The Internal Revenue Service recently completed its Nonprofit Colleges and Universities Compliance Project. The IRS had sent out an initial compliance questionnaire to more than 400 tax-exempt colleges and universities. Based on the responses, 34 colleges and universities were then selected for examination. The IRS has now completed 90 percent of these examinations. On April 25, 2013, the IRS released the Final Report on the project, summarizing the findings from the completed examinations and representing the culmination of almost five years of research and analysis.
Although the project has focused specifically on colleges and universities, the key points raised in the Final Report are applicable to all tax-exempt organizations and carry lessons for associations that are recognized as exempt under 501(c)(6) or 501(c)(3).
Unrelated business income findings
Unrelated business income arises when a tax-exempt organization regularly carries on a trade or business that is not substantially related to the tax-exempt purposes of the organization. The Internal Revenue Code imposes unrelated business income tax on an organization's UBI, reduced by the organization's related losses and deductions. The Final Report notes that 90 percent of the colleges and universities examined had misreported UBI on their Forms 990 and 990-T during the years under examination, and the resulting changes in the reporting of losses and net operating losses could result in more than $60 million in assessed federal taxes.
Other common findings among the examined colleges and universities included misallocation of expenses between activities related to tax-exempt purposes and those unrelated to such purposes; errors in computation of NOLs and the substantiation of such amounts; and misclassification of activities as related to the institution's tax-exempt purposes. It is interesting to note that the IRS identified numerous instances in which examined colleges and universities had reported net losses on activities "for which expenses had consistently exceeded UBI for many years." The IRS determined that these activities were not carried on with a profit motive and, as such, disallowed the NOLs that flowed from those activities.
Executive compensation and other compensation findings
With regard to executive compensation, the Final Report focuses on certain procedural shortcomings among many colleges and universities. As organizations described in § 501(c)(3) of the code, these colleges and universities are subject to the prohibition on "private inurement." As such, if an organization is deemed to make payments or engage in activities that improperly inure to the benefit of its "insiders," the IRS could seek to revoke the tax-exempt status of the organization. Alternatively, under Code § 4958 (also known as the "intermediate sanctions" rules), the IRS may impose punitive excise taxes on the insiders receiving undue benefit from their tax-exempt organizations, as well as a parallel excise tax on the organization's directors or managers that knowingly approved any "excess benefit transaction."
Organizations have an opportunity to lessen the exposure to excess benefit transactions if they follow a rebuttable presumption—have a disinterested decision-making body rely on valid comparability data to arrive at a compensation level for key officials and then have that decision- making body contemporaneously document its decision.
In the Final Report, the IRS found that 20 percent of the colleges and universities examined would not have successfully established the presumption that the compensation paid to key officials was reasonable. The key shortcomings included, for example, the use of comparability data that was derived, at least in part, from organizations that were not "similarly situated" to the institution in question (based on factors such as location, endowment size, revenues, total net assets, number of students, selectivity in admissions, and age of the institution); and the reliance on compensation studies that did not adequately document how and/or why certain comparability data was selected, and/or did not specify whether the amounts reported included salary only or also reflected other types of taxable and non-taxable compensation.
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