07/16/2010
The Internal Revenue Service is stepping up its tax collection efforts against tax-exempt colleges and universities. Despite their tax-exempt designation, colleges and universities routinely engage in a variety of transactions that may be subject to federal income tax and certain excise taxes. Moreover, within the non-profit sector, colleges and universities are attractive audit targets because of their size and complexity. Without proper planning, colleges and universities are increasingly likely to be liable for unanticipated taxes, interest, fees, and penalties.
A recent survey of 400 colleges and universities conducted by the IRS, as well as the report interpreting that survey, highlight two areas that will be closely scrutinized:
A major finding of the IRS report is that many more colleges and universities generate income from businesses that are potentially unrelated to their exempt mission—income that is, therefore, potentially taxable as UBI—than tax return data would suggest. This includes income from various sources including advertising, bookstores, facility rental, recreation center usage, and other common transactions. The IRS's survey further revealed that relatively few colleges and universities with less than 15,000 students have policies in place to reduce the taxability of certain transactions between the college or university and entities that it controls. These UBI issues are "an area of further study" for the IRS, and a number of colleges and universities have been referred to the IRS's enforcement division as a result.
Because the determination of whether income is UBI is highly fact specific, and because the majority of colleges and universities have not sought expert advice on UBI issues, the advice of an attorney specializing in nonprofit tax-exempt organizations is essential to both minimizing the cost of any audit that may occur and to minimizing the likelihood of such audits going forward.
Another "principal focus" of the IRS report was an examination of the procedures colleges and universities use to set compensation for officers, directors, trustees, and other key employees. These procedures have the IRS's attention because an excise tax may be imposed upon certain transactions in which a person who exercises substantial influence over a private college or university receives an "excess benefit" from that organization. And even though certain procedures serve as "safe harbors" in avoiding this tax, the survey revealed that many colleges and universities have failed to avail themselves of these protections.
The IRS Commissioner has argued that "good governance is essential to public trust and accountability, and critical to the success of all organizations and institutions, including governments, non-profits and for-profits." It is not surprising, therefore, that the number of colleges and universities that do not follow the IRS's recommended governance procedures when fixing the rate of compensation for their officers, directors, and other managerial employees is "an area of continued focus for the IRS."
Stinson Morrison Hecker (SMH) specializes in representing nonprofit tax-exempt organizations. The Chair of the nonprofit tax-exempt practice group, was formerly an attorney in the Chief Counsel's Office of the Internal Revenue Service, specializing in tax-exempt organizations. SMH conducts legal audits for tax-exempt colleges and universities with respect to UBI and excess benefit transactions, including compensation issues (among other issues). One of the attorneys in the SMH tax-exempt practice group is currently the Chair of the Great Lakes Tax Exempt Government Entities Council, which is a ten-state region that coordinates with the IRS on tax-exempt matters. The IRS has recommended "periodic reviews" for tax-exempt organizations, including colleges and universities. If you would like more information as to what is involved in an IRS "periodic review" and/or the SMH tax-exempt legal audit, please contact one of the attorneys of the nonprofit tax-exempt group.