New Tax Law Focus: Investment Income Tax will Snag Some Private Universities

This post continues our focus on the Tax Cuts and Jobs Act provisions that affect the tax-exempt sector. One such provision will subject certain private universities and to a 1.4 percent excise tax on their net investment income.

More specifically, the Act added Section 4968 to the Tax Code, which will levy the excise tax on private educational institutions with at least 500 students and assets (other than those used directly in carrying out exempt purposes) valued at $500,000 or more per student. The tax will affect wealthy, well-known institutions like Harvard. However, some schools will fall under the tax largely because of the small size of the student body (e.g., Claremont McKenna College in California), and some less traditional schools like Kentucky’s Berea College, which uses its substantial per-student endowment to provide tuition-free education.

The assets of related organizations typically will be treated as owned by the educational organization for the purposes of this tax. Related organizations include supporting/supported organizations and any organization that controls or is controlled by the educational institution, or organizations under common control with the educational institution. This could have implications for private universities with related organizations with significant donated assets, such as academic medical centers. State universities, however, are expressly exempt from the tax provision, and it appears their related organizations will be exempt as well since their assets would be considered assets of the state university.

A recent Inside Higher Ed article shows that reactions to the provision are fairly muted so far, in part because there is still some uncertainty as to how the tax will be calculated. The new provision states that net investment income will be determined under rules similar to those that apply to private foundations under Section 4940. However, it remains to be seen how exactly terms will be defined for purposes of the new law.

“We are expecting the Treasury Department to have to take some steps to help with some of the definitions,” said Liz Clark, director of federal affairs at the National Association of College and University Business Officers. “A lot is going to rest on the definition of assets used directly in carrying out the educational institutions’ exempt purpose, as well as the definition of net investment income.”

It is possible that covered universities may explore different financial arrangements to minimize the tax, such as increasing split-interest agreements like CRATs that would keep assets off their books, or shifting assets into buildings rather than endowments. Some in the university sector are wondering, too, if the new law is an entry point for broader taxation of universities and their assets.

Click here for our previous post on executive compensation excise tax, and here for our previous UBIT post.

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