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IRS Details College and University Audit Issues


The IRS recently released its final report on its Colleges and Universities Compliance Project. The report details the types of audit adjustments that were made on examination of several colleges and universities that were subjects of the project. Unrelated businesses and executive compensation were among the major focuses. The stated rationales for the adjustments will be of interest to colleges and universities generally.

The IRS began the project in 2008 by distributing questionnaires to 400 randomly selected institutions. In 2010, the IRS chose 34 of the institutions for audit because the questionnaire responses indicated a potential for noncompliance. Because these audited schools were not selected at random but instead represented high audit potential, the adjustments made are not representative of educational institutions generally.

The IRS proposed unrelated business income tax (UBIT) adjustments for 90 percent of the audited schools. The IRS found that several schools claimed that some activities were "unrelated" that had chronic losses, which offset income from other unrelated business activities. The IRS held that the loss activities were not businesses because they lacked a profit motive, and it disallowed the losses. The IRS also found that costs of the schools' exempt educational activities had been improperly allocated to unrelated activities, reducing the income subject to tax. Net operating losses were a particular problem; many were found to be unsubstantiated. (Since net operating loss deductions may involve activities that took place several years in the past, it is important for institutions to preserve the relevant records.) Finally, the IRS found that some profitable activities had been classified as related, and thus not taxable, when they were in fact unrelated. Fitness centers, sports camps, facility rentals, arenas, golf, art galleries, hotels, conference centers, and radio stations were among the frequent areas of adjustment. In about 40 percent of the cases where an institution had received an outside opinion that an activity was related, the IRS disagreed on audit and treated the activity as unrelated.

The IRS also focused on executive compensation. A special excise tax on excessive pay is applicable in the case of private institutions. The burden of showing that compensation is not excessive may be shifted from the institution to the IRS if the institution performs a comparability study. The IRS found that many studies fell short because the institutions covered by the study were not comparable, because the study failed to explain why the schools had been deemed comparable, or because the studies did not specify whether they covered only salary or other types of compensation as well. Where an institution named in a study was found not to be comparable, it was because of location, endowment size, revenues, total net assets, number of students, and/or selectivity.

In the compensation area, the IRS found many errors, including failure to include in income personal use of automobiles, club memberships, and travel; misclassification of individuals as independent contractors instead of as employees; failure to withhold on wages paid to non-resident aliens; and failure to include in income certain graduate tuition waivers. The IRS also found several instances in which taxation of wages had been improperly deferred.

Although the IRS characterized the audits as "closed," there is no indication in the report that the affected institutions agreed with the audit findings.  IRS audit adjustments are often reduced by the courts and even by the IRS's own Appeals Office. Nevertheless, the report is a good indication of areas the IRS considers sensitive and the IRS's approach to auditing them. The IRS identified UBIT and compensation comparability studies as areas that it will be pursuing. It is particularly significant that institutions that sought to insulate themselves with a UBIT opinion or a compensation comparability study were often unsuccessful. Institutions should consider whether they are pushing the envelope, and the relevant officials or trustees should review these studies carefully for reasonability. Possibly, the opinions obtained, even if ineffective in preventing the IRS from proposing adjustments, helped to avoid imposition of penalties.

IRS Circular 230 Disclosure: To comply with certain U.S. Treasury regulations, we inform you that, unless expressly stated otherwise, any U.S. federal tax advice contained in this communication, including attachments, was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding any penalties that may be imposed on such taxpayer by the Internal Revenue Service. In addition, if any such tax advice is used or referred to by other parties in promoting, marketing, or recommending any partnership or other entity, investment plan, or arrangement, then (i) the advice should be construed as written in connection with the promotion or marketing by others of the transaction(s) or matter(s) addressed in this communication and (ii) the taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor. To the extent that a state taxing authority has adopted rules similar to the relevant provisions of Circular 230, use of any state tax advice contained herein is similarly limited.

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