statistically valid sample. Thus, the IRS cautions against drawing any broad conclusions from the Report regarding the compliance practices of colleges and universities.
However, the results of these audits—including, in particular, significant adjustments and assessments of unrelated business income (UBI) and employment taxes and penalties—provide useful data points regarding compliance and reporting practices in the areas of unrelated business activities and executive compensation. Indeed, the Report confirms that the IRS will apply the lessons learned from these examinations in future unrelated business income tax (UBIT) and executive compensation audits, stating:
the IRS plans to look at UBI reporting more broadly, especially at recurring losses and the allocation of expenses, and to ensure, through education and examinations, that tax-exempt organizations are aware of the importance of using appropriate comparability data when setting compensation.1
In 2008, the IRS Exempt Organizations Division sent detailed "compliance check" questionnaires to 400 randomly selected colleges and universities in order to better understand these institutions and their practices involving endowments, executive compensation, and unrelated business activities. The IRS provided a preliminary overview of the questionnaire responses in an Interim Report released in May 2010.
According to the Final Report, 34 colleges and universities were selected for examination because their questionnaires and Form 990 information returns suggested the "greatest potential for compliance issues with respect to UBI or compensation." The group was evenly divided between public and private institutions, and about two- thirds were classified as "large," with at least 15,000 students. The ensuing audits covered all returns related to the institution, including Form 990, Form 990-T, employee plan returns, excise tax returns (Form 4720) and employment tax returns. The tax years under examination ranged primarily from 2006 to 2008.
Highlights of the Report
- Unrelated Business Taxable Income
One of the Service's primary areas of focus in the college and university examinations was the institutions' reporting of "business activities, including the characterization of activities as exempt or unrelated, the methodology for allocating expenses, the significance of recurring losses on specific activities, the calculation of net operating losses, and the application of exceptions and modifications." In the end, the Service determined that 90% of the colleges and universities examined underreported their UBI, and made upward adjustments to UBI for this group of approximately $90 million. More than half of the adjustments were connected to the schools' operation of fitness and recreation centers, sports camps, advertising, facility rentals, arenas, and golf courses. The Service also disallowed more than $170 million in losses and net operating losses (NOLs) on 75% of the returns examined.
The IRS reported four primary reasons for these adjustments:
- Lack of Profit Motive: According to the IRS, the disallowed losses related to activities that had consistently generated losses year over year and, therefore, were not considered "unrelated business activities." Observing that an activity cannot be considered a "trade or business"—let alone an unrelated trade or business—unless, "among other things, the taxpayer engaged in the activity with the intent to make a profit, the Report maintains that "a pattern of recurring losses indicates a lack of profit motive."
- Misallocation of Expenses: According to the Report, 70% of the organizations did not properly allocate expenses between "exempt" and "unrelated" business activities. Most organizations in the sample set failed to allocate mixed-use expenses on a reasonable basis or improperly allocated expenses that were not directly connected to the unrelated business activity—both errors resulted in excessive expense allocations which offset UBI.
- Errors in Computation or Substantiation of NOLs: The Report notes that UBI was also overstated by organizations that either could not substantiate their NOLs or miscalculated their NOLs in a manner that improperly increased the NOL amounts.
- Misclassification of Related Business Activities: The IRS reported that nearly 40% of the colleges and universities it examined incorrectly treated unrelated business activities—such as fitness centers, recreation centers, and golf courses—as exempt activities.
What this means…
Not surprisingly, we expect that UBIT issues will remain a major issue for IRS education and enforcement (i.e., examinations). So now would be a good time to work with counsel to review your organization's UBIT compliance and reporting practices with the following issues and filters in mind:
- What steps does your organization take to analyze business activities before determining that they are "related" or "unrelated"? Be sure to observe the fragmentation rule and examine each activity (or, put another way, each revenue stream) separately.
- Has your organization documented its reasonable basis for determining which expenses are "directly connected" to unrelated business activities? Have you documented the entity's basis for allocating expenses between mixed-use activities—for example, if your organization has facilities that are used both for exempt function activities and for commercial purposes (e.g., rented to the public)?
- Has your organization documented the intended profit motive for unrelated business activities—particularly those activities that produce recurring losses (e.g., during their start-up years)?
- Do you have records to substantiate the NOLs claimed on your organization's Form 990-T?
- Executive Compensation
The compensation segment of the Report focuses on compliance issues arising under the intermediate sanctions rules of section 4958 of the Code. Those rules mandate that charities pay their "disqualified persons" reasonable (i.e., not excessive) compensation, and impose penalties if compensation is not reasonable. A charity's disqualified persons include not only its officers, directors, trustees, and family members of these individuals, but also any other individual who is in a position to exert "substantial influence" over the organization's affairs. Some individuals who qualify as "key employees" for Form 990 reporting purposes may also be "disqualified persons."
The Report notes that most of the private colleges and universities examined by the Service attempted to satisfy the procedures prescribed in the Regulations under section 4958 for securing the "rebuttable presumption" that compensation is reasonable, i.e., by (1) having an independent body review and set the compensation; (2) using "appropriate comparability data" to set the compensation; and (3) keeping contemporaneous documentation regarding the compensation setting process. However, the IRS concluded that approximately 20% of the examined institutions—including ones that engaged compensation consultants to assist in the compensation-setting process—failed to secure the rebuttable presumption because of shortcomings in their comparability data.
The Report documents the IRS's first large-scale effort to look not only at whether comparability data was used but whether the data was "appropriate." The section 4958 Regulations explain that comparability data is "appropriate" if it provides the board or compensation committee with "information sufficient to determine whether … the compensation arrangement in its entirety is reasonable." Relevant information includes, but is not limited to, "compensation levels paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions" and "current compensation surveys compiled by independent firms," among other things.
In its examinations of colleges and universities, the IRS found that the comparability data used by some institutions was not "appropriate" because:
- it included data from schools not similarly situated based on the appropriate factors including, location, endowment size, revenues, total net assets, number of students, and selectivity;
- it failed to document why schools were selected as comparable to the school doing the study; and
- it failed to state whether compensation reported reflected only salary data, or whether it reflected total compensation as required by section 4958.
What this means…
Based on the clear language in the Report, we expect that executive compensation will remain a focus for future IRS education and enforcement efforts—with the IRS taking a hard look at the comparability data used to justify the compensation amount. As a result, organizations and their counsel should review their procedures for setting executive compensation with the following issues in mind:
- Are the "peers" selected by your compensation consultant or compensation committee, in fact, "similarly situated" to your institution, as it exists today? For example, do they have a similar programmatic focus; are they similarly-endowed; are they located in your geographic region?
- Has your organization carefully and reasonably documented the basis for selecting these comparable organizations? For example, if you relied on for-profit organizations as comparables (which is permitted under the section 4958 Regulations), did you or your compensation consultant explain the basis for that decision?
- Is the compensation setting process itself independent and well documented? For example, does your institution have clear procedures (memorialized in its conflict of interest policy or a separate compensation-setting policy) to guide compensation decisions by the board or compensation committee? Are you keeping accurate and contemporaneous records of all compensation deliberations and decisions, including necessary recusals? If the final decision regarding an executive's compensation package differs from the compensation consultant's recommendation or published 990 or survey data (e.g., because the salary exceeds the recommended range), have you documented the rationale for this departure from the available comparables?