On April 25, 2013, the IRS released its Colleges and Universities Compliance Project Final Report (revised May 2, 2013), which stated the Service's plan to look at how nonprofits across the sector report unrelated business income (UBI) and use comparability data in setting compensation. The Report's Executive Summary concluded:
The examinations of college and universities identified some significant issues with respect to both UBI and compensation that may well be present elsewhere across the tax-exempt sector. As a result, the IRS plans to look at UBI reporting more broadly, especially at recurring losses and the allocation of expenses, and to ensure, through education and examinations, that tax-exempt organizations are aware of the importance of using appropriate comparability data when setting compensation.
Unrelated Business Income
90 percent of the examined institutions underreported UBI. The Report cited the following primary reasons:
- Reporting losses as connected to unrelated business activities when they were not. Even though the institutions had losses, these were recurrent losses originating from activities that were not conducted with a profit motive and could therefore not meet the trade or business requirement.
- Misallocating expenses that were used to carry out both exempt and unrelated business activities and then applying an excessive proportion to offset UBI.
- Miscalculating net operating losses.
- Reporting unrelated business activities as exempt activities, thereby not properly reporting the income from such activities as UBI.
The majority of adjustments to UBI reporting came from the following activities: fitness, recreation centers and sport camps; advertising; facility rentals; arenas; and golf. Advertising and facility rentals are common sources of revenues for many nonprofits. It would be wise for many organizations to ensure that they understand how to classify income from these activities by conferring with a knowledgeable professional.
Compensation
The executive compensation component of the examinations focused on compliance with Section 4958 of the Code (excess benefit transactions). The regulations under this Section set forth a process by which organizations can obtain a rebuttable presumption that compensation paid is reasonable. This process involves the use of comparability data.
The Report identified a number of weaknesses in the comparability data relied on by colleges and universities to establish the rebuttable presumption:
- Comparisons were made with organizations that were not similarly situated to the institution being examined.
- No documentation was maintained regarding the selection criteria for comparable organizations.
- Compensation surveys were used that were not limited to comparable organizations.
- Compensation surveys were used even though they did not specify whether the compensation reported was for salary only or for total compensation (including benefits).
The Report also noted other problems:
- Failure to include in income the value of the personal use of automobiles, housing, social club memberships and travel.
- Misclassification of employees as independent contractors.
- Failure to withhold taxes for wages paid to non-resident aliens.
- Failure to include in income the value of certain graduate tuition waivers and reimbursements.
We encourage all charitable nonprofits to recognize and address these issues in order to comply with applicable laws and avoid the penalties and stress that may result from a difficult and embarrassing audit.
Revised May 2, 2013