IRS Exams Reveal Significant Underreporting Of Taxable Income by Colleges, Universities

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By Diane Freda  

Roughly 90 percent of the 34 colleges and universities the Internal Revenue Service examined for 2008 business activities unrelated to their tax-exempt purpose significantly underreported their taxable income--by about $90 million--IRS Director of Exempt Organizations Lois Lerner told exempt practitioners April 25.

The majority of adjustments pertained to fitness and recreation centers, sports camps, advertising, facility rentals, arenas, and golf courses, Lerner said at a Representing and Managing Tax-Exempt Organizations conference in Arlington, Va.

The examinations were an outgrowth of the Service's long-term college and university study, which previously explored the compensation and endowment practices of institutions that were sent a compliance check questionnaire in 2008 (88 DTR G-12, 5/10/10).

In total, IRS disallowed more than $170 million in losses and net operating losses, which could result in more than $60 million in tax liabilities for the affected organizations.

The findings were summarized in a long-awaited final report on colleges and universities released April 25.

Not a Legitimate Trade or Business

The underreporting primarily stemmed from poor practices, including claiming losses from activities that did not qualify as a trade or business, Lerner said.

An activity qualifies as a trade or business if, among other things, the taxpayer engaged in the activity with the intent to make a profit.

Nearly 70 percent of the examined colleges and universities reported losses from activities where expenses exceeded income for many successive years.

“Continual losses from activity year in and year out over a protracted period indicate a lack of profit motive,” Lerner said. “If you have a lack of profit motive you are not a business and it is not unrelated business income or losses and cannot be used that way.”

She cautioned that the report findings are not a statistically valid sampling and therefore cannot be extrapolated across all institutions. However, because the same issues may be present elsewhere across the tax-exempt sector, all exempt organizations need to be aware of the importance of accurately reporting unrelated business income and providing appropriate executive compensation, Lerner said in a news release (IR-2013-44) issued April 25.

Compliance Check Questionnaires Increasing

IRS has increasingly turned to the use of compliance check questionnaires to gather information about the exempt sector, including a more recent questionnaire that went out in March 2013 to all organizations that decided their own exempt status as tax code Section 501(c)(4) social welfare organizations, 501(c)(5) business leagues, or 501(c)(6) trade associations in 2010 and 2011.

While some practitioners have complained that those questionnaires were designed to force them into filing a Form 1024 (Application for Recognition of Exemption) and into getting IRS approval up front to begin operation as that type of organization rather than “self-declaring,” Lerner said it is her job to regulate the organizations, whether they come in for approval first or not.

Lerner said IRS needs to know whether the self-declarers--all exempts for that matter--are compliant and properly educated about IRS rules.

Generally, IRS gets a high response rate on the questionnaires, Lerner said, because the organizations know that if they do not respond, IRS might refer them for audit. “That's because when you are an organization manager, and you're weighing, 'Do I want to answer a questionnaire or do I want to get audited,' it's an easy question,” she said.

Basically she said there are two choices--respond to the questionnaire, or do not respond and take a chance that the organization will be referred for audit. However, she said that if the organization would prefer for IRS to get the information covered in the questionnaires through a more formal process, that is perfectly fine. There is no requirement that practitioners answer the questionnaire, she said.

Only a small number of audits result from the various types of compliance check questionnaires that are sent out, she said, and the exams mostly pertain to the organizations that did respond rather than the ones that did not.

Bruce Hopkins, a senior partner with Polsinelli Shughart, told the gathering earlier in the day that some of the questions on the questionnaire for the 501(c)4, 501(c)(5), and 501(c)(6) organizations appeared to be designed to trick the organizations into telling IRS what their real activities are. However, Judith Kindell, an IRS senior technical adviser, said the questions are designed to anticipate every possible answer the organizations might give.

On yet another compliance check questionnaire IRS sent out in 2012--this one to 2,000 parent exempt organizations with a subordinate group or chapter--Kindell said all of the 400 organizations that did not respond have been referred to IRS for examination.

By Diane Freda  

Text of the news release (IR-2013-44) is in TaxCore. Text of the Colleges and Universities Compliance Project Final Report is at


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