Key Issues in Tax Law - National Association of College and

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National Association of College and University
Attorneys –
46th Annual Conference
Chicago Marriott Downtown
Chicago, Illinois
Key Issues in Tax Law
Speakers:
Joseph R. Irvine, CPA
Tax Counsel, Assoc. Counsel
The Ohio State University
Bertrand M. Harding, Esq.
Law Offices of Bertrand M. Harding, Jr.
Sean P. Scally, Esq.
University Counsel and Tax Attorney
Vanderbilt University and Medical Center
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TABLE OF CONTENTS
I.
Final Regulations on Student FICA Exception
A.
B.
C.
II.
Background
Final Regulations and New Safe Harbors (Rev. Proc. 2005-11).
Medical Residents: Court Case
Retirement Plans and Other Benefit and Compensation Issues
A.
B.
C.
D.
E.
F.
G.
H.
I.
J.
K.
L.
M.
N.
O.
III.
American Jobs Creation Act of 2004 – Deferred Compensation –Section 409A
Proposed Regulations - 403(b) Tax Sheltered Annuity Contracts
Settlement payments: Supreme Court Decision and American Jobs Creation Act of 2004.
Compensation for injury or sickness – disability benefits: Rev Rul 2004-55
Amounts received under accident and health plans – unused reimbursement amounts: Rev Rul 2005-24
Wages – signing bonuses – cancellation of employment contracts: Rev Rul 2004-109, and 2004-110.
Taxation of Tenure Buyouts: Appolonia v. US and Kleder, et al, v. US and Rev Rul 2004-110
Payroll deductions to a PAC violate 501(c)(3) status: TAM 200446033
Gift Coupons: TAM 200437030
Scholarships or Wages: PLR 200414039
Wage withholding – IRS ruling on proposed method for withholding taxes on vacation payments
Cafeteria Plans: Notice 2005-42
Allemeier v. Commissioner TC MEMO. 2005-207
Retiree Health Benefits: PLR 200535015
Katrina Relief Effort
Enforcement
A.
B.
IV.
IRS Scrutiny of Exempt Organization
Compliance Measures that May affect Colleges and Universities
Unrelated Business Income
A.
B.
C.
D.
E.
F.
V.
Background
Trade or Business: Profit Motive; Tax Court case Freed
Relatedness
Gain from Sale of Capital Asset; PLRs 200510029, 200530029, 200532057
Unrelated Debt-Financed Income: Real Property Exception; PLR 200534025
Taxable and Exempt Affiliates
Reporting Requirements
A.
B.
C.
D.
E.
F.
VI.
Overview
Form 990, Return of Organization Exempt from Income Tax, including governmental units
Forms 1099-Misc, Miscellaneous Income for P-Card Transactions
Form 8802, Application for United States Residency Certification
Form 1098-T, Tuition Statement, and Forms 1098-E, Student Loan Interest Statement
Non-Resident Alien Pronouncements
Charitable Giving
A.
B.
C.
D.
E.
F.
Final Regulations on Charitable Remainder Trust (CRTs) distributions - T.D. 9190
Guidance on Donations of Qualified Intellectual Property - Temporary and Proposed Regulations 1.6050L-2T and
1.6050L-2 and Notice 2005-41
CRAT, CRUT Safe Harbor for Surviving Spouse – Rev. Proc. 2005-24
Sample Charitable Remainder Trust Forms: Rev Procs 2005-52 thru 2005-59.
Guidance on Charitable Deductions for Donated Vehicles – Notice 2005-44
IRS Explains International Grantmaking Rules - ILM 200504031
VII.
Proposed Regulations on Private Benefit and Excess Benefit Transactions
VIII.
Bonds
A.
B.
C.
D.
Background
Procedure to Correct Failure to Pay Arbitrage Rebate
Suit to Recover Arbitrage Rebate Untimely – TAM 200446021
Legislative Proposal to Remedy Private Use with Research Facilities
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I.
Final Regulations on Student FICA Exception
A.
Background
1.
IRC Section 3121(b)(10) excludes from the definition of employment those
services performed in the employ of a school, college or university (S/C/U) or an
affiliated public charity when the service is performed by a student who is
enrolled and regularly attending classes at that S/C/U.
2.
Revenue Procedure 98-16,1 dated January 16, 1998, sets forth generally
applicable standards or safe harbors to determine whether the student meets this
exception. The test to classify the worker as a student is whether such services are
incident to and for the purpose of pursuing a course of study. In essence, an
individual who is a half-time undergraduate student or half-time graduate, and
who is not a career employee will qualify for the student FICA exception. The
rationale is that a career employee cannot pursue predominantly a course of study.
a.
(i)
Career employee is defined to include those workers as follows:
eligible to participate in any of the S/C/U’s retirement plans under IRC Section
401(a),
eligible to receive an allocation of employer contributions other than contributions
described in IRC Section 402(g) under an arrangement described in IRC Section
403(b) (if the student-employee is only making salary reduction contributions
then such person will not be a career employee),
eligible to receive tuition waiver benefits, or classified as a career employee by
the S/C/U. (This criterion does not apply to teaching and research assistants)
(ii)
(iii)
Alternatively, a career employee may be eligible for the exception based on
consideration of facts and circumstances.
b.
This pronouncement does not apply to employees who are postdoctoral students,
postdoctoral fellows, medical residents and medical interns.
3.
Proposed Regulations on Student FICA Exception
February 25, 2004 the IRS issued proposed regulations regarding student FICA
exception as well as Notice 2004-12. This notice contains a proposed Revenue
Procedure that suspends and replaces Revenue Procedure 98-16.
a.
These proposed regulations amend the student FICA exception by broadly
defining the term ‘career’ employee and including a provision on ‘professional’
employees. Further, the facts and circumstances test discussed in Rev. Proc. 98-16
is removed. These regulations also define the term S/C/U.
1
1998-1 C.B. 403. As modified by IRS Rev. Proc. 2005-11 (January 10, 2005); see:
http://www.irs.gov/irb/2005-02_IRB/ar16.html.
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b.
Career Employee Status
(i)
The employee regularly performs service forty hours or more per week,
(ii)
The employee is a professional employee. A professional employee is anyone
whose duties consist of performing work requiring knowledge of an advanced
type; requires the consistent exercise of discretion and judgment, and whose work
is predominantly intellectual and varied in character (as opposed to routine
mental, manual, mechanical, or physical work) and is of such character that the
output produced or the result accomplished cannot be standardized in relationship
to a given period of time, or
(iii)
The employee is entitled to receive any of the following benefits:
□
□
vacation, sick leave, or paid holiday benefits,
eligibility to participate in any retirement plan described in IRC Section 401(a),
403(b), or 457 that is established and maintained by the employer (if the Service
requirements were met),
reduced tuition (other than for teaching and research assistants),
group-term life insurance, educational assistance plans, dependent care assistance
or adoption assistance programs, or,
classification by the employer as a career employee.
□
□
□
(iv).
The employee is required to be licensed under state or local law to work in the
field in which the employee performs services as a career employee.
c..
Definition of a School, College, or University
The regulations limit the definition of a school, college, or university to an entity
whose primary function is the presentation of formal instruction that maintains a
regular faculty and curriculum, and that normally has a regularly enrolled body of
students in attendance.
B.
Final Regulations and New Safe Harbors (Rev. Proc. 2005-11).
On December 21, 2005, the IRS issued final regulations to the student FICA
exception and Revenue Procedure 2005-11 that provides new safe harbors. See:
http://www.irs.gov/irb/2005-02_IRB/ar16.html.
1.
Significant changes to the proposed regulations include evaluating the educational
and service aspects of the career employee based on a ‘facts and circumstances’
test. The criteria are relevant factors, not dispositive criteria. Accordingly,
whether the employee is a professional or licensed employee, or is eligible to
receive employment benefits is a relevant factor in evaluating the service aspect
of the employee’s relationship with the employer.
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a.
Note, however, that the services of a full-time employee are not incident to and
for the purpose of pursuing a course of study, and, thereby, cannot qualify for the
exception. Hence, an employee whose normal work schedule is 40 hours or more
per week is considered a full-time employee.
b.
This pronouncement does not apply to employees who are postdoctoral students,
postdoctoral fellows, medical residents and medical interns.
2.
The Rev. Proc. 2005-11 modifies and supersedes the safe harbors put forth in
Rev. Proc. 98-16 by providing a more narrow application of the safe harbor than
the previous pronouncement. The half-time undergraduate and graduate student
will qualify for the student FICA exception unless the worker is a career
employee that is defined to include a full-time employee, a professional employee
or an employee who receives certain employee benefits.2
3.
The effective date of the final regulations and the notice is April 1, 2005 rather
than February 25 as put forth under the proposed regulations.
C.
Medical Residents: Court Case
The federal district court for the Southern District of Florida granted the
government's motion for summary judgment, holding that medical residents do
not qualify for the section 3121(b)(10) student FICA exception and, thereby, are
subject to FICA tax on their wages.3 The district court judge based his decision
primarily on his interpretation of the legislative history of section 3121(b)(10) and
concluded that it was Congress’ intent that social security cover medical residents.
In rendering his opinion, the judge refused to follow the 8th Circuit's opinions in
the University of Minnesota and Mayo Foundation cases. This case is on appeal
to the 11th Circuit with oral argument slated for late 2006, according to the Mount
Sinai Medical Center’s outside legal counsel, McDermott Will and Emery.
II.
Retirement Plans and Other Benefit and Compensation Issues
A.
American Jobs Creation Act of 2004 – Deferred Compensation –Section 409A
1.
New section 409A provides that all amounts deferred under a nonqualified
deferred compensation arrangement for all taxable years are currently included in
gross income to the extent that they are not subject to a substantial risk of
forfeiture and not previously included in gross income, unless certain
requirements are met.
2
The benefits in question are provided in the proposed regulations; but for one modification. The eligibility
to participate in a 403(b) plan is changed to read as originally proposed in Rev. Proc. 98-16, 5.02(2).
Further, the IRS stipulates that these benefits are ignored if mandated by state or local law.
3
United States of America v. Mount Sinai Medical Center of Florida, Inc., U.S. District Court, So. Dist.
Fla.; 02-22715-CIV-GOLD/SIMONTON, January 19, 2005. Corrected January 25, 2005.
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2.
Generally, any arrangement that provides for the deferral of compensation will be
covered by Section 409A, unless it is specifically excluded. The types of
arrangements excluded include:
a.
Qualified Retirement Plans under Section 401(a).
b.
403(b) Tax Sheltered Annuities.
c.
Eligible Section 457(b) Plans.
d.
Length of service award to bona fide volunteers under Section 457(b) (11)(a)(ii).
e.
Bona fide vacation leave, sick leave, compensatory time, disability pay, or death
benefit plans.
f.
Plans covered by Sections 422 or 423.
3.
General Requirements of Section 409A.
a.
Initial elections to defer compensation must be made either before the tax year in
which the participant performs the services generating the compensation or within
30 days after an individual first becomes eligible to participate in the plan.
b.
The time and form of distribution must be specified before the services are
performed. Distributions cannot be made earlier than:
1.
Separation from service.
2.
A specified time or according to a fixed schedule.
3.
An unforeseeable emergency.
4.
The participant’s death or total disability.
5.
The employer’s change in control.
c.
Special rules apply to the acceleration or postponement of distributions.
Generally, postponing a distribution will only be permitted if the election to
postpone cannot take effect for at least 12 months after it is made, the election
defers the first scheduled payment for at least 5 years, and the election is made at
least 12 months before the first scheduled payment.
4.
Failing to comply with the requirements of Section 409A may result in deferral
becoming subject to regular income tax as well as a penalty tax equal to 20% of
the amount includable in income. Interest may also apply.
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5.
Although grandfather rules exist for certain plans established prior to January 1,
2005, these grandfather rules will not apply to plans of tax exempt employers
because only vested plans can be grandfathered and a tax exempt employer cannot
have a vested plan without violating Section 457(f).
6.
See IRS Notice 2005-1 and the proposed regulations released on September 29,
2005. The text can be found at: http://www.irs.gov/irb/2005-02_IRB/ar13.html.
7.
Generally, taxpayers are required to have all plans affected by Section 409A
amended on or before December 31, 2006 and operate such plans in good faith
reliance on the proposed regulations prior to that time.
B.
Proposed Regulations - 403(b) Tax Sheltered Annuity Contracts
1.
A Notice for Proposed Rulemaking (NPRM) has been issued for proposed section
403(b) regulations.4 These proposed regulations provide guidance for complying
with section 403(b) and replace regulations originally issued in 1964.
2.
The proposed regulations require that the provisions of a 403(b) plan be satisfied
both in form and operation – which requires that 403(b) plan document(s) be
maintained. This document (or documents) would include all the material
provisions regarding eligibility, benefits, applicable limitations, contracts
available under the plan, and the time and form under which benefit distributions
would be made – the parameters of which are outlined in the proposed
regulations.5
C.
Settlement payments: Supreme Court Decision and American Jobs Creation Act
of 2004.
1.
For many years there has been a split among the circuit court of appeals on the
issue of whether a settlement payment by a defendant to the plaintiff’s attorneys
was excludable from the taxpayer’s gross income. In Commissioner v. Banks 543
US ____(2005), the Supreme Court ruled that attorney fees paid directly to the
plaintiff’s attorneys were includable in the plaintiff’s gross income.
2.
Code sections 62(a) (19) and 62(e) were added by the American Jobs Creation
Act (AJCA) to exclude from the plaintiff’s gross income payments to attorneys
relating to any action involving a claim regarding any aspect of employment.
D.
Compensation for injury or sickness – disability benefits: Rev Rul 2004-55. See:
http://www.irs.gov/irb/2004-26_IRB/ar06.html
4
5
NPRM dated 11/16/04. Fed. Reg. Vol. 69, No. 220, p. 67075 [REG – 155608-02]
Ibid, see preamble to the proposed regulations.
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If, prior to plan year, employee irrevocably elects to have disability insurance
coverage paid by employer on an after-tax basis for year in which employee
becomes disabled are attributed solely to employee contributions and are excluded
from the employees gross income under Code section 104(a)(3). However, if
coverage is paid by employer on a pre-tax basis for year in which employee
becomes disabled the benefits to employee are includable in employee’s gross
income under Code section 105(a).
E.
Amounts received under accident and health plans – unused reimbursement
amounts: Rev. Rul. 2005-24. See: http://www.irs.gov/irb/200516_IRB/ar08.html
1.
IRS describes four types of employer sponsored employee medical expense
reimbursement plans and rules that only one of the described plans results in
excludable income to the employee (the others resulted in taxable income to the
employee).
2.
The plan that was qualified limited payments to reimburse substantiated medical
care expenses incurred by current and former employees, spouses, and
dependents, and no one has right to receive cash or any other benefit under plan
other than reimbursement of medical expenses. Other described plans which
provided cash payment of unused reimbursement amount at end of year or
termination of employment, or paid out unused reimbursement amount as a death
benefit, or having option to transfer unused amounts to retirement plan, taking it
as cash, or carry it forward to next year, weren’t excludable from gross income
under Code section 105(b).
F.
Wages – signing bonuses – cancellation of employment contracts: Rev Rul 2004109, and 2004-110 (December 13, 2004); see, respectively:
http://www.irs.gov/irb/2004-50_IRB/ar07.html and http://www.irs.gov/irb/200450_IRB/ar08.html
1.
Amounts paid by employer as bonus for signing a contract are wages subject to
withholding, FICA and FUTA.
2.
Amounts paid to contractual employee after employment is ended prematurely by
mutual agreement in consideration for employee relinquishing his rights for
remaining period or contract is ordinary income and wages to the employee.
3.
Rev Rul 2004-109 does not apply to signing bonuses or similar amounts paid to
an employee under a contract entered into before January 12, 2005 provided the
amount is paid under facts and circumstances substantially the same as those in
Rev Rul 58-145 or Rev Rul 74-108. Rev Rul 2004-110 does not apply to
payments made by an employer to an employee before January 12, 2005,
provided the payment is made and the facts are substantially the same as Rev Rul
55-520 or Rev Rul 58-301.
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G.
Taxation of Tenure Buyouts: Appolonia v. US and Kleder, et al, v. US and Rev
Rul 2004-110
1.
Both of the above cases are from Federal District Courts in Michigan and they
reach opposite results regarding the taxation of tenure buyout payments. In
Kleder, the court ruled that tenure buyout payments for teachers were not wages
within the meaning of section 3121(a). The court discusses North Dakota State
University v. The United States, 255 F. 3d. 599 (8th Cir. 2001) and several other
cases. It states that Michigan courts have considered tenure for public school
teachers to be a property right. The court also cites Revenue Ruling 58-301 in
finding that the tenure buyout payments are not subject to FICA. An opposite
result is reached by the court in Appolonia. The teachers in this case were also
receiving incentive payments to take early retirements and give up their tenured
positions. After discussing many of the same cases, the court concludes that
payments in exchange for tenure rights are wages subject to FICA. Both of these
cases have been appealed to the Sixth Circuit Court of Appeals.
2.
The IRS issued Rev. Rul. 2004-110 which they indicate supersedes Rev Rul 58301, a key ruling in the above cases. In the brief submitted in the Appeals to the
Sixth Circuit Court the attorneys argue that Revenue Rulings are not issued as
part of the Treasury Department’s rulemaking authority and should not be
accorded deference that the courts have applied to Agency Rules.6 In addition,
they argue that changes in the Revenue Rulings, should only be given deference
when such rulings are well grounded in the validity of its reasoning and its power
to persuade rather control a particular point of tax law.7
H.
Payroll deductions to a PAC violate 501(c)(3) status: TAM 200446033. See:
http://www.irs.gov/pub/irs-wd/0446033.pdf
Nonprofit, tax-exempt corp’s administration of payroll deduction plan allowing
employees to contribute to hospital industry PAC as described in Code section
527, constitutes participation or intervention in political campaign prohibited by
Code section 501(c)(3). In addition, excise tax under Code section 4955 should
be imposed.
I.
Gift Coupons: TAM 200437030. See: http://www.irs.gov/pub/irswd/0437030.pdf
1.
An employer had been providing its employees with a ham, turkey, or gift basket
as an annual holiday gift. The employer stopped providing the gifts and began
providing gift coupons due to employee religious beliefs, dietary limitations, to
reduce previously incurred costs in obtaining and delivering the holiday gifts to its
employees and to eliminate any potential liability for providing food to its
employees.
6
See Chevron USA Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984) and AeroquipVickers, 347 F.3d at 180-81 (citing United States v. Mead Corp., 533 U.S. 218 (2001))
7
See Skidmore V. Swift & Co., 323 US 134 (1944)
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2.
The IRS rejected the taxpayer’s reliance on regulation section 1.274-3(b)(iv) in
which non negotiable gift certificates conferring only the right to receive tangible
personal property are treated as tangible personal property. Furthermore, the
Memorandum states “[w]hether a gift is ‘redeemable in cash’ is not determinative
of whether a gift coupon is a ‘cash equivalent fringe benefit’ for Income Tax
Regulations Section 1.132-6(c) purposes. The Memorandum goes on to stress
that whether it is administratively impracticable to account for the benefit is the
determining factor. It gives the example of providing coffee and donuts at a staff
meeting as an example of something that would be a de minimis fringe benefit
because of the difficulty in accounting for it.
J.
Scholarships or Wages: PLR 200414039. See: http://www.irs.gov/pub/irswd/0414039.pdf
1.
A seminary, which awards postgraduate degrees, wanted to award scholarships to
students interested in learning about fundraising and development. Recipients
were expected to identify and contact potential donors to the seminary. However,
once admitted to the program, a student could not lose a scholarship due to failure
to meet certain program goals. Due to the non-traditional nature of the program,
the seminary wanted to know if the students would be taxed on the scholarship
monies. The IRS determined that the scholarship recipients did not have to
include scholarship monies in their gross income.
2.
The ruling states “[a]lthough scholarships that represent payment for services are
not excludable under current law, not all grants that are subject to condition or
limitation represent payment for service.” The Service ruled that the fundraising
activity did not constitute the requirement of a substantial quid pro quo from the
recipients. The grants were made to enable the recipients to develop important
ministerial stewardship skills and abilities rather than benefit the grantor. The
awards were designed to accomplish the seminary’s religious and educational
training mission.
K.
Wage withholding – IRS ruling on proposed method for withholding taxes on
vacation payments: PLR 200505004 (October 18, 2004). See:
http://www.irs.gov/pub/irs-wd/0505004.pdf
Union’s proposed method for withholding income taxes on vacation payments
made by taxpayer to certain employees was not allowable where union agreement,
in same provision that detailed proposed withholding method, stated that the
intent of that provision was that taxes would be withheld at weekly rates rather
than higher rates for lump sum payment of vacation pay, which was in direct
contradiction to provision of Treas. Reg. 31.3402(h)(4)-1(a).
L.
Cafeteria Plans: Notice 2005-42 (June 6, 2005). See:
http://www.irs.gov/irb/2005-23_IRB/ar11.html
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1.
Notice 2005-42 modifies the “use it or lose it rule” applicable to cafeteria plans.
Generally, an employee who elects to defer monies into a cafeteria plan must use
the benefit by the end of the plan year or forfeit his or her account balance.
2.
This Notice creates a 2 ½ month grace period beyond the end of the plan year.
The effect of the grace period is that a participant may have as long as 14 months
and 15 days to use the benefits or contributions for a plan year before the amounts
are forfeited. For example, if an employer has a calendar year plan and an
employee defers $500.00 into a health FSA, the employee can be reimbursed for
any medical expenses incurred during the calendar year or during the first 2 ½
months following the close of the calendar year.
3.
To adopt the grace period, an employer must amend its cafeteria plan before the
end of the plan year.
M.
Allemeier v. Commissioner TC MEMO. 2005-207
1.
Mr. Allemeier was employed as a sales person for an orthodontic and pediatric
laboratory that specialized in making removable orthodontic appliances. His
duties expanded to include designing marketing strategies to sell products,
organizing seminars, traveling to meet new staff and promoting the company’s
products at conventions. He decided to pursue an MBA Degree and was told that
it would help his advancement in the company, but that his employer would not
pay for the degree.
2.
After the IRS disallowed his deduction for educational expenses, he petitioned the
tax court claiming they were deductible as an ordinary, necessary business
expense.
3.
Generally, educational expenses are a deductible if they maintain or improve the
skills required by the individual in his or her employment or meet the express
requirements of an individual’s employer. However, expenses are not deductible
if they enable the individual to meet the minimum educational requirements for
qualification in his or her employment or if the education leads to qualifying the
tax payer for a new trade or business. See 1.162-5(a) and (b).
4.
The tax court held that the basic nature of the tax payer’s duties had not
significantly changed after he received his MBA and that the MBA improved
existing skills that he used before enrolling in the program. The court
distinguished the tax payer’s facts from other cases where the court had denied
tax payers deductions for law school. The court pointed out that the MBA was
not a course of study leading to qualifying the tax payer for a professional
certification or license.
N.
Retiree Health Benefits: PLR 200535015 (September 2, 2005). See:
http://www.irs.gov/pub/irs-wd/0535015.pdf
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1.
In this PLR an employer proposed adding a revision to its plan that reimbursed
eligible medical care expenses. The new provision would allow the employer to
contribute to the plan in the amount equal to all or a portion of the value of a
retired employees unused sick days at retirement. The retired employee would
not make an election regarding the contribution to the plan. Prior to the beginning
of each plan year, the employer would determine whether it would contribute all
or a portion of un-used sick days to the plan on behalf of employees retiring
during the year.
2.
The amounts contributed to the plan would then be available for employees use in
reimbursing medical expenses incurred by the retired employee. The plan did not
discriminate in favor of highly compensated employees.
3.
The IRS concluded that contributions to the plan were excludable from employees
gross income and that payments or reimbursements from the plan to current or
retired employees were also excludable from gross income.
O.
Katrina Relief Efforts: IRS Website
The IRS has announced a new Hurricane Katrina Relief leave donation program
under which employees can elect to forgo their vacation, sick or personal leave in
exchange for the employer making cash payments to a qualified tax-exempt
organization providing relief for victims of Hurricane Katrina.
The employer receives the charitable contribution tax deduction and the employee
is not taxed on the value of the leave donated.
III.
Enforcement
The Internal Revenue Service (IRS), in following up on statements made by Mark
Everson, IRS Commissioner, to curb nonprofit abuses, has bolstered compliance
measures by increasing personnel and resources as well as establishing
compliance units.
A.
IRS Scrutiny of Exempt Organizations
1.
In testifying to the Senate Finance Committee on potential abusive transactions by
exempt organizations this past June 22, 2004, Mark Everson, IRS Commissioner,
cited as examples the following: (a) charity involvement in transactions that
benefit private parties, (b) excessive compensation paid to executives, and (c) use
of exempt status as tax shelters for donors.
2.
The IRS has increased its budget for Exempt Organization (EO) examinations by
more than twenty percent and received authorization to hire seventy-four
additional EO revenue agents. Martha Sullivan, the Exempt Organizations
Division Director, recently stated that the IRS is creating compliance units; a
Fraud and Financial Transactions unit will staff initially twenty agents, including
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two managers who will report to an area manager. It is expected that a second unit
which will conduct organization contacts and possibly correspondence audits will
be underway soon.8
3.
This past April the IRS announced the release of its Market Segment
Specialization Program (MSSP) audit guidelines that set forth examination
techniques in three different areas of potential interest to colleges and universities:
a.
b.
c.
Audit Techniques for Nonqualified Deferred Compensation Plans
Audit Techniques for Split-Dollar Life Insurance Plans
Audit Techniques for Executive Compensation and Fringe Benefits
4.
In a Chief Counsel memorandum, the Chief Counsel reminds Chief Counsel
attorneys of the IRS policy regarding the role and rationale of penalties when
administering tax laws. Specifically, the letter states that penalties assessed on
examinations are not to be used as a “bargaining point” when settling underlying
tax deficiencies, a situation that arises often when the taxpayer agrees to pay some
or most of the assessed tax liability for a waiver of penalties.9
B.
Compliance Measures that May Affect Colleges and Universities
As enforcement measures, the IRS implemented examination programs, targeted
topics of potential abuse and promulgated pronouncements to provide guidance
and clarity.
1.
Compensation – Soft Contact Reviews
a.
The IRS announced on August 10, 2004, that it will conduct a correspondence
review to identify and prevent abuses regarding compensation arrangements
entered into by tax-exempt organizations with their officers and insiders. This
program, to date, has contacted nearly 2,000 charities and foundations.
b.
The purposes of the program are to:
(i).
address the compensation of specific individuals or instances of questionable
compensation practices,
increase awareness of tax issues as organizations set compensation in the future,
learn about how these organizations report compensation to the IRS and public on
form 990.
(ii).
(iii).
c.
In particular, an issue of interest will be reviewing how exempt organizations
answer question 89(b) on their form 990 regarding excess benefit transactions.
8
Statements made by Martha Sullivan to the American Bar Association Section of Taxation Committee by
speakerphone on January 21, 2005.
9
CC-204-036, September 2004.
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d.
Commentary on findings to date, Catherine Livingston Fernandez, chief of the
Executive Compensation branch, Tax Exempt/Government Entities Division,
reported recently at an American Bar Association Section of Taxation - Employee
Benefits Committee, that the IRS has found situations regarding fringe benefits
that cause concern, such as, improper reporting of spousal travel, the use of
company aircraft, tax preparation services, the provision of computers, and loans.
In her words, the IRS is reviewing loans “that look a lot like compensation but
aren't being treated as compensation".
2.
NRA Audits
As noted, in its concern for appropriate compliance, the IRS has been conducting
examinations at schools nationwide specifically on the issue of reporting and
withholding on non-resident alien (NRA) in reaction to the poor participation of
the NRA voluntary compliance program.10 The IRS stated that the ‘Open Doors’
report,11 which provides information on the number of foreign students attending
that school, would serve as a basis in identifying schools to select.
a.
IRS Discusses Most Popular Errors12
As a result of these audits, the IRS has identified certain common errors that
schools make when complying with the reporting and withholding requirements.
Certain boxes on the form 1042S require certain answers and oftentimes the
information provided in the boxes contradict one another, as follows:
(i).
An entry is required in Box 1 (Income Code field). The income code must
accurately reflect the type of income paid and cannot be left blank or have entered
“00”.
(ii).
An entry is required in Box 5 (Tax Rate field). The correct rate of withholding
that applies to the income reported in Box 2 (Gross Income field) or Box 4 (Net
Income field), must be entered.
(iii).
The recipients name entered in Box 13 (Recipient’s Name and Address field)
must be consistent with the recipient code entered in Box 12 (Recipient Code
field).
(iv).
Country of residence entered in Box 15 (Recipient’s Country of Residence for
Tax Purposes field) must be consistent with the country code entered in Box 16
(Recipient’s Country Code field).
10
Note that the new IRS voluntary compliance program offered in 2004 that is provided in Rev. Proc.
2004-59 does not apply to colleges and universities or their affiliates.
11
This report is updated annually and published by the Institute of International Education.
12
In June, 2004, the IRS released as part of its Chapter Three Withholding (CTW) Program information
returns, the most common errors found during the processing of Form 1042S, Foreign Person’s U.S. Source
Income Subject to Withholding.
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b.
These Audits May Affect other Issues
These audits may affect other reporting issues. Steven T. Miller, Director of the
IRS Exempt Organizations Division, was quoted as saying that the IRS is
prepared to conduct further reviews on other issues should the initial NRA audit
give cause.13
3.
Form 990 Reviews
The IRS has put together a new compliance group to review these returns for
obvious inconsistencies, such as, large fund-raising revenues with minimal fundraising expenses, and will contact the organization with questions accordingly.
The IRS, at a tax conference in Washington, D.C. this year, provided a list of
common errors made when completing the form 990. Examples include failure to
complete the questions regarding compensation arrangements. For instance, not
including the list of receivables from its officers, directors or key employees when
such receivables are indicated on the balance sheet, or responding with an “N/A”
rather than the required “yes” or “no”.
4.
Inquiries of Certain Non-Profit Hospitals
As part of its on-going review of tax-exempt organizations, the Senate Finance
Committee has requested information on the charitable activities of non-profit
hospitals. Committee Chairman Charles Grassley (R-IA) sent letters to 10 nonprofit hospitals asking them to respond by July 11. The purpose is to account for
their charitable activities, given the tax-exempt status they receive. Senator
Grassley was quoted as saying “[i]t’s my duty to make sure charitable donations
actually help those in need. “It’s also my job to make sure charities are earning
their generous tax breaks. Tax-exempt status is a privilege… By gathering
information from non-profit hospitals, I hope to learn whether the benefits they
provide to the needy justify the tax breaks they receive.”
IV.
Unrelated Business Income
A.
Background: Internal Revenue Code (IRC) Sections 511-514
1.
Unrelated business income (“UBIT”) is defined as gross income derived by an
exempt organization from an (1) unrelated trade or business (2) that is regularly
carried on and (3) that is not substantially related to the organization’s exempt
purposes.14 Further, the deductions allowed must be directly connected with the
13
For instance, a news article released early this year in the Denver Post discussed that during an audit on
the NRA issue, the IRS sought conversion of tuition waivers as taxable income under the premise that the
services performed as part of the stipends were not reported initially as wages. Although the matter of
tuition waivers was not, in fact, raised as a material issue to the audit, this article illustrates how an issueoriented examination can expand to include other issues. Refer to 'New' tax stuns aides at Mines, By Dave
Curtin, Denver Post Higher Education Writer, Thursday, February 12, 2004.
14
IRC Sections 512(a)(1) and 513(a).
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carrying on of such trade or business.15 IRC provides exceptions and
modifications to UBIT, including the convenience exception and passive
income.16 Special rules, however, may apply to income derived from unrelated
debt, joint ventures, and controlled entities.17
2.
Its rationale is to prevent unfair competition by requiring exempt organizations to
pay taxes on revenues derived from unrelated activities the same as for-profit
businesses that pay taxes on income from the same activities.18
3.
The organization may not conduct substantial UBIT activities in relation to the
organization’s overall activities.19
4.
The use or destination of the funds for an exempt purpose does not make the
underlying activity a related business.20
5.
The tax is imposed upon both private institutions and state colleges and
universities.21
B.
Trade or Business: Profit Motive; Tax Court case Freed
IRC Section 513(c) provides that the term 'trade or business' includes any activity
which is carried on for the production of income from the sale of goods or from
the performance of services. Moreover, it states that "[w]here an activity carried
on for profit constitutes an unrelated trade or business, no part of such trade or
business shall be excluded from such classification merely because it does not
result in profit”.22 The IRS maintains that an activity must, at some point, produce
a profit to be considered a trade or business.23
1.
A primary concern to schools that file form 990-T is whether the IRS will
disallow the losses from unrelated activities that offset resulting gain from other
taxable activities. Historically, the IRS supported by the courts requires the
exempt organization to demonstrate a profit motive with respect to those activities
15
Id.
Id.
17
Id. IRC Sections 512(b)(13), 512(c) and 514.
18
Treas. Reg. 1.513-1(b).
19
Treas. Reg. 1.501(c)(3)-1(a)(1), Orange County Agric. Soc’y, Inc. v. Comm’r., 55 T.C.M. 1602(1988),
aff’d, 893 F2d. 647 (2d Cir. 1990), Better Business Bureau of Washington, D.C. v United States, 326 U.S.
279, (1945).
20
Treas. Reg. 1.513-1(a).
21
IRC Section 511(a)(2)(A) and (B).
22
The courts have provided a working definition of ‘profit motive’. In Louisiana Credit Union League v.
United States, 693 F.2 525 (5th Cir. 1982), the Fifth Circuit held that the proper test to determine whether
an activity was a trade or business is whether the organization "is engaged in extensive activity over a
substantial period of time with the intent to earn a profit." In Carolinas Farm & Power Equipment Dealers
Ass'n. v. United States, 699 F.2 167 (4th Cir. 1983), the Court also used a profit motive test, holding that
the taxpayer was engaged in a trade or business.
23
The IRS relies on Portland Golf Club v. Commissioner 110 S. Ct. 2780 (1990) and West Virginia State
Medical Association v Commissioner, 91 T.C. 651(1998), aff'd. 882 F. 2d 123 (4th Cir. 1989).
16
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that derive losses. The IRS uses factors relating to the ‘hobby loss’ provision to
determine whether the school has conducted the activity with the requisite profit
motive.24
2.
The Tax Court recently decided a case, Freed v. Commissioner, T.C.M. 2004-215,
that lists the different factors to indicate the taxpayer’s profit motivation when
conducting the activity. In general, the factors are as follows:
a.
the manner in which the activity is carried on, including accurate records,
and whether any changes are made to earn profits,
the expertise of the taxpayer’s advisors, and the time and effort expended in
carrying on the activity,
the expectation that the assets used will appreciate in value,
the success of the taxpayer with similar activities, and the taxpayer’s history of
income or loss with regard to the activity,
the amount of occasional profits and the financial status of the taxpayer.
b.
c.
d.
e.
3.
The court held that based on the facts and circumstances the taxpayer failed to
provide that the activity was conducted with the requisite profit motive.
C.
Relatedness
Section 513(a) defines the term “unrelated” as "any trade or business the conduct
of which is not substantially related.....to the exercise or performance by such
organization of its charitable, educational, or other purpose or function
constituting the basis for its exemption under Section 501...."
To be substantially related an activity must contribute importantly to the
accomplishment of the university's purposes.25 The size and extent of business
activities must be considered in determining whether they are substantially
related.26 If they are conducted on a larger scale and more extensive than
reasonably necessary for the performance of the exempt functions, they will be
considered unrelated.
Further, the sales of products resulting from the performance of exempt functions
do not constitute taxable income, provided; the product is sold in substantially the
same state it is in on completion of the exempt functions. An example of
‘relatedness’ includes income generated from the sale of milk and cream by an
exempt entity operating an experimental dairy herd.27 If the product, however,
was further manufactured for the sale of ice cream or pastries, such sales would
be unrelated.
24
IRC Section 183, Activities Not Engaged In For Profit.
Treas. Reg. 1.513-1(d).
26
Id..
27
Id..
25
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The determination regarding whether a trade or business is substantially related to
a university's purpose depends on the facts and circumstances.28
1.
Certification Program; Private Letter Ruling (PLR) 200439043 (June 28, 2004).
See: http://www.irs.gov/pub/irs-wd/0439043.pdf
a.
A charitable organization that is organized exclusively for scientific and
educational purposes under IRC Section 501(c)(3) operates a certification
program that certifies individuals in a particular field. The program requires these
individuals to satisfy four components: 1) pass an exam demonstrating a mastery
of a specific body of knowledge; 2) have experience in the profession being
certified; 3) take a certain amount of continuing professional education; and 4)
review a code of conduct and ethics. The exempt organization offers a variety of
workshops and education programs to help the candidates prepare for the exam
and also offers courses for continuing professional education.
b.
This letter ruling concludes that the program was an unrelated trade or business.
This letter cited Revenue Ruling 73-567 which concerned a medical specialty
board formed by members of a medical profession to improve the quality of
medical care offered to the public and to establish and maintain high standards of
excellence in a particular medical specialty. The ruling held that the specialty
board was primarily serving the interest of the medical profession and therefore
was exempt as a 501(c)(6) organization rather than a 501(c)(3) organization.
c.
The PLR concludes that the certification program is directed at primarily serving
the interests of the profession being certified. It consists of exam-based testing
designed to demonstrate mastery of a specific body of knowledge. Also, the
workshops are designed to primarily assist the candidates in passing the
examination. Therefore, the program is unrelated to the entity’s scientific and
education purposes. Because the certification program is not a substantial part of
the total activities conducted by the organization, it did not affect its status as a
501(c)(3) organization.
2.
Sales of Produce/Conference Centers/Golf Course; PLR 200512025 (December
28, 2005). See: http://www.irs.gov/pub/irs-wd/0512025.pdf
a.
An organization exempt as a charitable organization under IRC Section 501(c)(3),
generates revenues from activities offered to the general public. It sells ‘produce’,
a small portion of which is developed as part of its exempt purposes that is grown
on-site, offers conferences and catering services and operates a golf course in a
commercial manner.
b.
The IRS analyzed these scenarios under the traditional UBIT rules. The sale of
‘produce’ sold in the same state that it is in upon completion is considered related
to the organization’s exempt purposes. Thus, income derived from the produce
28
Id.
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grown on-site is related whereas the income derived from off-site sales is UBIT.
The offering of conferences and catering services for weddings constitutes UBIT
as well as the operation of a golf course to visitors of the organization. Although
the golf course improves the overall enjoyment of the experience at this
organization, it is not substantially related to its exempt purposes.
3.
Rehabilitation Clinics; PLR 200444030 (August 5, 2004). See:
http://www.irs.gov/pub/irs-wd/0444030.pdf
a.
An organization exempt as a public charity under IRC Section 501(c)(3) operates
a rehabilitation facility that offers many highly specialized programs, including a
multipurpose gym, indoor lap swimming pool, strength and resistance training,
and cardiovascular fitness, among other activities. The organization conducted
surveys to ensure that the services offered would benefit the community and that
the fees charged are reasonable.
b.
The IRS concludes that the operation of the facility is substantially related to the
organization’s exempt purposes. To be excluded from taxation, the activity must
benefit a significant segment of the population and ensure that the fees charged
are affordable. The organization provides extensive community education and
prevention programs, and charges fees that are based on the survey conducted.
c.
Authority supports the position that health and fitness facilities designed for the
general public may be substantially related to exempt purposes. In CPE Textbook
for FY 2000, the IRS published an article on Health Clubs. Cited as an example is
Rev. Rul. 77-365, 1977-2 C.B. 192, that concluded that an organization that
conducted clinics, workshops, lessons, and seminars at municipal parks and
recreation areas to instruct in a particular sport qualified for exemption. However,
the article provided examples of activities sponsored by educational institutions to
the general public for primarily recreational purposes. LTR 8020010 concluded
that the use of a university’s recreational facility by the general public for
personal recreation with minimal or no educational value resulted in UBIT.
Further, the IRS cited Rev. Rul. 78-98, 1978-1 C.B. 167, that provided that
income from the public’s use of a school’s ski facility for recreational purposes
was subject to taxation.
4.
Innovation and Incubator center: PLR 200537038 (September 16, 2005). See:
http://www.irs.gov/pub/irs-wd/0537038.pdf
a.
A charitable foundation proposes to construct and develop an innovation and
incubator center and a training center to attract high technology companies to its
state. It will participate in a public and privately financed real estate development
project, invest in small technology-based companies and will rent portions of the
building to ‘anchor tenants’. The building is financed from government and
private grants in addition to mortgages.
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b.
The IRS concluded that these activities are related to the organization’s purposes
since it provides economic development to an underprivileged local area and
lessens the burdens of government. To lessen the burdens of government the
organization must establish that a governmental unit considers the organization’s
activities to be its burden and that these activities actually lessen its burden.29
c.
Resulting revenues, including rental income, are excluded from taxable income.
5.
Operation of an Ice Arena: 200532058 (August 12, 2005). See:
http://www.irs.gov/pub/irs-wd/0532058.pdf
a.
A private non-operating foundation that is organized to operate for the purpose of
receiving and administering funds for charitable purposes amended its governing
documents to promote the health and welfare of the community and to lessen the
burdens of government by providing recreational amenities to the general public.
b.
The recreational facility will include ice arenas, pro shop, coffee shop and
concession area, a lounge, possibly a conference center, gymnastics facility and
an athletic medicine center. The building is financed by loans.
c.
The organization will lease the properties to for-profit parties who are required to
offer a day program to disadvantaged youths in the local area, hold skate events
on Friday nights for high school children, provide senior citizens with dedicated
exercise and meeting space, and make meeting rooms available on a first come
first serve basis to any non-profit or governmental organization.
d.
The IRS concludes that the rental income is not subject to tax under the debtfinanced rules since the activity is related to its charitable purposes. Also, the
provision of soft drinks or snacks and the rental of skating equipment do not
derive UBIT as ancillary activities to the Ice Arena. However, the sale of shirts
with the Arena’s logo may trigger taxable income.
6.
Internet Activities Conducted by a Trade Association; Rev. Rul. 2004-112
(December 20, 2004). See: http://www.irs.gov/irb/2004-51_IRB/ar09.html
a.
The question raised is whether the activity conducted by the trade show meets the
special rule for qualified convention or trade show activities to avoid UBIT.
b.
The IRS provides two scenarios involving the web site activities of a trade
association organized under IRC Section 501(c)(6). In the first scenario, the
association operates a web site that provides information on trade shows; it
provides links to exhibitors’ web sites, product order forms and online purchasing
features. These features are displayed during the trade shows and 3 days prior to
and after the shows. In the second scenario, the web site provides the same
features for a two-week period that does not coincide with a trade show.
29
Rev. Rul. 85-1, 1985-1 C.B. 178; Rev. Rul. 85-2, 1985-1 C.B. 178.
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c.
The activities conducted in the first scenario are excluded from UBIT since they
meet the special rule for qualified convention and trade show activities under IRC
Section 513(d). The activities under the second scenario must be analyzed under
the general UBIT rules since the special rule does not apply; the features are not
specifically tied to a particular trade show.
d.
Although this provision applies to charitable entities organized under IRC Section
501(c)(3), the provision states that the organization must regularly conduct as one
of its substantial exempt purposes a trade show to qualify for the special rule.
D.
Modification: Gain from Sale of Capital Asset; PLRs 200510029 (December 16,
2004), see: http://www.irs.gov/pub/irs-wd/0510029.pdf, 200530029 (May 5,
2005), see: http://www.irs.gov/pub/irs-wd/0530029.pdf, 200532057 (May 16,
2005), see: http://www.irs.gov/pub/irs-wd/0532057.pdf
IRC Section 512(b) provides, among others, the following modifications as
exclusions from UBIT:
▪
▪
▪
▪
▪
Dividends, interest, payments with respect to securities loans,
Royalties,
Rents from real property,30
Gains/Losses from sale/exchange of property, and
Research for U.S. or agencies or any state or political subdivision thereof
conducted by colleges and universities
These exceptions can be mired in tax law that requires legal interpretation. For
instance, to exclude gains from the sale of capital assets the property must not be
stock or other property that would be included in inventory if on hand at the close
of the year, or property held primarily for sale to customers in the ordinary course
of the trade or business.
These rulings discuss whether the sale of developed property triggers tax
consequences.
1.
PLR 200510029: An organization exempt as a public charity under IRC Section
501(c)(3) that educates at-risk and disadvantaged children seeks to sell part of its
home campus to support its growing national activities. The charity owned the
property for over 50 years, intends to employ a “patient and passive” marketing
approach, and the purchasers would be responsible for construction and
demolition of any buildings.
30
Real property is defined to include incidental personal property (no more than 10%). If the personal
property attributed to the rental income is between 10% and 50%, the income related to the real property is
entitled to the rent exclusion, but not the income related to the personal property. If the personal property
attributed to the rental income is in excess of 50%, the entire rental income is subject to UBIT. Treas. Reg.
1.512(b)(1).
National Association Of College and University Attorneys
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2.
PLR 200530029: A charitable remainder trust found it in its best interest to
liquidate underdeveloped acreage and to sell as subdivided lots. It received the
land as a bequest, intended to sell the lots over a 20 year period and employed a
passive marketing approach to identify interested parties.
3.
PLR 200532057: A charitable organization needed to sell land in order to afford
necessary remodeling on other property it owned and used for exempt purposes.
The property, as part of the zoning requirements, required subdividing and certain
improvements made to each parcel. The property was held for a significant period
of time and the improvements were limited to requirements imposed by the
county.
4.
In each case, the IRS concludes that although the sales constituted UBIT, the
resulting revenues are excluded from taxation as gains from sales of capital assets
under IRC Section 512(b)(5). The IRS uses a six prong criteria derived by the
courts to conclude that the property is not held primarily for sales to customers in
the ordinary course of business.
5.
The criteria are as follows:
a.
b.
c.
d.
e.
f.
the purpose for which the asset was acquired,
the frequency, continuity and size of the sales,
the activities of the seller in the improvement and disposition of the property,
the extent of the improvements made,
the proximity of the sale to the purchase of the land,
the purpose for which the property was held during the taxable year (Adam v.
Commissioner, 60 T.C. 996 (1973) [CCH Dec. 32,155]).
6.
When prioritizing these factors, a court has stated that the nature and purpose are
significant only when sales result from unanticipated, externally introduced
conditions, such as, acts of God or re-zoning (Houston Endowment v. United
States, 606F.2d 77 [5th Cir. 1979]).31
E.
Unrelated Debt-Financed Income: Real Property Exception; PLR 200534025
(May 31, 2005), see: http://www.irs.gov/pub/irs-wd/0534025.pdf
The exempt organization may derive UBIT from passive income that is typically
excluded from taxation. Unrelated debt-financed income under IRC Section 514
applies when investment income is derived from an unrelated use of property that
was acquired with borrowed funds. Investment income includes revenue from
interest, dividends, royalties, and rents previously excluded under IRC Section
31
Other examples include the following: A court held that gain derived by an exempt school for mentally
disabled children that sold 22 parcels of real estate over a 2 year period was subject to UBTI (Parkland
Residential School, Inc. v Commissioner, T.C.M 1983-139[CCH Dec. 39,964(M)]). Rev. Rul. 55-449,
1955-2 C.B. 599, concluded that the construction and sale of 80 houses by an exempt foundation for the
purpose of raising funds for a period of 18 months constituted a taxable activity.
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512(b). For example, income derived from assets funded by line of credit
arrangements may be subject to UBIT.32
A myriad of exceptions apply, however, that, in essence, swallow the general rule.
For instance, a specific exception applies to the higher education community
under Section 514(c)(9). This section provides that colleges and universities,
defined as qualified organizations, may acquire real property with debt and be
excluded from acquisition indebtedness, provided; that the arrangement includes
(1) a price for acquisition or improvement that is fixed on the date of acquisition
or upon completion of improvement, (2) that payment of indebtedness is not
contingent, in whole or part, on revenues, income or profits derived from such
property, and (3) that there shall be no leaseback arrangement to persons selling
the property or providing the financing.
This exception includes organizations that support educational institutions, such
as, alumni associations and foundations, provided; the organization qualifies as a
supporting organization under Section 509(a).
1.
An example of an exception under IRC Section 514(c)(9) includes PLR
200534025. In this scenario, a state university relocated to another site but kept
ownership of its previous location to lease the properties to office and commercial
businesses. As part of the renovation initiative, the university entered into a credit
arrangement on a revolving loan basis to borrow funds from a creditor.
2.
The terms of the arrangement required the university to repay on the loan with net
rental revenues from the leased properties, possibly falling outside of the real
property exception. However, an amendment to the agreement permitted the
university in its discretion to pay the loan using other university funds.
3.
The IRS concluded that the amounts borrowed met the exception and was
excluded from taxation under the debt-financed rules. Discretion to pay the loan
from general revenues meant that the loan is not dependent, in whole or part, upon
those revenues, within the meaning of IRC Section 514(c)(9).
F.
Taxable and Exempt Affiliates
Transactions between subsidiaries and exempt parent organizations may raise
UBIT implications.
The IRS may attribute the activities of a taxable subsidiary to the parent
organization when the parent so controls the affairs of the subsidiary that it is
merely an extension of the parent or its agent. Attribution of taxable activities
may affect the exempt status of the parent (GCMs 33912, 35719, 39326).
32
In LTR 200233032 and LTR 200235042 the IRC concluded that no UBIT arose, however, significant
restrictions were placed on the credit terms.
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Section 512(b)(13) provides that interest, annuities, rents and royalties that are
specifically excluded from UBIT may be subject to taxation when received from a
“controlled organization”. Dividends are precluded from this rule.
A ‘controlled’ organization is defined to include the following; (1) corporation,
when the exempt organization owns more than 50% of the stock in the company;
(2) an unincorporated association or partnership, when the exempt organization
owns more than 50% of the profits, capital or beneficial interests; and (3) a nonstock corporation, when the exempt organization controls more than 80% of the
directors or trustees of the exempt parent.33 The Treasury Regulation 1.512(b)-1(l)
provides examples on how to compute the UBIT.
1.
Taxable Subsidiary: Spin-off of Taxable Activity; PLR 20045050
a.
The exempt parent, a charitable organization under IRC Section 501(c)(3), intends
to market software it developed in consequence to furthering its exempt purpose
of operating a multi-service geriatric center. The software tracks the many
services provided to the elderly to report its funding sources to the Department of
Health and Human Services (DHHS).
The parent will transfer its rights, title and interest in the software and technology
to its for-profit subsidiary in exchange for 100% of the subsidiary’s capital stock.
The board of directors will consist of five members, only one of which will be a
director or employee of the parent organization. The subsidiary will pay dividends
to its parent.
The IRS concluded that the parent’s relationship with and ownership of capital
stock in its subsidiary will not jeopardize its exempt status. Also, the transfer of
ownership rights in the software to the subsidiary, the reimbursement of the cost
of employees, supplies, etc. to the parent, and the stock dividends paid by the
subsidiary to the parent organization will not result in UBTI.
b.
2.
Taxable Subsidiary: Self-Insurance Trust; PLR 200501017 (October 15, 2005),
see: http://www.irs.gov/pub/irs-wd/0501017.pdf
a.
This ruling involves a parent organization exempt as a charitable entity under IRC
Section 501(c)(3) that participates in a self-insurance trust that is also recognized
as a charitable entity. A taxable subsidiary of the parent participates in the trust as
well.
b.
The IRS concludes that the receipt of the insurance premiums by the trust that are
paid by the taxable subsidiary constitute UBIT to the trust.
3.
Exempt Affiliate: Sale of a Fraternity; PLR 200427031 (April 8, 2004), see:
http://www.irs.gov/pub/irs-wd/0427031.pdf
33
IRC Section 512(b)(13)(D)(i); Treas. Reg. 1.512(b)-1(l)(4)(i)(b).
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a.
A fraternity house was sold to a university by the fraternity. The fraternity
proposed to convert into a 501(c)(3) organization and invest the proceeds from the
sale to purchase securities, the income of which would be used to fund
scholarships.
b.
Generally, when a social club such as a fraternity sells property, it must recognize
gain on the sale unless the receipts of the sale are used to purchase other property
used for its exempt function.
c.
The IRS ruled that no capital gain would be recognized as long as the net
proceeds on the sale were used to purchase the securities within three years of the
date of the sale of the fraternity house.
V.
Reporting Requirements
A.
Overview
The IRS with supervision from the Treasury department and guidance from
Congress has issued pronouncements on filing information returns to ensure
compliance.
B.
Form 990, Return of Organization Exempt from Income Tax
1.
The IRS published temporary and proposed regulations that amend procedural
and administrative regulations to require large exempt organizations to file their
annual information returns annually beginning in 2006 [T.D. 9175 and REG –
130671-04, January 6, 2005].
a.
Exempt organizations with assets of $100 million or more will be required to
electronically file Form 990 for tax years ending on or after December 31, 2005.
This requirement is expanded to include exempt organizations with assets of $10
million or more for tax years ending on or after December 31, 2006.
b.
These requirements only apply to entities that file at least 250 returns, including
income tax, excise tax, information and employment tax returns during the
calendar year.
c.
This filing requirement does not include forms 990-T, Exempt Organization
Business Income Tax Returns.
d.
The IRS released publication 4453, IRS E-File for Charities and Non-Profits,
Form 990, that discusses the registration process.
2.
The IRS issued final regulations that discuss the automatic extension of time to
file for form 990. These regulations removed the requirement for a signature and
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an explanation to obtain an automatic extension of time to file these returns. [T.D.
9163, December 6, 2004]34
These final regulations clarify that corporate filers of Form 990-T may obtain a
six-month extension automatic extension to file by properly filing form 8868.
3.
Governmental Units Excluded from Filing Form 990
a.
Revenue Procedure 95-48 provides that pursuant to Treasury Regulation 1.60332(g)(6) governmental units and their affiliates are excluded from filing form 990,
Return of Organization Exempt from Income Tax.35 Importantly, this exclusion
does not apply to filing form 990-T, Exempt Organization Business Income Tax
Return.
b.
Private Letter Ruling (PLR) 200527019 (April 18, 2005), see:
http://www.irs.gov/pub/irs-wd/0527019.pdf
i.
The IRS concludes that a charitable entity under IRC Section 501(c)(3) organized
to provide financing for the purchase and construction of public facilities in the
county by issuing various types of debt for the benefit of the county is excluded
from filing form 990 since the charity is an affiliate controlled by a government
unit. The county officials govern the affairs of the charity, the charity is included
in the financial statements of the county and, upon termination, the assets of the
charity revert to the county.
ii.
The criteria put forth in Rev. Proc. 95-48 reads as follows:
An organization will be treated as an affiliate of a governmental unit if it is
described in IRC Section 501(c) and either (a) it has a ruling from the IRS that (i)
its exempt purpose is excluded under IRC Section 115 (ii) it is entitled to receive
deductible contributions under IRC Section 170(c)(1) because the contributions
are for the use of a governmental unit; or (iii) it is a wholly owned instrumentality
of a state or political subdivision for employment tax purposes; or, (b) without
such a ruling, the organization must meet the facts and circumstances test.
The criteria to meet the facts and circumstances test include (1) the organization is
either operated, supervised or controlled (within the meaning of Treasury
Regulation 1.509(a)-4(g)(1)(i)) by governmental units or by an organization’s
governing body that is elected by the public at large; (2) the organization
possesses two or more affiliation factors listed under Section 4.03 of the
procedure statement;36 and, (3) its filing of form 990 is not necessary for the
efficient administration of internal revenue laws.
34
Treasury Regulations amended include the following: 1.6081, 31.608(a)-1, 53.6081-1, 55.6081-1,
156.6081-1, 301.6651-1.
35
1995-2 CB 418 (1995).
36
These factors, in general, include (a) the organization was created by one or more governmental units in
their official capacity (b) the organization’s support is received principally from taxes, tolls, fines, fees
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iii.
For those affiliated government agencies that do not file form 990 and do not have
on file a letter ruling from the IRS described above, they should ensure that they
meet the facts and circumstances test accordingly.
C.
Forms 1099-Misc, Miscellaneous Income for P-Card Transactions
1.
The IRS issued final regulations for Form 1099 when reporting, and possibly
backup withholding, on payment card transactions.37 A payment card or credit
card is a card that is issued by a payment card organization and represents an
agreement by the cardholder to pay the merchant through the payment card
organization. The IRS recognizes the difficulty for the cardholder, the educational
institution, to report this transaction since the employee usually does not obtain
the merchant’s name and taxpayer identification number (TINs) at the time of the
transaction, and backup withholding is difficult since the payment card
organization makes the payment directly to the merchant.
2.
These regulations provide withholding exceptions when payments are made
through a Qualified Payment Card Agent (QPCA). A QPCA, i.e. American
Express, MasterCard, is given authority to validate merchants TINs on behalf of
the school.
3.
These reporting and back-up withholding rules apply to payments made in 2005.
4.
Note the IRS has always considered the cardholder to be responsible for payments
made by these payment cards when the transactions are required to be reported on
form 1099-Misc.
5.
Rev. Proc. 2004-43 gives IRS guidance on whether payments are reportable based
on the merchant classification code (MCC) assigned to entities that accept credit
cards.
D.
Form 8802, Application for United States Residency Certification
1.
The IRS explains in a recent information release that it has issued a new form
8802, in an effort to obtain proof of residency for those taxpayers who conduct
business in foreign countries.38 Many foreign countries withhold tax on certain
types of income paid from sources within those countries to non-residents. The
certification, Form 6166, results in lower treaty rates for those employees working
overseas as well as reduced or no withholding on grants, royalties and other types
of payments received by educational institutions from businesses or schools
collected pursuant to statutory authority; (c) the organization is financially responsible to one or more
governmental units; (d) one or more governmental units exercises control over the organization; (e) upon
dissolution, the organization’s assets revert to one or more of the governmental units.
37
T.D. 9136, July 7, 2004, amends Treasury Regulation 31.3406(g)-1(f).
38
IR-2004-78, June 8, 2004
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abroad. This certification may also abate value-added tax (VAT) in some
countries.
2.
Previously, the taxpayer used a form letter to obtain the certification letter,
however, this new form should systematize the process, streamlining requests.
E.
Form 1098-T, Tuition Statement and Form 1098-E, Student Loan Interest
Statement
1.
Revenue Procedure 2005-50 provides procedures for obtaining automatic consent
to change reporting method.
For calendar years beginning after Dec. 31, 2003, an eligible educational
institution had to elect to report either the aggregate amount of payments received
or the aggregate amount billed for qualified tuition and related expenses during
the calendar year for enrolled students on Forms 1098-T. Once elected, the
institution must continue to use that same method, unless it obtained permission
from the IRS.
The guidance sets forth the procedures to follow to obtain automatic consent to
change from one method to the other. The procedures include a written statement
signed by an authorized officer under penalties of perjury with reference to this
pronouncement and the following:





the educational institution’s name and employer identification number;
all locations and branch campuses included;
the method of reporting to which the institution system is changing;
the calendar year for which the change in reporting is effective; and
a statement as to whether the eligible institution, or any of its locations and
branch campuses, has changed its method of reporting within the four
previous years, and if so, the calendar year of the previous change and an
explanation of the extraordinary circumstances for the new change.
An eligible institution may only change its method of reporting under this revenue
procedure once every five years, unless there is some significant hardship or other
extraordinary circumstances.
This method of reporting is made at the institution level, thereby, impacting large
institutions with various locations and branch campuses. If the eligible
educational institution changes its method of reporting, then all locations and
branch campuses must also use the new method, if they were not already doing
so. However, because the IRS did not previously announce this conformity
requirement, it will allow eligible institutions to continue to use different methods
among your locations, if you elected the reporting methods before this revenue
procedure’s effective date of Aug. 8, 2005.
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2.
In LTR 200521011, dated February 15, 2005, the IRS concluded that the
university may report on Form 1098-T the qualified tuition and other expenses
billed in the calendar year that represent expenses incurred throughout the entire
academic year (i.e. the Fall session for this calendar year and the Spring session
for the next calendar year).
Since IRC Section 25A disallows the taxpayer in the current year an education
credit for those qualified expenses that are incurred beyond the first three months
of the following calendar year, the IRS recommended that the university advise
students that they may not claim such expenses as an education tax credit
currently.
3.
The IRS issued Notice 2004-63, dated September 17, 2004, that grants relief to
schools and other filers of form 1098-E for the deduction of interest paid on
qualified education loans. The IRS will not assert penalties for failure to report
information attributable to loan origination fees and capitalized interest received
from such loans made on or after September 1, 2004 provided the requirements
are met. This waiver applies to such fees and interest received during the calendar
year 2004.
F.
Non-Resident Alien Pronouncements
1.
Revenue Ruling 2005-44: Form 8233
a.
This revenue procedure renders obsolete previous rulings39, which describe the
representations that a nonresident alien student, teacher, or researcher at a
university or other educational institution must make to claim an exemption from
withholding tax on personal services income under certain provisions of U.S.
income tax treaties. Many treaties have been updated or replaced and, apparently,
are no longer correct. For instance, these requirements typically limit the number
of years in which the nonresident alien can claim the exemption, and provide a
maximum dollar amount for the exemption in a taxable year.
b.
In general, the school is exempt from withholding requirements if the payment is
exempt under a treaty. To obtain exemption, the individual must give the school a
Form 8233, Exemption From Withholding on Compensation for Independent (and
Certain Dependent) Personal Services of a Nonresident Alien Individual,
certifying that the compensation is exempt. This procedure corrects any previous
inconsistencies by requiring the school to have the individual complete the form
in accordance with the procedures set forth in Publication 519, , U.S. Tax Guide for
Aliens.
2.
Final Regulations under IRC Section 861
39
Rev. Proc.93-22, 1993-1 C.B. 535; Rev. Proc. 87-8, 1987-1 C.B. 366; and Rev. Proc. 87-9, 1987-1 C.B.
368.
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a.
The IRS has issued final regulations under section 861 that provide guidance on
income sourcing rules that determine whether the income paid to the non-resident
alien is excluded from taxation as non-U.S. sourced income.40 These rules
describe the proper basis for determining the source of compensation from labor
or personal services performed partly within and partly without the United States
for employees and other individuals or corporation.
b.
These regulations provide two methods to properly identify sources of
compensation that an individual receives, i.e. time and geographic basis. For
instance, remuneration is contingent on time, i.e. a ratio of days for labor or
personal services performed within the United States to the individual's total
number of days. Certain fringe benefits (housing, education, local transportation,
tax reimbursement, and moving expense reimbursements), are based on
geographical location.
VI. Charitable Giving
A.
Final Regulations on Charitable Remainder Trust (CRTs) distributions: T.D. 9190
These regulations discuss the ordering rules of IRC Section 664(b) for
characterizing distributions from charitable remainder trusts (CRTs). They reflect
changes made by a series of recent legislative acts that subject qualified dividends
to a capital gains tax rates rather than to ordinary income tax rates, and gains from
the sale of capital assets to varying tax rates.41
1.
Income derived by the CRT is to be assigned to three categories: the ordinary
income category, the capital gains category, or the other income category. Within
the ordinary income and capital gains categories, income is also assigned to
different classes based on the federal income tax rate applicable to each type of
income in the category. For example, both dividends and interest would be in the
ordinary income category; however, interest is taxed at ordinary tax rates while
qualified dividends are taxed at the lower capital gains tax rates.
2.
Distributions are to be made in the following order: ordinary income, capital gain,
other income, and trust corpus. Within the ordinary income and capital gains
categories, income is treated as distributed from the classes of income in that
category beginning with the class subject to the highest federal income tax rate
and ending with the class subject to the lowest federal income tax rate. For
example, interest would be distributed prior to qualified dividends. With respect
to capital gains, twenty-eight percent capital gains would be distributed before the
lower taxed capital gains.
This regulation also withdraws the notice of proposed rulemaking REG-208254-90
published in the Federal Register on January 21, 2000 (65 FR 3401).
40
41
Taxpayer Relief Act of 1997 (TRA), Public Law 105-34 (111 Stat. 788); The Internal Revenue Service
Restructuring and Reform Act of 1998, Public Law 105-26 (112 Stat. 685); Jobs and Growth Tax Relief
Reconciliation Act of 2003 (JGTRAA), Public Law 108-27 (117 Stat. 752).
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3.
The proposed regulations further discuss the process of netting capital gains and
losses with respect to gains taxed at varying rates.
B.
Guidance on Donations of Qualified Intellectual Property: Temporary and
Proposed Regulations 1.6050L-2T and 1.6050L-2 and Notice 2005-41
1.
The American Jobs Creation Act of 2004 added sections to and amended a section
of the IRC regarding donations of qualified intellectual property. IRC Section
170(e)(1)(B)(iii) provides that the amount of a donor’s initial charitable
contribution of qualified intellectual property is limited to the lesser of the fair
market value of, or the donor’s adjusted basis in, the property. IRC Section 170
(m) allows the donor to deduct as charitable contributions additional amounts
based on a percentage of the qualified donee income received by or accrued to the
donee. IRC Section 6050L is amended to require the donee to issue a report on the
amount of the donation.
2.
Qualified intellectual property includes patents, trade names, trade secrets,
trademarks, know-how property, certain copyrights and software that are donated
to charitable organizations that qualify as public charities under IRC Section
509(a). Qualified donee income is defined as any net income properly allocable to
the qualified intellectual property that is received by or accrued to the donee
organization during the year.
3.
To qualify for the additional deductions, the donor must inform the donee at the
time of the contribution that the donor intends to treat the contribution as a
qualified intellectual property contribution. The donee is required to file an
information return with the IRS and the donor on or before the last day of the first
full month following the close of the donee’s taxable year. The new form to use is
form 8899.42 The information included is similar to language in the
acknowledgement letters.
4.
The additional deduction is equal to 100% of the qualified donee income in the
first two years. The percentage is reduced by 10% each year thereafter until it
reaches 10 percent in the eleventh and twelfth years following the gift. For all
years, the deduction is available only to the extent that the aggregate of all
otherwise qualified donee income exceeds the amount deducted for the initial
contribution of the property.
5.
No information return is required if there is no net income for the donee’s taxable
year. No return is required if the income is received or accrued after the ten-year
period beginning with the date of the contribution or after the expiration of the
legal life of the property.
C.
CRAT, CRUT Safe Harbor for Surviving Spouse – Rev. Proc. 2005-24
42
Transitional rules apply regarding the filing date and donor notice of intent to treat the donation as a
qualified intellectual property contribution.
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1.
The IRS issued a revenue procedure to resolve conflict between federal tax
regulations and state inheritance laws. IRC Section 664(d) requires that no
payments of the remainder interest from the Charitable Remainder Annuity Trust
(CRAT) or Charitable Remainder Unitrust (CRUT) be paid to or for the use of
any person other than the charitable organization provided in the agreement. State
statutes, in particular those that adopt the Uniform Probate Code, however, may
allow the surviving spouse the right to elect a statutory share of the decedent’s
estate, in some cases, broadly defined to include the CRATs and CRUTs,
triggering a violation of the federal regulation. This safe harbor allows the IRS to
disregard this right of election.
2.
The safe harbor requires the surviving spouse to waive the right of election
effective under state law for those trusts created on or after June 28, 2005. For
those trusts that precede this date, no waiver is required provided the surviving
spouse does not exercise the right of the election. This waiver must be obtained
on or before the date that is 6 months after the due date of the annual information
tax return (Form 5227) for the CRAT or CRUT in the year in which the later of
the following occurs:
a.
b.
c.
the creation of the trust,
the date of the grantor’s marriage to the surviving spouse
the date in which the grantor first becomes a resident of a state that provides this
right of election,
the effective date when the state law created this right of election.
d.
3.
No waiver is required if the state law does not provide the surviving spouse with
the right of election, or the grantor’s estate does not include the assets of the
CRAT or CRUT. This safe harbor is not available if the surviving spouse
exercises the right of election.
D.
Sample Charitable Remainder Trust Forms: Rev Procs 2005-52 thru 2005-59.
1.
The IRS has issued sample charitable remainder trust forms replacing the sample
forms issued in 1990.
2.
The forms include annotations and explanatory material.
E.
Guidance on Charitable Deductions for Donated Vehicles – Notice 2005-44
1.
The IRS issued this notice as interim guidance to the provision in American Jobs
Creation Act of 2004 that includes rules for deducting charitable contributions of
qualified vehicles. Qualified vehicles include motor vehicles, boats, and airplanes
that have a claimed value of more than $500.00. 43 If the qualified vehicle is sold
by the donee organization without significant intervening use or material
43
Pub. L. No. 108-357, 118 Stat. 1418 (2004).
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improvement by that organization then the deduction claimed by the donor may
not exceed the gross proceeds from the sale of the vehicle. If there is significant
intervening use or material improvement accordingly, then the gross proceeds
limitation does not apply, however, the deduction is limited to the fair market
value of the vehicle at the time of the contribution. This notice provides a special
rule that allows the donor to claim a fair market value deduction when the charity
gives or sells the vehicle at a low price to a needy individual in furtherance of the
organization’s charitable purposes.
2.
The donor must meet the substantiation requirements provided. The IRS recently
released form 1098-C and instructions for use in providing the substantiation to
both the IRS and the donor regarding the gifts of donated vehicles.
3.
This notice is effective for contributions made on or after January 1, 2005.
F.
IRS Explains International Grantmaking Rules - ILM 200504031
The memorandum reviews some general rules for donors when engaging in
international grant making activities. Contributions to a foreign charity are
generally non-deductible. Contributions to a charitable organization under IRC
Section 501(c)(3) that transmits the funds to a foreign charitable organization are
deductible only if it can be shown that the contribution is in fact to or for the use
of the domestic charity, and that the domestic charity is not serving as an agent
for, or conduit of, a foreign charitable organization.
VII.
Proposed Regulations on Private Benefit and Excess Benefit Transactions
The IRS issued proposed regulations under IRC Sections 501(c)(3) and 4958 that provide
examples of private inurement and benefit as well as give guidance on the interrelationship between these two sanctions.
A.
B.
As background, Treasury regulation 1.501(c)(3)-1(c)(2) provides that an
organization is not operated for charitable purposes if any of its net earnings inure
to the benefit of a private shareholder or individual. Treasury regulation
1.501(c)(3)-1(d)(1)(i) provides that no exemption will be recognized if the
organization benefits private interests, such as, designated individuals, the creator
or his family, shareholders of the organization, or persons controlled, directly or
indirectly, by such interests.
The regulations give examples that illustrate that private inurement and benefit
proscriptions may involve non-economic as well as economic benefits and may
include payments made to private interests that are reasonable and not excessive.
Examples of such cases include an educational organization that provides
genealogy studies to only one family; a museum that sells art on consignment,
remitting 90% of sales proceeds to artists; and an educational organization that
provides programs that benefit a for-profit company that created the charity even
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though it pays that company reasonable rates for the use of licensing intellectual
property.44
C.
As background, IRC Section 4958 imposes certain excise taxes on transactions
that provide excess economic benefits to disqualified persons with respect to
public charities, private schools and other charitable organizations, i.e.
foundations and alumni associations, etc.
This Section imposes an intermediate sanction of 25% for an excess benefit
amount on a disqualified person and 10% on an insider. A disqualified person is
defined as a person who is in a position to exercise substantial influence over the
affairs of the charitable organization.45 An insider is defined to include an
organization manager who knowingly participates in an excess benefit
transaction.
IRC Section 4958(c)(1) defines excess benefit transaction as a transaction that
provides economic benefit by an applicable organization, i.e. an educational
institution, directly or indirectly to or for the use of any disqualified person if the
value of the economic benefit exceeds the value of the consideration.
D.
The regulations give examples that indicate that the proscriptions for private
inurement and private benefit are not mutually exclusive in relation to the excess
benefit transactions, i.e. in certain situations, the disqualified person may be
subject to an intermediate sanction and the charitable organization may lose its
exemption.
Factors used to determine whether a charitable organization may lose its
exemption for violations under the excess benefit rules includes the following:
1.
2.
3.
4.
E.
whether the organization has been involved in repeated excess benefit
transactions,
the size and scope of the excess benefit transactions,
whether the organization has implemented safeguards to prevent recurrences,
whether there was compliance with other applicable laws.
Note that IRC Section 4958 goes on to state that the economic benefit shall not be
treated as consideration for the performance of services unless such organization
clearly indicated its intent to so treat such benefit. This provision has been
interpreted to provide an ‘automatic’ excess benefit if compensation items, such
44
The IRS recently released private letter rulings that support transactions between related parties that do
not trigger private inurement or benefit for sales of property from one to the other. PLR 200532052
concluded that sales of property between a fraternity and charitable fund did not raise any exemption
concerns since the transactions were conducted at fair market value. PLR 200517031 concluded that a real
estate sale between a private foundation and disqualified person did not trigger violations of private
inurement or benefit since the amounts are based on fair market values as evidenced by independent
appraisal and valuation reports.
45
IRC Section 4958(f)(1).
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as, taxable fringe benefits, were not properly reported as compensation when
earned.46
The IRS recently released a myriad of related technical advice memorandums
(TAMs) that assessed intermediate sanctions for conducting excess benefit
transactions on family members who operate a charitable organization. These
rulings imposed penalties on the founder, a disqualified person, his spouse, son
and son-in-law for failing to satisfy the accountable plan requirements with
respect to travel, meals, use of the cell phones and other miscellaneous
expenses.47
VIII. Bonds
A.
Background
1.
The IRS has allocated additional resources and increased its focus on the taxexempt bonds (TEB) area over the past few years. Between the Field Operation
and Outreach & Planning offices, the IRS closes over 300 audits annually. In
general, the review issues include arbitrage and private use matters.
2.
The issuer must comply with the restrictions on arbitrage to maintain the interest
exemption. IRC Section 103 excludes from gross income interest on government
or qualified 501(c)(3) bonds; provided, the issuer rebates arbitrage, if any, to the
IRS. Arbitrage is reported on form 8038-T, Arbitrage Rebate, and is typically due
every 5th year during the term of the issue. IRC Section 148(a) generally defines
arbitrage as using bond proceeds to acquire higher yielding investments. Failure
to pay the rebate when required can result in the bonds being classified as
arbitrage bonds, losing the exemption for interest.
3.
The issuer must comply with the private use restrictions to maintain this interest
exemption. The Internal Revenue Code (IRC) Section 103(a) excludes from gross
income interest on any state or local bond unless the bond is a private activity
bond that is not a qualified 501(c)(3) bond. IRC Section 141(b) provides that a
bond is a private activity bond if it is part of an issue that meets either (a) the
private business use test and the private payment or security test48, or (b) the
private loan financing test. IRC Section 141(b)(1) states that except as otherwise
provided, an issue meets the private business use test if more than 10% of the
proceeds of the issue are to be used for any private business use. IRC Section
145(a) limits this threshold to 5% for qualified 501(c)(3) bonds. Failure to comply
with these restrictions results, in general, in taxability of the bonds.
46
The IRS released this past year a new chapter to its FY 2004 Continuing Professional Education textbook
that discusses that economic benefits received by a disqualified person from a charitable organization may
qualify as an automatic excess benefit transaction, thereby, triggering intermediate sanctions.
47
Technical Advice Memorandums 200435018-200435022 (Aug. 27, 2004).
48
Note that the private use tests are written as some experts say ‘upside down’. For example, to ‘meet’ or
‘pass’ the private use tests means that the bond derives the requisite ‘private use’ to constitute a private
activity bond, causing the bond to lose its exemption benefits.
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4.
Note that although the IRS examines the records maintained by the issuers or
conduit borrowers in a field or correspondence examination, the bondholders are
the parties that are being audited, not the issuer or borrower. Thus, upon dispute,
the issuer or borrower generally does not have recourse to the judicial system and
must settle matters with the IRS Appeals office. Alternatively, the IRS has
implemented programs and promulgated regulations.
B.
Procedure to Correct Failure to Pay Arbitrage Rebate – Notice 2005-40
1.
As background, the rebate must be paid no later than 60 days after the
computation date to which the payment relates.49 Failure to pay the correct rebate
amount when required will cause the bonds of an issue to be arbitrage bonds
unless the Commissioner determines that the failure was not caused by willful
neglect and the issuer promptly pays a penalty accordingly. The penalty for a
bond that is not a private activity bond is 50% of the rebate amount not paid when
required, plus interest. Otherwise, the penalty is 100% of the rebate amount. If the
payment on the amount due, plus interest, is made within 180 days after the issuer
discovers its error, the bond is not subject to the penalty.50
2.
Procedures for correcting a failure to pay rebate include submitting the form
8038-T with the correct payment amount and an explanation that the late payment
is not due to willful neglect. Factors to establish lack of willful neglect includes
the following:
a.
b.
c.
d.
e.
f.
g.
the unpaid rebate amount,
the sophistication of the issuer,
the length of the delay,
the steps taken to comply once the late payment is discovered,
the nature of the failure,
history of late payments, and
any other relevant information.
C.
Suit to Recover Arbitrage Rebate Untimely – TAM 200446021
1.
In this technical advice memorandum, the issuer filed on form 8038-T its
arbitrage rebate when the last bond of the issue was redeemed. Seven years later
the issuer discovered that the payment was in excess of the actual amount owed
and filed for refund.
2.
The IRS concluded that the limitations period for a bond issuer to bring an
arbitrage rebate refund is the general six-year period, and, thereby, denied the
issuer its claim.51 This six-year period begins upon payment of the rebate
submitted with the form 8038-T. The IRS rejected the issuer’s argument that it
49
Treasury regulation 1.148-3(g).
Treasury regulation 1.148-3(h)(3).
51
28 U.S.C. Sections 2401(a); 2501.
50
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may file a refund as provided with IRC Section 6532. This provision provides that
the taxpayer may bring a suit to recover refund claims within a two-year period
from the date the claim is denied when the refund claim represents a tax, a penalty
or sum paid in excess. Per the IRS “the payment of a rebate is an alternative to a
payment of tax and stands apart from any tax”, and with respect to ‘a sum’, in the
IRS’ opinion it “does not encompass an arbitrage rebate”.
3.
The typical statute of limitations period, i.e. three years, for tax refund claims as
defined under IRC Section 6511 was rejected for the same reasons.
D.
Legislative Proposal to Remedy Private Use with Research Facilities
1.
Educational institutions that finance research facilities with tax-exempt debt may
derive private use by receiving funds from federally sponsored research programs.
The federal government is considered to be a private party when determining
whether bond proceeds meet the private use restrictions.52 The IRS has put forth a
‘fact and circumstances’ test and safe harbors to prevent sponsorship research
from resulting in private use, however, these provisions do not necessarily apply
to federally sponsored research.53
2.
The paucity of authority with respect to the ‘facts and circumstances’ test leaves
the issuer with no comfort or reliance that this exception applies to federally
sponsored research programs.
3.
The two safe harbors arguably fail to specifically include such federal funding
arrangements.
a.
The ‘corporate sponsored research’ safe harbor provides that private use may not
arise if any license or other use of resulting technology by the sponsor is on the
same terms as other unrelated, non-sponsoring parties, i.e. the sponsor is paying a
competitive price for use of the intellectual property. The price is determined at
the time the license or other resulting technology is made available for use. Since
the federal government receives non-exclusive royalty-free rights with respect to
its research as provided under the Bayh-Dole Act, this safe harbor does not seem
to apply to those schools that commercialize their research results.
b.
The ‘cooperative research agreements’ safe harbor states that private use is not
triggered when two or more ‘unrelated’ sponsors who agree to fund
governmentally performed basic research receive non-exclusive, royalty-free
licenses to use the product; provided, the school performs the research and
maintains title to the resulting property. Since federal funding tends not to involve
multiple, unrelated sponsors, this provision does not readily apply.
52
Treasury regulation 1.103-1.
The facts and circumstances test is found in Treasury Regulation 1.141-3(b)(6); the safe harbors are
discussed in Rev. Proc. 97-14, 1997-1 CB 634 (Jan. 10, 1997).
53
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4.
With much contribution and effort from Council on Government Relations
(COGR) and NACUBO Tax Council, a proposal has been submitted for
legislation to remedy this oversight. The following language (as underlined) is
intended to be attached to a bill that should be reintroduced to Congress:54
Private business use defined
In general. For purposes of this subsection, the term “private business use”
means use (directly or indirectly) in a trade or business carried on by any person
other than a governmental unit. For purposes of the preceding sentence, use as a
member of the general public or use in the performance of research using, in
whole or in part, funds of the United States or any agency or instrumentality
thereof, shall not be taken into account.
IX.
NACUA ListServe Questions
A. Charitable Contribution Pledges and Payments
This question pertains to the enforceability, from a contractual perspective, of a
donor’s pledge to make a payment toward a promised donation in the current or a
future year. Is such a pledge a legally enforceable obligation rising to the level of
a contractual status? Can the institution consider the pledge as an asset to
evaluate the overall financial picture of the institution, including the reliance of
the pledge in obtaining loans/bond proceeds?
B. Clarification and Application of the Rules and Formula Applicable to University
Owned/Provided Lodging
The Tax Code sets out rules for lodging provided for the convenience of the
employer. IRC 119. Special rules are applicable to lodging provided to
employees of educational institutions. IRC 119(d). Under those rules, the value
of qualified campus lodging furnished to an employee of an institution of higher
education is not included in the employee’s gross taxable income so long as the
employee has paid rent of at least (1) five percent (5%) of the appraised value of
the lodging or (2) an average of rental payments for comparable lodging paid by
those who are not employees. IRC 119(d)(2).
C. Tax Treatment of Fellowship Payments to Post-doctoral Students.
D. Status of Whether Federally Funded Research Must be Treated as “Private Use”
In Determining the Amount of Tax-Exempt Bond Financing That May Be Used
in Facilities Constructed with Such Bonds.
E. Use of IRS Circular 230 Disclaimer Language: When is it necessary or
appropriate?
54
Sen 2737, Science Park Administration Act of 2004, , (August 12, 2004) will be amended accordingly.
National Association Of College and University Attorneys
38
F. State Income Tax: For employees who live or work outside the state jurisdiction
of the institution, is it necessary/appropriate to withhold and report income tax
for the foreign jurisdiction?
G. Current Status of Joint Ventures with/between tax-exempt and for-profit entities.
H. Whether Qualified Tuition Reduction arrangements (IRC 117(d)) Are Permitted
to be Extended to Retired Employees and, if so, Under What Criteria.
I.
Repayment or Forgiveness of Educational Loans: Are Such Arrangements
Taxable Under IRC 108?
National Association Of College and University Attorneys
39
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