Proposed Regulations Would Tax More Than Just College and University Endowments

Morgan Lewis

Morgan Lewis

An expansive interpretation of Section 4968 under proposed regulations issued by the US Treasury Department and IRS would tax not only “endowment” income but also any interest, dividends, rent, and royalties a college or university earns from assets used in its educational mission, like dormitories, faculty housing, institutional student loans, and intellectual property.

Colleges and universities should pay close attention to the proposed regulations that the US Department of the Treasury and Internal Revenue Service (IRS) recently issued interpreting the new “endowment tax” under Section 4968[1] (the Proposed Regulations), and may wish to consider writing comments even if they are not currently affected by the tax because the Proposed Regulations would tax more—potentially much more—than what is traditionally considered part of the endowment. The Proposed Regulations take an expansive interpretation of what income may be subject to the tax; however, it is not uncommon for final regulations to take a narrower interpretation based on further consideration of issues raised during the comments process. Comments are due by October 1, 2019.


Section 4968 imposes a 1.4% excise tax on the “net investment income” of certain colleges and universities. This “endowment tax,” as it is generally known, was enacted as part of the Tax Cuts and Jobs Act (TCJA) in 2017.[2] Prior to enactment of the TCJA, private colleges and universities, like most nonprofits, were exempt from income tax on their investment income.[3] If adopted in temporary or final regulations, the interpretive guidance in the Proposed Regulations would likely result in more private colleges and universities having to pay the Section 4968 excise tax, with a greater amount of their income being subject to the excise tax than many had expected.

As currently drafted, the Proposed Regulations would tax interest, dividends, rent, and royalties a college or university earns from any asset it holds, including assets used in furtherance of a college or university’s educational mission. As discussed below, this could in theory mean that rent paid by students to live in college dormitories, rent paid by other nonprofits for use of academic buildings for educational purposes, and royalties from intellectual property produced by the ideas of university faculty may all be subject to the endowment tax. This expansive definition of net investment income is due to the cross reference in the statute to the private foundation net investment income tax under Section 4940, rather than from a specific intent on the part of Congress to tax colleges on their revenues from room and board.

The Proposed Regulations also determine which private colleges and universities are subject to the excise tax under Section 4968 by defining “applicable educational institutions.”[4] Applicable educational institutions include colleges and universities with at least 500 “tuition-paying students” and endowments worth at least $500,000 per student in the immediately preceding taxable year.[5] The Proposed Regulations adopt an expansive definition of “tuition-paying students” to include students receiving third-party scholarships and governmental assistance, even if they do not in fact pay tuition, thereby increasing the number of colleges and universities subject to the tax and making it less likely that a college or university will provide tuition-free education in order to avoid the tax.

If a private college or university meets the threshold definitions under the Proposed Regulations, and is therefore subject to the excise tax as an applicable educational institution, then its net investment income is subject to the 1.4% excise tax. As discussed below, the Proposed Regulations draw a distinction not between investment assets held in an endowment and other income-producing assets but rather between assets used in furtherance of the college or university’s tax-exempt purposes and all other assets—a much broader tax base.

Applicable Educational Institution

Definition of Tuition-Paying Students

As noted above, Section 4968 defines an applicable educational institution, in part, with respect to how many “tuition-paying students” attend the institution.[6] Specifically, an institution must have had at least 500 tuition-paying students during the preceding taxable year,[7] and more than 50% of its tuition-paying students must have been located in the United States during the preceding year.[8]

The 500 tuition-paying student rule ostensibly creates an incentive for colleges and universities to reduce the number of tuition-paying students below 500 in order to avoid application of the excise tax. Indeed, at least 14 private colleges and universities have eliminated tuition for students by providing scholarships from their endowments, but only in conjunction with assistance from third-party scholarships and government aid.[9]

Section 4968 does not define the term “tuition paying,” and, unfortunately, the Proposed Regulations define “tuition-paying students” as including students who rely on federal, state, or private grants, regardless of whether those students in fact pay tuition. Scholarship payments provided by third parties, even if administered by the educational institution, are considered payments of tuition on behalf of the student. Only students who receive full scholarships from the educational institution itself are considered non-tuition-paying students under the Proposed Regulations.

This expansive definition of “tuition-paying students” means that a college or university cannot rely on government aid or third-party scholarships to defray a portion of the tuition. This definition limits the utility of the 500-student exception because very few, if any, colleges or universities have the resources to provide free tuition without relying on government aid or third-party scholarships. Indeed, Congress amended Section 4968 as part of the 2018 budget deal to include the 500 tuition-paying student exception so that tuition-free schools like Berea College would not be subject to the tax, and, perversely, the Proposed Regulations appear to carve those schools back in, frustrating congressional intent in that regard.[10]

While the Proposed Regulations request comments about most aspects of the new excise tax, they are notably silent with respect to comments on the definition of “tuition-paying students,” which suggests that this definition may stick through subsequent regulations.

Definition of Exempt Purpose Assets

In addition to having 500 tuition-paying students, an applicable educational institution under Section 4968 must have assets (other than those assets that are used directly in carrying out the institution’s exempt purpose), the aggregate fair market value of which is at least $500,000 per student.[11]

The Proposed Regulations explain that “an asset is used directly in carrying out an educational institution’s exempt purpose only if the asset is actually used by the institution in carrying out its exempt purpose,” and this determination should be “based on all the facts and circumstances.” Property that is used more than 5% for a nonexempt purpose should be reasonably allocated between such exempt and nonexempt uses. We note that this 95% exempt purpose rule is considerably stricter than the standard for exempt use assets under Section 514, which exempts property from the debt-financed income rules if “substantially all” of the property’s use—defined as 85%—is substantially related to exempt purposes.[12]

Examples of exempt purpose assets include real estate (or the portion of any building) used directly in the college or university’s exempt activities and any property the institution leases to others at no cost or nominal rent to the lessee in furtherance of the institution’s mission. Tangible physical property such as paintings or works of art on public display and fixtures and equipment that serve a useful purpose in the conduct of the institution’s exempt activities are exempt purpose assets. Various “administrative assets,” such as office equipment and supplies used directly in the administration of the school’s exempt activities are exempt purpose assets. In addition, an institution’s “reasonable cash balances” necessary to cover administrative expenses and other normal and current disbursements are considered exempt purposes assets, with a safe harbor for cash balances less than 1.5% of the institution’s non–charitable use assets.

Certain assets are treated as non–exempt purpose assets per se, including assets held for the production of income or for investment such as “stocks, bonds, interest-bearing notes, endowment funds, or leased real estate.” Office space and other property used to manage the endowment is also not considered to be an exempt purpose asset.

The Proposed Regulations value non–exempt purpose assets by cross reference to the private foundation minimum distribution rules of Section 4942(e) and Treasury Regulations Section 53.4942(a)-2(c)(4), with only minor changes. These rules, however, require private foundations to obtain annual valuation studies for assets other than cash and publicly traded securities, and quinquennial valuation studies (i.e., every five years) for real property.[13] Obtaining such appraisals can be costly and burdensome.

Net Investment Income

Income from Dividends, Interest, Rent, and Royalties

Some tax practitioners may be familiar with the peculiar definition of net investment income set forth in the Proposed Regulations because a similar set of rules applies to the excise tax on private foundation net investment income imposed by Section 4940.

It is worthy to note that this new excise tax on net investment income of certain private colleges and universities is unprecedented given that private colleges and universities are, by definition, public charities exempt from the private foundation excise taxes—including the tax on investment income, minimum distribution requirement, and strict governance restrictions prohibiting certain self-dealing transactions, excess business holdings, jeopardizing investments, and taxable expenditures.[14] The purpose of the private foundation net investment income tax was not to raise revenue on endowment income; rather, it was to pay for IRS oversight and enforcement of the private foundation excise taxes. Colleges and universities have funding sources that are much more diverse than private foundations, thereby eliminating (or at least reducing) the concerns lawmakers have had with regard to private foundation self-governance, and they are not subject to the private foundation excise taxes, leaving little reason for Congress to impose a net investment income tax.

Setting aside the wisdom of imposing a net investment income tax on colleges and universities, colleges and universities may be surprised to discover that the Proposed Regulations define net investment income broadly, encompassing far more categories of income that are subject to the excise tax than would be expected under an “endowment tax.”[15] This is because the Proposed Regulations cross reference the private foundation net investment income excise tax rules under Section 4940, merely substituting the words “applicable educational institution” for the words “foundation” or “private foundation” and substituting the date “December 31, 2017” wherever the date “December 31, 1969” appears.

The Section 4940 rules generally subject all gross “investment income” to tax, including interest, dividends, rents, and royalties, regardless of whether the asset giving rise to the investment income is devoted to charitable activities.[16] Ironically, the Section 4940 rules give the example of interest that a private foundation earns on a student loan as being subject to the Section 4940 tax. An applicable educational institution, therefore, would be subject to tax under the Proposed Regulations on interest earned from any student loans it might make. College institutional loans are a mechanism that some colleges and universities use to attract students who do not qualify for need-based federal financial aid or are ineligible due to citizenship status or academic progress. Some schools offer institutional loans to bridge the gap left by state and federal funds when they do not fully cover the cost of a college education.

Likewise, under the Section 4940 analogy, rent that a college or university earns from dormitories or faculty housing would appear to be subject to tax under the Proposed Regulations, despite the fact that this income is earned in the performance of the organization’s mission and that rent on real property generally is not subject to the unrelated business income tax.[17] On-campus living is a core part of the college experience at many colleges and universities; providing student housing is not an activity that schools undertake to grow their endowment and shouldn’t be treated as “net investment income” for purposes of Section 4968. Similarly, colleges and universities regularly lease their facilities to other nonprofit organizations to conduct charitable and educational activities, such as athletic and educational summer camps. They also lease space to book stores and other academic service providers, all in furtherance of their educational mission rather than for investment purposes.

The taxation of a college or university’s intellectual property is another matter of concern under the Proposed Regulations. Unlike private nonoperating foundations, which generally speaking are grant-making institutions that do not generate significant intellectual property as part of their activities, colleges and universities are, at their core, engines of new ideas. Whereas the taxation of royalties a private foundation earns from licensing intellectual property is largely inoffensive as such income is likely extraneous to the private foundation’s mission, taxing a college or university on its intellectual property strikes at the heart of the institution.

In their defense, the Proposed Regulations are following the statute that defines net investment income “under rules similar to the rules of section 4940(c).” The Treasury and the IRS have requested comments in the Proposed Regulations on whether specific types of income should be excluded from gross investment income under Section 4968, explicitly noting to taxpayers that, “[i]n explaining why each such type of income should be excluded, [they should] please state specifically how the proposed exclusion is still ‘similar to’ the rules of section 4940(c) [which applies only to private foundations] and the specific characteristics of each type of such income that would warrant deviating from the rules provided in section 4940 and the regulations thereunder.”[18] Colleges and universities should accept this invitation to argue for more appropriate standards that focus on traditional endowment income.

Treatment of Capital Gains

In addition to gross investment income from interest, dividends, rents, and royalties, taxable “net investment income” also includes net capital gains, other than those arising from the sale or other disposition of property used for the organization’s exempt purposes, as discussed above. So, for example, gain or loss on the sale of a college or university’s classrooms or other academic buildings used for the exempt activities would not be subject to the Section 4968 tax, but gain or loss on the sale of the offices used to manage the endowment would be subject to tax.


Taxing colleges and universities on their investment income is itself a significant departure from historic US federal income tax policy. Given widespread and vigorous agreement that the cost of attaining higher education is already exceedingly high, it is paradoxical that Congress would enact new taxes on college and university endowments because such taxes are likely to reduce the amount of funds available for scholarships and other tuition relief, and may well increase tuition at many institutions. The Proposed Regulations do little to ameliorate this tax policy muddle, and would in fact worsen it by defining “applicable educational institution” and “net investment income” expansively.

Fortunately, the interpretation of Section 4968 set forth in the Proposed Regulations is not set in stone. Colleges and universities, and other stakeholders, have until October 1, 2019, to submit comments to the IRS and Treasury to advocate for reasonable exceptions to the private foundation rules for activities that colleges and universities commonly undertake for mission-related purposes rather than solely to generate investment income. As discussed above, such activities include rent from student and faculty housing or use of facilities by other nonprofit organizations, royalties earned by the applicable educational institution from the ideas of its faculty and students, and interest earned on institutional student loans—all of which seem particularly far off the mark. There are no doubt many other examples of interest, dividends, rent, and royalties from exempt use assets that colleges and universities should bring to the IRS’s and Treasury’s attention.

In addition, colleges and universities seeking to avoid the tax by providing free tuition will be stymied by the Proposed Regulation’s treatment of government assistance and third-party scholarships as “tuition,” thereby requiring such applicable educational institutions to bear the full cost of tuition on their own.

Colleges and universities with multiple affiliated entities should be aware that the Proposed Regulations request comments on whether and when to tax assets held in a controlled entity. Each institution’s particular fact pattern will be of interest to the drafters of the Proposed Regulations.

Colleges and universities may rely on the Proposed Regulations for taxable years beginning before publication of any final regulations; however, the IRS will not seek to enforce the positions set forth in the Proposed Regulations until after they have received comments from the field and published revised regulations in temporary or final form in the Federal Register.


[1] Unless otherwise stated, all references to “section” refer to a section under the US Internal Revenue Code of 1986, as amended, or the Treasury regulations issued thereunder.

[2] Tax Cuts and Jobs Act, P.L. 115-97, 131 Stat. 2054 (2017). The excise tax under Section 4968 is effective for tax years beginning after December 31, 2017.

[3] Historically, only private foundations were subject to an excise tax on net investment income. See I.R.C. § 4940.

[4] Prop. Treas. Reg. § 53.4968-1(a)(2).

[5] Prop. Treas. Reg. § 53.4968-1(a).

[6] I.R.C. § 4968(b)(1).

[7] I.R.C. § 4968(b)(1)(A).

[8] I.R.C. § 4968(b)(1)(B). “A student is considered to have been located in the United States if the student resided in the United States for at least a portion of the time the student attended the institution during the applicable educational institution’s preceding taxable year.” Prop. Treas. Reg. § 53.4968-1(a)(3)(iii).

[9] See Katy Hopkins and Farran Powell, 14 Tuition-Free Colleges, US News and World Report (Sept. 10, 2018).

[10] See Danielle Douglas-Gabriel, Treasury Rules Could Thwart Sen. Mitch McConnell’s Bid to Protect Kentucky College from Endowment Tax, Wash. Post (July 3, 2019).

[11] Prop. Treas. Reg. § 53.4968-1(a)(2)(iv).

[12] See I.R.C. § 514(b)(1)(A).

[13] See Treas. Reg. § 53.4942(a)-2(c)(4)(iv)(a) and (b).

[14] See I.R.C. §§ 509(a)(1) and 170(b)(1)(A)(ii) (defining colleges and universities as public charities); I.R.C. §§ 4940-4945 (imposing certain excise taxes on private foundations).

[15] Section 4968(a) imposes on each applicable educational institution a tax equal to 1.4% of its net investment income for the taxable year. Section 4968(c) provides that net investment income is determined under rules similar to the rules of Section 4940Section 4940(c)(1) defines net investment income as the amount by which the sum of the gross investment income and the capital gain net income exceeds certain specified allowable deductions. Section 4940(c)(2) provides that, for purposes of Section 4940(c)(1), gross investment income means the gross amount of income from interest, dividends, rents, payments with respect to securities loans (as defined in Section 512(a)(5)), and royalties, but not including any such income to the extent included in computing the unrelated business income tax imposed by Section 511.

[16] Prop. Treas. Reg. § 53.4968-1(b)(2).

[17] See I.R.C. § 512(b)(3) (exempting certain rental income from unrelated business taxable income).

[18] Guidance on the Determination of the Section 4968 Excise Tax Applicable to Certain Private Colleges and Universities, 84 Fed. Reg. 31,795, 31,800 (July 3, 2019) (emphasis added).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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Facebook, Twitter and other Social Network Cookies. Our content pages allow you to share content appearing on our Website and Services to your social media accounts through the "Like," "Tweet," or similar buttons displayed on such pages. To accomplish this Service, we embed code that such third party social networks provide and that we do not control. These buttons know that you are logged in to your social network account and therefore such social networks could also know that you are viewing the JD Supra Website.

Controlling and Deleting Cookies

If you would like to change how a browser uses cookies, including blocking or deleting cookies from the JD Supra Website and Services you can do so by changing the settings in your web browser. To control cookies, most browsers allow you to either accept or reject all cookies, only accept certain types of cookies, or prompt you every time a site wishes to save a cookie. It's also easy to delete cookies that are already saved on your device by a browser.

The processes for controlling and deleting cookies vary depending on which browser you use. To find out how to do so with a particular browser, you can use your browser's "Help" function or alternatively, you can visit which explains, step-by-step, how to control and delete cookies in most browsers.

Updates to This Policy

We may update this cookie policy and our Privacy Policy from time-to-time, particularly as technology changes. You can always check this page for the latest version. We may also notify you of changes to our privacy policy by email.

Contacting JD Supra

If you have any questions about how we use cookies and other tracking technologies, please contact us at:

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