The Internal Revenue Service (IRS) recently released a report (Report) summarizing its findings after a multiyear compliance examination of tax-exempt colleges and universities following the distribution of detailed questionnaires to 400 randomly selected entities. As the Report outlines, the IRS chose 34 of the 400 for examination because of their responses and reporting on their Forms 990-T, which indicated potential noncompliance in the areas of unrelated business income and executive compensation.
The Report provides that the examinations uncovered substantial underreporting of unrelated business taxable income (UBTI). By way of background, unrelated business income (UBI) is income derived from a trade or business regularly conducted by an exempt organization that is not substantially related to its exempt purpose. UBTI is the UBI that is taxable after deducting expenses directly connected to the trade or business. Because UBTI is calculated by totaling the UBI from all activities and subtracting the total allowable deductions, losses from one activity can offset profits from another.
The Report outlines that the 34 examinations resulted in the following:
- An aggregate of $90 million of increases to UBTI for 90 percent of the entities;
- More than 180 changes to the amount of UBTI reported by the entities on their Forms 990-T; and
- Disallowance of more than $170 million in losses and net operating losses (NOLs) that could amount to more than $60 million in assessed taxes.
As the Report presents, the IRS found that the primary reasons for increases to UBTI in the completed examinations were:
Disallowance of expenses not connected to unrelated business activities: The examined entities were reporting certain losses as being connected to unrelated business activities when, in fact, they were not. The Report notes that the misreporting occurred in two ways:
- Lack of profit motive: Organizations were claiming losses from activities that did not qualify as a trade or business, and nearly 70 percent of the entities reported losses from activities for which expenses had consistently exceeded UBI for many years. The IRS noted that UBI must be generated by a "trade or business," i.e., an activity the taxpayer engages in with an intent to make a profit, and that a pattern of recurring losses indicates a lack of profit motive. The IRS disallowed reporting of activities for which the entity had failed to show a profit motive, which meant that those losses could no longer offset profits from other activities in the current year or future years, and so disallowed more than $150 million of NOLs.
- Improper expense allocation: The IRS also found that nearly 60 percent of the Forms 990-T examined demonstrated that the entities had misallocated expenses to offset UBI for specific activities where those expenses were not related to the unrelated business activity.
- Errors in computation of substantiation: The IRS found that, on more than one-third of the returns NOLs were either improperly calculated or were unsubstantiated, and so disallowed nearly $19 million in NOLs.
- Reclassifying exempt activities as unrelated: The IRS determined that nearly 40 percent of the entities examined had misclassified certain activities as exempt or as otherwise unreportable on their Forms 990-T. The IRS also found that fewer than 20 percent of those activities had generated a loss, and so reclassified nearly $4 million in income as unrelated, subjecting those activities to taxation.
The examinations resulted in more than 180 changes to UBTI reported for more than 30 different specific activities. The majority of the adjustments came from the following activities: fitness, recreation centers, and sports camps; advertising; facility rentals; arenas; and golf.
The Report continues with an extensive informative discussion of the IRS findings on compliance with executive compensation under Section 4958 of the Code.
Although the focus of the Report is on the IRS' study of colleges and universities, the principles and findings outlined in the report are relevant and instructive for all nonprofit organizations. We encourage you to read the Report, which can be found at http://www.irs.gov/pub/irs-tege/CUCP_FinalRpt_042513.pdf.