The IRS announced it is nearing completion of a five year long compliance project involving tax-exempt colleges and universities. The project, which began with questionnaires to 400 randomly-selected institutions, focused on reporting of executive compensation and unrelated business income. The IRS’s findings provide warning to all non-profit colleges and universities regarding their process to establish and report executive compensation.
In its analysis of executive compensation, the IRS found most universities attempted to avail themselves of the “safe harbor” to Section 4958 of the tax code. Section 4958 provides for certain intermediate sanctions on tax-exempt institutions when revocation of tax-exempt status is not an appropriate remedy. Under the safe harbor, a presumption of reasonableness is given to compensation decisions if:
- The decision came from the review and consideration of an authorized body of the institution, whose members were free of any conflict of interest;
- Appropriate comparability data was relied upon in the decision; and
- The compensation-setting process is documented contemporaneously.
Unfortunately for numerous schools, the IRS found their attempts to use the safe harbor deficient. The IRS concluded the safe harbor should not apply for 20% of the reporting institutions because of issues with their comparability data. Common problems included use of schools that were not similarly situated, failure to document the selection criteria of comparable universities and use of compensation surveys with incomplete disclosure of information.
As a direct outcome of the IRS compliance project, 34 colleges and universities were selected for examination. One-third of these institutions were further reviewed for employment tax returns. Each of the completed audits resulted in an adjustment of wages leading to tax assessment and, in some cases, penalties. To date, the wage adjustments arising from the project total approximately $36 million and the additional taxes and penalties total $7 million.
The higher education community will face more sophisticated and targeted review of compensation reporting of their senior leadership and well-paid coaches as the IRS sharpens its toolkit with the lessons learned from the compliance project. In addition to Section 4958 compliance, universities must be alert to the tax treatment accorded certain types of compensation and benefits. The IRS report cites several areas as cause for wage adjustments, including failure to recognize personal use of certain perquisites as income (such as cars, housing, travel and social clubs), misclassification of employees as independent contractors, failure to withhold taxes for wages of non-resident aliens, and failure to include income from the value of certain tuition waivers and reimbursements.
All non-profit educational institutions should have their executive compensation philosophy and reporting process evaluated in light of the report’s findings. Failure to address the deficiencies noted by the IRS could result in penalties to the board members who authorized the compensation package, as well as senior administrators or athletics personnel paid such funds.