With classes in full swing at university campuses this fall, institutions continue to face increased tax compliance and reporting complexities. These complexities create additional risk. Understanding some of the key risks and how to mitigate them through proper planning and consultation are of utmost importance.
- Unrelated Business Income (UBI) Focus
In recent years, the IRS has continued to show interest in exempt organization UBI. The IRS has conducted compliance checks and audits on Forms 990-T with continual losses. In addition, a report issued by the Treasury inspector general called for an increased emphasis on identifying areas of UBI during IRS examinations, with the underlying concern that UBI is both underreported and has expenses overallocated. With gross collections from UBI of more than $1.1 billion in fiscal year 2021, it is clear that exempt organizations generate UBI.
Educational institutions conduct a broad range of activities and often have varied investments that could result in potential UBI. Whether it’s operational activities, real estate ventures, sponsorship and advertising agreements, or investments, all have the potential to generate UBI. As IRS and public scrutiny increases, it is critical that institutions evaluate revenue streams to ensure they are reporting and properly documenting UBI. In addition, unrelated activities that have resulted in continued losses should be evaluated to assess whether expense allocations are reasonable; while the siloing of UBI activities under Internal Revenue Code Section 512(a)6 has somewhat lessened concerns around expense allocations and the creation of net operating losses, it remains an area for consideration. Reviewing UBI on an ongoing basis can assist with tax compliance, as well as inform management and boards of directors of the use of tax-exempt funds.
- Reporting Considerations for Alternative Investments
As the stock market fluctuates, investment committees continually evaluate an institution’s portfolio to maximize returns as well as mitigate risk. An increasingly common strategy is the use of alternative investments to help diversify an institution’s portfolio. While investment income is generally excluded from UBI, alternative investments create certain complexities that require additional attention and tax planning.
For example, when investing in private equity partnerships, the tax-exempt investor is now responsible for evaluating the source and nature of the income to determine whether there are income tax implications. Ordinary income attributed to the investment is generally considered UBI and, therefore, taxable. Flow-through passive income such as rental income, interest and dividends, and realized gains or losses would generally be excluded from UBI, unless they are debt financed. As with traditional operating UBI, institutions must assess their filing obligations with state and local jurisdictions. UBI from these investments will often be sourced to multiple states, therefore triggering additional state tax filings.
In addition to generating UBI, alternative investments can create additional tax reporting related to foreign transactions and foreign investments. International activity reporting often comes with steep penalties for noncompliance, and institutions should monitor carefully.
- Scholarship Funds for Unpaid Internships
Scholarship taxability emerges periodically as a question in the business office. Scholarships used for tuition and related expenses (books, course fees, equipment) are nontaxable to the student, while scholarships for room and board, or which exceed the student’s tuition and related expenses, are taxable.
An emerging interest area for donors is funding scholarship opportunities for students with unpaid internships. This is a commendable way of equalizing access to hands-on opportunities but could result in taxable income for the student when funds are intended to offset living expenses and transportation costs. Institutions should be aware that these amounts may be taxable and inform students accordingly.
In addition, receiving these grants for unpaid internships could have an impact on a student’s overall cost of attendance and their financial aid awards. The financial aid office should work with students to gain an understanding of the impact of these grant programs on overall cost of attendance and potential tax filing.
- International Student Scholarship Reporting
As institutions seek to address ongoing enrollment challenges, attracting international students can help bolster declines in U.S. student enrollment. International students who receive nontaxable scholarships do not trigger any tax reporting requirements for the institutions where they are enrolled. When scholarships or grants are used to help offset room and board or other living expenses for international students, those funds are taxable.
When it is determined that a scholarship is taxable, international students have additional reporting requirements. Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, is required to be filed by the institution. Institutions are generally required to withhold U.S. tax at a 14% tax rate on an international student’s taxable scholarship income unless the income is exempt under a tax treaty. If the U.S. has a tax treaty with the student’s country of citizenship, the income may not be taxed to the student; however, the reporting requirement remains. International students may need to file a Form 1040-NR to report their U.S. taxable income, but that requirement can vary based on individual facts and circumstances.
- Excise Taxes
A relatively new excise tax on endowments is affecting a growing number of colleges and universities. The Tax Cuts and Jobs Act of 2017 was created in part to impose a 1.4% tax on institutions enrolling at least 500 students that have endowment assets exceeding $500,000 per student. When enacted, it was anticipated that only about 40 institutions would meet this requirement; however, institutions with declining enrollments may find themselves subject to the tax. Institutions should continue to monitor the mix of students and endowment assets on an annual basis.
The same 2017 tax legislation also enacted an excise tax on compensation paid in excess of $1 million to the five highest-paid employees of nonprofits, including colleges and universities. The excise tax is payable by the institution and is 21% of the amount exceeding $1 million. This requirement generally does not apply to governmental institutions, exempting most public universities from this requirement. For those subject to the tax, the most common triggers are compensation packages of coaches and other highly paid administrators, as well as compensation packages that include nonqualified plans such as 457(f) plans. Institutions should consider the excise tax in the annual compensation review and approval process. Due diligence should be taken in engaging in nonqualified plans to gain an understanding of excise tax implications.
As institutions navigate a complex and dynamic environment, keeping these hidden tax risks top of mind can help increase overall compliance and reduce risk. When in doubt, it’s always a best practice to have regular conversations with your tax advisor regarding these and other tax reporting requirements.
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Article reprinted with permission from Bloomberg Tax. All rights reserved.