Leading Practices to Mitigate Tax Risk for a Nonprofit School

Independent schools risk embarrassment and possibly sanctions if they make tax-related mistakes. Seemingly simple mistakes on a tax filing or engaging in certain activities could force an institution to spend valuable time and resources for months — or even years — on damage control.

What can tax-exempt schools preemptively do, right now, to protect themselves? Here are a few leading practices and policies nonprofit schools should consider.

Adopt and follow written policies

One of the better ways to implement good controls across your school is to create and enforce written policies. Organizations should have clear, thoughtful, well-communicated tax and governance policies and procedures guiding anything from what board members should do if they have a conflict of interest to how the organization should accept nontraditional contributions. The IRS believes if nonprofits have strong policies and procedures in place, they’ll be more likely to comply with tax laws.

Know the tax rules

Tax-exempt schools need to be aware of all tax requirements that may impact them.

Remaining compliant with every tax rule and regulation isn’t always easy. Schools are often tight on resources, rules are sometimes counterintuitive, and a common perception is that nonprofits don’t have any tax issues.

One of the more common tax rules for a tax-exempt school is that net revenue from business activities not related to the organization’s exempt purpose may be subject to unrelated business income tax.

For example, many schools receive revenue from renting their conference space and athletic facilities. Some institutions treat this as unrelated business taxable income and others do not. As is often the case with many tax positions, it’s essential to understand the many nuances, exceptions, and gray areas in the rules. The answer to whether the conference or athletic facility rental is taxable or not is very dependent on the institution’s specific facts and circumstances — and there’s not always a bright line test.

Understanding the tax rules also provides a foundation for good tax planning and beneficial structuring, as well as reducing tax risks.

A few other areas tax-exempt schools should understand include:

• Is there any worker reclassification exposure? If so, that could be a costly mistake.
• Are your nonqualified deferred compensation agreements set up correctly? Especially in light of the excise tax on excess compensation, it’s important to carefully consider items like severance agreements, sabbaticals, and early retirement incentives.
• Is your executive fringe benefit tax treatment in order? The federal rules related to this item are not always intuitive, leading to tax exposure for many schools.
• All organizations should carefully follow the accountable plan rules for their travel, meals, and entertainment reimbursements.

If institutions have endowments with alternative investments, we recommend they make sure they’re complying with federal and state tax filing requirements. This means, like those in the for-profit sector, tax-exempt schools may need to:

• Be aware of quarterly estimated tax requirements
• Know the tax extension requirements to avoid penalties
• Be aware of any additional disclosure filings generated from direct and indirect foreign investments to avoid the potential for significant noncompliance penalties

Documentation is key

Documentation is another excellent risk management tool.

We recommend reviewing and documenting not only any new activities, to determine if they are related to the exempt purpose or not, but also revisiting certain existing activities with a fresh set of eyes.

Sometimes there is turnover in the financial management level, and administration executives “inherit” tax positions from their predecessors. Sometimes the facts change — or the tax laws change. So, it can be very worthwhile to have good documentation; then there’ll be no need to completely reinvent the wheel.

To give a typical example, many private schools provide their presidents and heads of school with campus housing. Most of the time the president or head of school is required to live on campus in the head of school’s house — and living there is essential to the performance of the responsibilities of the position. Customarily, schools treat it as nontaxable. But to qualify for tax-free treatment, the requirements in the tax law must be followed.

What if the head of school of a nonresidential day school, rather than a boarding school, is provided the on-campus housing? What if the school provides the head with a residence a couple miles away from the main campus? What if there are three heads of school over a period of time, and the middle one negotiates the ability to forgo living in the head’s residence; does this mean the first and third were not also technically required to live in the house to perform their responsibilities? Do all of these qualify as tax free?

Properly documenting previous tax-related decisions goes a long way in helping nonprofit financial management avoid expending valuable time and energy trying to remember, explain or justify why they came to their conclusion.

And although being consistent is often a fine approach, just because “that’s how we’ve always done it” or the perception “that’s how everyone else treats it” is not always the strongest stance.

Proper documentation helps reduce tax exposure — and helps an institution’s leadership enjoy confidence in its excellence.

Review the IRS’s new Audit Technique Guides

The Internal Revenue Service has also provided a tax risk management tool. The IRS has “Audit Technique Guides” for various types of tax-exempt organizations. The guides are meant to help IRS examiners, but can also be excellent resources for tax-exempt board members, executives, and their advisors.

Interestingly, but also predictably, a few of the many areas the IRS audit plans cover are:

• Unrelated business activities that produce continual losses
• Donors reported on the IRS form as anonymous when “otherwise identifiable”
• Employer-provided housing

There are several guides, including those for public charities, private schools and colleges/universities, other educational organizations, religious organizations, other 501(c)(3) organizations, social clubs, business leagues, and one audit guide for fundraising activities that applies to many types of exempt organizations.

How we can help

Clearly, there are various potential tax-related issues nonprofit organizations need to consider, and many additional potential red flag areas, from corporate sponsorship rules to compensation matters to unrelated business activities.

The good news is, with a continual improvement frame of mind, just about any tax-related mistake can be corrected. CLA’s nonprofit industry professionals can help your school reduce the risk from most tax-related oversights by planning, documenting, and implementing strong governance and written policies.