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In the current economic climate, nonprofit organizations must watch for legislative initiatives that could have an effect on their operations. With the government looking for ways to raise revenue, it is possible that the government subsidy to tax exempt organizations could be cut back. This subsidy consists of several elements. First, revenue of tax exempt organizations is generally exempt from tax to the extent it is received as a contribution, generated by a related activity or meets an exception or modification in the Internal Revenue Code that prevents it from being taxed. Investment income is for the most part not taxed, allowing nonprofit organizations to build substantial endowments. The government also subsidizes section 501(c) (3) organizations by allowing donors to take charitable deductions for gifts to these organizations. Section 501(c)(3) organizations also have the benefit of being able to obtain low rate financing through tax exempt bonds, the income on which is tax exempt to the holder of the bond. All of these provisions result in lost tax revenue to the Federal government.

Charitable Giving

One legislative proposal that could surface is a cap of 28 percent on the value of itemized deductions, including the charitable contribution deduction. In addition, changes to income tax rates and estate tax rates can have an impact on charitable giving.

Other proposals could surface as the result of studies that are underway at IRS and other government agencies.

IRS Studies

The IRS had undertaken a study of the hospital industry that focused on compensation practices and also the provision of charity care and community benefits. In part due to the hospital study, Congress just enacted new Internal Revenue Code section 501(r) that would require tax exempt hospitals to assess community needs every three years and meet certain other requirements in order to maintain 501(c)(3) tax status.

The IRS is now completing a compliance project on colleges and universities, one of the largest and most complex segments of the nonprofit industry. The results of the study may provide a framework for Congress to enact legislation for non-profits in general. The IRS Exempt Organization Colleges and Universities Compliance Project Interim Report (Report) was issued May 7, 2010, with preliminary findings based on responses from a sampling of 400 small, medium and large colleges and universities in both the public and private sectors. The main areas of focus of the project were: compensation, endowments and investments, and unrelated business income. Some of the results were as follows:

Compensation

There have been concerns that nonprofit executives are receiving pay that is too high at the cost of the taxpayers. The Report indicated that compensation of the highest paid officer, director or key employee of large universities averaged $428,000 per year and these persons were usually the president or chancellor of the college or university. The highest paid employees of large universities, other than officers, directors and key employees, averaged $798,000 per year and these persons were either faculty members or sports coaches.

The Report found that more than half of the organizations reported using the rebuttable presumption procedure to establish executive compensation. The rebuttable presumption shifts the burden of proof to the IRS to prove that compensation is unreasonable if the organization is audited. The procedure requires that an independent governing body determine compensation based on comparable data and contemporaneously document the decision-making process. For-profit comparables can be used as well as non-profit data. Senator Grassley, ranking minority member of the U.S. Senate Finance Committee, had proposed an amendment to one of the iterations of the healthcare reform bill to eliminate the rebuttable presumption, but withdrew the amendment. It is possible that such a proposal may surface again in the future, because many think that the rebuttable presumption serves to increase compensation of nonprofit executives and at the same time puts the IRS at an unfair disadvantage to enforce the tax laws.

Endowments

The IRS and Congress are concerned about how tax exempt organizations invest and use their endowments. Are organizations just piling up money or are they actually using the money for exempt purposes? When the return on investments was much greater a few years ago, this was a greater concern than it may be today.

The Report also indicates that a large segment of the sampling of the colleges and universities have foreign and alternative investments in their portfolios, areas that Congress is looking into in general.

As far as legislation in this area, there had been rumor of requiring a minimum payout each year similar to private foundations. However, at this point it appears that such a proposal will not be forthcoming because it could have the adverse effect of establishing a ceiling rather than a floor on spending and it may be wiser to leave these financial decisions to the institutions themselves.

However, another aspect of the use of endowments has been raised and that is “indirect arbitrage,” where colleges and universities borrow money at a low rate through the use of tax exempt bond proceeds and then earn money on endowments at a higher rate. If Congress somehow required organizations to use their own money and not borrow, this could reduce the number of outstanding tax exempt bonds, thus resulting in a revenue gain to the Federal government.

Unrelated Business Income and Expenses

Finally, the IRS College and University Questionnaire used in the compliance project asked numerous questions about activities of colleges and universities in four areas: advertising, corporate sponsorship, rentals and other. There were also numerous questions regarding expenses associated with these activities. The Report indicates that in many cases, colleges and universities reported conducting an activity that was not reported on their Form 990-T and that this will be an area of further study. It has been reported that at least 30 schools that had participated in the survey are now under IRS audit.

The Report points out that many exempt organizations receive opinions from counsel to determine if an activity is related or unrelated. However, many organizations do not report net unrelated business income because of the expenses that they use to offset the income. The IRS Questionnaire asked questions about expenses from activities that generate losses year after year. The IRS takes the position that in order for there to be an unrelated trade or business there must be a profit motive and if there are constant losses there may not be the requisite profit motive; therefore, expenses from loss activities may not be unrelated trade or business losses which could be used to offset other unrelated trade or business income. Although not necessarily on the immediate horizon, future legislative proposals could include bright line tests for the use of expenses from loss activities and also what constitutes a reasonable allocation for purposes of allocating expenses between related and unrelated uses.

Conclusion

It is hard to predict how, whether or when Congress will legislate in the nonprofit arena. Various government reports provide some insight as to what future action may be taken. In the meantime, proactive steps should be taken by organizations to be in compliance with the tax laws and maintain sound financial practices as the best defense against future actions.

Please contact Marc Azar with any questions regarding this article (404.874.6244) or email mazar@smith-howard.com.