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IRS Final Report on Tax-Exempt Colleges and Universities Compliance Project—Compensation Issues

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The Internal Revenue Service (IRS) issued its final report last year summarizing the audit results from its college and university compliance study, which began in 2008.  The final report focuses on two primary areas:  reporting of unrelated business taxable income (UBTI) and compensation, including employment tax and retirement issues.  A previous article summarized the UBTI reporting issues identified in the report. This article focuses on the compensation, employment tax and retirement issues identified in the final report.

As part of the Tax-Exempt Colleges and Universities Compliance Project, the IRS distributed detailed questionnaires to 400 randomly selected colleges and universities.  The IRS selected 34 of these institutions for examination because their questionnaire responses and Form 990 reporting indicated potential non-compliance in the areas of UBTI and executive compensation.

The executive compensation component of the IRS exams focused mainly on reasonable compensation issues under Section 4958 of the Internal Revenue Code.  Section 4958 provides for an excise tax on officers, directors, trustees and key employees (ODTKEs) who receive payment of unreasonable compensation.  An excise tax can also be imposed on those that approve an unreasonable compensation arrangement.

An organization can shift the burden of proving unreasonable compensation to the IRS by following these rebuttable presumption procedures:

  • Use of an independent body to review and determine the amount of compensation;
  • Reliance on appropriate comparability data to set the compensation amount; and
  • Contemporaneous documentation of the compensation-setting process.

While most of the organizations examined attempted to meet the rebuttable presumption standard, approximately 20% of them failed to do so because of problems with their comparability data including:

  • Use of institutions as comparables that were not similarly situated to the school relying on the data based on at least one of the following factors:  location, endowment size, revenues, total net assets, number of students and selectivity
  • Compensation studies that did not document the selection criteria for the schools included, and did not explain why those schools were deemed comparable to the school relying on the study
  • Compensation surveys that did not specify whether amounts reported included only salary or included total other types of compensation, as required ty Section 4958

In addition, many of the examined colleges and universities relied on a survey completed by an independent firm in which their compensation data was included; however, the survey itself was not limited to schools that were sufficiently comparable.

In addition to the comparability issues identified, the IRS also initiated employment tax examinations on 11 of the colleges and universities that were examined.  All of the completed employment tax examinations resulted in adjustments.  Reasons for the adjustments included the following:

  • Failure to include in income the value of personal use of autos, housing, social club dues
    and travel;
  • Misclassification of employees as independent contractors;
  • Failure to withhold taxes for wages paid to nonresident aliens; and
  • Failure to include in income the value of certain graduate tuition waivers and reimbursements.

The IRS also opened retirement plan examinations at eight of the universities and colleges being examined, which resulted in deferred compensation-related wage adjustments including:

  • Contributions to 457(f) plans that needed to be included in income, as the payments were not conditioned upon future performance of substantial services (e.g., there was no substantial risk of forfeiture); and
  • 403(b) plan loans, deferrals and additions that exceeded Internal Revenue Code limits.

Based on these audit results, we recommend the following action items:

  • Education institutions should review and document compensation comparability data to ensure they are using similarly situated institutions for comparison when setting compensation for ODTKEs.
  • Organizations should also review the taxability of benefits to ODTKEs to ensure all taxable items are included in wages.

Disclaimer: Any written tax content, comments, or advice contained in this article is limited to the matters specifically set forth herein. Such content, comments, or advice may be based on tax statutes, regulations, and administrative and judicial interpretations thereof and we have no obligation to update any content, comments or advice for retroactive or prospective changes to such authorities. This communication is not intended to address the potential application of penalties and interest, for which the taxpayer is responsible, that may be imposed for non-compliance with tax law.

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