In 2008, the IRS launched its Colleges and Universities Compliance Project to gather information about endowments, executive compensation and unrelated business income (UBI) at randomly selected institutions of higher learning. The IRS distributed questionnaires to 400 schools, choosing 34 to audit because their survey responses and Form 990 indicated potential noncompliance.
The IRS recently issued its final report. The agency’s findings should be of interest not only to colleges and universities, but to all tax-exempt organizations.
A significant portion of the final report focuses on compensation practices — specifically, compliance with Internal Revenue Code Section 4958. Sec. 4958 prohibits organizations from paying more than “reasonable” compensation to “disqualified persons,” which generally include officers, directors, trustees and key employees (ODTKEs). Private (but not public) colleges and universities that don’t comply can be subject to excise taxes.
The IRS reviewed the compensation of ODTKEs and identified “significant issues” with all 34 schools. In the end, it made wage and tax adjustments and assessed penalties totaling more than $7 million.
In its final report, the IRS stresses the use of appropriate comparability data when setting ODTKE compensation. Comparable data should be derived from organizations that have similar locations, endowment size, revenues, total net assets, number of students and selectivity. In addition, schools need to document why the organizations selected are comparable.
The final report’s other primary focus is on UBI — income from business regularly conducted by a tax-exempt organization that’s not substantially related to its exempt purpose. The examined colleges and universities also fared poorly in this area.
The IRS repeatedly encountered several types of mistakes in the examined institutions’ UBI tax filings, such as:
• Expenses deducted against revenue that weren’t directly connected to unrelated business activities,
• Improper or unsubstantiated calculations of net operating losses (NOLs), and
• Misclassifying nonexempt activities as related to the exempt purpose.
The IRS increased UBI taxes on 90% of the 34 schools, for a total of more than $90 million, and disallowed 70% of the NOLs. In the future, the IRS plans to look at UBI reporting more broadly, especially at recurring losses and the allocation of expenses.
What does this mean for your organization?
Even if your organization is not a college or university, much can be gleaned from this study. When it comes to officer compensation, please make sure the comparability data you are using meets the criteria the IRS mentions, such as size of the organization, number of members, geograpic area, and the type of services provided. The penalties for excess benefit payments are punitive.
Although no one wants to pay tax, if an activity is truly unrelated to the mission of the organization, it should be reported on a 990T, and tax should be paid. Remember, it is how the revenue is earned, and not how it is used that identifies it as related or unrelated. Once an activity is identified as unrelated, proper accounting of direct expenses is critical to the determination of taxable income. An allocation of indirect or mixed costs should also be calculated. The IRS does not prescribe an exact method for this, but it must be reasonable. It is generally easier to determine a method for how direct and indirect costs will be tracked before they are incurred. Doing so will allow for a more accurate calculation and better record keeping.
Please contact Jane Pfeifer with any questions or for more information on this topic at [email protected].