The IRS published its final report concerning its Colleges and Universities Compliance Project, finding compliance issues related to unrelated business taxable income (UBTI) and compensation practices. The IRS conducted the study to find out why colleges and universities had so much unrelated business activity but owed so little tax and to examine their compensation practices. The IRS examined tax returns from 34 colleges and universities it selected from among 400 it surveyed by questionnaire. The examined schools were divided almost evenly between private and public institutions, with about two-thirds reporting enrollments greater than 15,000 students.
Unrelated business taxable income. An exempt organization, including exempt colleges and universities, must pay tax on income from an unrelated trade or business, defined as an activity not substantially related to the accomplishment of the organization’s exempt purposes, even if the income from the business is used to support those purposes. Losses from one activity can offset income from another; however, continuing losses can indicate a lack of profit motive, which would disqualify the activity’s losses from the netting process.
The IRS found that UBTI was underreported at 90% of the institutions examined, with a total understatement of more than $90 million from 30 unrelated activities. The majority of the activities with unreported UBTI were fitness and recreation centers, sports camps, advertising, facility rentals, arenas, and golf courses. Nearly half of the institutions had adjustments to UBTI from advertising and/or facility rentals, and about one-third had adjustments from fitness and recreation centers and sports camps, arenas, and/or golf courses. The report identified four primary reasons for understated UBTI: (1) lack of profit motive, (2) improper expense allocation, (3) misclassification of certain activities as exempt, and (4) miscalculated or unsubstantiated net operating losses.
The IRS reported that nearly 70% of the institutions examined reported losses from activities that lacked a profit motive since the activities had losses for many years. These activities should not have been classified as a trade or business, and the institutions improperly used the losses to offset income from unrelated trade or business activities. In addition, nearly 60% of the institutions reduced their UBTI by improperly allocating expenses to an unrelated trade or business activity that did not have the required proximate and primary relationship to the activity. Also, the IRS determined that more than 40% of the institutions incorrectly omitted income from activities they believed to be related to their tax-exempt purpose that were actually unrelated activities subject to tax.
Compensation. Sec. 4958 imposes an excise tax on unreasonable compensation paid by exempt organizations (in this case, private colleges and universities) to a disqualified person, namely, an officer, director, trustee, or key employee (ODTKE). An institution’s compensation is presumed to be reasonable if the college or university (1) uses an independent body to review and determine the amount of compensation, (2) relies on appropriate comparability data to set the compensation amount, and (3) contemporaneously documents the compensation-setting process. The IRS found that the compensation of 94% of ODTKEs examined in the study was determined using a process intended to satisfy the rebuttable presumption requirement; however, 20% of the examined institutions failed to meet the requirement due to the use of inappropriate comparability data. The data was inappropriate because it was (1) from another institution not comparable to the examined school, (2) obtained from an independent firm but used without any adjustments to make it comparable to the examined school, or (3) obtained from a survey that did not precisely define compensation.
The IRS also examined the employment tax returns of 11 schools and found problems in all of them, resulting in increased taxable wages of more than $35 million. The adjustments were due to failure to include the value of the personal use of autos, houses, social club memberships, and travel as wages; failure to include the value of graduate tuition waivers as wages; failure to withhold taxes on wages of nonresident aliens; and misclassification of employees as independent contractors. Also, the retirement plans at eight schools were examined, resulting in wage adjustments at four institutions totaling $1,115,007 due to excess deferrals, additions, and loans related to Sec. 403(b) plans, and nonqualifying contributions to Sec. 457 plans.
Due to the compliance issues related to UBTI and compensation found at the colleges and universities examined, the IRS concluded that similar problems may exist across the tax-exempt sector and plans to look at these issues more broadly.
IRS, Colleges and Universities Compliance Project Final Report, available at tinyurl.com/brkhfz3
By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.