The IRS issued final regulations on Sept. 18, 2020, (TD 9917
) regarding the excise tax on the net investment income (NII) of certain colleges and universities under Section 4968.
Section 4968 was enacted as part of the Tax Cuts and Jobs Act (TCJA), and imposes an excise tax of 1.4% on NII of certain private colleges and universities. In June 2019, the IRS issued proposed regulations which provided general guidance on how a college or university can determine whether it is an Applicable Educational Institution (AEI) and subject to the tax, and, if applicable, how to calculate the NII of an AEI. The proposed regulations requested comment on several critical definitional items and left certain questions unanswered.
The final regulations, which are effective for the first tax year after publication in the Federal Register, adopted the proposed regulations with significant and favorable changes for taxpayers. In response to comments which focused on the difference between colleges and universities and private foundations, the IRS made significant changes including the clarification and modification of certain definitions, related organization rules, and narrowed the definition of NII to exclude certain income items.
Key aspects of the final regulations are discussed below. Colleges and universities should review and consider the impact of these changes as to their status as an AEI and, if required, the calculation of the NII excise.
Definition of AEI
The final regulations adopted the definition of AEI provided in the proposed regulations. An AEI is an eligible education institution which has 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 (other than those assets used directly in carrying out the institution’s exempt purposes) at the end of the preceding taxable year with a fair market value (FMV) of at least $500,000 per student. In adopting this definition, the IRS modified certain incorporated terms including the definition of “tuition-paying” and “student” and expanded the assets that can be considered in carrying out the institution’s exempt purpose.
The proposed regulations provided that a student is not considered tuition-paying if their tuition is fully covered by grants from the institution. The final regulations expand this definition to provide that “tuition-paying” should be determined after taking into account government grants or other federal, state or local financial aid, in addition to institutional grants.
Definition of 'student’
The final regulations provide a broader definition of “student.” A student is not only a tuition-paying student enrolled in a degree or “other certification program”, but anyone who is taking a course for academic credit at a tuition that is commensurate with the tuition rate charged to students enrolled for a degree.
Assets used for institution’s exempt purpose
The final regulations expand on the proposed definition of assets used for an institution’s exempt purposes. The IRS agrees that in certain circumstances, intangible assets may be used directly in carrying out an institution’s exempt purpose. Therefore, to the extent that royalty income would be excluded from NII (i.e. it is related to educational mission), these intangible assets are likewise treated as used for the furtherance of the exempt purpose. The IRS specifically carved-out that an institution’s logo, name and donated intellectual property are not assets used directly for the institution’s exempt purpose.
In another favorable change, the final regulations provide that institutions are not limited to 1.5% of total assets in calculating cash balances that can be considered reserved for exempt purposes. The final regulations, recognizing that a larger balance may be necessary due to the operational needs of a college or university, provide that any reasonable method may be used to establish necessary cash balance to cover current administrative expenses and other normal disbursements. One example of reasonableness includes using one-fourth of the total program service expenses on the Form 990 (Part IX, Column B) to equate to three months of available cash balance to meet current needs.
Calculation of NII
Under the final regulations, the regulations no longer align to the private foundation rules under Section 4940(c) for calculation of NII. The regulations instead provide specific rules under Section 4968 for an AEI’s NII calculation. Under Section 4968, a tax is imposed on AEI equivalent to 1.4% of the institution’s NII.
Gross investment income - Exclusions from NII
One of the most favorable changes in the final regulations excludes the following from NII for qualifying institutions:
- Student loan interest income
- Student housing rental income
- Certain faculty and staff housing rental income (faculty loan interest is not excluded)
- Royalty income from faculty or student generated intangible assets
Under Section 4968, royalty income from patents, copyrights and other IP from students and faculty work is excluded, although, as stated above, it does not exclude income from logos.
Allowable deductions are no longer limited to the deductions included in Section 4940(c). Deductions are permitted to the extent that they are not already taken against unrelated business income and are applicable to investment assets. The final regulations provide that charitable deductions, net operating losses and certain special deductions cannot be taken against the excise tax.
Under the final regulations, the IRS confirmed that a depreciation deduction is allowed, but only under the straight-line depreciation method. The IRS also allows a depletion deduction, but it is only permitted without regard to percentage depreciation. The regulations are consistent with the private foundation rules for both depreciation and depletion before Dec. 31, 2017.
The final regulations also adopt, consistent with the private foundation rules, that deductions associated with program related investment income cannot exceed the program income.
When the net income from capital gains is used in exempt purposes, the capital gain is disregarded to the extent it is used in the exempt purpose. Additionally, the final regulations favorably provide that appreciation of donated property is only captured from the date of donation, essentially providing for a “step up” on the date of donation. This change alleviated the concern expressed by several institutions that they would need to obtain basis information from many donors of publicly traded stock. Further, an organization may carryover a capital loss, but is not permitted to carryback the loss.
Basis has long been an area of focus for institutions subject to the tax as institutions faced limitations in data available from partnerships and looked to fully utilize the step-up in basis provided in prior guidance. The final regulations clarify the calculation of basis for 1) a gain from the sale of property other than a partnership interest; 2) distributive gain from sale or other disposition of asset in partnership; 3) gain on sale of partnership interest; and 4) loss.
Distributive share and partnership interests
In response to comments from taxpayers, the final regulations simplify the step-up basis calculation for partnerships by removing the substantiation rule provided in the proposed regulations. Commenters noted the many challenges associated with the substantiation requirement, including the need to obtain information from hundreds of partnership interests and the challenges with getting inside basis information that is not required to be tracked by the partnership. Under the final regulations, institutions are not required to step–up assets within a partnership.
In determining gain from distributive share, the final regulations provide that for each partnership interest held on Dec. 31, 2017, the AEI may determine an unadjusted step-up amount that is equal to the excess, if any, of the FMV as of that date over the adjusted basis of such partnership interest as of that date. Then, for purposes of determining investment income from such partnership on a yearly basis it will reduce its share of capital gain net income by the least of:
- The AEI’s share of applicable capital gain from such partnership (short-term and long-term gain for the first year after Dec. 31, 2017, and long-term gain thereafter)
- One-third of the AEI’s unadjusted step up for such partnership
- The AEI’s adjusted step up for such partnership, which is generally is its unadjusted step-up reduced by any capital gain that was previously excluded pursuant to the partnership disposition rules
As no methodology was provided for the first year of calculations, AEIs will need to review the impact of this methodology on the prior year’s calculation and on calculations going forward. Further, in aligning to this approach, the final regulations provide that an AEI can reduce the amount of its capital gain net income upon the sale or other disposition of all or a portion of its partnership interest by an amount that bears the same relation to the AEI’s adjusted step-up for such partnership as the FMV of the transferred portion of the interest bears to the FMV of the AEI’s entire interest in such partnership.
Gain from sale on property other than partnership interest
The calculation of basis for the sale of property other than a partnership interest is consistent with both the proposed regulations and private foundation rules. Under the rules, the basis for determining gain from the sale or other disposition of property is generally the greater of 1) the FMV of the property on Dec. 31, 2017, plus or minus all adjustments after that date but before disposition, or 2) basis as generally calculated under the rules of Part II of Subchapter O (subject to modifications).
Basis for purposes of calculating a Loss
The calculation of loss from sale or other disposition of property is consistent with the proposed regulations and private foundation rules. For purposes of determining loss on sale or disposition of partnership interest, basis is determined under the partnership rules (Subchapter K).
The final regulations create a more favorable result for organizations with related organizations. Assets (for purposes of determining whether the institution is subject to the tax) and NII of any related organization are to be treated as assets and NII of the educational institution. However, the IRS made key changes to remove many entity structures from the related organizations definition and allow the assets of related Sections 501(c)(2) and 501(c)(3) organizations to be excluded if they are used to further education or the AEIs other exempt purposes.
Under the final regulations, unfunded employee plans are considered related organizations, whereas the following are excluded as related organizations: taxable related organizations, funded employee plans, charitable trusts, decedent estates, partnerships, S corporations and other pass-through entities. Further, the final regulations narrowed the control definition and provided that the downward attribution rules under Section 318 do not apply.
The final regulations apply to taxable years of an educational institution beginning after the rules are published in the Federal Register but may be relied upon prior to applicability. Educational institutions can continue to rely on prior guidance for fiscal years prior to the publication of the final regulations. However, they should review the final regulations as changes may have a favorable impact on whether the institution is subject to the excise and the calculation of the excise tax itself.
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