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Final Colleges and Universities Compliance Report Issued by IRS

By Bruce R. Hopkins, Editor July 3, 2013

As noted in last month’s issue, April 25 brought issuance of the IRS’s final report on its colleges and universities compliance-check project, launched in 2008 (summarized in the December 2008 issue). The IRS in that year distributed detailed questionnaires to 400 randomly selected private and public institutions of higher education. Thirty-four of these institutions were selected for examination. An interim report was published in 2010 (summarized in the July 2010 issue).

This final report provides additional analyses of the questionnaire responses and focuses on the examination results. The IRS wrote: “Because colleges and universities were not randomly selected for examination, no assumptions should be drawn about the UBI [unrelated business income] and compensation practices of other colleges and universities based on the examination results.”

Underreporting of Unrelated Business Taxable Income

IRS examinations have resulted in the following outcomes:

  • increases in the amount of unrelated business taxable income (UBTI) for 90 percent of colleges and universities examined, totaling approximately $90 million;
  • over 180 changes to the amounts of UBTI reported by colleges and universities on Forms 990-T; and
  • disallowance of more than $170 million in losses, including net operating losses, which could amount to more than $60 million in assessed taxes.

There are several reasons for the increases in UBTI. One of them found by the IRS is that examined colleges and universities were reporting certain losses as being connected to unrelated businesses when they were not. There are two causes of this misreporting.

One of these causes is the rule that losses can only be utilized where the activity involved is a business. The existence of a business, for tax-law purposes, requires a profit motive. A pattern of recurring losses indicates a lack of profit motive. Nearly 70 percent of examined colleges and universities reported losses from activities for which expenses consistently exceeded unrelated income for many years. These disallowances amounted to more than $150 million of the total losses disallowed.

Organizations may allocate expenses that are used to carry on both exempt and unrelated businesses, but these allocations must be reasonable and the expenses allocated to unrelated business income must be directly connected to the unrelated business. The IRS found that, on nearly 60 percent of examined Forms 990-T, colleges and universities had misallocated expenses.

The IRS determined that nearly 40 percent of the colleges and universities examined misclassified activities as exempt or otherwise not reportable on Forms 990-T. These examinations resulted in reclassification of nearly $4 million as unrelated income.

The IRS checked the calculations for all net operating losses reported on these returns under examination and found that they were either improperly calculated or unsubstantiated on more than one-third of the returns. The IRS disallowed nearly $19 million in net operating losses.

Examinations resulted in changes to UBTI reported for specific activities of colleges and universities, primarily fitness and recreation centers, sports camps, advertising, facility rentals, arenas, and golf-related activities. [24]

Compensation and Comparability Data

Most of the private colleges and universities that were examined attempted to meet the rebuttable presumption of reasonableness in ascertaining the reasonableness of compensation, although about 20 percent of them failed in the exercise due to problems with their comparability data, including:

  • inclusion in comparability analyses of institutions that were not similarly situated to the college or university relying on the data, on the basis of at least one of the following factors: location, endowment size, revenue, net assets, number of students, and selectivity;
  • compensation studies that neither documented the selection criteria for the institutions included nor explained why those institutions were deemed comparable to the college or university relying on the study; and
  • compensation surveys that did not specify whether amounts reported included only salary or total other types of compensation (as required by the intermediate sanctions rules).

Compensation Amounts

The report differentiates between compensation paid by colleges and universities to officers, directors, trustees, and key employees (ODTKEs) and non-ODTKEs.

Each college or university examined generally identified its top management official, who was usually the president, as its highest-paid ODTKE. Overall, the average and median base salary and total compensation for the top management official of the colleges and universities examined, public and private, were as follows:

  • Average base salary: $448,981
  • Median base salary: $363,943
  • Average total compensation: $561,135
  • Median total compensation: $458,152

The most highly paid non-ODTKEs were those in one of five categories: investment managers, sports coaches, heads of departments, faculty, and administrative/managerial positions. The average compensation for investment managers was $894,214, while the average compensation for coaches was $884,746.

Compensation amounts for the other non-ODTKEs differed based on whether the non-ODTKE was a medical doctor (who comprised 30 percent of the non-ODTKEs). Including MDs, the average compensation for department heads was $753,738, faculty was $575,632, and administrative/managerial personnel was $462,872. [21]

Employment Tax Issues

The IRS looked at employment tax returns at about one-third of the colleges and universities examined. All of the completed examinations have resulted in adjustments in wages, leading to assessment of taxes and, in some instances, penalties. Wage adjustments totaled about $36 million; taxes and penalties amounted to over $7 million.

Retirement-Plan Issues

The IRS reviewed retirement-plan reporting at about 25 percent of the colleges and universities examined, finding problems at about one-half of them. These examinations resulted in increases in wages of more than $1 million, along with assessment of more than $200,000 in taxes and penalties.

IRS’s Look Ahead

The IRS observed that these examinations of colleges and universities “identified some significant issues with respect to both UBI and compensation that may well be present elsewhere across the tax-exempt sector.” As a result, the IRS reported, it “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.”

Commentary: This report understates a most important point, which is that these matters, such as claiming losses from nonbusiness activities, misallocation of expenses, and use of inappropriate comparability data, are by no means confined to colleges and universities. These are problem areas throughout the exempt sector. In some quarters, institutions of higher education are being singled out and unfairly criticized as if these tax-law issues are unique to them.

This report fails to state a very important point, which is that for the most part the law in these areas (some of it statutory) is quite clear. (Maybe the IRS deliberately omitted this observation, not wanting to get embroiled in so-called tax reform efforts.) This means that the problem largely lies with the judgment of those who are preparing returns. In some of these aspects, reasonable individuals can differ, such as whether an activity is related or unrelated or whether an organization is comparable to another.

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