Originally Published In Journal Of College And University Law, Vol. 37, No. 1
NEW SCRUTINY
I. INCREASING CONGRESSIONAL AND IRS FOCUS ON COLLEGES AND UNIVERSITIES
A. Climate of Heightened Scrutiny and Greater Enforcement
Today colleges and universities are subject to close scrutiny by the United States Congress and the Internal Revenue Service (the "IRS"). Investigations of excessive executive compensation and private benefits have led to the dismissal and resignation of college and university officers.1 The downturn in the U.S. economy has prompted Congress and the public to question why seemingly large endowment funds are not being used to provide assistance to needy students, particularly in the face of escalating tuition costs. Press reports regarding businesses operated by educational institutions have raised concerns in the for-profit sector. Suggested reforms in the tax treatment of charitable organizations, originally issued in 2004 by the United States Senate Finance Committee, have resulted in certain legislative changes as well as an increased focus on compliance and enforcement initiatives. Senator Charles E. Grassley (R-Iowa) continues to address the need for additional charitable reforms and has focused on hospitals, colleges and universities, and other large charities, questioning whether these organizations should be subject to the same rules as local soup kitchens and homeless shelters. His principal concern is that funds raised by § 501(c)(3) organizations should be used for "charitable" purposes, particularly in the education sector.2
Senator Grassley more recently has turned his attention to colleges and universities. He has questioned why wealthy colleges and universities are not spending more endowment money on student aid, and he has sought more information on how colleges and universities "are maximizing their tax-exempt status to fulfill their charitable mission of educating students."3 Senator Grassley has also indicated the possibility of legislation that would require an annual payout equal to five percent of an educational institution's endowment. In November 2009, following the release of a survey in the Chronicle of Higher Education on annual executive compensation, Senator Grassley continued to express concerns by stating that "[t]he executive suite shouldn't be insulated from belt-tightening."4
At an American Bar Association Section of Taxation meeting in September 2009, Emily Lam, an attorney-advisor in the Office of Tax Policy, indicated that exempt organizations are in a climate of enforcement and disclosure rather than leniency, and that the trend is toward disclosure and transparency (noting "the price to get to exemption is sunshine").5 She also noted that within the IRS there has been an increased focus on compliance and enforcement "with a lot more looking at what charities are doing."6
The IRS's increased focus on compliance and enforcement is evidenced by a number of new initiatives (many of which are directed towards colleges and universities), including the following:
- The IRS 2008 fiscal-year work plan for the Exempt Organization Division announced a renewed focus on IRS examinations of tax-exempt colleges and universities, especially college and university endowments and their use (or lack thereof) in the context of the rising cost of higher education.7
- The release of a dramatically revised Form 990 that not only serves as a roadmap for areas of IRS concern, but also gathers significant amounts of information to assist the IRS in its compliance and enforcement efforts.
- The IRS issuance in late 2008 of a compliance questionnaire to over 400 colleges and universities, focusing on endowments and investments, unrelated business taxable income, governance, and executive compensation.8
- Continued focus on executive compensation and the application of the excess benefit transaction rules in a number of exempt organization sectors, including colleges and universities.9
- Continued focus on governance practices of exempt organizations, including questions on the revised Form 990 and the issuance of a governance checksheet and guidesheet for use by IRS agents in examinations.10
- An announcement that more than 30 colleges and universities are currently under audit as a result of responses to the college and university compliance questionnaire.11
- The issuance of a Congressional Budget Office report on April 30, 2010 on indirect tax arbitrage achieved by colleges and universities through the use of tax-exempt bond financing, which may indicate an additional area of future IRS inquiry.12
These initiatives reflect the growing significance of the nonprofit sector in the U.S. economy. And with increasing pressure on national, state, and local governments to raise revenues, nonprofits are likely to continue to find themselves in the crosshairs. In 2005, assets held by § 501(c)(3) organizations exceeded $2.2 trillion, and these organizations generated over $1.25 trillion in revenue. Colleges and universities held more than $400 billion in endowment assets in 2008, the most recent year for which national data is available.13 In addition, compensation for private college presidents continues to rise. A recent survey found that the presidents of 30 private colleges had annual compensation in 2008 of over $1 million, and that the average annual compensation for the top three most-highly paid presidents exceeded $3 million.14
There is also heightened scrutiny by the public of the manner in which exempt organizations compensate their managers. For example, a self-professed public watchdog group recently petitioned the IRS, the Senate Finance Committee, and the Pennsylvania Department of Banking to review alleged excessive compensation paid by the Milton Hershey School and the Milton Hershey School Trust.15 The petition challenges the reasonableness of compensation paid to certain board members and also alleges certain conflicts of interest.
B. IRS Compliance Questionnaire and Interim Report for Colleges and Universities
In October 2008, the IRS began a coordinated effort to learn more about the operations and activities of colleges and universities. Of the 2,402 public and private colleges and universities identified as offering four-year degrees or higher in the United States, the IRS selected 400, stratified by size and population, to receive a detailed compliance questionnaire. An entire portion of the questionnaire focused on activities of colleges and universities and the potential unrelated business taxable income from such activities, including expense allocation, losses, and debt-financed property issues. Substantial sections of other portions of the questionnaire related to executive compensation and supplemental benefits. On May 7, 2010, the IRS issued an Interim Report based on the responses to this questionnaire.16 Meanwhile, more than 30 institutions are currently under IRS examination as a result of their responses to the questionnaire.
The Interim Report summarizes responses from the questionnaire based upon the responding institutions' 2006 tax years.17 The Interim Report reports the data received from 344 responding colleges and universities—177 of them private and 167 of them public.18 For the purposes of the Interim Report, the IRS divided the institutions into three groups based on population (small: fewer than 5,000 students; medium: 5,000-14,999 students; large: 15,000 or more students).19 Of particular relevance to the future landscape for colleges and universities are the findings summarized in the Interim Report regarding executive compensation and unrelated business taxable income and debt-financed property.
1. Executive Compensation Findings
The Interim Report includes information provided by the responding institutions regarding compensation of their executives, as well as their general practices in setting compensation, including amounts and types of compensation, compensation provided by related organizations, executive loans and other extensions of credit, and use of the rebuttable presumption of reasonableness and initial contract exception under the excess benefit transaction rules of I.R.C. § 4958.
In most cases, the institution's highest-paid executive was its chancellor or president.20
For executives (meaning officers, directors, trustees, and key employees), the compensation paid by large institutions averaged $420,000 with a median of $357,000, while small institutions paid an average of $200,000 with a median of $174,000.21 A smaller number of institutions (seven large, five medium, and three or fewer small institutions) also paid compensation to executives through related organizations.22 In small and medium institutions, the highest paid employee (other than executives) was most often a faculty member, but for large institutions, most often (in forty-three percent of organizations) it was an athletic coach.23 The average compensation of the highest-paid employee (other than an executive) ranged from $727,000 for large institutions to $142,000 for small institutions, while the median compensation was $285,000 for large institutions and $98,000 for small institutions.24 Again, a small number of institutions also reported providing compensation (approximately one-half of the total compensation paid) from related organizations (thirteen large, three medium, and five small institutions).25
Nearly all institutions reported compensating their executives by base salary and contributions to employee benefit plans, as well as contributions to life, disability, and long-term-care insurance. 26
Approximately one-third of all institutions offered bonuses, and over one-half of medium and large institutions provided housing or utilities as part of their compensation package.27 Institutions also reported on the provision of institutional vehicles for personal use, personal travel for the employee or the employee's family members, expense reimbursements, personal services provided at the employee's home, health- or social-club dues, and other fringe benefits not covered by I.R.C. § 132.28
For the questions relating to the process used to set compensation of the highest paid executives, the IRS instructed public colleges and universities not to complete this section of the questionnaire because, as discussed below, they are not subject to the excess benefit transaction rules of I.R.C. § 4958.29
For the private institutions, while more than half of all sizes of such institutions reported taking steps to raise the rebuttable presumption of reasonableness when setting compensation, these institutions relied on compensation comparability data less frequently than the other rebuttable presumption requirements (i.e., approval by an independent governing body and contemporaneous documentation).30
A small number of private institutions reported using the initial contract exception for their six highest paid executives, even though a majority of institutions reported that none of those executives were previously disqualified persons and therefore any fixed payments for such executives would not be subject to the excess benefit transaction rules.31 The IRS recently announced that it will begin to more closely review the information in the Interim Report to determine whether the comparability data relied upon by reporting institutions is defensible. The IRS will apparently assess whether comparisons were based on individuals within similarly-sized organizations, in similar geographic areas, and with responsibilities similar to those of the senior executives of the reporting institutions.32
The Interim Report also indicates that many of the responding institutions (forty-five percent of small, eighty-two percent of medium, and ninety-six percent of large organizations) have related entities, the most common type being related tax-exempt organizations. Many of these institutions also reported that they controlled one or more other organizations. As previously noted, some institutions used such related organizations to provide compensation to their highest paid executives and other employees.
2. Unrelated Business Taxable Income and Debt-Financed Property Findings
The questionnaire asked the institutions to report on the extent of their activities in forty-seven different areas and then queried whether the institutions treated the revenue derived from these activities as tax-exempt or as subject to unrelated business income tax.33
Questions focused primarily on (1) advertising, including printed publications, internet advertising, billboards, and television or radio broadcasting; (2) corporate sponsorship, including printed materials, events, internet sponsorship, billboards, and television or radio broadcasting; (3) rental of property, including facilities, arenas, recreation centers, athletic facilities, personal property, and telecommunications; and (4) a wide range of miscellaneous activities, including internet and catalog sales, royalties, mailing lists, affinity cards, scientific research and intellectual property, hotels and conference centers, catering and food services, parking lots, bookstores, golf courses, investments in partnerships and S corporations, and controlled entities.34
The questionnaire also asked the institutions to indicate whether they filed a Form 990-T and reported the activities and the revenue generated on the Form 990-T. The IRS notes in the Interim Report that it intends to explore further the differences between the number of institutions responding that they engaged in certain activities and the lower number of institutions responding that they reported such activities on Form 990-T.35
The IRS acknowledges that this difference may be attributable to the fact that some business activities are substantially related to the institution's exempt purposes. It is also possible that an exception or exemption, such as the "convenience" exception, is available to shelter the income generated by business activities from the unrelated business income tax. But the IRS states that this will be an area of further study.36
Additional questions on the questionnaire required the institutions to report on their expense allocations and whether they relied on advice from independent accountants or counsel when determining whether an activity generated unrelated business income. More than half of the institutions in all size categories indicated that they had indirect expenses, and at least sixty percent of all responding colleges and universities responded that they did not rely on outside advice for determining the tax treatment of revenue from these activities.37
3. Anticipated Final Report
The IRS anticipates that it will issue a final report on the information gathered by the compliance questionnaire. The final report will also likely include information from the college and university examinations that are now underway and will allow for extrapolation of its findings to colleges and universities as a sector.38 The IRS expects that this study will identify areas that warrant additional guidance or further scrutiny, including executive compensation.39
4. Resulting College and University Audits It is possible that the final report will generate additional examinations of colleges and universities focused on compensation-related or other issues.
As a result of responses to the college and university questionnaire, the IRS now has more than thirty colleges and universities under audit. It is unknown what responses triggered these examinations, although it is likely that the use of tax-exempt financing, unreasonable executive compensation, and unrelated business activities are the primary areas of focus overall. The IRS has not commented on the reasons for the audits, but it previously indicated that it intends to be "exceptionally active" in reviewing the executive compensation paid in tax-exempt organizations.40
One concern expressed has been that the use of comparables from third-party organizations that set their executive salaries using the initial contract exception under the excess benefit transaction rules may result in inappropriate skewing of the comparables relied upon when determining the reasonableness of executive compensation.41 The IRS will also have at its disposal additional information about compensation levels and practices based upon filings on the redesigned Form 990 beginning with the 2008 tax year. Other areas of focus may also include employer-provided housing, below-market or interest-free loans, deferred compensation, and miscellaneous items of income such as tax gross-ups, spousal travel expenses, and similar benefits.42
The selection of more than thirty colleges and universities for further examination following receipt of the responses to the questionnaire clearly indicates that the IRS is serious about pursuing compliance issues arising from the data and information gathered. Colleges and universities need to be prepared not only to deal with an examination and to explain their positions in the event the IRS implements an examination, but they also should take steps to avoid further scrutiny or adverse findings should an examination occur. This will require colleges and universities to review their executive-compensation practices as well as their reporting positions with respect to business activities.
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Footnotes
1. For example, see NCSU Fires Mary Easley, Chancellor Quits Amid Turmoil, NEWS 14 CAROLINA (June 9, 2009), http://charlotte.news14.com/content/top_stories/610366/ncsu-fires-mary-easley--chancellor-quits-amid-turmoil /; Statement from the American University Board of Trustees, Thomas Gottschalk (Oct. 24, 2005), http://www.american.edu/trustees/statements/10242005.html .
2. Charles E. Grassley, Salaries for College Presidents Go Up, http://grassley.senate.gov/about/Salaries-for-college-presidents-go-up.cfm (last visited Nov. 18, 2010).
3. Charles E. Grassley, Wealthy Colleges Must Make Themselves More Affordable, CHRON. HIGHER EDUC., May 30, 2008, at A36.
4. Press Release, U.S. Senate Committee on Finance, Private College Salaries Soar as Tuition Goes Up (Nov. 2, 2009), http://finance.senate.gov//newsroom/ranking/release/index.cfm?id=8e69a8a4-7e4a-422f-9739-29e80a2be490 .
5. Alison Bennett, Treasury Official Lam Stresses Charities Face Climate of Enforcement, Transparency, Daily Tax Rep. (BNA), Sept. 25, 2009, at G-8 .
6. Id.
7. See FY 2008 EO Implementing Guidelines, Section III.A.2, available at http://www.irs.gov/pub/irs-tege/fy08_implementing_guidelines.pdf .
8. A copy of the questionnaire is available at http://www.irs.gov/pub/irs-tege/sample_cucp_questionnaire.pdf .
9. See INTERNAL REVENUE SERVICE, EXEMPT ORGANIZATIONS: FY 2009 WORK PLAN 17 (2008), available at http://www.irs.gov/pub/irs-tege/finalannualrptworkplan11_25_08.pdf .
10. See Internal Revenue Service, Governance and Tax-Exempt Organizations––Examination Materials (2009), available at http://www.irs.gov/charities/article/0,,id=216068,00.html .
11. See INTERNAL REVENUE SERVICE, IRS EXEMPT ORGANIZATIONS: COLLEGES AND UNIVERSITIES COMPLIANCE PROJECT: INTERIM REPORT at 5 (2010), available at http://www.irs.gov/pub/irs-tege/cucp_interimrpt_052010.pdf [hereinafter Interim Report].
12. See CONG. BUDGET OFF., TAX ARBITRAGE BY COLLEGES AND UNIVERSITIES (2010), available at http://www.cbo.gov/ftpdocs/112xx/doc11226/04-30-TaxArbitrage.pdf \. The Joint Committee on Taxation estimated the cost of this tax advantage, measured in terms of lost revenues had the institutions used taxable debt, at $5.5 billion in 2010. The CBO study focuses on approaches to measuring the amount of tax arbitrage practiced by colleges and universities and the effect of expanding the definition of tax arbitrage and thereby eliminating some of the benefits of tax-exempt financing. This report may lead the IRS to raise questions relating to such indirect tax arbitrage of any colleges and universities under audit.
13. U.S. GOV'T ACCOUNTABILITY OFF., POSTSECONDARY EDUCATION: COLLEGE AND UNIVERSITY ENDOWMENTS HAVE SHOWN LONG-TERM GROWTH, WHILE SIZE, RESTRICTIONS, AND DISTRIBUTIONS VARY (2010), available at http://www.gao.gov/new.items/d10393.pdf .
14. Andrea Fuller, Compensation of 30 Private-College Presidents Topped $1-Million in 2008, CHRON. HIGHER EDUC., Nov. 19, 2010, at A1.
15. A copy of the letter requesting review is available at http://www.witf.org/images/stories/Article_Images/news/PDF/Hershey_Trust_Excessive_Compensation.pdf
16. Interim Report, supra note 11, at 5.
17. Interim Report, supra note 11, at 1.
18. Interim Report, supra note 11, at 1.
19. Interim Report, supra note 11, at 2.
20. Interim Report, supra note 11, at 54, Fig. 63.
21. Interim Report, supra note 11, at 55, Fig. 64.
22. Interim Report, supra note 11, at 55, Fig. 64.
23. Interim Report, supra note 11, at 51, Fig. 58.
24. Interim Report, supra note 11, at 52, Fig. 59.
25. Interim Report, supra note 11, at 52, Fig. 59.
26. Interim Report, supra note 11, at 57, Fig. 67.
27. Interim Report, supra note 11, at 57, Fig. 67.
28. Interim Report, supra note 11, at 57, Fig. 67.
29. Interim Report, supra note 11, at 60.
30. Interim Report, supra note 11, at 63–64, Fig. 79, 81–83.
31. Interim Report, supra note 11, at 63, Fig. 80.
32. Diane Freda, University Compensation – Setting Procedures Will Get Further Review by IRS, Lerner Says, Daily Tax Rep. (BNA), Nov. 26, 2010, at G-3.
33. Interim Report, supra note 11, at 22.
34. Interim Report, supra note 11, at 23–26.
35. Interim Report, supra note 11, at 29.
36. Interim Report, supra note 11, at 31.
37. Interim Report, supra note 11, at 31–33.
38. Interim Report, supra note 11, at 5.
39. Interim Report, supra note 11, at 1.
40. Tom Gilroy, IRS Plans to Stay Focused on EO Executive Compensation, Miller Says, Daily Tax Rep. (BNA), Nov. 21, 2008, at G-6.
41. Diane Freda, IRS Exploring Initial Contract Exception's Impact on Exempts' Executive Compensation, Daily Tax Rep. (BNA), July 2, 2009, at G-2.
42. The IRS appears to have a particular interest in exempt organization deferred compensation. This is likely influenced by the requirements of I.R.C. § 409A that were enacted in 2004. The IRS has announced its intent to coordinate the deferred-compensation rules for tax-exempt organization plans in I.R.C. § 457 with the § 409A requirements. See I.R.S. Notice 2007-62, 2007-32 I.R.B. 331 (announcing the intent to issue new guidance regarding (1) the exemption under § 457(e)(11) for bona fide severance-pay plans and (2) the definition of "substantial risk of forfeiture" in § 457(f)(3)(B)).
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