IRS Highlights Concerns with Tax on Unrelated Business Income and Compensation
The IRS concluded a multi-year study of colleges and universities last year, issuing a report that is now being carefully reviewed by advisors to the nonprofit sector. The IRS is using the study to send a message to the entire exempt sector, so the information we can glean from it must be considered a strong indication of IRS concerns about all 501(c) entities.
The report focuses on three aspects of IRS concern: (1) the underreporting of unrelated business income (UBI) generated by for-profit activities, (2) compensation of officers, directors, trustees and key employees, and (3) employment taxes.
UNRELATED BUSINESS INCOME
The IRS found that over ninety percent (90%) of the exempt organizations it examined had under-reported their unrelated business income, and thus they had paid either no tax or insufficient tax on it. Its auditors disallowed over $170 million of reported losses, and assessed over $60 million in unassessed taxes. Attorneys and accountants are now advising their clients to look carefully at their operations.
By way of background, the IRS has for many years allowed tax-exempt organizations to engage in businesses that are unrelated to their exempt purpose, so long as they properly report the for-profit activities on Form 990-T and pay taxes on the net operating income. These taxes are called UBIT – Unrelated Business Income Taxes.
There are a number of issues involved in the IRS’ examination:
Lack of a Profit Motive. Nonprofits that report losses year after year from ostensibly “for-profit” enterprises are being taxed on income that would otherwise have been exempt from taxes under IRS regulations. When the IRS disallowed expenses for chronically losing businesses, it determined that there was, across the board, more than $150 million in additional taxable income.
Misallocation of Expenses. When expenses might be allocated to either the for-profit enterprise or the exempt functions, the IRS has determined that over sixty percent (60%) were misallocated. By “burdening” their for-profit business with expenses from the nonprofit side, the colleges and/or universities reduced taxes or eliminated them entirely. The biggest areas of concerns were:
- Fitness and recreation centers and sports camps
- Facility Rentals
- Golf Courses
Computation Errors. Simple mistakes in math resulted in more than $19 million in additional disallowances of net operating losses.
Misclassification of Related Activities. IRS auditors determined that at more than forth percent (40%) of the colleges and universities studied, the institutions had failed to report activities as unrelated to their exempt purpose, and thus should have been reported on a Form 990-T. When they resulted in net income to the institution, they were subject to tax.
Failure to Obtain Independent Legal or Accounting Advice. Only twenty percent (20%) of the institutions studied obtained independent review of their unrelated business operations, and in forty percent (40%) of those cases, the outside advisors gave (in the IRS’ opinion) incorrect advice.
The IRS reviewed compensation to officers, directors, trustees and key employees (ODTKEs) to determine whether it was reasonable in light of IRS compensation limitations in Section 4958 of the IRS Code. The regulations for Section 4958 set forth a process by which exempt organizations can obtain a “rebuttable presumption” that the compensation paid is reasonable.
Briefly, exempt organizations create a “rebuttable presumption of reasonableness” by adhering to the following process:
- Provide an independent body to review and approve compensation of ODTKEs.
- Use appropriate comparables (usually three similar individuals based on the size, type and complexity of the person under review.
- Prepare contemporaneous documentation of the process used.
The biggest failure noted by IRS examiners was that compensation decisions were being based on inappropriate comparables, but they also commented on the fact that documentation of the process was not sufficient to support the decisions made, and that not all aspects of compensation were included in the decision process.
Not surprisingly, the chancellors or presidents of the university were the highest paid “ODTKEs”. Also not surprisingly, the schools’ investment managers and athletic coaches were the highest paid of those who were not “ODTKEs”.
This article is provided for general information and should not be relied upon as legal advice for a specific situation. If you are in need of specific advice or legal representation, please do not hesitate to contact us.
©2014 Bea & VandenBerk
 The “Colleges and Universities Compliance Project Final Report was issued on April 23, 2013. The IRS examined 34 colleges and universities, about equally divided between private and public institutions.
 The review was of private colleges and universities only, as public educational institutions are not subject to Section 4958 of the Code.
 In addition to size, type and complexity of the comparable institution itself, the IRS looked at its location, endowment size, revenues, total net assets, number of students and selectivity.