Treasury and the IRS recently released an advance copy of final regulations (T.D. 9917) under section 4968, providing guidance to private colleges and universities with respect to computing the excise tax on net investment income. The final regulations expand upon the proposed regulations issued in June 2019 and address many of the comments received from the tax-exempt sector.
The 2017 tax law (Pub. L. 115-97) added new section 4968, which imposes a 1.4% excise tax on the net investment income of certain private colleges and universities. In June 2018, the IRS issued Notice 2018-55, providing interim guidance on the determination of basis for appreciated property continuously held since Dec. 31, 2017. On June 28, 2019, Treasury and the IRS released proposed regulations regarding the requirements of section 4968, including the manner for determining the excise tax applicable to the net investment income of a private college or university. The proposed regulations requested public comment from affected institutions with respect to how to adjust the proposed regulations for modern educational institutions’ investment activities.
After reviewing the 18 comments submitted in response to the proposed regulations, the Treasury and IRS promulgated final regulations under section 4968. The final regulations largely adopt the proposed regulations but provide additional clarifications and some modifications in response to the comments. The regulations appear in three distinct parts:
- Excise tax based on investment income of private colleges and universities (Treas. Reg. § 53.4968-1)
- Net investment income (NII) (Treas. Reg. § 53.4968-2)
- Related organizations (Treas. Reg. § 53.4968-3)
Highlights of the final regulations, discussed in further detail below, include the following:
- A reasonable cash balance allowance for exempt use property
- Examples of exempt use assets and assets held for investment
- Exclusions from the computation of NII, including special rules for partnerships held before Dec. 31, 2017
- Exceptions to the definition of related organizations
- Capital loss carryovers
The final regulations apply to taxable years of an educational institution beginning after the date of publication in the Federal Register.
The excise tax imposed by section 4968 applies to the NII of applicable educational institutions. As defined in section 4968(b)(1), an applicable educational institution is an eligible educational institution defined in section 25A(f)(2) and Treas. Reg. § 1.25A-2(b) that meets the following criteria:
- Had at least 500 tuition-paying students during the preceding taxable year,
- More than 50% of its tuition-paying students are located in the United States,
- Is not a state college or university, and
- The aggregate fair market value (FMV) of the assets at the end of the preceding taxable year, other than those assets that are used directly in carrying out the institution’s exempt purpose, is at least $500,000 per student.
When analyzing section 4968, a private college or university must first determine whether the section applies by determining whether its tuition-paying student population is sufficiently large and whether the amount of non-exempt assets it holds per student is at least $500,000. After determining applicability, the college or university must then compute its net investment income to determine the amount of excise tax it owes.
Therefore, private colleges and universities hope to demonstrate that they do not have 500 tuition-paying students by reducing total student numbers by those paying no tuition as a result of scholarships. In the alternative, these institutions hope to use the largest numbers possible when determining the size of their student population such that the asset size per student is reduced. Failing either option, the last way to avoid the classification of an applicable educational institution is to demonstrate that the majority of the institution’s assets are used directly in carrying out the organization’s exempt purposes.
A student is any person enrolled and attending a course for academic credit from the institution and who is being charged tuition at a rate that is commensurate with the tuition rate charged to students enrolled for a degree. Because the application of the excise tax depends upon the number of students (both tuition-paying and total number), private colleges and universities have a vested interest in understanding how to count students, particularly those who receive scholarships or who are part-time. Generally, the total number of students is based on the daily average of full-time students, with part-time students included on a full-time equivalent basis.
Whether a student is tuition-paying is determined after taking into account any scholarships and grants provided directly by the educational institution; the federal, state, or local government; and after application of any work study programs operated directly by the institution. Therefore, students that receive non-governmental third party scholarships or grants, even when administered by the educational institution, are tuition-paying students.
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 as long as that method is consistently applied.
Assets used directly in carrying out an institution’s exempt purpose
Because the excise tax only applies to institutions that have at least $500,000 of nonexempt use assets per student, an educational institution has a vested interest in categorizing assets as used directly in carrying out its exempt purposes. The final regulations generally provide that an asset is used directly in carrying out an educational institution’s exempt purpose only if the institution actually directly uses the asset in carrying out its exempt purposes, based on all facts and circumstances.
As set forth in the final regulations, examples of assets used for exempt purposes 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, research facilities, and related equipment used in the conduct of the institution’s exempt activities
- Patents, copyrights, and other intellectual and intangible property to the extent that such income is excluded from net investment income (as described below)
- 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
The final regulations also permit educational institutions to include as an exempt purpose asset a reasonable cash balance using any reasonable method, necessary to cover current operating and administrative expenses and other normal and current disbursements directly connected with the educational institution’s exempt activities. Institutions can opt for a safe harbor equal to three months of operating expenses allocable to program services (by dividing the annual functional expenses allocable to program services by four).
Examples of assets held for other than exempt purposes include those held for the production of income or investment (e.g. stocks, bonds, interest-bearing notes, endowment funds, investment real estate) and property used for the purpose of managing the institution’s endowment funds (such as offices or equipment).
Mixed use assets, or those used for an exempt purpose in addition to other purposes, generally must be reasonably allocated between the exempt and nonexempt uses. However, the final regulations also provide a safe harbor that permits treating mixed use assets as though they are used exclusively for exempt purposes if the exempt use represents at least 95% or more of their total use.
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 section 4942(e), with certain modifications as are “reasonable and necessary.”
Net investment income
Once an educational institution is subject to the excise tax, it must then annually compute the NII generated by its nonexempt use assets in order to compute the amount of tax owed. Recognizing that educational institutions operate differently from private foundations, the final regulations draw upon section 4940(c), as required by statute, but provide specific guidance to these institutions. The same general rules continue to apply: NII generally consists of gross investment income and capital gain net income, less allowable deductions. Gross investment income includes items such as interest, dividends, rents, royalties, and similar income sources but does not include unrelated business taxable income. Allowable deductions include all ordinary and necessary expenses related to the production or collection of gross investment income or the management, conservation, or maintenance of investment property, subject to certain modifications.
However, the final regulations account for the different purposes and operations of educational institutions by introducing the following:
- Gross investment income does not include:
- 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, or
- Royalty income derived from patents, copyrights, and other intellectual and intangible property resulting from the work of students or faculty.
- 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 is includable in gross investment income.
- Taxes paid or incurred under section 4968 are not deductible.
- Expenses incurred for both investment and exempt purposes must be allocated accordingly.
- Deductions related to the production of gross investment income earned incidental to a charitable function may not exceed such income for the taxable year.
Capital gains and losses
Although NII generally includes capital gain net income, the final regulations address the specifics of such computation in substantial detail to address the operational differences of educational institutions. Unlike the rules governing private foundations, educational institutions exclude from NII the gains and losses from property used for exempt purposes. In addition, NII does not include gain attributed to appreciation of donated property that occurred prior to its donation to the institution. Moreover, if an educational institution held appreciated property on Dec. 31, 2017 and continuously thereafter, it can use the FMV of the assets as of Dec. 31, 2017 solely for purposes of determining NII on the property’s sale or disposition.
Finally, the regulations provide specific rules with respect to gains and losses related to the sale of partnership interests or partnership assets. Although the Subchapter K rules generally prevail, the final regulations contain a special rule to address pre-Dec. 31, 2017 built-in gain. To minimize the burden on both the educational institution and the partnership, an educational institution may compute its NII by reducing the amount of its distributive share of capital gain net income from a partnership by the lesser of (1) its share of capital gain from such partnership; (2) one-third of its unadjusted step-up for such partnership; or (3) its adjusted step-up for such partnership. Ultimately, these provisions enable an educational institution to exclude pre-Dec. 31, 2017 built-in gain without burdensome asset-by-asset matching. A similar rule, with some adjustments, applies to the sale of partnership interests.
With respect to net capital loss in a given taxable year, it may not be deducted from gross investment income. However, the final regulations provide a significant new provision that permits a carryover of net capital losses to reduce future capital gains.
In determining the FMV of its nonexempt use assets and computing its NII, an educational institution must include the assets and NII of certain related organizations. Generally, a related organization is as follows with respect to the educational institution:
- Controls or is controlled by
- Commonly controlled (brother-sister)
- Supported organization
- Supporting organization
However, the regulations add a number of exceptions to this general definition. The following entities are not related organizations for purposes of section 4968:
- Taxable corporations
- Taxable trusts
- Non-grantor charitable lead trusts (except to the extent controlled by the institution)
- Grantor charitable lead trusts
- Charitable remainder trusts
- S corporations
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 NII 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.
The 156 pages of regulations generally provide taxpayer favorable guidance and exceptions, limiting both the application of section 4968 and the amount of excise tax. However, the nuances with respect to these rules and exceptions are many and a critical part to the analysis. Furthermore, because the $500,000 per student threshold is not indexed for inflation, it is important for all private colleges and universities with significant nonexempt use assets to familiarize themselves with these rules and to track FMV of assets as of Dec. 31, 2017.