Client Alert. IRS Targets Colleges and Universities in New Compliance Initiative. Background. Matters Under Review

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1 Number 754 October 20, 2008 Client Alert Latham & Watkins Tax Department IRS Targets Colleges and Universities in New Compliance Initiative The US colleges and universities in receipt of a compliance questionnaire recently sent by the IRS should understand that responding to the questionnaire may be the first step of what could be a long and arduous legal process. Background With the support and involvement of Senator Charles Grassley, ranking minority member of the Senate Finance Committee, the Internal Revenue Service (IRS) recently sent approximately 400 US colleges and universities compliance questionnaires. These questionnaires are designed to identify tax issues involving unrelated business income, endowments and executive compensation practices. The list of targeted colleges and universities is not being made public. A copy of the press release issued by Senator Grassley is attached to this Client Alert. Although not specifically articulated in either the press release or in the correspondence to the targeted colleges and universities, the questionnaire is designed, in part, to identify institution-specific compliance issues for IRS audit follow-up. In this regard, this latest compliance questionnaire has significant similarities with Senator Grassley s prior coordinated compliance initiative involving nonprofit hospitals. It also is similar to the IRS s Executive Compensation Compliance Project. According to the FY 2008 EO Implementing Guidelines, sixty-four percent of the charities and foundations that received the executive compensation questionnaire were subjected to follow-up IRS examinations. The colleges and universities receiving the questionnaire should understand that responding to the questionnaire may be the first step of what could be a long and arduous legal process. This highlights the importance of obtaining privileged legal advice and taking appropriate steps to maintain that privilege with respect to even this early phase of a potential controversy. Matters Under Review The press release indicates that the questionnaire will focus on unrelated business income, endowment and executive compensation practices. Part I of the questionnaire includes a section designed to help the IRS understand metrics relative to a college or university s student body, faculty, tuition policies, as well as identifying applicable financial regulation, internal controls and relative transparency. Part III is designed to capture information concerning endowment funds, including the composition of the investment of the funds, management, oversight, internal controls and use of funds. With respect to much of Parts I and III, the questionnaire is similar to the tax-exempt hospital questionnaire s focus on community benefit, which was an exercise in getting one s arms around just how community benefit was being defined and measured by tax-exempt hospitals in order to Latham & Watkins operates as a limited liability partnership worldwide with affiliated limited liability partnerships conducting the practice in the United Kingdom, France and Italy. Under New York s Code of Professional Responsibility, portions of this communication contain attorney advertising. Prior results do not guarantee a similar outcome. Results depend upon a variety of factors unique to each representation. Please direct all inquiries regarding our conduct under New York s Disciplinary Rules to Latham & Watkins LLP, 885 Third Avenue, New York, NY , Phone: Copyright 2008 Latham & Watkins. All Rights Reserved.

2 Latham & Watkins Client Alert inform revisions to Form 990 and future guidance. It is also the case that the public reports based on the information received in connection with the taxexempt hospital initiative are expected to play a role in policy decisions and legislative initiatives. Turning back to the college and university questionnaire, the information requested regarding structure, unrelated business income and compensation appears to be a straightforward effort to identify existing perceived abuses in order for the IRS to identify audit targets and set up tax adjustments. For example, Question 18 of Part I is designed to identify the structure of the college or university s operations through related entities, such as disregarded entities, partnerships and related tax-exempt organizations. Questions 19 through 22 address internal controls and transfer pricing concerns is the college or university inappropriately using tax planning to structure its operations to maximize the benefit of its tax-exempt status? Is the college or university inappropriately sharing the benefit of its tax-exempt status with taxable entities? Part II spans thirteen pages and contains nine questions with multiple subparts, designed to tease out numerous potential adjustments concerning unrelated business income. Part II requests that amounts related to specific categories of defined expenditures be broken out, as well as assigning categories of explanations based on predominant reason codes which could result in the college or university committing to a position on the issue at a very early stage. Part II also inquires as to whether there was reliance on external tax advisors in connection with determining which activities were unrelated and which were exempt, how expenses should be allocated and how pricing was determined in connection with the 2006 tax year. Part IV addresses executive compensation, including requesting information concerning 34 different types of remuneration ranging from base salary, to deferred compensation plans, to use of vehicles and provision of personal services. In addition, Part IV addresses loans or extensions of credit, and compensation policies (for private colleges and universities). Next Steps Latham s tax attorneys have extensive experience in advising and representing companies, including tax-exempt organizations, in Congressional and administrative tax inquiries, investigations and related surveys, audits and studies. Our tax controversy practice also has significant expertise in IRS audits, administrative appeals, alternative dispute resolution and, where necessary and appropriate, litigation. Our executive compensation and benefits practice has expertise in the myriad federal tax provisions that are unique to the types of employee benefit plans and arrangements maintained by tax-exempt organizations. We understand the significance of standardized industry-wide questionnaires, as well as the multiple ways the information sought may be ultimately used. Our early participation in the process, coupled with our broad base of technical tax and tax controversy expertise enables us to anticipate areas of governmental focus in order to handle the matter as efficiently as possible while maximizing protection of our clients interests in the event of subsequent proceedings. We will be sharing our views concerning the current IRS initiative with clients and potential clients via a teleconference on Monday, October 27 at Noon ET, and will discuss the following issues of importance to colleges and universities that have received the questionnaire: Number 754 October 20, 2008

3 Latham & Watkins Client Alert If you have any questions about this Client Alert, please contact one of the authors listed below: Kim K. Boylan Julian Y. Kim Susan E. Seabrook Joseph M. Yaffe Andrew R. Roberson Or any of the following attorneys listed to the right. Overview of the tax issues targeted and potential consequences of proposed adjustments Importance of understanding the follow on consequences and potential uses of information provided in connection with the questionnaire Best practices for coordinating sharing information with other recipients while protecting and maintaining privilege Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends. The information contained in this publication should not be construed as legal advice. Should further analysis or explanation of the subject matter be required, please contact the attorneys listed below or the attorney whom you normally consult. A complete list of our Client Alerts can be found on our Web site at If you wish to update your contact details or customize the information you receive from Latham & Watkins, please visit to subscribe to our global client mailings program. Office locations: Abu Dhabi Barcelona Brussels Doha Dubai Frankfurt Hamburg Hong Kong London Los Angeles Madrid Milan Moscow Munich New Jersey New York Northern Virginia Orange County Paris Rome San Diego San Francisco Shanghai Singapore Tokyo Abu Dhabi Barcelona José Luis Blanco Brussels Howard Rosenblatt Robert G. Goldman Doha Dubai Frankfurt Hans-Jürgen Lütt Hamburg Götz T. Wiese Hong Kong Joseph A. Bevash London Daniel Friel Los Angeles James D. C. Barrall Laurence J. Stein Madrid José Luis Blanco Milan Fabio Coppola Moscow Mark M. Banovich Munich Stefan Süss New Jersey David M. McLean New York Jed W. Brickner David S. Rabb Northern Virginia Eric L. Bernthal Orange County David W. Barby Paris Christian Nouel Rome Fabio Coppola San Diego Bruce P. Shepherd San Francisco Scott R. Haber Shanghai Rowland Cheng Joseph M. Yaffe Singapore Mark A. Nelson Tokyo Hisao Hirose Gerald A. Kafka Number 754 October 20, 2008

4 M E M O R A N D U M To: Reporters and Editors Re: IRS questionnaire of colleges, universities Da: Wednesday, Oct. 1, 2008 Approximately four hundred U.S. colleges and universities will begin receiving compliance questionnaires from the Internal Revenue Service in the next few days as part of the agency s focused effort to study key areas in the tax-exempt community. Sen. Chuck Grassley, ranking member and former chairman of the Committee on Finance, has long urged the IRS to beef up its Form 990, the disclosure form for tax-exempt groups, to include specific information on hospitals and universities. The IRS has made significant progress toward those goals, releasing an improved Form 990 and revised schedules for certain entities. Grassley made the following comment on today s announcement of a new IRS questionnaire of colleges and universities. This questionnaire is overdue. Colleges and universities should be much more transparent about their activities, just as tax-exempt hospitals are being asked to do. Transparency brings accountability. As tuition increases go through the roof, and families are struggling, colleges need to show they re going the extra mile to control costs and provide financial support to students. They need to show they re making good use of the tax exemption and other federal subsidies they receive. I urge the IRS complete this study more quickly than its study of nonprofit hospitals, which it began more than two years ago. I also encourage the IRS to be quick about creating a separate Form 990 schedule for colleges and universities. The questions the agency is asking of these 400-some institutions should be asked of all tax-exempt colleges and universities as soon as possible. The text of today s IRS press release follows here. IRS Sends Compliance Questionnaires to 400 Colleges and Universities IR , Oct. 1, 2008 WASHINGTON Approximately four hundred U.S. colleges and universities will begin receiving compliance questionnaires from the Internal Revenue Service in the next few days as part of the agency s focused effort to study key areas in the tax-exempt community. The college and university questionnaire will focus on unrelated business income, endowments, and executive compensation practices. The questionnaires are being sent to a cross-section of small, mid-sized and large private

5 and public four-year colleges and institutions. 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. This effort reflects our work to build a better understanding of the largest, most complex organizations in the tax-exempt sector, said Doug Shulman, IRS Commissioner. The information gathered will help us identify issues and areas that may need more outreach and education or further scrutiny. Among other things, the questionnaire will gather information from the schools about how they report revenues and expenses from their trade or business activities, classify their activities as exempt or taxable activities, and calculate and report income or losses on taxable activities. The questionnaire also will gather information regarding how the organization invests and uses its endowment funds and determines compensation of certain highly paid individuals. The IRS said it expects to receive most of the responses within the next several months, analyze the results of the compliance questionnaire, and conduct examinations of a sample of the organizations. The IRS said it expects to issue a report on the project in