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IRS to Scrutinize Academic Institutions’ Finances, Including Tech-Transfer Activity

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The Internal Revenue Service is seeking to gather information from hundreds of US colleges, universities, and affiliated organizations such as foundations and academic medical centers about their financial practices, including those related to technology licensing, investments, and corporate sponsorship, according to the agency.
 
Last week, the IRS’ Exempt Organizations Compliance Unit began sending “compliance” questionnaires to approximately 400 US colleges and universities in order to study the financial architecture that supports them, including unrelated business income, endowments, and executive compensation practices.
 
The IRS said the voluntary questionnaire is part of an effort by the agency to “better understand” tax-exempt organizations and perhaps more intently scrutinize what it considers “key” areas in the tax-exempt community.
 
The questionnaire is not an audit, and schools will not be penalized for refusing to participate, according to the IRS. However, the agency said that it reserves “the option of opening a formal investigation, whether or not the organization agrees to participate in a compliance check.”
 
The 33-page-long document contains 74 questions intended for all 400 institutions and 20 additional questions applicable only to private organizations. Private nonprofit universities are generally exempt from tax under Internal Revenue Code section 501(c)(3) and, like state universities, are subject to unrelated-business income tax, the IRS said.
 
The agency sent the questionnaires last week to a cross-section of small, mid-sized, and large private and public four-year colleges and institutions. An IRS spokesperson declined to identify the recipients or how they were chosen. A copy of the questionnaire, including instructions and a cover letter, has been posted on the IRS website.
 
“This effort reflects our work to build a better understanding of the largest, most complex organizations in the tax-exempt sector,” Doug Shulman, IRS commissioner, said in a statement. “The information gathered will help us identify issues and areas that may need more outreach and education or further scrutiny.”
 

“These guys are now under the microscope, if you will.”

Among other things, the questionnaire will gather information from schools about how they report revenues and expenses from their trade or business activities, how they classify their activities as exempt or taxable activities, and how they calculate and report income or losses on taxable activities.
 
The questionnaire also seeks to learn how the organizations invest and use endowment funds, and how they determine compensation of certain highly paid individuals.
 
As an example of how the questionnaire touches the technology-transfer sector, a section in it entitled “activities” seeks to gather information on the nature and amount of unrelated business income in categories such as “other royalties,” “commercial research,” “patents,” and “copyrights and trade names or trade secrets.”
 
These activities are among 47 that the IRS views as potential sources of unrelated-business income. According to law firm Jones Day, which provides an online guide to the questionnaire, for each activity in which an institution was directly engaged, it must disclose how it treated income from the activity; explain the treatment of all or part of the activity as non-UBI; disclose whether the activity was managed or operated by an unrelated third party; indicate whether the institution incurred a loss from the activity in at least three out of the five previous years; indicate whether expenditures to non-501(c)(3)-related organizations exceeded $50,000 during any single loss year; provide a reason for any losses; and indicate whether the institution has future plans for making a profit from the activity.
 
Institutions must also list the five largest activities by gross revenue from the preceding list that were not treated as unrelated-business activities.
 
‘Under the Microscope’
 
According to James King, a partner at Jones Day and one of the authors of the questionnaire guide, the IRS’ investigation mirrors one that it made in 2006 when it sent compliance questionnaires to approximately 600 hospitals.
 
King told BTW that an estimated 1 percent of all tax-exempt businesses in the US hold more than 60 percent of all the assets and revenues in that sector. The two biggest components of that 1 percent are hospitals or healthcare centers and colleges or universities.
 
“These guys are now under the microscope, if you will,” King said. “Their processes will be put under a microscope and, to the extent that they’ve got internal valuation glitches [or] large process glitches … they’re going to have to refocus on that, and look to whether they’re doing things right.”
 
Based on his experience with the hospital compliance questionnaire, King said that the IRS will likely “take a year and a half to kind of wade through the responses, and look and see where they think they have people that have issues. They take the data, refine it, and see where people are not doing what they ought to be doing, and try to go after some low-hanging fruit.”
 
King, who has in the past advised hospital and non-profit academic medical center clients on similar tax issues, said that some of that low-hanging fruit could be related to university tech-transfer activities such as licensing royalty income, equity in spinouts, or other investments, but added that it “was hard to tell” at this point how significantly income from such activities might play into the IRS’ examination.
 
“Let’s say what’s going on is that people [in] a tech spinoff of some kind are getting too rich a deal as opposed to the university side of it,” King suggested. “I would anticipate [the IRS] in that context nosing around the valuation process and how the [institution] set the values; and set the values for the interests in any spinoff companies, and set the royalty rates.”
 
King also advised that universities and colleges that do not receive a questionnaire “ought to pretend that they did, to some degree, and take a look at how they would have answered these types of questions.”
 
The reason for this, he said, is that audits of anyone could be forthcoming based on the information the IRS receives from the questionnaires. “When they went through a similar process with the hospitals, after having been absent as an audit-and-enforcement presence of any significance for the previous 10 years, I now know of five new examinations that people just got notice of in the last two months, and these are large organizations.”
 
In its statement, the IRS said that it expects to receive most of the responses “within the next several months.” It will then analyze the results and examine a sample of the organizations. The IRS also said it expects to issue a report on the project in 2009.

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