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Colleges as Potential Tax Targets

May 10, 2010

The Internal Revenue Service is focusing mostly on issues related to executive compensation and payment (or non-payment) of tax on unrelated business income in more than 30 reviews it is conducting of individual colleges and universities, the agency said Friday, as it released the preliminary results of its survey of 400 institutions.

The interim report issued Friday offered the first official look at the information the federal tax agency has collected from a wide-ranging questionnaire it sent to colleges in 2008 to gauge their compliance with tax laws and identify possible areas for further examination (and enforcement, of course). The IRS focused on higher education (following a similar questionnaire it sent to hospitals), the agency said, because "colleges and universities make up one of the largest nonprofit segments in terms of revenue and assets" -- and that status has made it a target for members of Congress and others in the federal government at a time of ever-tightening federal budgets.

Two higher education groups, the Association of Governing Boards of Universities and Colleges and the National Association of College and University Business Officers, collected a subset of the colleges' responses to offer a preview of the findings last fall.

The IRS's interim report includes data for a total of 344 colleges, 177 private and 167 public. Several dozen of the original recipients of the questionnaire were excluded because they offered only two-year degrees or were not tax exempt, and 11 institutions that responded to the survey were omitted from the report because they submitted questionnaires on behalf of their entire university systems; information about them will be part of the IRS's final report, which will be released later.

The IRS broke the 344 respondents into several categories: 159 small colleges (139 private and 20 public), 94 medium-sized institutions (30 private and 64 public) and 91 large universities (8 private and 83 public).

Of the major areas on which the IRS sought to gather information in the questionnaire, the agency seemed least captivated by what it learned about tuitions and endowments. The survey included a significant number of questions on endowments, particularly -- including size of the funds, breakdowns of the areas in which colleges were investing (stocks vs. alternative investments, U.S. vs. international assets, etc.), spending rates, etc.

But many of the "findings" seemed obvious, at least to those who follow higher education closely: "Not all students pay the full amount of the annual full-time [tuition] rate published by the college or university because of financial aid or other discounts"; "most colleges and universities reported adopting and meeting their target spending rate," and the rates "were similar (approximately 5%) throughout the size categories." And the sections of the report on endowments and tuitions identified no areas that the IRS intended to scrutinize more closely in the narrower examinations of individual campuses.

The story was different, though, when it came to unrelated business income, where colleges' survey responses most seemed to concern the IRS. Nonprofit entities are required to pay tax on income they receive from revenues that are deemed unrelated to their charitable purpose -- education, in the case of postsecondary institutions. As colleges have become more complex financially and increasingly turned to sources other than students, states (for public colleges) and donors (for private institutions), unrelated business income tax, or UBIT, has become a topic of greater interest and scrutiny for the government.

The information the IRS gathered that most appeared to intrigue its officials is found in the table below, which compares the proportions of colleges that said they had engaged in certain types of commercial activities with the proportion that said they had reported engaging in taxable activity in those areas in the 990-T forms they had filed in 2006.

The IRS acknowledges that colleges may engage in some seemingly commercial activities without generating taxable revenue from them, when "an activity is conducted exclusively for the exempt purpose of the organization," for example, "for a bookstore that only sells books and supplies to students."

But the wide differences in some of the categories -- for instance, 23 percent of small colleges and 82 percent of large ones reported engaging in advertising activity, while just 6 percent of small institutions and 53 percent of large ones reported advertising income on their tax forms -- clearly caught the eye of the agency. "This is an area for further study for the IRS," the report says ominously, noting specifically that it would examine issues related to "expense allocation, losses, and debt-financed property."

Types of Commercial Activity and How Colleges Reported to IRS and on Their Tax Forms

  Small Institutions Medium-Sized
Institutions
Large Institutions
Activity Reported Activity
to IRS
Reported Activity
on 990-T
Reported Activity
to IRS
Reported Activity
on 990-T
Reported Activity
to IRS
Reported Activity
on 990-T
Advertising 23% 6% 54% 21% 82% 53%
Facility Rental 57% 11% 83% 22% 95% 41%
Arena Rental 4% <2% 26% 11% 42% 16%
Recreation Center Usage 14% 7% 38% 13% 65% 32%
Athletic Facilities Usage 26% 5% 48% 10% 60% 13%
Personal Property Rental 9% 2% 21% 7% 43% 14%
Telecommunications Related Rental 9% 3% 21% 7% 56% 19%
Catalog Sales <3% <2% 10% 5% 19% 4%
Internet Sales 6% 2% 18% 4% 37% 10%
Travel Tours 6% 2% 14% 5% 35% 11%
Exclusive Use Contracts 6% <2% 35% 3% 43% 4%
Commercial Research 3% 2% 13% 3% 25% 5%
Patents 3% <2% 20% <3% 41% <3%
Intellectual Property 2% <2% 10% <3% 34% <3%
Hotel Operation 3% 3% 7% 5% 25% 11%
Conference Center Operation 6% 6% 20% 12% 43% 15%
Restaurant Operation 2% 2% 11% 4% 34% 4%
Catering Services 19% 7% 37% 14% 48% 16%
Food Services 43% 2% 61% 6% 70% 7%
Parking Lots 16% 2% 52% 5% 76% 23%
Bookstore 53% 7% 57% 7% 63% 21%
Income from Controlled Organizations 6% 3% 14% <3% 13% 3%

Source: Internal Revenue Service

Compensation of colleges' leaders and other highly paid employees was another realm in which the information gathered in the questionnaire seemed to intrigue, and potentially trouble, the IRS.

Among the findings that the agency's interim report highlighted and, in some cases, suggested warranted further examination:

  • More than a third of large universities and nearly half of small colleges said they had not used a process -- known as "rebuttable presumption" -- for setting the compensation of their top officials that would ensure they would be exempt from IRS rules designed to guard against excessive compensation. Under tax law, it is normally up to a nonprofit institution to prove that it is paying its executives appropriately. But if a nonprofit institution follows the elements of the rebuttable presumption procedure, which requires a review by uninvolved members of the governing board after considering comparable data and other evidence related to a salary decision, the burden of proof shifts to the IRS to show that an institution has awarded excessive compensation.
  • A significant minority of institutions, in setting compensation levels for senior employees, did not use independent surveys that compared their own compensation levels to other institutions. "[T]his is an area of continued focus for the IRS," the report noted.
  • Sports coaches were the highest paid employees at 43 percent of the large universities in the sample.
  • Several small and medium-sized colleges said they had given loans to senior leaders whose terms were not documented in writing.
  • Twenty-one percent of large institutions reported that at least one of their five highest-paid employees received compensation from a related organization (foundation, athletic association, etc.).

Other areas that the IRS said it would examine going forward were: "the use of and relationship with controlled entities and related organizations; the reported differences in treatment by organizations of various activities as exempt or unrelated and of cost allocation practices across activities and related organizations"; and "the reporting of losses from certain exempt and unrelated activities."

 

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