IRS issues proposed regulations regarding net investment income tax of private colleges and universities

On July 3, 2019, the Internal Revenue Service (“IRS”) issued proposed regulations under Internal Revenue Code section 4968. That section, passed as part of the 2017 Tax Cuts and Jobs Act, imposes a 1.4% excise tax on the investment income of certain private colleges and universities. The controversial tax applies not just to colleges and universities with the largest endowments such as Harvard and Yale, but also to smaller schools such as Grinnell College, Swarthmore, and Williams College. The resulting cost to institutions of higher learning can be substantial – tens of millions of dollars in some cases. While commonly referred to as an endowment excise tax, the statute does not actually use the word “endowment” and the tax applies to net investment income from all sources, not just investment income from endowment funds.

Background

Code section 4968 imposes the excise tax on any private institution of higher education which had (1) at least 500 tuition-paying-students during the preceding taxable year, more than half of whom are located in the United States and (2) assets at the end of the preceding taxable year (other than assets used directly in carrying out the institution’s exempt purpose) with an aggregate fair market value of at least $500,000 per student. The last-minute addition of the words “tuition-paying” was sponsored by Kentucky Senator and Senate Majority Leader Mitch McConnell to protect Berea College in Kentucky, which does not charge tuition.

The proposed regulations provide guidance in several areas, including the below areas.

Who is a student?

The proposed regulations provide that the term “student” as used in section 4968 means a person enrolled in a degree, certification or other program (including a program of study abroad approved for credit) leading to a recognized educational credential at an eligible educational institution, and not enrolled in an elementary or secondary school. Students merely accepted for enrollment are not considered students for this purpose and there is no requirement that the student have at least half the normal full-time workload. The proposed regulations also make clear that for purposes of the $500,000 per student test, all students are counted, not just tuition-paying students.

Tuition is defined to mean tuition and fees required for enrollment or attendance and does not include expenses with respect to a course or other education involving sports, games, or hobbies, unless the course is part of the individual’s degree program. Room and board and other personal living expenses are not considered tuition. Whether a student is “tuition-paying” is determined after taking into account any scholarships provided directly by the educational institution and any work/study programs operated directly by the educational institution. However scholarship payments provided by third parties, even if administered by the institution, are considered payments of tuition on behalf of the student.

Code section 4968(b)(1)(B) provides that at least 50% of the educational institution’s tuition-paying students must have been located in the United States. A student attending the institution in the preceding taxable year who was studying abroad is considered to have been a student 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 educational institution. Students at foreign campuses with no US residency period during such time would not be counted for purposes of the 50% test.

Finally, the proposed regulations leave it to the institution to determine who is a full-time student, a part-time student, a full-time student equivalent, and the daily average of students, so long as the determinations are consistent with the institution’s practices in determining full-time and part-time status for other purposes. The Treasury asked for specific comments on this issue.

What are assets used directly in carrying out an institution’s exempt purpose?

Since assets used directly in carrying out the institution’s exempt purpose are excluded from the  $500,000 of assets per student test, “assets which are used directly in carrying out the institution’s exempt purpose” requires definition. The phrase is not defined in Code section 4968. However, the proposed regulations rely heavily on definitions under Code section 4942 which uses similar words for purposes of determining the minimum investment return of private foundations. Consistent with those regulations, the proposed regulations clarify that only assets actually used by the institution in carrying out its exempt purpose will meet this test.

Administrative assets, real estate and physical property used by the institution directly in its exempt activities are all examples of such direct purpose assets. Helpfully, a reasonable cash balance necessary to cover current administrative expenses and other normal and current disbursements directly connected with the educational institution’s exempt activities are considered to be used directly in carrying out the institution’s exempt purpose. The proposed regulations note that for section 4942 purposes, a reasonable cash balance is defined as 1.5% of the fair market value of the private foundation’s non-charitable use assets, and the proposed regulations propose a similar rule under section 4968:

“However, the Treasury Department and the IRS note that the 1.5 percent standard in the section 4942 context is an average monthly amount over the entire taxable year and thus has to take into account fluctuations in cash needs. Thus, in light of the differences in the exempt activities of an educational institution and the section 4968 requirement to measure the assets only at the end of the taxable year, the Treasury Department and the IRS request comments on whether another percentage or other measurement should be deemed to be a reasonable cash balance at the end of the taxable year. The Treasury Department and the IRS specifically request comments supporting why any such other amount would be reasonable, and how utilizing a different amount would be administrable.”

Whether an asset is used directly by an educational institution to carry out its exempt purposes is determined based on facts and circumstances. If property is used both for charitable, educational or similar exempt purposes and for other purposes or if the exempt use represents 95% or more of the total use, the property will be considered to be used exclusively for a charitable, educational or similar exempt purpose. If the exempt use represents less than 95% of the total use, the institution must make a reasonable allocation between the exempt and non-exempt use period.

Determining net investment income

One helpful provision in the proposed regulations is the step up to fair market value on December 31, 2017 of basis of investment assets. This should substantially reduce tax on investment assets held in the endowment – gain from sale of investment assets is considered investment income for purposes of the tax. On the other hand, the tax on net investment income is not limited to what we might think of as endowment income. For example, interest received on a student loan might be considered investment income. However, the proposed regulations recognize that student loans can be seen as helping the educational institution fulfill its mission of educating students and below market interest loans might be distinguishable from income from investment purposes generally.

The Service requests that comments advocating an exception for interest received on student loans address the administrative challenges of determining the relevant market rate and acceptable lower rate, and in adjusting rate changes during the course of the loan. What about rental income? Colleges and universities offer various types of housing for use by students, non- students (for example, during the summer) and faculty. The Service asks for comments on the differences, if any, among the housing arrangements.

Conclusion

There is much more in the proposed regulations, including provisions dealing with institutions and related organizations. In brief, for purposes of determining the aggregate fair market value of the assets and net investment income of an educational institution, the assets and net investment income of any related organization will be treated as assets and net investment income of the educational institution.

The proposed regulations are only applicable to taxable years beginning after the date of publication of final regulations. In the meantime, taxpayers can rely on the proposed regulations for taxable years beginning before publication of the final regulations.

Larry Katzenstein is a nationally known authority on estate and charitable planning. He is a member of Thompson Coburn’s private client practice group. Larry is also the creator of Tiger Tables actuarial software used by law and accounting firms nationwide.