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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.
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Activities and Unrelated Business Income
The activities section of the questionnaire includes questions about advertising sources, corporate sponsorships, rental activities, sales activities, travel tours, broadcast rights, affinity credit cards, mailing list rentals, royalties, patents, and the operation of various facilities. For purposes of the Interim Report, the data pertains to the extent to which the institutions engaged in the listed activities. The final report will address the extent to which the institutions reported unrelated business income from the activities. Activities other than the specific activities listed on the questionnaire reported by the institutions will also be discussed in the final report.
Large organizations reported the highest percentage regarding the conduct of activities that generate unrelated business taxable income. The most common business activities were advertising and facility rental. Eighty-two percent of large institutions engaged in advertising activities. Only 15% of large institutions engaged in internet advertising, a statistic likely to have increased by 2010. For small institutions, 23% engaged in advertising activities.
Seventy-six percent of large institutions, 52% of medium institutions, and 33% of small institutions engaged in corporate sponsorship activities. Corporate sponsorship activities included printed materials, events, internet, facilities, and TV and radio broadcasting.
Significant numbers of institutions engaged in rental activities, from 96% of large institutions to 67% of small institutions. The categories of rentals were facilities, arenas, recreation centers, athletic facilities, personal property, telecommunications related or broadcast tower, and other rentals.
Of the other listed activities on the questionnaire, the most common for large universities were logo usage, operation of conference center, patents, royalties (other than oil and gas), catering services, food services, parking lot operations, and bookstores. Other significant activities were internet sales, travel tours, commercial research, copyrights, trade names, or trade secrets, operation of restaurants, and computer services. Relatively few of the small organization engaged in any of the other activities. For example, the most common activities reported by small institutions were catering services, food services, parking lot operations, and bookstores. Eleven percent of small institutions received oil and gas royalties, income from affinity cards, and other (not from oil and gas) royalties. For most of the other activities, only 0% to 6% of small organizations were involved.
Form 990-T, Exempt Organization Business Income Tax Return, is used by exempt organizations to report their unrelated business taxable income. Only 4% of large organizations had never filed a Form 990-T. Twenty-nine percent of medium institutions and 48% of small institutions had never filed a Form 990-T.
Several questions in the survey pertained to indirect expenses. Whereas direct expenses can be allocated to the activities to which they directly relate, indirect expenses, such as overhead, often have to be allocated among several exempt and nonexempt activities. To the extent an exempt organization allocates too much of an indirect expense to exempt activities, there will be an understatement of the organization's unrelated business taxable income. The questionnaire first looked at how many colleges and universities reported having indirect expenses on Form 990-T. The percentages of institutions reporting indirect expenses greater than zero were 80% for large institutions, 60% for medium institutions, and 56% of small institutions. The average percentages of indirect expenses compared to total expenses for large, medium, and small institutions were 28%, 27%, and 34%, respectively.
In contrast to indirect expenses, less than 20% of all institutions reported inter-company expenses. Additional analysis regarding inter-company expenses will be conducted to compare the percentages reporting inter-company expenses with the percentages reporting having one or more related organizations.
Topics covered in the questionnaire regarding endowment funds pertained to the amount of the endowment, the manner in which the endowment funds are invested, management of the endowment, and uses of endowment funds.
Almost all colleges and universities reported that they either held endowment funds or that another organization maintained endowment funds on their behalf. The data from 2006 with respect to the average and median endowment fund values does not reflect the current values. The target spending rate for all three categories is 4.7% to 5%.
With regard to the management of the endowment funds, most institutions had external parties to manage their funds. Some had in-house investment committees or management by related entities. Almost all institutions had an endowment fund investment policy. Most institutions had investment committees which selected external fund managers. The average size of investment committees ranged from seven to twelve individuals.
The compensation paid to endowment fund managers seems to be a topic of interest to the IRS. Most institutions using internal fund managers compensated the managers with a salary. In contrast, for external fund managers the most common form of compensation was asset-based fees. In most cases, compensation arrangements for external managers were approved by a committee or by the full board.
The institutions answered specific questions about the composition of their endowment funds. Almost all of the respondents had interests in U.S. fixed income funds and U.S. and non-U.S. equity funds. About half of the endowment funds invested in real estate. From 44% to 78% of the endowment funds held alternative investments, such as hedge funds or venture capital funds. The percentages of institutions with international investments are 82%, 67%, and 53%, respectively, for large, medium, and small organizations. The survey also gathered data about the percentages of their total endowment funds that were invested in each type of asset.
The Interim Report contains data regarding distributions from endowment funds of colleges and universities. Almost all colleges and universities make distributions for scholarships, awards, grants, or loans. Well over half of the institutions made distributions for general education support or libraries. Of large, medium, and small institutions, 64%, 23%, and 14%, respectively, distribute funds for research. Almost all institutions reported that they monitored distributions to make sure they were being used for the intended educational purposes.
Each respondent was required to provide information about its highest paid officers, directors, trustees, and key employees. Questions pertained to their compensation and benefits and to transactions between the individuals and the institution. No doubt the IRS will closely examine the compensation data to look for any indications of excessive compensation.
The average compensation paid to an officer, director, trustee, or key employee by a large institution was $428,000 (median $361,999). In contrast, the average compensation paid by small institutions to an officer, director, trustee, or key employee was $202,000 (median $174,000). The institutions also indicated the forms of remuneration paid to at least one of their officers, directors, trustees, or key employees (referred to as ODTKEs). Numerous types of compensation were reported in addition to a base salary. Examples are bonuses, employee benefit plans, life, disability and long-term care plans, personal use of organization vehicles, housing and utilities, and health and social club dues. Only 28 of the total number of respondents provided loans to ODTKEs.
What Practitioners Can Learn from the Interim Report
The Interim Report contains much information that will be of interest to practitioners who represent colleges and universities as well as to college and university managers. For a number of purposes, it is helpful to know where a particular institution stands compared to comparable institutions. For example, the compensation data for medium-sized colleges and universities would help another medium-sized institution in evaluating compensation arrangements for its present and future managers. While the Report sets forth the raw data from many areas of the questionnaire, however, it does not contain much analysis of the data. Thus, for the most part, practitioners will await the final report to find out what changes the IRS will make in response to the questionnaire.
There are a few likely conclusions that can be drawn from the data contained in the Interim Report. For example, based on the inconsistencies in the data pertaining to controlled organizations, the IRS will view this area as deficient in compliance. Issues that are likely to come under scrutiny are transactions between colleges and universities and their controlled organizations, policies and statutes pertaining to arm's-length transactions, and reporting of income from controlled organizations under §512(b)(3). The IRS is also likely to examine closely the reporting of unrelated business income from the various activities listed on the questionnaire.
Practitioners may be surprised to learn that more than 60% of institutions in all categories do not rely on outside advice for unrelated business income issues and inter-company pricing between the organizations and related entities. This is a somewhat surprising statistic, given the complexity of the exempt organization rules and the importance of maintaining tax-exempt status and avoiding intermediate sanctions. Some larger institutions have their own counsel and small organizations may receive pro bono assistance from board members who are attorneys or accountants. Nevertheless, the data shows that a good number of exempt colleges and universities could benefit from professional guidance in their operations and reporting.
The compliance project for colleges and universities is in its final phase. The IRS audits of the selected organizations are in progress. After completing the examinations and further analyzing the collected data, the IRS will issue a final report. The final report will describe and analyze the findings of the project and discuss changes planned by the IRS to improve compliance and reporting by exempt colleges and universities. Meanwhile, exempt colleges and universities and their representatives can begin work on correcting prior improper practices or reporting based on the content of the questionnaire and the Interim Report.
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.
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