Earlier this spring, IRS Exempt Organizations issued the long-awaited final report on colleges and universities. Although the report focuses on higher education, all nonprofits should take a look at it, because the IRS states that it has identified "some significant issues ... that may well be present elsewhere across the tax-exempt sector," including unrelated-business ventures and "the importance of using appropriate comparability data when setting compensation."
The IRS sent out questionnaires to 400 randomly selected tax-exempt colleges and universities in 2008 and then selected 34 of them for more detailed examination because their questionnaire responses and Form 990 reporting indicated potential noncompliance in the areas of unrelated business income and executive compensation. The IRS cautions that the 34 schools selected for examination are not a statistical sample of all colleges and universities—the IRS looked at those in which noncompliance seemed probable.
And a lot of problems were uncovered in those examinations.
Unrelated Business Income—or Just Losses?
Unrelated business income reporting has been a long-time concern for the IRS. Most organizations typically offset unrelated business income, reported on Form 990-T, with deductions, and only about half of organizations required to file a 990-T report any tax liability. So EO investigated why there was so much unrelated business activity yet so few taxes owed.
The findings were dramatic, with unrelated business income underreported by over $90 million. Most of the problems areas for the colleges and universities were from five types of activities:
- fitness and recreation centers and sports camps;
- arenas; and
- golf courses.
The IRS characterized the practices of underreporting of taxable income as follows:
- Claiming losses from activities that did not qualify as a trade or business. The activities must include the intent to make a profit. Continual losses from an activity year in and year out for a protracted period indicates a lack of profit motive to the IRS. Because the activities involved did not qualify as a trade or business, the claimed losses could no longer be used to offset profits from other unrelated activities in the current year or in future years, which resulted in the disallowance of about $150 million in losses.
- Misallocating expenses to offset unrelated business income for specific activities. Although expenses can be used to offset income, they must be reasonable and "have a proximate and primary relationship to the activities to which they are attributed."
- Claiming income-producing activities as related to the organizations' tax-exempt purpose exempt when the activities in fact were unrelated.
- Miscalculating or failing to substantiate the expenses and losses on Forms 990-T. This omission resulted in the disallowance of nearly $19 million in net operating losses.
The IRS disallowed losses on 75 percent of returns examined, finding that these organizations incorrectly reported losses on unrelated business income from activities that were never meant to turn a profit. The IRS position is clear—if losses from an activity are reported for many years, they indicate a lack of profit motive, and unrelated business losses cannot be used to avoid paying taxes. And these organizations did pay for not reporting correctly—more than $170 million in losses were disallowed, which could amount to more than $60 million in assessed taxes.
So what are the lessons for all nonprofits?
- Think about how you report your activities. Which ones are related to your tax-exempt purpose and which ones are not?
- Make sure the allocation of expenses to these programs is reasonable and that expenses shown are related to that specific activity.
- Beware of activities that show a loss year after year. Do they meet the IRS definition of trade or business by showing the intent to make a profit?
Failure to Use Comparable Compensation Data and Report Accurately
The IRS requires that compensation for officers, directors, trustees, and key employees be reasonable (see IRC Section 4958). An organization can, however, shift the burden of proof of unreasonable compensation to the IRS (creating a rebuttable presumption of reasonableness) by:
- using an independent body to review and determine the amount of compensation;
- relying on appropriate comparability data to set the compensation amount; and
- contemporaneously documenting the compensation-setting process.
Among the private colleges that were audited, nearly 20 percent failed to follow tax rules requiring them to compare the compensation of their top employees to that of similar officials at appropriate peer institutions. Most colleges attempted to conduct such comparisons, the report says, but they relied on figures from the wrong kind of institutions or didn't consider whether the salary comparison included other kinds of compensation. Thus, in many cases, the requirements of rebuttable presumption of reasonableness were not met. The most common mistakes were:
- Using data that were not comparable, from schools that were not similar.
- Relying on compensation studies without specific information on criteria for inclusion in the study or an explanation of what made the data relevant to the school relying on the study.
- Failing to use the same definition of compensation across the comparables (some included direct salary only, while others added pension and other benefits) and make the appropriate comparisons, as required by Section 4958.
For these 34 schools, the average total compensation for the top management was a little over $600,000, and the median total compensation was about $500,000. Not surprisingly, sports coaches and investment managers received the highest average compensation, close to $900,000 per year. A caveat—these averages are only for the 34 schools examined and are actually an example of what the IRS would not consider comparable for any given nonprofit using salary data to create a rebuttable presumption. The data needed must be from similarly situated organizations.
The IRS also reviewed employment tax returns at about a third of the 34 colleges and universities and found reporting issues that resulted in $36 million in increased wages and over $7 million in taxes and penalties. Retirement plans were also reviewed, with a resulting increase in reported wages of more than $1 million and $200,000 in taxes and penalties.
So, again, there are some more lessons for all nonprofits when setting compensation:
- Use data from comparable organizations (size, type of services, geographic location).
- If using or commissioning a survey, make sure there are precise definitions of which organizations are included so that the resulting averages and medians will be for similar organizations.
- Compare apples to apples when reviewing salaries—using the same definition of compensation (direct salary, other benefits, total compensation).
- Check to see that your Form 990 is consistent with other reports to the federal government (such as the quarterly employment reports and pension plan filings)—the IRS has the ability to run these checks, and with this report, has shown that it is doing so.
Not setting compensation thoughtfully by using comparable data and not reporting accurately can cost you a lot in taxes and penalties.
Some Additional Issues
- IRS Exempt Organization research and investigations are increasingly multi-year projects. For example, the college and university report started with questionnaires in 2008, a selection of organizations for further investigation in 2009, an interim report in 2010, and a final report in 2013. The nonprofit sector should expect similar time frames for future research.
- For newly formed charities, the IRS is trying to provide more assistance up front in the application process. The current effort is an Interactive Form 1023, now in a draft stage, that provides education and assistance to applicants while they fill out the form. Although the final form won't be filed electronically, it will provide pop-up definitions of unfamiliar terms and clickable links to related pages on IRS.gov and StayExempt.irs.gov. The hope is that the Interactive Form 1023 will provide more complete applications to the IRS and enable easier processing of applications without requiring contacts with the applicants.
Implications of the Report for All Nonprofits
Although the IRS is careful to say that these results are from a group of organizations where noncompliance was expected to be found, the findings also indicate areas of particular concern not only for all colleges and universities but also for all nonprofits. They include:
- Unrelated business income, especially if there are recurring losses. Be careful to allocate organization expenses to these activities accurately. And make sure the activities are meant to generate profits.
- Executive compensation documentation. Use appropriate comparability data when setting compensation. This information is easily obtained from Forms 990 filed by similar organizations.
- Employment tax returns. Report compensation accurately and consistently on employment tax returns and on Form 990—the IRS now checks to see that these two sources match.
Linda M. Lampkin, ERI Economic Research Institute
© 2013, ERI Economic Research Institute
Linda M. Lampkin is research director of ERI Economic Research Institute, a company that provides Form 990 compensation data for use by nonprofits, and former director of the National Center for Charitable Statistics at the Urban Institute. She can be reached at firstname.lastname@example.org or (877) 799-3428.