Excise tax on investment income of private colleges and universities

Jan 26, 2018
Jan 26, 2018
0 min. read

There was foreshadowing that Congress had something planned for the higher education industry related to tax reform as increasing public scrutiny of the sector has been occurring over a number of years.

In Jan. 2008, the Senate Finance Committee sent a letter to 136 colleges and universities that had endowments of $500 million or more. The communication focused specifically on endowment management in the context of making college more affordable for low and middle income families, with several questions devoted to schools’ tuition costs and financial assistance programs. Many members of the Senate Finance Committee were quoted in news articles making statements such as:

“Tuition has gone up, college presidents’ salaries have gone up, and endowments continue to go up and up. We need to start seeing tuition relief for families go up just as fast. It’s fair to ask whether a college kid should have to wash dishes in the dining hall to pay his tuition when his college has a billion dollars in the bank. We’re giving well-funded colleges a chance to describe what they’re doing to help students. More information will help Congress make informed decisions about a potential pay-out requirement and allow universities to show what they can accomplish on their own initiative.” – Senator Charles Grassley, Jan. 14, 2008

On Oct. 7, 2015, the U.S. House Ways and Means Subcommittee on Oversight held a hearing on the rising costs of higher education and the related tax policy. Following that hearing, the Congressional Research Service (CRS) published a report (College and University Endowments: Overview and Tax Policy Options) on Dec. 11, 2015, which discussed tax policy options such as imposing a minimum payout requirement on endowments (or a tax on endowment investment earnings), limiting the charitable deduction for certain gifts to endowments, and changing the tax treatment of certain offshore investment strategies that endowments employ.

On Feb. 8, 2016, the Senate Finance Committee and the U.S. House Ways and Means Committee issued a joint letter to 56 colleges and universities with endowments greater than $1 billion. The letter sought information about the schools’ endowments as part of a larger U.S. Congressional inquiry into the activities of colleges and universities in relation to the numerous tax preferences they enjoy under the Internal Revenue Code. The letter cited concerns that many colleges and universities have raised their tuition rates far in excess of inflation despite the large and growing size of their endowments. The stated purpose of the letter was to gather information, in addition to what was already publicly available, to better understand how schools were using endowment assets to fulfill their charitable and educational purpose.

The legislative development of new section 4968

The House led the charge with the issuance of H.R. 1, Tax Cuts and Jobs Act in Nov. 2017, proposing the new section 4968 that imposed an excise tax on an applicable educational institution for each taxable year equal to 1.4 percent of the net investment income of the institution for the taxable year. The Senate plan adopted the House version with a few upgrades, and the Conference Committee provided its own changes. At the end of the legislative process, the remaining statutory requirements of new section 4968 are as follows:

The excise tax is assessed only against an applicable educational institution which means an eligible educational institution (as defined in section 25A(f)(2)):

  • Which had at least 500 tuition-paying students during the preceding taxable year,
  • More than 50 percent of the tuition paying students of which are located in the United States,
  • Which is not described in the first sentence of section 511(a)(2)(B) (relating to state colleges and universities), and
  • The aggregate fair market value of the assets of which at the end of the preceding taxable year (other than those assets which are used directly in carrying out the institution’s exempt purpose) is at least $500,000 per student of the institution

The definition of eligible educational institution is described in section 25A as an institution which is described in section 481 of the Higher Education Act of 1965 (20 USC 1088) and which is eligible to participate in a program under Title IV of the Act. For this purpose, an eligible education institution to which section 4968 applies is:

  1. A proprietary institution of higher education;
  2. A postsecondary vocational institution; and
  3. Only for the purposes of part D of subchapter IV, an institution outside the United States that is comparable to an institution of higher education

A proprietary institution of higher education means a school that provides an eligible program of training to prepare students for gainful employment in a recognized occupation; or provides a program leading to a baccalaureate degree in liberal arts, and has provided such a program since Jan. 1, 2009; and is accredited by a recognized regional accrediting agency or association, and has continuously held such accreditation since Oct. 1, 2007, or earlier.

For the purposes of determining the number of students of an institution (including for purposes of determining the number of students at a particular location) it shall be based on the daily average number of full-time students attending such institution (with part-time students taken into account on a full-time student equivalent basis).

What income based is the 1.4 percent excise tax is assessable on? The net investment income of the institution is taken into account and is determined under rules similar to the rules of section 4940(c) that apply to private foundations.

In determining the breadth of assets that are subject to the excise tax, the assets and net investment income of any related organization with respect to an educational institution shall be treated as assets and net investment income, respectively, of the educational institution, except that:

  • No such amount shall be taken into account with respect to more than 1 educational institution, and
  • Unless such organization is controlled by such institution or is described in section 509(a)(3) with respect to such institution for the taxable year, assets and net investment income which are not intended or available for the use or benefit of the educational institution shall not be taken into account

A related organization means, with respect to an educational institution, any organization which:

  • Controls, or is controlled by, such institution,
  • Is controlled by 1 or more persons which also control such institution, or
  • Is a supported organization (as defined in section 509(f)(3)), or an organization described in section 509(a)(3), during the tax able year with respect to such institution

A few observations related to the new rules:

  1. The smaller the student population, the higher the likelihood that the institution may be subject to this excise tax if it has a large endowment as the safe harbor threshold could be easily surpassed
  2. Due to the high per student threshold of $500,000 each in the calculation of reasonableness, this should result in a very limited number of colleges and universities in the United States being subject to this punitive excise tax
  3. There is no cliff calculation related to surpassing the $500,000 per student threshold, which means that if the threshold is exceeded, all investment income of the endowment is subject to the excise tax of 1.4 percent, not just that portion of investment income allocable to the amount above the calculated threshold safe harbor amount, as the entire endowment is then considered an unreasonable accumulation
  4. Only non-exempt use assets are subject to the threshold calculation of $500,000 per student, as such, all exempt use assets in the educational activity that forms the basis of tax-exempt status for the institution should not be taken into account when determining whether or not there is an unreasonable accumulation of endowment assets
  5. Pre-college educational institutions, e.g., secondary schools, do not meet the definition of applicable education institution for section 4968 purposes and will not be subject to this excise tax, notwithstanding the size of its endowments


Congress was developing its argument for new section 4968 since its first query of the higher education industry in 2008. We are anticipating regulations to be issued in this area to address many aspects of compliance calculations under the new rules and will keep you apprised of developments as they occur.

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