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The IRS has issued proposed regulations (REG-106877-18) on the IRC Section 4968 investment income tax for certain private colleges and universities and their related organizations. The proposed regulations provide key definitions and a welcome exception for certain supporting organizations.

Background

IRC Section 4968, added by the Tax Cuts and Jobs Act (TCJA), imposes an annual 1.4% excise tax on the net investment income of an "applicable educational institution" for tax years beginning after December 31, 2017. Net investment income is to be determined using rules similar to the rules of IRC Section 4940(c), relating to the net investment income of a private foundation.

An "applicable educational institution" is an eligible education institution described in IRC Section 25A(f)(2) (relating to the Hope and Lifetime Learning credits) that:

• Has at least 500 tuition-paying students during the preceding tax year, more than 50% of whom are located in the US
• Is not described in the first section of IRC Section 511(a)(2)(B) (i.e., generally describing state colleges and universities)
• Has assets with an aggregate fair market value of at least $500,000 per student at the end of the preceding tax year (other than those assets that are used directly in carrying out the institution's exempt purpose)

An institution's number of students is based on the daily average number of full-time students attending the institution, with part-time students being taken into account on a full-time student equivalent basis.

When determining whether an institution meets the asset-per-student threshold and the amount of an institution's net investment income, certain assets and net investment income of related organizations must be taken into account. An organization is treated as related to the institution for this purpose if the organization:

• Controls, or is controlled by, the institution
• Is controlled by one or more persons that control the institution

or

• Is a supported organization (as described in IRC Section 509(f)) or a supporting organization (as described in IRC Section 509(a)(3)) during the tax year with respect to the institution

All of the assets and income of controlled organizations and supporting organizations are attributed to the institution (though the regulations propose an exception for Type III supporting organizations described below). If an organization is related but not controlled by, or a supporting organization of, the institution, then only assets and income that are intended for, or available for the use or benefit of, the institution are attributed to the institution.

In June 2018, the IRS announced in Notice 2018-55 that it planned to issue proposed regulations stating that, for property held by an applicable educational institution on December 31, 2017, and continuously thereafter to the date of its disposition, the basis of such property for determining gain (but not loss) is deemed to be not less than the fair market value of that property on December 31, 2017, plus or minus all adjustments after December 31, 2017, and before the date of disposition consistent with the regulations under IRC Section 4940(c). See Tax Alert 2018-1220.

Proposed regulations

The proposed regulations include definitions clarifying which institutions are subject to the tax, guidance for determining investment income, and special rules with respect to related organizations. The regulations are proposed to apply to tax years beginning after the date that final regulations are published; however, taxpayers may rely on the proposed regulations for tax years beginning before the publication of the final regulations.

Institutions subject to the tax

The proposed regulations define various terms used in determining whether an entity is an "applicable educational institution" subject to the tax. In general, these definitions draw from definitions already in place under IRC Section 25A (relating to the American Opportunity [formerly the Hope Scholarship and Lifetime Learning credits) for the definition of eligible educational institution, and under IRC Section 4942 (relating to private foundation asset measurement) for the definition of exempt use assets.

Eligible educational institution defined in IRC Section 25A(f)(2)

In the Preamble to the proposed regulations, the IRS states that it believes that colleges already know if they are eligible educational institutions described in IRC Section 25A, but it requests comments on whether further guidance is needed in this area.

Student

The proposed regulations generally follow the definition of student in IRC Section 25A(b)(3)(A), which cross-references to Section 484(a)(1) of the Higher Education Act of 1965 (20 USC 1091(a)(1)). Thus, the regulations propose defining "student" for IRC Section 4968 purposes as "a person enrolled in a degree, certification or other program (including a program of study abroad approved for credit by the eligible institution at which such student is enrolled) leading to a recognized educational credential at an eligible educational institution, and not enrolled in an elementary or secondary school." The proposed regulations include small variations from the definition of student in 20 USC 1091(a)(1). For example, the proposed regulations would exclude from the definition of "student" individuals merely accepted for enrollment, and they do not include any requirement that the student have at least half the normal full-time workload.

For students, the proposed regulations further specify that "tuition-paying" means the payment of tuition and fees required for the enrollment or attendance of a student for courses of instruction at an eligible educational institution, but 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. The proposed regulations also specify that whether a student is "tuition-paying" is determined after taking into account any scholarships provided directly by the educational institution and any work study programs operated directly by the educational institution. Consequently, if some outside source pays the educational institution for the student's tuition (e.g., scholarships from sources other than the educational institution), the student will still be considered tuition-paying even if the student pays no money out of pocket.

The proposed regulations state that a student will be considered to have been "located in the United States" if the student, regardless of citizenship, resided in the US for at least a portion of the time the student attended the educational institution based on the applicable educational institution's preceding tax year. Furthermore, a student attending the educational institution who was studying abroad in a foreign country is considered a student located in the US if the student resided in the US for at least a portion of the time the student attended the educational institution.

Under the proposed regulations, each applicable educational institution may make its own reasonable determinations of full-time students, part-time students, full-time student equivalents, and daily average of students attending 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. Unlike IRC Section 25A, IRC Section 4968 does not require that a student carry at least half the normal full-time workload in order to be considered a student. However, the standard provided in Reg. Section 1.25A-3(d)(1)(ii) (defining "eligible student" for the Hope Scholarship Credit) is a helpful model to follow when determining the full-time equivalent requirement in IRC Section 4968(b)(2).

Assets used directly in carrying out an institution's exempt purpose

The proposed regulations generally follow the IRC Section 4942 regulations governing private foundation asset measurement for purposes of determining whether an educational institution's assets are used directly in carrying out the institution's exempt purpose. Accordingly, based on facts and circumstances, the proposed regulations specify 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. These include real estate when the institution conducts its teaching, research or other exempt activities. A "reasonable cash balance" is also considered an exempt use asset. Reasonable means up to 1.5% of the fair market value of the institution's non-exempt use assets (determined without regard to the reduction for the reasonable cash balance).

When property is dual-use or used for a combination of charitable, educational or other purposes, the property is considered to be used exclusively for charitable, educational or other exempt purposes if the exempt use represents 95% or more of the total use. If the exempt use is less than 95%, an allocation must be made between the exempt and nonexempt use.

The proposed regulations specify types of assets that are not used directly in carrying out an institution's exempt purpose, including assets that are held for the production of income or for investment, even if the income from such assets is used to carry out the exempt purpose. These non-exempt use assets include stocks, bonds, interest-bearing notes, endowment funds, and real estate leased to others, even if the income generated is used to fund exempt activities.

The proposed regulations also generally follow IRC Section 4942 regulations for purposes of determining the value of an institution's non-exempt use assets, with two modifications:

• The phrase "applicable educational institution" is substituted for "private foundation" or "foundation,"
• 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 tax year (rather than any other frequency provided by the IRC Section 4942 regulations)

The proposed regulations do not address whether a functionally-related business would be considered an exempt-use asset for the purposes of this test, and the IRS requests comments on this issue.

Determination of net investment income and basis of property

For purposes of determining net investment income, the proposed regulations generally follow the regulations under IRC Section 4940(c) relating to private foundation net investment income measurement. Under those rules, "gross investment income" means the gross amounts of income from interest, dividends, rents, payments with respect to securities loans (defined in IRC Section 512(a)(5)), royalties and capital gain net income received from all sources but does not include such income to the extent included in computing the unrelated business income tax imposed by IRC Section 511. The Preamble to the proposed regulations specifies that this includes interest received on a student loan, but it requests comments on whether specific types of income (including the aforementioned student loan interest) should be excluded from gross investment income for purposes of IRC Section 4968.

Gross investment income could be offset by deducting all the ordinary and necessary expenses paid or incurred for the production or collection of gross investment income or for the management, conservation or maintenance of property held for the production of income. However, modifications to these expenses include the following:

• The deduction provided by IRC Section 167 would be allowed, but only on the basis of the straight-line method of depreciation.
• The deduction for depletion would allowed under IRC Section 611, but determined without regard to IRC Section 613 percentage depletion.

For purposes of determining capital gain net income, the following rules would apply:

• No gain or loss, to the extent of any gain from the sale or other disposition of property, would be taken into account for purposes of computing the tax on unrelated business taxable income imposed by IRC Section 511.
• The basis for determining gain on property held on December 31, 2017, and thereafter until sold or otherwise disposed would be deemed to be not less than the fair market value of the property on December 31, 2017 (along with a special rule for assets held in partnerships).
• If the disposition of an asset would result in a loss, the basis rules under IRC Section 4940(c) would apply, and the taxpayer would recognize the loss only to the extent of gains, with no capital loss carryovers or carrybacks (any losses by related parties would be allowed to offset gains from other related organizations or the applicable educational institution)
• Similar to IRC Section 1031 like-kind exchange rules, no gain or loss would be taken into account for any portion of property used for one year or more for an exempt purpose if the entire property were exchanged, and the new property were immediately used for exempt purposes

Under the proposed regulations, an applicable education institution would compute gain on the sale or disposition of donated property using the donor's basis. This rule is the same as that used in calculating a private foundation's gain on the disposition of donated property, but the proposed regulations 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 what the authority for such a rule would be).

Related organizations

The proposed regulations include definitions and special rules relating to related organizations, which generally follow those used in Form 990 reporting.

Definition of related organization

The proposed regulations track the statutory language regarding related entities and then go on to define "control" to mean:

• Ownership (by vote or value) of more than 50% of the stock of the corporation (for corporations)
• Ownership of more than 50% of the profits, interests or capital interests in such partnership (for partnerships)
• Ownership of more than 50% of the beneficial interests in the trust (for trusts with beneficial interests)

For a nonprofit organization or other organization without owners or persons having beneficial interests (nonstock organization), including a governmental entity, control means:

• More than 50% of the directors or trustees of the applicable educational institution or nonstock organization are either representatives of, or are directly or indirectly controlled by, the other entity

or

• More than 50% 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 applicable educational institution

Assets and net income treated as assets and net income of only one educational institution

When an organization is a related organization with respect to more than one educational institution, the proposed regulations would require the assets and net investment income of the related organization to be allocated among the educational institutions being supported by the related organization. This allocation would have to be made in a reasonable manner, taking into account all facts and circumstances, and be consistently applied across all related organizations.

Assets and net investment income "not intended or available for the use or benefit of" an educational institution

When a related organization that does not meet IRC Section 509(a)(3)'s requirements controls an educational institution, the proposed regulations would require the assets and net investment income of the related organization to be allocated between those intended or available for the use and benefit of the educational institution and those not intended or not available for the use and benefit of that educational institution. This allocation would have to be made in a reasonable manner, taking into account all facts and circumstances, and be consistently applied across all related organizations. The same requirements would apply if the related organization were controlled by one or more persons that also control the educational institution.

The regulations further clarify that the related organization's assets and net investment income are "intended or available for the use and benefit of an educational institution" they are specifically earmarked or restricted for the benefit of, or are otherwise fairly attributable to, the educational institution.

The proposed regulations include a special rule for related organizations of an educational institution that are IRC Section 509(a)(3) Type III supporting organizations with respect to the applicable educational institution on December 31, 2017. Specifically, they permit such institutions to 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 applicable educational institution." In discussing this exception to the statute, the IRS noted that Type III supporting organizations are not controlled by their supported organizations, unlike Type I and II supporting organizations. Consequently, the IRS allowed these types of supporting organizations to be subject to the more lenient asset and inclusion rule applicable to other related organizations that are not controlled by the educational institution.

Implications

The proposed regulations generally make use of existing definitions within the Internal Revenue Code, particularly those used by private foundations, in calculating their net investment income tax and minimum distribution requirements.

While using existing rules can be an efficient approach, there may be areas where rules created for different purposes do not align with an educational institution's operations. Educational institutions should carefully review these rules and submit comments to the IRS on areas that would pose significant administrative challenges and how the rules could be better adapted. For example, the requirement to track and use the donor's basis when calculating gain on disposition of property may prove challenging for large institutions with a broad donor base. Similarly, taxing capital gain on the disposition of property used in furtherance of an institution's exempt purpose may impose a greater burden on an institution trying to reduce its real estate footprint (such as classrooms and dormitories) than it does in the private foundation context from which these rules are drawn.

The IRS's exception for Type III supporting organization asset and income inclusion may be very favorable for some organizations, but it only applies to entities that were Type III supporting organizations as of December 31, 2017. The IRS's rationale for this exception (lack of control, lack of access to information) would seem to apply to any Type III supporting organization, including a newly formed one, but the exception as written does not appear to be available for those new entities.

Any private educational institution that may be affected by IRC Section 4968 should review the proposed regulations and consider:

• How the proposed regulations currently apply to that institution
• Whether changes to institution's scholarship programs or legal structure would be warranted to reduce the organization's tax burden
• Whether the institution should provide comments, including specific examples, that address certain aspects of the proposed regulations that could be modified to meet legislative intent without imposing a significant burden on the institution

Please contact your Ernst & Young LLP professional for further information.

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