Bertrand M. Harding Jr.
Bertrand M. Harding Jr. Law Offices
bharding@erols.com

Marilee J. Springer
Ice Miller LLP
marilee.springer@icemiller.com

Reading Between the Lines of the
Compliance Questionnaire:
What Substantive Guidance Does it Provide?

         As most institutions are aware, in late 2008 the IRS sent a Compliance Questionnaire to approximately 400 public and private colleges and universities.  According to an IRS press release, the primary purpose of the questionnaire was, "to identify issues and areas that may need more outreach and education or further scrutiny."  IRS officials have publicly stated that, after they have a chance to review and analyze the responses, they plan to audit a number of the recipient institutions.

         What will the IRS be looking for in these follow-up audits?  This is a question that is not only important to those schools responding to the questionnaire but to all colleges and universities that are interested in tax compliance.   Interpreting the substantive positions of the IRS from the questions posed is a bit tricky, but it appears that the IRS will be looking at the following areas: 

• Identification of Potential Unrelated Activities.   The questionnaire lists 44 different activities, ranging from advertising to travel tours to parking lot operations, and asks the school to indicate whether it conducts the particular activity.  If it does, the school is then asked whether it treats any of the income as UBI.  In this manner, the IRS can quickly identify those activities with the highest UBI potential (e.g., travel tours, golf course operations, exclusive use contracts) and determine whether the school treats any income from the activity as UBI.  This is information that cannot be gleaned from the school's Form 990-T, which only reports those activities that the school chooses to treat as unrelated.  Thus, schools should carefully examine the "no UBI" activities checked on the questionnaire to ensure that they have a valid basis for such treatment.
  
  
• Loss Activities.   The questionnaire is structured in such a way to capture situations where the school incurred a loss on an activity in at least three out of the prior five years and reported that loss on its Form 990-T.  Using losses on unrelated activities to offset income from other activities has been a major IRS concern for many years.  This concern is underscored in a recently released IRS statistic that 45 - 55% of the Forms 990-T received from colleges and universities show a net loss.  Thus, schools that indicate that they have claimed loss deductions for activities that have failed to generate a profit in at least three out of the last five years are at greater risk for additional attention from the IRS in regards to whether the losses were related to a "trade or business" and were appropriate to offset other unrelated income.
  
  
• Cost Allocations.   For decades, the IRS has been concerned about the manner in which tax-exempt organizations allocate costs for UBI purposes, but has provided very little, if any, useful guidance in this area.  The questionnaire asks the school to identify the formula it uses in making its cost allocations (e.g., gross receipts, actual time) and, in addition, requires the school to identify the percentage of direct and indirect costs that are allocated to all activities reported on the Form 990-T.  It is difficult to determine what the IRS might do with this information. It may be used only to gather internal background and statistical information, or it may be that the IRS has some kind of an informal bright line safe harbor percentage for indirect expenses and that schools exceeding this percentage will receive a follow-up inquiry and even an audit.
  
  
• Related Party Arrangements.   The questionnaire includes questions relating to whether a school has policies and procedures that govern pricing of transactions with its affiliates (e.g., the provision of facilities, personnel and assets).  These questions, and the resulting disclosures, trigger at least three sets of risks:  (a) Is the school allowing its assets to be used by a for-profit affiliate for less than fair market value (i.e., private benefit or private inurement concerns); (b) Does a taxable affiliate have unreported (or deemed) income from assets it receives from the school for less than fair market value; and (c) Does the school have unreported UBI from interest, rents, royalties or annuities it received or accrued from an affiliate for purposes of Code Section 512(b)(13)?  In any event, these questions may serve as a starting point as schools develop policies and procedures that govern their relationships with affiliates in the future.
  
  
• Executive Compensation.   Much of the questionnaire is devoted to requesting traditional information on different components of executive compensation, including base salary, retirement plan contributions, and taxable and nontaxable fringe benefits.  More interesting are the questions directed at payments made to the executives by third parties and loans made by the college or university to these key employees.  Schools reporting third party payments and/or loans would seem to be more likely to receive follow-up inquiries and examination than those reporting what might be viewed as high salaries and substantial fringe benefits.
  
  
• Endowments.   There has been much discussion over the past couple of years regarding college and university endowments, including how the funds are invested and how much of the income is used to finance the school's activities, award scholarships, etc.  These discussions, however, have for the most part been limited to Congress, not the IRS.  It is hard to imagine what substantive action the IRS could take on its own with respect to endowments, and it is likely that the endowment section of the questionnaire is primarily intended to gather information on how endowments are operated rather than pave the way for future audit inquiries.

         Certainly, one of the main objectives of the questionnaire is to help the IRS to better understand how colleges and universities are organized and operated, and many of the questions are purely informational in nature.  However, the questionnaire has at least two additional uses.  First, the IRS is likely to use the responses to identify schools that present a higher profile of risk in regards to unreported UBI and serve as the starting point for broader IRS audits.  Second, schools can use the information that they discovered to memorialize and strengthen their tax positions and overall tax compliance.