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By Carla Neeley Freitag
TaxResearchAndWriting.com, Merritt Island, FL
The IRS commenced a major compliance project involving colleges and universities in 2008. The project has three phases. The first phase was to send compliance questionnaires to 400 institutions that represent a cross-section of small, medium, and large public and private four-year colleges and universities. Examinations were initiated on some of the recipients who returned the questionnaires and all of the recipients who did not return the questionnaires. The second phase was to compile the data from the questionnaires and issue an Interim Report on the findings. The Interim Report was released on May 7, 2010. The third phase is to compile data based on the examinations and issue a final report analyzing the need for future guidance or changes in reporting by educational institutions.
About the Questionnaire
In an effort to obtain a representative sample, the IRS sent questionnaires to 200 small educational institutions, 100 medium-sized institutions, and 100 large institutions. Small organizations have fewer than 5,000 students. Medium-sized institutions have 5,000 to 14,999 students. Large colleges and universities have 15,000 students or more.
The questionnaire is a lengthy four-part form requiring detailed information about the institution and how it operates based on the tax year ending in 2006.1 Each part addressed a subject of concern to the IRS:2
Part I Organization information
Part II Activities and unrelated business taxable income
Part III Investment of endowment funds
Part IV Executive compensation
The utility of the data compiled from the questionnaires depended on obtaining a representative sample. The rate of response was very good. Overall, 387 colleges and universities returned the questionnaires in varying degrees of completion. Only 13 institutions did not respond to the questionnaire.
The questionnaire was designed to prevent the recipients from making general or vague responses. For example, the questionnaire asks about the compensation paid to executives and how it was determined. If the question asked "How was the executive compensation determined?," the organization might respond by stating it used comparability data. To elicit greater detail, the questionnaire assumes that comparability data was used and asks about ten specific compensation factors, such as whether the comparables were taxable or tax-exempt, whether the organization considered factors such as specific responsibilities, the geographic or metropolitan area, and annual budget. In each case, the organization was required to indicate if the particular factor had been taken into account by checking a box. The questionnaire also listed ten sources from which an organization might obtain comparability data, such as internet research, phone surveys, and Forms 990 of other organizations. Again, the organization answered the question by checking a box for each specific source listed.
What Practitioners Can Learn from the Questionnaire
The questionnaire is educational for practitioners because of its specificity. The questions not only indicate general areas of concern for the IRS but also reveal specific issues of interest in each area of concern. Some examples are set forth below.
Related Entities. The questionnaire contained several questions about related entities. For purposes of the survey, a related organization is: (a) a parent that owns or controls the institution; (b) a subsidiary owned or controlled by the institution; (c) commonly controlled by the same parent that also controls the institution; (d) a supporting organization that supports the institution; or (e) a supported organization that the institution supports.
With related organizations, there is always the potential for abuse when at least one party is taxable. If a college or university owns a non-exempt subsidiary or is a member of a partnership with non-exempt partners, the IRS is concerned that the non-exempt entities will profit at the expense of the exempt educational institution. For taxable related organizations, the IRS asked several questions about the institution's top five related organizations based on gross revenue. For each related organization reported, the questionnaire asked about the location (foreign or domestic), the primary business activity, the name of the direct controlling entity, and the percentage of the institution's ownership. For organizations taxable as partnerships, the organization had to indicate whether it was the general or managing partner. For related organizations taxable as corporations or trusts, the institution had to specify whether the related organization was a C corporation, S corporation, trust, or personal service corporation.
The IRS concern with related party transactions reflected by the survey may prompt a practitioner to recommend that the practitioner identify the organizations to which the institution is related and review the institution's transactions with the related parties. Any improprieties can be corrected before the IRS challenges them. The practitioner can also verity that the related organizations are properly reported on the Form 990.3
Controlled Organizations. The questionnaire also asked about the number of organizations controlled by the institution within the meaning of §512(b)(13). For purposes of the unrelated business income tax, passive receipts such as interest, dividends, and royalties are not taxed. Under §512(b)(13), however, a organization must include interest, annuities, royalties, or rent received from a controlled organization as gross income from an unrelated trade or business. Recipients were required to indicate the specific number, if any, organizations they controlled. As in the case of related organizations, a practitioner may want to identify and review the institution's transactions with controlled organizations. The practitioner can also verity that the controlled organizations are properly reported on the Form 990.4
Arm's-Length Policies. In the case of both related organizations and controlled organizations, the questionnaire focuses on transactions with the college or university. Private institutions were asked about written policies designed to assure that transactions with non-501(c)(3) related organizations are made at arm's length. Public institutions need to report whether such transactions are covered by a specific state statute designed to assure arm's-length transactions. Delving into deeper detail, the questionnaire asks whether such policies or statutes are applicable with respect to: (a) provision of goods or services; (b) lending of money; (c) rental of property; (d) transfers of assets; (e) cost sharing and expense reimbursement arrangements; (f) licensing arrangements; (g) shared employees; and (h) any other transfers of assets, liabilities, or funds. Thus, the IRS is concerned about transactions between related organizations that might allow a related organization to profit from transactions with the institution.
The questionnaire recipients were also asked about policies and statutes governing transactions with controlled entities. Private institutions are required to indicate specific items of income for which a written policy establishes arm's length assurances regarding payments made to the institution from a controlled organization. Similarly, public institutions must indicate specific items of income from controlled organizations for which there are specific statutes designed to assure arm's length transactions. The specific receipts are: (a) management fees; (b) interest; (c) rents; (d) royalties; and (e) annuities. Once again, the concern is that the controlled organization may be taking advantage of the institution's exemption.
Based on the pointed questions, practitioners who represent a private college or university should verify whether the institution has a written policy designed to assure arm's-length transactions with related and controlled organizations. If not, the practitioner would want to draft a suitable policy and advise the organization's board to adopt it. Similarly, the practitioner should research the applicable state law to see if any specific statutes apply to the institution with regard to arm's-length transactions with related or controlled organizations. If there are no statutes, or even if there are applicable statutes, the practitioner should advise the public institution to adopt written policies. Having these policies and statutes in place will bring the issue of arm's-length transactions to the institution's management and may weigh in the institution's favor if the IRS ever questions its transactions with related or controlled organizations.
Executive Compensation. A practitioner may be concerned that a client university is overpaying its president. Looking at the compensation questions, the practitioner can advise the client what specific factors to take into account and what sources to consult. Based on the IRS interest as evidenced by the questionnaire, the practitioner can also advise the organization to keep detailed minutes of meetings during which compensation was determined and documents or sources that were consulted.
Unrelated trades or businesses. Rather than asking an institution to list any activities that produce unrelated business taxable income, the questionnaire provided a laundry list of 47 business activities that typically generate unrelated business taxable income. For each activity pursued, the organization must check the applicable box from "All UBI," "Part UBI," "No UBI," or "Debt Financed UBI." In addition, the organization must enter codes, such as "B = Actual costs were significantly greater than anticipated or budgeted." Finally, four additional "yes or no" responses are required. While no doubt exasperating for the colleges and universities receiving questionnaires, the laundry list is useful for practitioners who do not want inadvertently to overlook any business income sources that a client organization may receive. For example, a client may tell a practitioner that it derived advertising income from its monthly alumni magazine but neglect to mention advertising income from the internet. By inquiring about each of these activities specifically, a practitioner is alerted to any issues that need to be addressed, such as whether the income is related or unrelated or whether the income is debt financed.
Losses from Business Activities. The questions about unrelated business activities also asked whether an organization had losses in three of the past five years, i.e., 2001 through 2005. This question alerts the practitioner and the educational organization that recurring losses are of interest to the IRS. An activity that habitually generates losses may not be treated as a trade or business for tax purposes. If so, the organization cannot use the losses to offset unrelated business income from other activities. Also, if an activity that generates excessive losses does not contribute importantly to an organization's exempt function, the organization's exempt status might be in jeopardy if the activity is more than insubstantial.
Press Release IR-2010-58 (5/7/10).
Sample Compliance Questionnaire – Colleges and Universities.
Interim Report on Colleges and Universities Compliance Project.
Executive Summary of Interim Report (May 2010).
For more information, in the Tax Management Portfolios, see Stophel and Gorsline, 482 T.M., Tax Issues of Educational Organizations, and in Tax Practice Series, see ¶6510, Charitable Organizations and ¶6520, Other Tax-exempt Organizations.
2 The questions asked in the survey and the questions on Form 990, Return of Organization Exempt From Income Tax, overlap in some areas. The two documents, however, have different purposes, so items not addressed on the Form 990 are in the questionnaire, and vice versa.
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