Internal Revenue Code section 4968, enacted as part of the 2017 Tax Cuts and Jobs Act, imposes a 1.4 percent excise tax on the net investment income of certain private colleges and universities. The U.S. Treasury Department issued final regulations effective Oct. 14, 2020, that addressed multiple comments received on the previously issued proposed regulations. The final regulations also made multiple modifications to key definitions that impact the implementation of this new excise tax.
As background, Internal Revenue Code section 4968 generally requires that certain private colleges or universities pay a 1.4 percent excise tax on their net investment income, which is determined under rules similar to those applicable to private foundations. Private colleges and universities are subject to this new excise tax for tax years beginning after 2017 if they have more than 500 tuition-paying students, more than 50 percent of whom are located in the United States, and investment assets of at least $500,000 per student. State colleges and universities are specifically excluded by statute from this new excise tax. The Internal Revenue Service and the Treasury Department acknowledged in the final regulations that important differences exist between educational institutions and private foundations and accordingly made important modifications to the proposed regulations.
For example, the proposed regulations would have imposed the tax on interest, dividends, rent and royalties that a college or university earns on any assets, including those used in connection with its educational purposes. They also would have subjected rental income from student or faculty housing and interest income on student loans to the 1.4 percent excise tax. In the final version of the regulations, the Treasury Department opted against importing all the rules of Internal Revenue Code section 4940 that apply to private foundations, which prevents inclusion of many types of income typically earned by colleges and universities in net investment income for purposes of the tax under Internal Revenue Code section 4968. Highlighted below are the significant changes made in the final regulations.
Total Number of Tuition-Paying Students
Who Is Considered a Student? A “student” is any person enrolled and attending a course for academic credit who is being charged tuition at a rate that is commensurate with the tuition rate charged to students enrolled for a degree. A “student” does not need to be enrolled in a degree program to be counted, resulting in an expanded definition of “student” in the final regulations.
What Is the Total Number of Students? The total number of students is based on the daily average number of full-time students, with part-time students included on a full-time equivalent basis. Consistent with the proposed regulations, the final regulations allow each college or university to establish standards for calculating the total number of students who meet the definitions above when determining if it is subject to the tax.
Which Students Pay Tuition? The term “tuition-paying” means the payment of any tuition or fees for the enrollment or attendance of a student for a course of instruction. The final regulations modified this determination by stating that it is made after taking into account any scholarships and grants provided directly by the educational institution, the federal government, or a state or local government, and after application of any work-study programs operated directly by the educational institution. As a result, students who receive nongovernmental third-party scholarships or grants, even when administered by the educational institution, are deemed tuition-paying students even though they may not actually make out-of-pocket payments to the college or university. But, tuition and fees do not include payment for supplies or equipment or payment for room and board or other personal living expenses.
Which Students Are Located in the United States? A student is treated as located within the United States if he or she resided in the United States for at least a portion of the time the student attended the educational institution during its preceding taxable year. Whether a student resided in the United States in any given year can be determined using any reasonable method implemented by the college or university as long as that method is consistently applied.
$500,000 Per Student Asset Threshold
To be subject to the section 4968 excise tax, the aggregate fair market value of a private college’s or university’s assets for the end of the preceding tax year must exceed $500,000 per student. However, assets used directly in carrying out the institution’s exempt purpose, based on all facts and circumstances, are excluded when determining if a private college or university exceeds this threshold.
What’s Included? Examples of assets held for other-than-exempt purposes, which are included in determining if the institution exceeds the $500,000 per student threshold, include:
- assets held for the production of income or investment (e.g., stocks, bonds, interest-bearing notes, endowment funds, investment real estate);
- property used for the purpose of managing the institution’s endowment funds (such as offices or equipment);
- trademarks on an institution’s logo or name and intellectual property that are donated or sold to the institution and are not exempt-use assets; and
- mixed-use assets, the value of which generally must be reasonably allocated between the exempt and nonexempt uses.
The final regulations provide that educational institutions must value their investment assets as of the last day of the preceding taxable year using the same methods employed by private foundations under Internal Revenue Code section 4942(e), with certain modifications as “reasonable and necessary.”
What’s Excluded? Assets that are used directly for exempt purposes are excluded from the calculation in determining if the institution exceeds the $500,000 per student threshold. Examples of these assets include:
- office equipment and supplies used directly in the administration of exempt activities;
- real estate used directly in exempt activities;
- physical property, such as artwork, owned by the institution that is held for public display;
- fixtures and equipment in classrooms and research facilities, and related equipment used in the conduct of the institution’s exempt activities;
- a reasonable cash balance necessary to cover current operating and administrative expenses and other normal and current disbursements directly connected with the educational institution’s exempt activities;
- property that is leased to other persons at no cost (or nominal rent) in furtherance of the institution’s exempt purposes;
- patents, copyrights and other intellectual and intangible property to the extent that the income from such assets is excluded from net investment income; and
- assets of certain related organizations used directly in carrying out either the institution’s exempt purpose or the exempt purpose of a related section 501(c)(3) organization (which could differ from that of the educational institution).
Note: To calculate a reasonable cash balance, the final regulations adopted the approach of allowing educational institutions to use any reasonable method or opt for a safe harbor equal to three months of operating expenses allocable to program services (by dividing by four the annual functional expenses allocable to program services). This is a change from the proposed regulations, which provided a safe harbor for a reasonable cash balance equal to 1.5 percent of the fair market value of the noncharitable-use assets of the institution.
Calculation of Net Investment Income
Net investment income is generally the amount by which the sum of the gross investment income and capital gain net income exceeds certain deductions allowed by Internal Revenue Code section 4968.
Gross Investment Income. Gross investment income includes amounts of income from dividends, rents, payments with respect to securities loans, and royalties unless such income was included in the organization’s computation of unrelated trade or business income under Internal Revenue Code section 511. The final regulations make it clear that gross investment income includes royalty income from trademarks on the institution’s logo or name or from intellectual property donated or sold to the institution.
If an educational institution held appreciated property on Dec. 31, 2017, and continuously thereafter, it can use the fair market value of the assets as of Dec. 31, 2017, solely for purposes of determining its gross investment income on the property’s sale or disposition. The final regulations retain this general rule for all assets, but adopt a special rule for assets held through partnerships.
Investments in Partnerships. In response to concerns that determining the basis of each asset held through a partnership would be burdensome if not almost impossible for educational institutions, the final regulations provide that the step-up for assets held through a partnership is determined by reference to an educational institution’s adjusted basis in the partnership interest itself (commonly referred to as “outside basis”). Under the final regulations, an educational institution receives, with respect to each partnership interest held, an “unadjusted step-up amount” equal to the amount by which the fair market value of the institution’s partnership interest exceeds the institution’s adjusted basis in such partnership interest as of Dec. 31, 2017. The institution can then use up to one-third of the unadjusted step-up amount in a given year to reduce its capital gain net income from the relevant partnership. A similar rule applies to sales of partnership interests.
Exclusions. Unlike the rules governing private foundations, educational institutions may exclude from their calculation of gross investment income, the following types of income:
- gains and losses from property used for exempt purposes;
- interest income from student loans made by the educational institution (or a related organization) to its students;
- rental income from the provision of housing to students, or to faculty and staff if contingent on their roles as faculty or staff of the educational institution (which limits the availability of the exclusion for colleges and universities that do not make faculty and staff housing explicitly contingent on continued employment);
- royalty income derived from patents, copyrights and other intellectual and intangible property resulting from the work of students or faculty; and
- gains attributed to appreciation of donated property that occurred before its donation to the institution.
Deductions. The final regulations permit certain deductions in computing net investment income. Permissible deductions include ordinary and necessary expenses paid or incurred for the production or collection of such gross investment income (excluding any taxes paid or incurred under section 4968), including compensation of officers, other salaries and wages of employees, outside professional fees, interest, and rent and taxes on property used in such investment operations. Expenses incurred for both investment and exempt purposes must be allocated accordingly, and the ones allocated to investment purposes are deductible. Deductions related to the production of gross investment income earned incidental to a charitable function may not exceed such income for the taxable year.
The final regulations also make it clear that no deduction is allowed for charitable contributions, the net operating loss deduction, and certain adjustments are required for any depreciation or depletion deductions.
Capital Loss Carryover. An educational institution may not offset against its gross investment income a capital loss in a given year or use such losses to reduce gains in prior taxable years. However, the final regulations contain a significant new provision that permits a carryover of net capital losses to reduce future capital gains.
Under Internal Revenue Code section 4968, the assets and net investment income of any “related organization” are included when determining whether an educational institution meets the threshold requirements for application of the section 4968 excise tax. The final regulations clarify the definitions relevant in determining whether an organization is a “related organization” and provide several exceptions that narrow the scope of entities and assets that need to be considered.
In determining the fair market value of its nonexempt-use assets and computing its net investment income, an educational institution must include the assets and net investment income of certain related organizations. Generally, a related organization includes an organization that:
- controls or is controlled by the educational institution;
- is commonly controlled (brother-sister) with the educational institution;
- is a supported or supporting organization of the educational institution described in Internal Revenue Code section 509(a)(3); or
- is an unfunded benefit plan (meaning that assets to be used to provide such benefits are available for general use by the institution and can be reached by the institution’s creditors).
The final regulations provide detailed guidance with respect to determining control in the various contexts listed above. For example, a tax-exempt stock corporation is controlled by an educational institution if the institution owns (by vote or value) more than 50 percent of the voting and nonvoting stock or membership interests of the corporation. For nonstock corporations, the educational institution controls such organization if it can (i) appoint or elect (and can remove) more than 50 percent of the members of the nonstock corporation’s governing body, (ii) require the organization to make an expenditure (or prevent the organization from making an expenditure), or (iii) require the organization to perform any act that significantly affects its operations (or prevent the organization from performing such act). The final regulations also clarify that the principles of constructive ownership described in Internal Revenue Code section 318(a)(2) apply.
However, the final regulations made adjustments to the definition of a related organization to address concerns over double taxation, among other things, and determined that the following entities are not considered related organizations:
- Taxable corporations
- Taxable trusts
- Nongrantor charitable lead trusts (except to the extent controlled by the educational institution)
- Grantor charitable lead trusts
- Charitable remainder trusts
- S corporations
- Certain trusts or similar funding vehicles of an employee benefit plan or arrangement
The final regulations also include a special exception for related organizations that were Type III supporting organizations as of Dec. 31, 2017. Specifically, the institution takes into account only the assets and net investment income of the Type III supporting organization that are intended or available for the use or benefit of, or otherwise are fairly attributable to, the educational institution. Despite requests from the commenters, the final regulations did not expand this special rule to Type III supporting organizations established after Dec. 31, 2017, or to other types of supporting organizations.