Over the last two years, tax-exempt colleges and universities have become targets of increased scrutiny by the Secretary of Education, the Internal Revenue Service ("IRS") and the Senate Finance Committee. With the looming budget crisis and an ever-increasing deficit, regulators are taking a hard look at whether these institutions are providing the public benefits commensurate with the tax breaks they receive as a result of their tax-exempt status. As with other sectors in the nonprofit area, such increased scrutiny will most likely lead to audits, investigations, and possible legislative action.
This article addresses the recent actions taken by regulators, lessons learned from other nonprofit sectors that have faced similar increased scrutiny, and steps necessary to reduce the risk of audit and investigation.
Recent Actions
In September 2006, the U.S. Secretary of Education's Commission on the Future of Higher Education issued a report that called for urgent reform in higher education, including expanding access to colleges and universities, boosting affordability, streamlining the financial aid system, improving the quality of education, increasing transparency and accountability, and cultivating a culture of innovation and quality improvement.
Beginning in December 2006, the Senate Finance Committee took a number of actions that placed higher education institutions under the microscope. In a hearing titled "Report Card on Tax Exemptions and Incentives for Higher Education: Pass, Fail, or Need Improvement?," the Senate Finance Committee sought information on the types of activities that colleges and universities undertook in an effort to determine whether their tax-exempt status was warranted.
Nearly a year later, the Senate Finance Committee issued a questionnaire regarding endowments to 136 of the nation's wealthiest colleges and universities whose endowments were in excess of $500 million. The questionnaire had only 11 questions, which requested information regarding tuition and fees, financial aid, and detailed information regarding endowments, including how they are managed and the fees paid for such management.
This past September, Sen. Charles Grassley (R-Iowa) and Rep. Peter Welch (D-Vermont) convened a roundtable discussion titled, "Maximizing the Use of Endowment Funds and Making Higher Education More Affordable." Although no specific legislative proposals have resulted from these actions, Grassley has expressed an interest in mandating that wealthier colleges pay out 5 percent of their endowments.
The IRS also jumped on the higher education bandwagon by distributing a 33-page questionnaire to approximately 400 public and private four-year institutions across the country. The questionnaire requests information about the recipient's unrelated business income ("UBI") activities, endowments, and executive compensation. In addition, the questionnaire seeks information regarding the organization's operational activities, financial status, policies, affiliates and employees.
More specifically, the questionnaire focuses on the following topics:
- Endowment Funds: Institutions are required to provide information regarding the asset allocation, management, and distribution of endowment funds. Specifically, the IRS appears to be focusing in on the Board's investment policy and oversight exercised by the investment committee, the approval and employment of an outside party/consultant to manage the institutions endowment investments, and the process by which the organization compensates such party or consultant. Significantly, the questionnaire also requests information on an issue repeatedly raised by the Senate Finance Committee: what is the average amount of endowment funds per full-time equivalent student?
- Unrelated Business Income: Colleges and universities are required to disclose detailed information with respect to 47 activities that, in the IRS's view, are likely to generate UBI, such
as advertising, sponsorships, food services, credit card/affinity agreements, and facility rentals. Specifically, institutions must disclose how they report revenues and expenses from such activities; determine whether an activity is exempt or taxable (including whether they relied on the advice of independent accounting or legal professionals); and manage taxable activities. Institutions are required to provide additional information where these activities are conducted through a joint venture or are managed by an entity that is not exempt under Section 501(c)(3) of the Internal Revenue Code ("IRC").
