Session 3A. Current Tax Developments

Bethany J. BridghamDiara M. Holmes, Caplin & DrysdaleSean Scally, Vanderbilt UniversityLorry Spitzer, Ropes & Gray

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Current Tax Law Developments Roadmap

1. IRS Mishandling of 501(c)(4) Applications – Fallout, Next Steps, Silver Lining?

2. IRS College & University Compliance Project -- Recap• Results and Implications for UBIT, Executive Compensation, and

Employment Tax

3. 403(b) Plans

4. Final Regulations re: Supporting Organizations

5. Charitable Giving

6. Assorted Recent Developments

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The Elephant in the Room IRS Apology and the Resulting

Firestorm• May 10: EO Director Lois Lerner apologized for IRS mishandling of

Tea Party and other groups’ 501(c)(4) exemption applications in Cincinnati (EO Determinations).

• May 14: TIGTA report re: IRS mismanagement of these cases

• Attorney General has called for FBI/DOJ criminal investigation

• Governors call for Special Prosecutor

• May 17: House Ways & Means Hearing

• Senior level departures (Miller, Lerner, Paz), with “acting” EO officials in place for now.

• Silver lining: Will we see meaningful guidance re: c4 “primary” test?

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IRS College & University Compliance Project Recap

Step 1: Questionnaire• Sent to 400 colleges and universities in

October 2008. • Issues included: executive compensation,

endowment funds, UBIT, controlled organizations.

• High (“voluntary”) response rate (97%)

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C&U Compliance Project Interim Report

Step 2: Interim Report

• Released in May 2010• Presented preliminary findings on respondents’

organizational structures, demographics, exempt and unrelated business activities, endowments, executive compensation and governance practices.

• Answers showed potentially conflicting responses – e.g., schools reported controlling entities, engaging in rental activities, and receiving corporate sponsorships, yet few reported such activities on Form 990-T.

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C&U Compliance Project Selective Audits

Step 3: Selective examinations of 34 institutions

• 31 exams have closed; 3 remain open.• Not a statistically valid sample. • Organizations selected because questionnaire responses

and Form 990s indicated potential noncompliance in the areas of UBI and executive compensation.

• IRS examined 990, 990-T, employee plan return, excise tax returns, employment tax returns.

• 24 institutions received written advisories.• (So far) no “excess benefit transactions” leading to 4958

tax

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C&U Final Report Signals Continued IRS

Focus on UBIT and Compensation

Step 4: Final Report

“ …the IRS plans to look at UBI reporting more broadly, especially at recurring losses and the allocation of expenses, and to ensure, through education and examinations, that tax-exempt organizations are aware of the importance of using appropriate comparability data when setting compensation.”

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C&U Final Report -- UBTI

Outcomes:

• Increases to UBTI for 90% of institutions examined, totaling about $90 million

• Over 180 changes to the amounts of UBTI reported on Form 990-T

• Disallowance of more than $170 million in losses and NOLs, which could amount to more than $60 million in assessed taxes.

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C&U Final Report – UBIT

Primary reasons for UBTI Adjustments

• Disallowed expenses (losses) that were not connected to unrelated business activities

• lack of profit motive (no “trade or business”)• improper expense allocations

• Errors in calculations or substantiation

• Reclassified activities from exempt to unrelated

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C&U Final Report – UBIT

Lack of Profit Motive

• IRS disallowed losses and NOLs for lack of profit motive in 70% of the exams. These disallowances amounted to more than $150 million of the total losses and NOLs disallowed in the C&U exams.

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C&U Final Report – UBIT Advice

• 20% of institutions sought outside advice about potential unrelated business activities.

• In 40% of those cases where an institution had obtained an outside opinion, the IRS disagreed with the opinion when the issue came up on examination.

Of Form 990-Ts examined: • 13% were reviewed by outside counsel before filing. • 57% were reviewed by independent accountants before filing. • 50% were reviewed before filing by the Board or a Board

committee.

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C&U Final Report – UBIT

Over 180 adjustments to UBTI reporting on C&U returns, from more than 30 different activities.

Majority of these adjustments came from:

• Fitness, recreation centers and sports camps • Advertising • Facility rentals • Arenas• Golf Facilities

C&U Final Report – UBIT Recommendations

• Document Business Purpose: Particularly Important when the Activity Results in Gain/Loss Over Multiple Years

• Document Expense Allocations: (1) Maintain Good Records; (2) Substantiate Allocation of Expenses Between Related and Unrelated Activity; (3) Document and Record Detail to Support NOLs for carrybacks

• Perform UBIT Analysis on All Income Streams and Revenue Producing Activity to ensure compliance with “Related” Income Standards

C&U Final Report – UBIT Recommendations

• Dual Use of Facilities – Allocation Methodology (Available not Actual Use Basis): Use 24-hour-day/12-month year period, with an allocation ratio of hours used for unrelated activity over the total number of hours in the year. PLR 9149006;

• Direct Expenses/Costs AND Indirect Expenses (Personnel Salaries/General Overhead) – Allocation On a Reasonable and Proportional Basis. Treas. Reg. 1.512(a)-1, referencing the ‘ordinary and necessary’ business deduction standard per IRC 162; Disabled Amer. Veterans v US, 704 F.2d 1570 (Fed. Cir. 1983).

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C&U Final Report – Executive Compensation

• For private colleges, IRC section 4958 analysis

• In these audits, ODTKEs were “disqualified persons.”[Query….]

• 2006-2008 tax years examined. The 2008 Form 990 was the first time organizations were required to report about their compensation practices and policies.

• 20% of the private institutions examined failed to meet the “rebuttable presumption” standard because of problems with their comparability data.

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Problems with Comparability Data

• LBI Engineers went behind compensation studies and found that 20% of the private schools included institutions in their data set that were not similarly situated.

• Engineers looked to factors such as: type (e.g., private or public; liberal arts, research university, etc.), size of undergraduate enrollment, faculty size, location (urban, rural, suburban; region of the US), endowment size, tuition and cost to attend, selectivity (SAT ranges, etc.) and age of the institution (year founded).

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Problems with Comparability Data

• Peer Institutions not similarly situated, based on at least one of the following factors: location, endowment size, revenues, total net assets, number of students, and selectivity

• Compensation studies failed to document selection criteria for peers, and failed to explain why those schools were deemed comparable to the school relying on the study.

• Surveys did not specify whether amounts reported included only salary or other types of compensation, as required by section 4958.

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C&U Final Report – Executive Compensation

• Highest paid non-ODTKEs: Sports Coaches, Investment Managers, Head of Departments, Faculty and Administrative/Managerial.

• Sports Coaches ($884,746 ) and Investment Managers ($894,214 ) received the highest average compensation at the colleges and universities examined.

• In the remaining non-ODTKE categories, compensation differed based on whether or not the individual was a medical doctor.

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C&U Final Report – Employment Tax

• IRS looked at employment tax returns in 11 of the exams, all of which have resulted in adjustments.• increases in taxable wages of $35.5 million• over $7 million in employment taxes• $167,243 in penalties

• Reasons for wage adjustments: • failure to include value of the personal use of automobiles,

housing, social club memberships and travel• misclassification of employees as independent contractors• failure to withhold taxes for wages paid to non-resident aliens• failure to include value of certain graduate tuition waivers and

reimbursements.

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National Research Project Employment Tax

• Announced in November 2009. Specific areas of interest: worker classification, officer compensation, fringe benefits, employee expense reimbursements, and non-filers. • 6,000 randomly selected organizations examined, including 1,500 EOs.

• Audits commenced in February 2010, with 2 goals: • Obtaining statistically valid information to compute “Employment Tax

Gap”.• Determining compliance characteristics to facilitate IRS enforcement.

• Final report forthcoming.

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Voluntary Classification Settlement Program IRS Anns. 2012-45 and

2012-46• Allows employers that currently treat workers (or a class or group of

workers) as independent contractors or other nonemployees to prospectively treat them as employees.

• To participate, employer must have consistently treated the workers as independent contractors /nonemployees, and must have filed all required Forms 1099 for past 3 years.

• Modified and expanded in December 2012• Orgs that are under audit, other than employment tax audit, may participate

in VCSP.• Org may not participate if it is contesting in court the classification of the class

or classes of workers from a previous audit by the IRS or DoL.• Orgs no longer required to agree to extend the SOL as part of the VCSP closing

agreement.• Members of an affiliated group are not eligible to participate in the VCSP if

any member of the affiliated group is under employment tax audit.• Orgs that have not filed 1099s for 3 years may participate through June 30,

2013.

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C&U Final Report Retirement Plan Issues

Reasons for Wage adjustments:

• IRS looked at retirement plan reporting in 8 of the exams, and found problems at half of those institutions.

• Results: deferred compensation-related wage adjustments on Forms 941 and 1040 of $1,115,007, generating $201,298.00 in taxes and $12,036.74 in penalties.

• contributions that had to be taken into income in current years because the payments were not conditioned upon the future performance of substantial services sufficient to convey a substantial risk of forfeiture under section IRC 457(f)(3)(B).

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C&U Final Report Retirement Plan Issues

Reasons for Wage adjustments:

• loans from 403(b) plans exceeded IRC 72(p) limits so that deemed distributions were included in gross income.

• deferrals for a 403(b) plan exceeded IRC 402(g) limits.

• additions to a 403(b) plan exceeded IRC 415(c) limits.

• is your institution fulfilling its affirmative duty to test for the aggregated IRC 415(c) limits?

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IRS Finalizes Program for Pre-Approval of 403(b) Plan

Documents

• On March 28, 2013, the IRS finalized the program for pre-approval of prototype and volume submitter 403(b) plan documents first announced in 2009.

• See Rev. Proc. 2013-22; IRS Announcement 2009-34

• Vendors who expect a plan to be adopted by at least 30 employers may submit the applicable plan document(s) to the IRS for pre-approval, beginning on June 28, 2013.

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Update re Supporting Organizations

• On December 28, 2012, IRS issued final and temporary regs re: requirements to qualify as a Type III SO that is “operated in connection with” one or more supported organizations.

• The IRS also issued a Notice of Proposed Rulemaking, withdrawing portions of the one published in September 2009, regarding the payout requirements for non-functionally integrated (NFI) Type III SOs.

• NFI Type III SOs must annually distribute the greater of 85% of adjusted net income or 3.5% of the FMV of the SO’s non-exempt-use assets. Final regs allow set-asides approved in advance by IRS to count toward the distributable amount.

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IRS Confirms Deductibility of Contributions to

Domestic Disregarded LLCs

• On July 31, 2012, the IRS confirmed that donors may claim charitable deductions for their contributions to domestic disregarded LLCs that are wholly owned and controlled by U.S. charities.

• The Service remains silent on the issue with respect to disregarded entities organized under foreign law, leaving the treatment of those entities to be determined under the existing regulations.

• IRS Notice 2012-52

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Charitable Solicitation Check List

• Changing Landscape • Increase in use of social media• Changes in the manner of giving• Increase in the number of individuals reached

• State-by-State Registration Requirements• Unified Registration Statement(URS) –

http://www.multistatefiling.org• Discussion Handout – summary of state-by-state requirements

• National State Attorneys General Program at Columbia Law School• Charities Oversight and Regulation Project

Assorted Recent Developments (ARD)

• PLR 201306023 – Cap Gain Exclusion for Condo Sales per IRC 512(b)(5)

• US v Quality Stores IRS files Cert Petition to USSC over 6th Circuit loss that severance pay not “wages” for FICA

• PLR 201251019 – No UBIT on ticket sales to read-aloud events for (c)(3) reading/literacy EO; detailed IRC 513 analysis

• Notice 2012-52 – Charitable deduction allowed to SMLLC• IRS Pub 598, Tax on Unrelated Business Income of Eos• O’Connor v Commr TCM 2012-317 – Pay to clinical trial/med study

participants properly reported on Form 1099-MISC

ARD

• PLRs 201311032/201311036 – Endowment Unit/Trust Arrangement: No UBIT for (1) making/receiving unit payments; (2) holding/redeeming units

• IRS INFO Ltr 2013-0001 (1/15/13) – EOs use of Internet for Fundraising OK; reference IRS Pub 4221-PC, Compliance Guide

• Villareale v Commr TCM 2013-74 – charitable ded disallowed for failure to substantiate $250/more per IRC 170(f)(8)

• IRS Pub 526 (Rev’d 2012), Charitable Contributions• IRS Pub 571 (Feb 2013), Tax Sheltered Annuity Plans For Public

Schools/TE Orgs under IRC 403(b)

ARD

• PLR 201222040 – No UBIT for Xsactions between Supporting and Supported Orgs/Asset, Personnel, Facilities and Services

• PLR 201222043 – No UBIT for EO/Labor Union (c5) offering pharmacy benefit program to members

• PLR 201250025 – No UBIT for Income from Clinical DB operation for a Regional Health Information Exchange AND No Private Inurement/Benefit for Merit Based Comp to Drs.

• Mohamed v Commr, TCM 2012-152 – Real Prop donation to CRUT disallowed if Donor Performs “Qualified” Appraisal

• PLR 201224036 – Marijuana Dispenser Cannot be (c)(3)

Joint Ventures Revisited

• Defn: Partnership between/among two or more parties in which each party contributes assets and/or expertise.

• Four JV Types: Ancillary (limited portion of assets/services of EO); Whole Venture (all or subtantially all of the assets of the EO); Exempt-Only Arrangements (between/among EOs); Investment-Type (EO in a limited/passive capacity).

• IRS Administrative Guidance: Rev. Rul. 2004-51 – LLC with equal (50/50) EO/Taxable Ownership to conduct “distance learning” program; “Control” of the JV by the EO is not as critical as the EO’s control of the educational activity (the activity that furthers the EO’s purpose) See, also, PLR 200610022 (Scholarly Journal/For Profit Publisher – No UBIT)

JVs

• Prior Case Law: Redlands Surgical Services, Inc. (9th Cir) – EO must maintain effective control of the JV;

• St. David’s Health Care System v. US, (5th Cir) – EO will lose exempt status “if it cedes control to the for-profit entity.”

• Beware the MOOCs! Consider the terms of the Participation Arrangement to Evaluate Tax Consequences

Questions?

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