The Internal Revenue Service has found that the vast majority of colleges and universities have endowment funds invested in a wide range of securities.
The agency disclosed the finding in an interim report on responses to a compliance survey that comes on the heels of a Congressional Budget Office study concluding Congress could save billions of dollars by prohibiting tax-exempt colleges and universities from earning arbitrage indirectly through endowments that are invested at higher interest rates than what they are paying on their tax-exempt bonds.
The IRS also said the report has led it to initiate over 30 audits of schools to look into unrelated business expenses and executive compensation issues. In addition, 13 other schools were referred to the IRS Exempt Organizations Division’s audit team for not responding to the survey, which were sent out to 400 schools of varying sizes.
Of the 344 schools that responded to the survey, the vast majority reported that they had endowment funds. Specifically, 83% of small schools, 88% of medium schools, and over 95% of large schools reported endowment funds, which were widely invested in a variety of securities, including hedge funds, real estate, and foreign investments, as well as fixed-income funds.
In turn, those endowments were used to fund a variety of initiatives. Over 95% of the schools reported using endowment funds for scholarships, awards, grants, and-or loans to students. Over half of the schools reported using the funds for general education support and-or libraries, and roughly half used them for “general university operations” as well.
“This compliance project … gives us a lot of valuable information on activities conducted by those organizations that will help us in our enforcement and services efforts,” said Lois Lerner, director of the Exempt Organizations Division.
The service plans to release a final report later, after all the data has been analyzed.
The IRS’ findings come just one week after the CBO found that if Congress decided to expand the definition of arbitrage to take into account all of the investment assets of nonprofit borrowers, roughly 90% of schools would be considered to be earning arbitrage profits.
Nonprofit universities, like all other tax-exempt borrowers, are restricted from earning arbitrage by investing bond proceeds at a significantly higher interest rate than the one on the bonds. However, the CBO report concludes that the tax law currently does not prevent borrowers from “engaging in what is essentially indirect tax arbitrage.”
Indirect arbitrage, according to the CBO, is when a borrower earns interest on investment assets not directly financed with bond proceeds at an interest rate higher than the one on its tax-exempt bonds. If the borrower holds onto those investments and instead sells tax-exempt bonds to pay for capital expenditures for a project, it is effectively using tax-exempt proceeds to invest in higher-yielding securities, the CBO said.
Sen. Charles Grassley, R-Iowa, who commissioned the CBO report, said it raises questions about why schools should be able to borrow on a tax-exempt basis “when they have money in the bank.”
“These schools are using their tax exemption to amass investments, receive tax-deductible donations, and float tax-exempt bonds,” said Grassley, the ranking minority member of the Senate Finance Committee.