On May 7, 2010, the Internal Revenue Service (the “IRS”) released the Interim Report on its Nonprofit Colleges and Universities Compliance Project (the “Interim Report”), summarizing the status of the Compliance Project and the information that it received in response to the compliance check questionnaires sent out to more than 400 nonprofit, tax-exempt colleges and universities in October 2008.
The information revealed from the questionnaires and the discussion of the issues by the IRS in the Interim Report are insightful and enlightening for all tax-exempt organizations.
Findings of the Colleges and Universities Compliance Project
This Compliance Project began when the IRS mailed compliance check questionnaires to 400 colleges and universities in October 2008. After reviewing information received from the compliance questionnaires, the IRS initiated examinations. Based on the Interim Report, to date, the Compliance Project has resulted in 30 examinations, approximately 8% of the colleges and universities that received questionnaires. The focus of these examinations has been principally in the areas of unrelated business income and executive compensation.
With respect to unrelated business income, the Interim Report noted that:
- Nearly half of the small colleges that completed the questionnaire reported never filing a Form 990-T, the annual reporting form on which they would identify taxable unrelated business income.
- A higher number of organizations reported that they engaged in unrelated activities on the questionnaire than those that reported such activities on their Forms 990-T.
- There seems to be substantial confusion and non-reporting of unrelated business income resulting from transactions with related or controlled entities.
- Approximately 65% of the colleges and universities that responded to the questionnaire reported that they have neither sought nor relied on the advice of legal or tax counsel when determining whether an activity was unrelated.
With respect to executive compensation, the Interim Report noted that:
- Less than 40% of the organizations that responded to the questionnaire indicated that they had a formal compensation policy and less than 30% hired independent consultants to assist the organizations by providing or analyzing comparability data.
- With respect to loans to officers, directors, trustees, and key employees (the “ODTKEs”), only about 50% of the small and medium-sized colleges and universities that reported providing loans to ODTKEs reported that the terms of the loans were in writing.
The Interim Report also indentified troubling statistics in the areas of identifying related entities and reporting income from controlled entities. Finally, the Interim Report noted low overall use of outside advisors and a general lack of written governance policies.
Lessons for Colleges and Universities Not Yet under Examination
The information in the Interim Report is particularly helpful to colleges and universities that are not currently under examination, as it provides a blueprint for what the IRS considers to be optimal compliance. Colleges and universities not yet under examination should take the following steps with respect to the issues in highlighted in the Interim Report:
- Unrelated Business Income – Colleges and universities should compare the data presented in the Interim Report to their own activities to determine whether they engage in any of the activities that the IRS characterized as potentially unrelated. If so, organizations should either report such income on the annual Form 990 and/or 990-T, or should take steps to document why such activities are related to the organization’s exempt purposes. Structuring or restructuring activities to make them related or eligible for one of the exemptions from unrelated business income may be in order. Obtaining guidance from legal or tax counsel can be helpful.
- Compensation – With the potential penalties of revocation of exempt status or imposition of intermediate sanctions in mind, colleges and universities should use the Interim Report as a guide to ascertain whether their compensation policies are compliant with IRS expectations. They also should determine if the amount of compensation provided is safely within the range of compensation provided by comparable organizations and should seek the assistance of independent compensation consultants when making such determinations.
- Governance – Organizations should develop and implement appropriate policies and procedures as discussed in the Interim Report. Implementation of such policies will both reduce the likelihood of a future examination based on deficiencies reported on the Form 990 and also can help the organization avoid some of the problems that could jeopardize the organization’s tax-exempt status, result in unrelated business income, or in the imposition of intermediate sanctions.
While the recommended steps require time and resources, it is significantly less expensive and easier to address potential tax issues prior to an examination than it is to do so during an examination.
Lessons for All Tax-Exempt Organizations
The benefits of the information contained in the Interim Report are not limited to colleges and universities; rather, they are beneficial to all tax-exempt organizations by providing lessons for future compliance projects and current tax compliance.
Future Compliance Project Lessons
- If you receive a compliance check questionnaire, complete it. The IRS opened an examination on each of the 13 organizations that received, but did not complete, a questionnaire.
- Avoid lack of uniformity within your industry. The Interim Report noted a significant lack of uniformity on certain issues, such as the way in which unrelated income is defined and reported. This lack of uniformity likely increased the number of individual examinations. Members of industry trade associations should request more education about industry practices and common issues where required.
- Smaller organizations should catch up on compliance. The Interim Report revealed that small colleges and universities were less likely to have implemented certain governance policies, engaged independent consultants for advice on compensation, and prepared certain annual tax filings, such as the Form 990-T. These institutions would benefit from membership in a trade association of similar entities to pool their resources and, collectively, hire the appropriate experts to provide general information and develop guidelines for governance, compensation and annual tax reporting.
Lessons Relevant for Current Tax Compliance
- Unrelated business activities and executive compensation will continue to be issues of significant focus. During this Compliance Project, the IRS has gone to great lengths to educate its revenue agents about these issues, and they will continue to be at the forefront of an agent’s focus during future examinations, including those outside of the Compliance Project.
- Future IRS focus will be on related entities and organizational governance among other areas. In the Interim Report, the IRS noted that it was going to use the Compliance Project to develop and review information regarding transactions with related entities and organizational governance. Combined with the addition of new sections to the Form 990 on these issues, this puts the entire tax-exempt community on notice that future examinations will include reviews of related entities and corporate governance.
Conclusion
The Interim Report provides a wealth of information that can be used by colleges and universities, as well as other members of the tax-exempt community, to ensure compliance with applicable provisions of the federal tax code. As industries and organizations engage in various activities and assess their risk, they should analyze the Interim Report and conduct their activities accordingly, ideally prior to becoming the subject of an IRS examination.
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For a more extensive version of this article, please click here.
To review our May 2010 article on the IRS tax-exempt organization audit process, please click here.
This article is not intended to provide legal advice or opinion and should not be relied on as such. Legal advice can only be provided in response to a specific fact situation.