On September 18, 2020, the United States Department of the Treasury (“Treasury”) and the ‎Internal Revenue IRS (the “IRS”) issued final regulations (the “Final Regulations”) under section ‎‎4968 of the Internal Revenue Code of 1986, as amended (the “Code”), that address how to ‎determine the excise tax owed by certain private colleges and universities.  The Final Regulations ‎are expected to become effective on the date of filing in the Federal Register. ‎

Background

The Tax Cuts and Jobs Act (the “TCJA”), became law in December 2017 and created an excise ‎tax on the Net Investment Income (the “NII”) of certain private colleges and universities.  In ‎June 2019, Treasury and the IRS issued proposed regulations (the “Proposed Regulations”) ‎intended to provide guidance concerning this newly imposed excise tax.  The Proposed ‎Regulations generally addressed two critical issues – first, how to determine whether an ‎educational institution qualifies as an Applicable Educational Institution (an “AEI”) that is ‎subject to the tax, and, second, how to calculate the NII of the AEI.  However, even after the ‎release of the Proposed Regulations, certain questions remained unanswered, and, thus, the ‎Treasury and the IRS requested comments and input from the public to better assist with the ‎drafting and implementation of the Final Regulations.‎

Overview of Final Regulations

The Final Regulations seek to respond to such open items, particularly the treatment of interest ‎income earned from student loans made by the AEI or a related organization, student housing ‎rental income, royalty income derived from patents, copyrights, and other intellectual property ‎and intangible property to the extent such assets come from the work of a student or faculty ‎member, and clarification or modification of certain critical definitions, including “applicable ‎educational institution,” “student,” “tuition-paying,” and “located in the United States.”‎

Interest Income from Student Loans

Although the Proposed Regulations noted the regulations under Code Section 4940(c) ‎specifically include student loan interest as gross investment income, Treasury and the IRS ‎requested comments on potentially distinguishing the interest earned based on whether the loan ‎was made at a market rate or above market and treating the interest in different manners.  ‎Nevertheless, after receiving numerous comments supporting the exclusion of all interest earned ‎on student loans regardless of the terms, the Final Regulations have adopted the favorable ‎position that all interest income from a student loan that was made by the AEI or a related ‎organization to a student of the institution in connection with the student’s attendance at the ‎institution shall be excludable from gross investment income.  Although Treasury and the IRS ‎adopted this approach on student loans, they rejected the notion that faculty loans should receive ‎similarly favorable treatment, so interest income on faculty loans must still be included in ‎calculating NII. ‎

University Housing Rental Income

In a surprising reversal from the Proposed Regulations and in response to a number of public ‎comments, the Final Regulations exclude income received from the housing of current students ‎of an educational institution from the gross investment income component of the NII calculation.  ‎Treasury and the IRS agreed that such income is distinguishable from other types of traditional ‎rental income and should be excluded, regardless of whether the housing is provided to the ‎educational institution’s students by the institution or by a related organization of the institution.‎
Additionally, Treasury and the IRS further agreed with commenters that rental income from ‎housing provided to an institution’s faculty and staff should likewise be excluded from the NII ‎calculation, especially if the rental agreement contains a provision that the person must be ‎currently employed as faculty or staff of the AEI.  However, the Final Regulations do not ‎exclude rental income received from other persons, such as former faculty or former staff.‎

Royalty Income from Various Sources

The Final Regulations similarly draw a clear line between certain activities that produce royalty ‎income.  Specifically, the Final Regulations exclude royalty income derived from patents, ‎copyrights, and other intellectual property and intangible property to the extent those assets come ‎from the work of a student or faculty member in their capacities as such with the AEI.  However, ‎neither royalty income from trademarks on the institution’s logo or name nor royalty income from ‎intellectual property that is either donated or sold to the institution is excluded from gross ‎income under the Final Regulations.‎

Clarification and Modification of Certain Definitions

The Final Regulations also clarified and modified certain definitions.  Specifically, the Final ‎Regulations adopted the definition of “applicable educational institution” as initially proposed.  ‎

Treasury and the IRS rejected a recommendation to substitute the definition of “student” in the ‎Proposed Regulations with the definition contained in the Family Educational Rights and ‎Privacy Act (“FERPA”). In doing so, Treasury and the IRS stated the FERPA definition is too ‎broad and highlighted the definition included, for example, individuals who previously attended ‎the institution.  Instead, the Final Regulations define student ‎to apply only to a person enrolled ‎and attending a course for academic credit and charged ‎tuition at a rate that is commensurate ‎with the tuition rate charged to students enrolled for a ‎degree.‎

The Final Regulations also adopted the definition of “tuition-paying” found in the Proposed ‎Regulations, which concluded that scholarships awarded by the institution are not tuition “paid” ‎on behalf of the student, whereas scholarships from third parties are in essence payments of the ‎student’s tuition, but the Final Regulations add that whether a student is tuition-paying is also ‎determined after taking into account grants made by the Federal government or any state or local ‎government. ‎

The Proposed Regulations provided that the term “located in the United States” referred to the ‎location of the student, and that the 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 AEI’s preceding taxable year, but Treasury and the IRS ‎requested comments on whether further guidance was needed.  One commenter requested ‎flexibility for each institution to be permitted to determine whether a student is located in the ‎United States using any reasonable and consistently applied approach.  Treasury and the IRS ‎responded that the Proposed Regulations contemplated that AEIs could make such a ‎determination using any reasonable method, but the Final Regulations explicitly state this ‎proposition.‎

Conclusion

While the Final Regulations may provide helpful clarification and favorable relief in certain areas, ‎additional guidance and assistance will be required in analyzing and applying this tax.  Our ‎Public Finance and Tax attorneys continue to closely monitor and provide insight into the ‎legislative and regulatory response to the Tax Cuts and Jobs Act.  Should you require any ‎guidance on these or any other matters, our team members stand ready to assist.   Please contact ‎the authors or one of your other Locke Lord attorneys with any questions.‎