The IRS and Department of the Treasury have released guidance explaining how certain colleges and universities should apply the excise tax on endowments enacted as part of the Tax Cuts and Jobs Act (TCJA).
The TCJA imposed a 1.4 percent excise tax on the net investment income (NII) of private institutions with more than 500 full-time equivalent students and assets of at least $500,000 per student. The proposed rules define terms intended to provide college administrators a roadmap for determining whether the tax applies to their institution and if so, how to calculate the amount of tax.
The notice of proposed rulemaking (NPRM), which will be published in the July 3 Federal Register, has a 90-day public comment period. Comments will be due by October 1, 2019.
Definition of tuition-paying student
The proposed regulations require that a student be both enrolled at and attending the applicable educational institution (“institution”). Students must be enrolled or accepted for enrollment in a degree, certification, or other program (including a program of study abroad approved for credit by the student’s “home” institution) leading to a recognized educational credential. The notice points out that a requirement found in section 25A(b)(3)(B) for the education tax credits that a student must carry at least half the normal full-time work load for the course of study the student is pursuing is not relevant for purposes of the net investment tax. Comments are requested regarding whether more guidance is needed on this issue.
Determinations of full-time students, part-time students, full-time student equivalents, and daily average number of students attending the institution may be made by the institution as long as the determinations are consistent with the institution’s practices in determining full-time and part-time status for other purposes. For example, it may be reasonable for an institution to determine that two students, each carrying half a full-time load, are equivalent to one full-time student. However, the standards a school uses may not be lower than the applicable standards established by the Department of Education.
Calculating the $500,000 per student threshold
Fair market value of assets per student is based upon the total number of all students attending the institution, not just the number of tuition-paying students. Generally, schools should base the definition of “tuition- paying” on the definition of qualified tuition and related expenses that is provided for education tax credits in section 25A(f)(1) and the regulations thereunder, without regard to course materials in section 25A(f)(1)(D). This does not include any separate payment for supplies or equipment required during a specific course once a student is enrolled in and attending the course (e.g., art supplies). Tuition-paying also does not include payment of room and board or other personal living expenses.
Scholarship payments provided by third parties, even if administered by the institution, are considered payments of tuition on behalf of the student. Accordingly, a student will be considered a tuition-paying student if payment of any tuition or fee is required for the enrollment or attendance of the student for courses of instruction after the application of any scholarships offered directly by the institution or work-study program operated directly by the institution.
Proposed regulations provide that a student is considered to have been 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. Like the other requirements of section 4968(b), this measurement is based on the institution’s preceding taxable year.
Determining Exempt Purpose Assets
Consistent with the rules governing private foundations, the proposed regulations provide that an asset is used directly in carrying out an institution's exempt purpose only if the asset is actually used by the institution in carrying out its exempt purpose. Administrative assets, real estate, and physical property used by the institution directly in its exempt activities are all examples of such exempt purpose assets. In addition, 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 is considered to be used directly in carrying out the institution's exempt purpose. For consistency with the private foundation rules, the Treasury Department and the IRS propose that a cash balance of 1.5 percent of the fair market value of the educational institution’s non- charitable use assets, determined without regard to the deduction for the reasonable cash balance, will be deemed to be a reasonable cash balance for purposes of section 4968. The Treasury Department and the IRS request comments on whether and how educational institutions use functionally-related businesses in conducting their operations and whether functionally-related businesses should be explicitly included or excluded as examples of exempt use assets in the final regulations.
Where property is used both for charitable, educational, or other similar exempt purposes as well as non-exempt purposes, if the exempt use represents 95 percent or more of the total use, the property will be considered to be used exclusively for a charitable, educational, or other similar exempt purpose. If the exempt use represents less than 95 percent of the total use, the institution must make a reasonable allocation between the exempt and nonexempt use. The proposed regulations deem certain assets to not be used directly in carrying out an institution’s exempt purpose, including assets that are held for the production of income or for investment (e.g., stocks, bonds, interest-bearing notes, endowment funds, or, generally, leased real estate), even if the income from such assets is used to carry out the exempt purpose.
The Treasury Department and the IRS propose that, for purposes of valuing the institution’s non-exempt use assets, institutions should use rules similar to the private foundations rules of section 4942(e) and §53.4942(a)-2(c)(4), with two modifications. First, the phrase “applicable educational institution” is substituted for “private foundation” or “foundation” every place they appear. Second, an institution will have to make such adjustments as are reasonable and necessary to obtain the fair market value of non-exempt use assets as of the last day of the valuation taxable year. Comments are requested regarding whether this rule makes sense or whether alternatives approaches are better.
Defining net investment income
These proposed regulations adopt the private foundation rules and regulations, which specify that “gross investment income” means the gross amounts of income from interest, dividends, rents, royalties (including overriding royalties), and capital gain net income received by a private foundation from all sources, but does not include such income to the extent included in computing unrelated business income tax. Under this definition, interest, dividends, rents, and royalties derived from assets devoted to charitable activities are includible in gross investment income. Therefore, for example, interest received on a student loan would be includible.
The Treasury Department and the IRS request comments on whether specific types of income should be excluded from gross investment income. For example, the proposed rules specifically include student loan interest as net investment income. However, the Treasury Department and the IRS recognize that student loans provided directly by an applicable educational institution to its students can be seen as helping the institution fulfill its mission of educating its students. If the interest rate is set at a substantially below-market rate, the difference between the market interest rate and the interest rate on the student loan might be viewed as similar to a scholarship from the school to the student. Specifically, the NPRM notes that it would be helpful if such comments provide information regarding the number of student loans institutions make each year, how they set the interest rates on those loans, and whether the rates are set below market, or at market rates.
Similarly, under section 4940(c), net investment income includes rents. The Treasury Department and the IRS recognize that colleges and universities offer various types of housing (such as dormitories or apartments) for use by students, non-students (for example, during the summer), and faculty. The Treasury Department and the IRS request comments on the differences, if any, among the housing arrangements and why certain housing should be exempt.
Treatment of gifts of appreciated property
Accordingly, under the proposed regulations, an applicable education institution computes gain on the sale or disposition of donated property using the donor’s basis. The Treasury Department and the IRS request comments on whether a special rule excluding any appreciation in a gift of donated property that occurred before the date of receipt by the applicable educational institution should be included in the final regulations and how such a special rule would be consistent with the statutory language of section 4968.
Basis: inside and outside
The proposed regulations state that if an applicable educational institution held an interest in a partnership (including through one or more tiers of partnerships) on December 31, 2017, and continuously thereafter, and the partnership held assets on December 31, 2017, and continuously thereafter to the date of disposition, the partnership’s basis in its assets with respect to the applicable educational institution for purposes of determining the institution’s share of gain upon sale or disposition of the assets shall be not less than the fair market value of such asset on December 31, 2017, plus or minus all adjustments after December 31, 2017, and before the date of disposition. For purposes of applying this special partnership basis rule, an institution must obtain documentation from the partnership to substantiate the claim.
Treatment of related organizations
The NPRM provides rules that generally align with the definition of related organization for purposes of the annual reporting requirements on Form 990.
The proposed regulations provide that the term “control” means:
(1) in the case of a corporation, ownership (by vote or value) of more than 50 percent of the stock of the corporation;
(2) in the case of a partnership, ownership of more than 50 percent of the profits interests or capital interests in such partnership;
(3) in the case of a trust with beneficial interests, ownership of more than 50 percent of the beneficial interests in the trust; or
(4) in the case of a nonprofit organization or other organization without owners or persons having beneficial interests (nonstock organization), including a governmental entity, that more than 50 percent of the directors or trustees of the institution or nonstock organization are either representatives of, or are directly or indirectly controlled by, the other entity or that more than 50 percent of the directors or trustees of the nonstock organization are either representatives of, or are directly or indirectly controlled by, one or more persons that control the institution.
The proposed regulations adopt the control test under section 512(b)(13)(D) to align more closely with other exempt organization control tests and to ensure consideration of available assets consistent with congressional intent that would not occur under the higher 80 percent control threshold. Taxable entities are not considered related organizations.
The NPRM explains that, in any case in which an organization is a related organization with respect to more than one institution, the assets and net investment income of the related organization must be allocated between the educational institutions being supported by the related organization. Such allocation must be made in a reasonable manner, taking into account all facts and circumstances, and must be consistently applied across all related organizations. Also, assets and net investment income of a related organization must be reasonably allocated between those intended or available for the use and benefit of an institution and those not intended or not available for the use and benefit of that institution.
According to the notice, an institution with a related organization that was a Type III supporting organization on December 31, 2017, may take into account only the assets and net investment income of the related Type III supporting organization that are intended or available for the use and benefit of the institution. A college or university can determine whether the assets and net investment income of such a Type III supporting organization are intended or available for the use and benefit of the institution using any reasonable method. A method using all the distributions received from the Type III supporting organization subject to this special rule as net investment income of the applicable educational institution each year will be deemed to be reasonable.
The proposed regulations are not retroactively effective for any fiscal years that end prior to the date the NPRM is published (July 3, 2019). For institutions, this means that for the first fiscal year being reported, any reasonable method may be used for determining applicability of the tax as well as the calculation of the tax.
The preamble to the proposed regulations provides that the rules apply to taxable years beginning after the date of publication final regulations in the Federal Register. Institutions may rely on the proposed regulations for taxable years beginning before publication of final regulations.