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Colleges Face Tax Challenges From the IRS

May 13, 2010

The IRS released findings last week from their 2008 survey of U.S. colleges and universities. The survey scrutinized college finances, looking for discrepancies between their financial activities and what they report to the government. The agency found a number of compliance issues that have already led them to begin auditing over 30 institutions.

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Calculating Taxes

In 2008, the IRS sent out a survey to 400 public and private postsecondary institutions. The 42-page survey is part of their ongoing effort to keep a closer eye on the finances of non-profit and tax-exempt organizations. It asked for details of financial activities such as compensation for executives and profit from business ventures in order to uncover any discrepancies between institutions' finances and what they're reporting to the government.

Last week the agency released preliminary findings based on data from 344 colleges and universities. Some schools from the original sample failed to respond, others fell outside of the target type of institution or responded together as part of a university system. The sample for the current report includes institutions of all sizes, 177 of which are private and 167 of which are public. The report does not include the names of any specific schools.

Educators Salary

Setting Top Salaries

One of the issues that originally caught the attention of the IRS was the question of 'executive compensation.' In the case of colleges and universities, this refers to the salaries of top employees such as chancellors and presidents.

From the Internal Revenue Service

From the IRS Exempt Organizations Colleges and Universities Compliance Project interim report, page 55.

As the graph above shows, the larger the institution, the greater reported compensation for their highest-paid ODTKE (short for 'officer, director, trustee and key employee').

Part of the tax code governing private organizations dictates that executives can't receive 'excess benefits,' defined as economic benefits that 'exceed the value of consideration received by the organization.' In other words, an executive shouldn't be able to benefit from an organization's tax-exempt status by drawing a salary that's in excess of their role in the organization. That's best defined by comparing executive salaries to those paid by peer institutions. Private colleges and universities can actually be subject to a tax penalty if they pay their top employees more than those at comparable institutions.

The report shows that 45% of small private colleges and 38% of large private institutions indicated that they were not following IRS guidelines in determining compensation for their highest-paid employees. The agency notes that the fact that very few institutions are using independent surveys of peer institutions to determine salaries may be contributing to the problem.

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Institutions Failing to Report Income From Business Activities

Certain enterprises are built into the structure of most colleges and universities: bookstores, facilities rentals, food service and catering, etc. The IRS survey explored how institutions are reporting profits or losses from these activities. If an activity loses money or can be defined as part of the 'core mission' of the college, then it is exempt from taxes. Although many such activities fall outside of the exempt categories, the survey found that almost half of small colleges had never filed any forms reporting these activities.

The separate business ventures of postsecondary institutions were another major concern when the IRS set out to study college finances. The report confirms that many public and private schools are involved with business activities that they're not reporting as taxable income. Even though the institutions themselves are tax exempt, they must report income from private business ventures in which they have a controlling interest.

Large colleges and universities, defined as those with over 15,000 students, were the most likely to report being engaged in any 'unrelated business activity' - 45% indicated that they had a controlling interest in a separate business. These included a wide range of ventures, such as academic foundations or the development of commercial applications for university research. Yet out of that group, only 26% reported receiving any income from their separate businesses.

The report notes that there may be many cases where institutions truly earned no reportable income from such ventures. But the extreme discrepancy between the number of schools that have separate business activities and those reporting income from those activities suggests that there's a failure to accurately report taxable income.

Colleges and Universities

The IRS report indicates that, as with executive salaries, most institutions have failed to seek third-party assistance to determine correct reporting procedures. Over 60% of all the respondents indicated that they had not sought the advice of an independent accountant or the institution's general counsel on the issue of business income.

These findings suggest that many of the compliance issues may simply come from ineffective bureaucracy rather than a malicious attempt to avoid taxes. Nevertheless, the problems need to be corrected, not simply to get colleges and universities back in tax compliance, but also to rehabilitate the fiscal reputation of higher ed. U.S. Senator Charles E. Grassley, (R) Iowa, has spearheaded the federal examination of tax-exempt organizations. He and other members of Congress have indicated that it's time for colleges and universities, as well as other non-profit organizations, to be more fiscally accountable to the public.

After this survey, many postsecondary institutions will be held accountable. The IRS is already conducting an audit of 30 organizations, 13 of which are schools that never responded to the initial survey. The agency plans to release a second, more detailed report after the audits are complete.

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