On May 7, 2010, the Internal Revenue Service (the “IRS” or “Service”) issued an interim report (the “Interim Report”) summarizing the information that it received in response to compliance check questionnaires that were sent out to hundreds of nonprofit, tax-exempt colleges and universities in October 2008.
In the introduction of the Interim Report, the Service briefly touches on how it plans to use the information collected. The remainder of the report focuses on a summary of the information obtained through the compliance check questionnaires.
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.
An Introduction to Compliance Projects
The Colleges and Universities Compliance Project (the “Compliance Project”) is part of the Service’s effort to review the largest and most complex organizations in the tax-exempt community. Prior to this project, the Service engaged in similar reviews of tax-exempt hospitals and tax-exempt credit counseling organizations. Through compliance projects, the Service broadly reviews an entire industry at one time, comparing organizations within the industry to gain an understanding of common practices for reporting income, characterizing activities, and serving their communities. By taking a snapshot of an entire industry, the Service is able to identify anomalies that may be indicative of misreporting or other areas of tax noncompliance. Additionally, such compliance projects allow the Service to identify specific areas for potential abuse on which to focus during reviews of tax-exemption applications and during examinations.
Compliance project initiatives involve several phases. Upon identifying an industry, the first phase of a compliance project involves the Service sending out compliance check questionnaires to a significant portion of the selected industry. This phase of the compliance project impacts the largest segment of the selected industry. For instance, in this Compliance Project, the Service sent compliance questionnaires to 400 tax-exempt colleges and universities; more than 16% of the entire industry.
The questionnaires are used to gather a substantial amount of information about the industry as a whole, as well as how the organization, operations and reporting activities of particular entities compare to the industry as a whole. From this information, the Service can determine the specific categories of noncompliance on which it will focus its examinations, and identify certain information reported on the annual Forms 990 that is indicative of misreporting or noncompliance.
Based on the information obtained from the compliance questionnaires, the Service will begin the next phase of the compliance project, on-site examinations. Though impacting far fewer organizations, this portion of the compliance project is the most burdensome and time-consuming. Also, unlike the consequences of a compliance check questionnaire, based on the results of an examination, the Service may revoke an organization’s tax-exempt status. The number of examinations which the Service will open during a compliance project is largely unknown until after the Service completes its initial review of the questionnaires and is able to assess the state of the industry. During the Hospital Compliance Project, which began in 2006, the Service opened up 20 examinations of tax-exempt hospitals; however, during the Credit Counseling Compliance Project, the Service conducted examinations of more than 80% of the industry, as measured by revenue. Currently, this Compliance Project has resulted in 30 examinations, although more may still be opened.
Findings of the Colleges and Universities Compliance Project
As noted above, this Compliance Project began when the Service mailed compliance check questionnaires to 400 colleges and universities in October 2008. Of the 400 organizations that received compliance check questionnaires, 13 organizations failed to respond, 31 organizations indicated that they were not the type of organization that was part of this Compliance Project, 11 organizations were not included in the interim report because they were separate parts of a single university system, and one entity was removed. As such, the interim report discusses the activities of 344 colleges and universities.
Based on the report, to date, the Compliance Project has resulted in 30 examinations, more than 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. Additionally, during the examinations, the Service will review related entity issues and collect and review data on corporate governance.
The Service selected these areas of focus based on the information reported on the questionnaires, which indicated inconsistencies with respect to organizational reporting and tax compliance procedures.
With respect to unrelated business income, the Interim Report noted that:
- Nearly half of the small-sized 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. While on its face this statistic seems high, it is especially high when compared to medium and large-sized colleges and universities, of which only approximately 17% reported having never filed a Form 990-T.
- Reporting is inconsistent. A higher number of colleges and universities reported on the questionnaire that they engaged in unrelated activities, such as advertising or leasing facilities, than those who reported engaging in such activities on their Form 990-T.
- There seems to be substantial confusion and non-reporting of unrelated business income resulting from transactions with related or controlled entities.
- Finally, 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 related or unrelated. This is especially troubling considering the fact that engaging in any unrelated activity, if substantial, can result in revocation of an organization’s tax-exempt status.
With respect to executive compensation, the Interim Report noted that:
- The executive compensation issues considered by the Service include the compensation of officers, directors, trustees, and key employees (the “ODTKEs”); highly compensated non-ODTKEs such as professors and athletic coaches; investment advisors; and independent contractors.
- With respect to loans to ODTKEs, only about 50% of the small and medium-sized colleges and universities that provided loans to ODTKEs reported that the terms of the loans were in writing.
- 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 related entities, the Interim Report noted that:
- More than half of the responding colleges and universities stated that they were related to other organizations, and a significant portion of the respondents were controlling entities, as defined by the Internal Revenue Code (the “Code”).
- Less than half of the colleges and universities that reported the receipt of income from controlled entities indicated that they previously reported this income on their Form 990-T. As such, during the examinations of colleges and universities, the Service will consider whether any income received from controlled entities should be subject to tax as unrelated business income.
With respect to corporate governance, the Interim Report noted that:
- A majority of the colleges and universities had various governance policies in place, including written conflict of interest policies and disclosure policies. However, an alarmingly low number of organizations had written compensation policies or policies established to ensure that transactions with related entities are at arm’s length.
- Use of outside advisors was limited. Less than one-third of the respondents relied on the advice of an independent compensation consultant when setting compensation for ODTKEs. Also, as previously mentioned, the vast majority of colleges and universities surveyed did not obtain advice from legal or tax counsel with respect to whether activities were related to the organization’s exempt purposes.
Lessons for Colleges and Universities Not Yet under Examination
The information in this report is valuable for all tax-exempt organizations, but it is particularly helpful to colleges and universities that are not currently under examination. The information in the Interim Report provides such organizations with a blueprint for what the Service considers to be optimal tax compliance, and, as such, a map for the successful resolution of future IRS examinations.
The first priority for the Service’s examinations of colleges and universities is unrelated business income. As such, 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 Service characterized as potentially unrelated. If so, an organization should either report such activities as unrelated on its annual Form 990 and 990-T and/or take the necessary 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. Not only can such guidance help protect colleges and universities in the event of an IRS examination resulting from a compliance project, but it may prevent colleges and universities from having to make a FIN 48 (uncertain tax position) disclosure on its Form 990, something that may result in an examination independent of the Compliance Project.
When setting executive compensation, colleges and universities need to be aware of the private inurement and intermediate sanctions provisions of the Code. Organizations need to be cognizant of private inurement because the presence of excessive compensation practices that result in private inurement can cause the Service to revoke the organization’s tax-exempt status. Executives need to pay attention to the intermediate sanctions provisions of the Code because if the Service determines that an executive received an excessive benefit, under the intermediate sanctions provisions of the Code, the Service may require the individual to return the excessive portion of the compensation to the organization, and may also impose an excise tax of up to 200% (of the excess benefit amount) on the individual who received the excessive benefit. Additionally, the Service may impose an excise tax of 10% on every ODTKE that approved the transaction. With these potential penalties in mind, colleges and universities not yet under examination should use the information provided in the Interim Report to ascertain whether their compensation policies are compliant with the Service’s expectations. They also should determine if the amount of compensation provided is safely within the range of compensation provided by comparable organizations. Once again, it is suggested that colleges and universities seek the assistance of independent compensation consultants when making such determinations.
With respect to corporate governance, there are very few actual legal requirements. However, prudent governance, including the development and implementation of appropriate policies and procedures, provides organizations with at least two tangible benefits. First, organizations with appropriate corporate governance policies are perceived to be more responsible organizations, both by the Service and the public. With the substantial reporting requirements of the Form 990, the disclosure of appropriate governance policies may reduce the likelihood of a future examination. Second, during an examination, the use of appropriate governance procedures may result in greater deference to the decisions made by the organization’s governing body with respect to organization activities and positions. Another benefit of appropriate governance policies is that the use of such policies, by their nature, will help the organization avoid many of the issues that may jeopardize the organization’s tax-exempt status. For instance, the mere use of a conflict of interest policy will substantially reduce the possibility that an organization will engage in an inappropriate transaction with an ODTKE.
By following these steps, colleges and universities that are not yet under examination can substantially mitigate the risk of a future examination. Organizations that fail to take these recommended steps do so at their own peril. Currently, more than 8% of the colleges and universities that received compliance check questionnaires are under examination, and, depending on the extent of noncompliance that the Service finds in these organizations, this number could increase significantly. 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 entities. This is true for several reasons, including providing lessons to organizations subject to future compliance projects, highlighting issues of current interest in IRS examinations, and providing a preview of issues on which the Service may focus in future examinations.
Future Compliance Project Lessons
The Service has indicated that it will continue to develop industry-focused compliance projects. As such, the tax-exempt community needs to understand and respect the methodology of the compliance project process. Other industries should analyze this Compliance Project for lessons in the event of a future compliance project in their industry. These lessons include:
- Every organization that receives a questionnaire must complete it. Of the 369 questionnaires sent to colleges and universities, the Service initially opened 30 examinations, approximately 8%. Of the 13 colleges and universities that received, but did not complete, a questionnaire, the Service opened 13 examinations. The obvious lesson is that if your organization receives a compliance check questionnaire, complete and return it.
- Avoid lack of uniformity within your industry. One of the significant issues noted in the Interim Report was a general lack of uniformity within the industry, especially with respect to how colleges and universities report unrelated income. The lack of uniformity creates a wide spectrum of answers to the compliance check questionnaire, resulting in a greater number of inconsistencies and likely increasing the number of individual examinations. With this in mind, tax-exempt organizations that are members of industry trade associations should request more education about industry practices and common issues where required.
- Smaller organizations should focus on compliance. The Interim Report highlighted the differences between the compliance efforts of small-sized colleges and universities and large-sized colleges and universities. For instance, small colleges and universities were less likely to have implemented certain corporate governance policies, engaged independent consultants for guidance on executive compensation, and prepared certain annual tax filings, such as the Form 990-T. Each of these failures could jeopardize the organizations’ tax-exempt status; however, due to size and financial concerns, such organizations are usually unable to hire the necessary consultants to make themselves aware of these issues. These institutions would have received substantial benefits from membership in a trade association of similar entities that could pool their resources and, collectively, hire the appropriate experts to provide general information and develop guidelines for governance, compensation and annual tax reporting. There will always be differences between large and small organizations; however, as one of the purposes of compliance projects is to find and examine anomalous practices, small organizations in large industries should look to join or build trade associations of similar entities to take advantage of the economies of scale.
Lessons Relevant for Current Tax Compliance
As discussed above, the Interim Report notes that the IRS is focused primarily on the areas of unrelated business activities and executive compensation. As such, in the course of this Compliance Project, the Service has gone to great lengths to educate its revenue agents about these issues and their consequences. Therefore, regardless of whether an examination is commenced through a compliance project, these are issues that will be at the forefront of an agent’s focus during future examinations.
Also, the Service’s focus on these issues, especially executive compensation, is consistent with our experience in examinations of organizations outside the field of higher education. For instance, we have seen revenue agents impose intermediate sanctions more often in this past year than in the previous five years combined. Additionally, in informal discussion with IRS officials, we have been told that compensation is an issue of focus at all levels of the IRS from the Examinations Division to the Office of Chief Counsel. Thus, all tax-exempt organizations should take heed of unrelated activity and executive compensation pitfalls.
Future Issues of Focus During IRS Examinations
In the Interim Report, the Service noted that it was going to use the Compliance Project to develop and review information regarding transactions with related entities and organizational governance. This should put the entire tax-exempt community on notice that the future examinations will include a review of related entities and corporate governance. Also, all tax-exempt organizations should note the additional requirements of the Form 990 which include Part VI, Governance Management, and Disclosure; Schedule J, Compensation Information; Schedule L, Transactions with Interested Persons; and Schedule R, Related Organizations and Unrelated Partnerships. The information disclosed in these new sections can be used by the Service to select organizations for individual examinations and to target industries to be the subject of a future compliance project.
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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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.