United States: IRS To Audit Colleges And Universities - A "Lesson Plan" On Preparing For The IRS

Last Updated: August 20 2009
Article by Gerald M. Griffith, James R. King and Janice M. Smith
Most Read Contributor in United States, September 2019

Last fall, the IRS distributed a compliance questionnaire to approximately 400 colleges and universities nationally. As a follow-up to those questionnaires, the IRS is now prepared to undertake examinations (audits) of several institutions based on the responses submitted. Whether or not your institution received a questionnaire or is selected for a follow-up exam, the focus of the upcoming exams can serve as a "lesson plan" to prepare your institution for increased IRS scrutiny across the higher education sector.

IRS Interest in Colleges and Universities

The college and university compliance project is following the same general path as the previous hospital compliance project. Higher education, like health care, garners much interest from the IRS because of the significant dollars represented in the sector.

Now that the college and university project questionnaires have been completed and substantially returned by those who received them, the next steps involve the commencement of IRS examinations based on the responses received and the release by the IRS of an interim report. The interim report, which IRS officials anticipate will be released by the end of 2009, is expected to mirror the hospital project interim report, in that the content will consist primarily of raw data rather than substantive analysis.

Two Anticipated Focal Points of Follow-up Exams—Executive Compensation and UBI

On June 11, 2009, at the AICPA National Not-for-Profit Industry Conference, Ronald J. Schultz, Senior Technical Advisor, Tax Exempt and Government Entities Division of the IRS, and Nikole C. Flax, Senior Tax Law Specialist at the IRS, discussed the upcoming college and university exams. Specifically, they discussed two anticipated focal points of the follow-up exams—executive compensation and unrelated business income ("UBI").

Executive Compensation. The compliance questionnaire sought detailed information from colleges and universities on their six highest paid officers, directors, trustees, and key employees. Some questions focused solely on loans and extensions of credit to the institution's top executives. Private institutions were required to disclose significant detail regarding their compensation review and approval process, including whether they have a formal written compensation policy for setting executive compensation; whether they retained the services of an outside executive compensation consultant to provide comparable compensation data, and, if so, whether the consultant provided other services to the institution; and what factors were included in compensation analyses.

The compliance questionnaire also asked institutions to report whether they used the rebuttable presumption procedure to determine the compensation of their top executives, and whether any fixed payments to those persons were made pursuant to the initial contract exception.

At the AICPA conference, Ms. Flax noted that the IRS will be looking closely at comparability data used in setting executive compensation, as well as usage of the initial contract exception to the intermediate sanctions rules for "excess benefit transactions" under section 4958 of the Internal Revenue Code (the "Code").

Comparability Data. According to Ms. Flax, the IRS is interested in the comparability data percentile that was used by institutions to establish compensation, and the usage of percentile ranges generally by the institution (for example, whether every executive compensation arrangement is based on the 95th percentile); what comparability data was used and whether it was truly comparable; and whether comparability data from the for-profit sector was used, and, if so, the impact of that data on establishing a compensation amount (for example, the impact of using equity-based compensation among the comparables).

The IRS is interested in practices and trends related to the quality of comparability data used by exempt organizations because reliance on appropriate comparability data is a necessary step in establishing a "rebuttable presumption" that compensation paid by the organization is reasonable. Specifically, section 4958 of the Code establishes a procedure by which certain tax-exempt organizations may establish a "rebuttable presumption" that any benefit the organization provides (including compensation) to a disqualified person is reasonable. Disqualified persons are generally those individuals who, any time in the last five years, were in a position to exercise substantial influence over the affairs of the organization, such as directors, officers, or other individuals who supervise the management, administration, operation, or finances of the organization or its activities.

Three elements are necessary to trigger the rebuttable presumption. First, providing the benefit to the disqualified person must have been approved by an authorized body composed entirely of individuals who do not have a conflict of interest with respect to the transaction. Second, prior to making its determination, the authorized body must have obtained and relied upon appropriate data to determine that providing the benefit was reasonable in exchange for the disqualified person's services. Third, the authorized body must have adequately and timely documented the basis for its determination concurrently with making that determination. If the conditions for the presumption are satisfied, the burden of proof shifts to the IRS to demonstrate that the amounts paid were unreasonable.

Initial Contract Exception. Also, the IRS may look at what percentage of executive compensation arrangements in an institution were subject to the initial contract exception under the intermediate sanctions rules. By way of background, section 4958 of the Code does not apply to any fixed payments made by an organization to a disqualified person pursuant to an "initial contract." An initial contract is a binding written contract between an applicable tax-exempt organization and a person who was not a disqualified person immediately before entering into the contract. It may be, but is not necessarily, the first contract with the institution. In some institutions, even though the initial contract exception may apply, the institution may (for transparency and fiduciary duty reasons) still choose to follow the rebuttable presumption process set forth in the intermediate sanctions rules—that is, having compensation reviewed by an authorized body, using appropriate comparability data, and documenting the decision-making process.

Unrelated Business Income

The compliance questionnaire contained various questions relating to an institution's potentially UBI-generating activities. At the AICPA Conference, Mr. Schultz highlighted potential areas of interest for the IRS in the upcoming college and university exams in connection with UBI—controlled entity issues, transfer pricing methods under section 482, and expense allocations.

Controlled Entity and Transfer Pricing Issues. By way of background, controlled entity issues arise under section 512(b)(13) of the Code, which generally treats otherwise excluded rent, royalty, annuity, and interest income as UBI if such income is received from a controlled subsidiary (direct or indirect ownership of more than 50 percent). Before 2010, however, this general rule applies only to the portion of payments received or accrued in a tax year that exceeds the amount of the payment that would have been paid or accrued if the payment had been determined under section 482 (which generally allows the IRS to allocate income and deductions among controlled entities—or "reprice" arrangements—if the terms of an arrangement are other than arm's length). The purpose of this rule is to prevent a tax-exempt organization from inappropriately sharing the benefits of its tax-exempt status with taxable entities.1

The IRS had asked four questions of colleges and universities on the compliance questionnaire related to transactions with controlled entities—(1) to identify any arrangements for which the institution had a written policy designed to ensure that transactions with non-501(c)(3) related organizations (whether taxable or tax-exempt) are made at arm's length; (2) to identify any items of income for which the institution had a written policy that established arm's length assurances when such amounts were paid or accrued to the institution from a controlled entity; (3) to describe how the institution determined pricing in its dealings with related organizations; and (4) to identify the number of entities controlled by the institution within the meaning of section 512(b)(13).

Undoubtedly, the responses to the above questions will provide insight to the IRS into this important aspect of unrelated business income for purposes of the upcoming follow-up exams.

Expense Allocations. The compliance questionnaire also had requested various items of information relating to expense allocations. Institutions were asked to describe their expense allocation method for each activity reported on their Form 990-T, to provide a breakdown of direct versus indirect expenses shown on Form 990-T, to identify the UBI activities that resulted in the largest losses on Form 990-T, and to provide a breakdown of intercompany expenses versus other expenses. According to Mr. Schultz, expense allocations are of interest to the IRS and are expected to be targeted on the college and university exams because the reporting of UBI losses, or zero net UBI, is common on Form 990-T. It is not unusual on audit for the IRS to assert underreporting of net UBI based on alleged lack of a profit motive due to losses (which should not be determinative alone) or misallocation of dual use expenses or overhead.

IRS Selection of Exam Targets

At the AICPA conference, Mr. Schultz emphasized that the upcoming exams will not be traditional exams based on regular risk assessment. In other words, it is not necessarily the amount of a potential adjustment that will guide the IRS in the audit target selection process. For example, the IRS may be more interested in learning about how a particular institution uses comparability studies to establish executive compensation than the actual amount of a potential adjustment, if any, for payment of excessive compensation by the institution. That data may in turn shape future policy decisions such as the scope of Form 990 reporting required of colleges and universities.

Also, Mr. Schultz explained that some organizations may be selected for a follow-up exam on the basis of UBI, but they will also be examined for executive compensation. Likewise, some organizations may be selected for an exam on the basis of executive compensation, but they will also be examined for UBI. (Public institutions, however, were not required to answer questions on executive compensation and will not be subject to examination on executive compensation.)

A "Lesson Plan" on Preparing for the IRS

As stated above, whether or not your institution received a questionnaire or is selected for a follow-up exam, the focus of the upcoming exams can serve as a "lesson plan" to prepare your institution for increased IRS scrutiny across the higher education sector. The following are some ways that you can prepare your institution:

Executive Compensation

  • Analyze the comparability data that your institution uses in order to establish executive compensation. Perhaps consider modifying current compensation policies to provide such guidance as to how comparability data should be chosen and obtained, how outside consultants should be selected, how the data should be interpreted (based on what factors), how percentile ranges are to be used, and how for-profit comparability data should be considered. Taking additional time in obtaining and interpreting comparability data, and considering the impact of your policies regarding comparability data on overall executive compensation, should create a more defensible position with the IRS if the institution's executive compensation is ever brought under scrutiny.
  • Ascertain the number of executive compensation contracts for which your institution has relied on the initial contract exception, and, if appropriate, consider adapting compensation policies to specifically address the handling of initial contracts.

Unrelated Business Income

  • Undertake an internal audit to (1) identify all controlled entities, (2) identify all of the institution's financial arrangements with those controlled entities, and (3) assess whether the pricing methods used to establish payments from controlled entities are based on arm's length, fair market value principles.
  • Review all expense allocations used in preparation of Form 990-T, with particular emphasis on the allocation of indirect expenses. For example, be sure to ascertain whether a particular method of allocating indirect expenses that perhaps has been used for many years still provides an appropriate basis for allocation.

Footnote

1. On August 4, 2009, final regulations under section 482 were published (74 Fed. Reg. 38830). The regulations generally apply to tax years beginning after July 31, 2009. Among other things, the regulations address shared services arrangements. While the regulations are somewhat lengthy and complex, they generally provide, among other things, that if a taxpayer reasonably concluded that a shared services arrangement allocated costs for covered services on a basis that most reliably reflects the participants' respective shares of the reasonably anticipated benefits attributed to the services (as evidenced by appropriate documentation as described in the regulations), then the IRS may not adjust the allocation basis. Treas. Reg. § 1.482-9(b)(7). Other provisions would protect low-margin covered services that have a median comparable markup of seven percent or less. Treas. Reg. § 1.482-9(b)(3)(ii).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions