By Sarah Huang, CPA
Ninety percent of schools had underreported taxable income according to the statistics from the IRS’s final report on the College and University Compliance Project released at the end of April; $170 million in adjustments were made to net operating losses (NOLs). Wages increased $36 million, netting $7 million in taxes and penalties. The list goes on. But what does this really mean to the non-profit sector and what should you do about the results?
The IRS began its study on colleges and universities in 2008 with the goal of gaining a deeper understanding of the sector. Surveys were sent to 400 public and private colleges and universities around the country. A preliminary report came out in 2010 highlighting the initial results from the survey. Based on these preliminary findings, the IRS then chose 34 schools to audit. The results from these audits were released on April 25th of this year.
Before we dive into the key action steps from the report, it is important to first understand what the report does and does not mean:
- Doesn’t mean this is only applicable to colleges & universities. Although the findings are based on the audits for the college and university sector only, the issues addressed in these audits are issues many charities have. Charities outside the higher education sector should look at these findings to see what changes are needed for their own organizations. The IRS plans to look at unrelated business income (UBI) more broadly across the entire exempt organization sector.
- Does mean documentation is key. Lack of substantiation for NOLs had negative consequences to the schools audited. The IRS disallowed nearly $19 million of losses due to lack of substantiation or improper calculation. Without proper documentation, charities risk having the IRS create its own determination of what the amounts should be. This has the potential to result in unfavorable tax consequences.
- Doesn’t mean this is a statistical sample. The final report highlights various percentages from the audit results but it is important to remember that these percentages are not a statistical sample. While the report itself even mentions this, it is easy to gloss over and focus on the dollars and percentages. Just because 90% of the schools audited had adjustments to their UBI doesn’t mean your charity can expect an adjustment too.
- Does mean you may need to re-think your comparability data for compensation. The audits looked at how the schools determined compensation and the compensation surveys they used in the process. Some schools used data that wasn’t actually comparable or didn’t contain enough information to understand what the salary figures included (base compensation, benefits, etc.) The final report identified about 20% of the schools audited didn’t have proper comparability data.
- Doesn’t mean the schools actually owed more tax on Form 990-T. One thing the report doesn’t mention is the total tax dollars received from the NOL adjustments. The report indicates overall adjustments of $170 million to current year losses and NOL carryovers but doesn’t identify the current tax dollars resulting from this. Either the extra dollars received weren’t noteworthy or the schools still had large losses at the end of the day to offset the increases in taxable income. Most likely it is the latter.
- Does mean compensation is a hot topic and will continue to be. Of the 34 schools audited, the IRS netted over $7 million in taxes and penalties from wage adjustments. Unlike in the UBI section, the IRS wasn’t shy at highlighting the additional tax revenue generated. Wages were adjusted for a number of reasons including failure to include value of personal use autos, housing and club dues as well as misclassification of employees as independent contractors. Charities can expect this to be an area of continual IRS focus going forward.
Action Steps for Charities
Fitness centers, sports camps, advertising, facility rentals, arenas and golf courses were the UBI activities with the most adjustments. Some of these activities are exclusive to schools while others, such as advertising and facility rentals, can occur at any charity. If your charity has any of these activities, it may be worth taking a closer look.
The rules for UBI and compensation can be complex. The key action steps below will help your charity be one step closer to compliance with the issues identified by the IRS in the final report.
Check if Your UBI Activities Actually Meet the Definition
To be classified as UBI, an activity must meet three criteria: 1) a trade or business; 2) regularly carried on; and 3) unrelated to your exempt purpose. Activities that sustain losses on an annual basis have the potential to not meet the first requirement – trade or business. The IRS wants to see a profit motive and that the activity is conducted like a for-profit organization would. If your charity has losses reported on its Form 990-T, you may want to verify the activity meets all three criteria and that the reasoning is documented.
Verify 990-T Expense Allocations are Substantiated
Charities that allocate a percentage of expenses on the Form 990-T need to make sure the allocation is realistic. The IRS allows for a lot of flexibility in this area and many methods have been deemed acceptable. You can use square footage, hours, revenue, or any reasonable method. In the end, the key is making sure the allocation method is fully documented and a logical reasoning exists.
Review Employee Classifications and Taxability of Benefits
Sometimes individuals are hired and their role will change over time. If your charity has paid an individual as a contractor for a substantial period, it may be time to double check that the individual still meets the qualifications as an independent contractor and hasn’t crossed the employee line. Additionally, if an individual receives both a 1099 and a W-2 from your charity, this should be scrutinized and well documented.
Evaluate if Your Comparable Salary Data is Actually Comparable
Charities should carefully evaluate the data gathered in the compensation evaluation process. Comparable data should actually be comparable. The IRS has noted many charities rely on the rebuttable presumption of reasonableness standards when determining compensation. This means charities can shift the burden of proving unreasonable compensation to the IRS if the following three steps have been taken:
- Use an independent body to review and determine compensation data in advance of the actual payment;
- Use appropriate comparability data to set compensation; and
- Document the compensation process contemporaneously.
If the comparability data in step 2 is not actually comparable, the charity will then fail to shift the burden of proof.
Conduct Your Own UBI Survey or Mock IRS Audit
It may seem crazy to pretend an IRS agent shows up at your door but it is better to be prepared than be caught off guard. Your CPA can help you identify areas are of concern and help create proper documentation to prepare in advance for an IRS audit. This could include interviewing key department heads to uncover unrelated activities, doing a walk through to see what is actually occurring in the facility, exploring your charity’s website for potential UBI activities, or reviewing the expense allocations in detail to ensure proper substantiation exists.
All charities, not just colleges and universities, will be impacted by the results of this study. Charities should carefully review their records and the action steps above to be prepared in advance of an IRS audit. A full report has been issued by the IRS along with other documents released during the study.
© Clark Nuber PS, 2013. All Rights Reserved