The IRS has issued an advance copy of final regulations (TD 9917) under IRC Section 4968 addressing how to determine the excise tax on the net investment income of certain private colleges and universities. The final regulations make some taxpayer-favorable changes to the proposed regulations issued in 2019, including excluding certain types of student- and faculty-related income from the tax. However, colleges and universities remain generally subject to tax on the income of most of their controlled and supporting organizations, even if the taxpaying college or university doesn't have access to that income.

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) that:

• Had 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)
• Held assets with an aggregate fair market value (FMV) of at least $500,000 per student at the end of the preceding tax year (other than assets used directly in carrying out the institution's exempt purpose)

An institution's number of students is based on the school's daily average number of full-time students, with part-time students being taken into account on a full-time student equivalent basis. When determining the amount of an institution's net investment income and whether an institution meets the asset-per-student threshold, 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 who control the institution
• Is a supported organization (IRC Section 509(f)(3)) or a supporting organization (IRC Section 509(a)(3)) during the tax year with respect to the institution

All the assets and income of controlled organizations and supporting organizations are generally attributed to the institution. 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 mid-2018, the IRS issued guidance (Notice 2018-55) announcing that it planned to issue proposed regulations stating that, for purposes of determining gain (but not loss), the basis of property that an applicable educational institution held on December 31, 2017, and continuously thereafter to the date of its disposition, would be deemed to be not less than the FMV 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.)

In mid-2019, the IRS incorporated Notice 2018-55 in proposed regulations (REG-106877-18) under IRC Section 4968 that provided definitions clarifying which institutions are subject to the tax, guidance for determining investment income, and special rules with respect to related organizations. Taxpayers could choose to rely on the proposed regulations for tax years beginning before the publication of the final regulations. (See Tax Alert 2019-1236.)

Changes from the proposed regulations

The final regulations largely track the proposed regulations but make some changes in response to certain comments the IRS received on the proposed regulations.

The following discussion highlights aspects of the final regulations that reflect changes from the underlying proposed regulations.

Tuition-paying

The final regulations generally adopt the "tuition-paying" definition of the proposed regulations: scholarships awarded by the institution do not constitute tuition paid on behalf of the student, but scholarships from third parties are considered payments of the student's tuition. However, the final regulations add that, in determining whether a student is tuition-paying, government grants — federal, state and local — are taken into account.

Located in the United States

Although the proposed regulations "contemplated that that educational institutions could [use any reasonable method to] determine whether a student resided in the United States for at least a portion of the time that the student attended the institution" during the school's preceding tax year, the final regulations provide three specific examples:

1. When a student attended an educational institution in the preceding tax year and is a citizen of a foreign country, the student is considered to be located in the United States if the student resided in the United States for at least part of the time that the student attended the educational institution in the preceding tax year.
2. When a student attended the educational institution in the preceding tax year and was studying abroad, the student is considered to be located in the United States if the student resided in the United States for at least a part the time that the student attended the educational institution.
3. When a student did not reside in the United States for any portion of the time that the student attended the educational institution during the preceding tax year, that student would not be considered located in the United States

Assets used directly in carrying out exempt purpose

The final 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 an exempt purpose. Accordingly, based on facts and circumstances, the final regulations specify that an asset is used directly in carrying out an institution's exempt purpose only if the institution actually uses the asset in carrying out its exempt purpose. This includes real estate used by the institution to conduct its teaching, research or other exempt activities. Property that is dual-use or used for a combination of charitable, educational or other purposes 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.

Intangible assets

Unlike the proposed regulations, the final regulations outline circumstances in which intangible assets may be treated as used directly in carrying out an educational institution's exempt purpose. To the extent royalty income would be excluded from investment income, patents, copyrights and other intellectual property that generate this royalty income are treated as assets the institution uses directly in carrying out its exempt purpose. But, trademarks on the institution's logo or name and intellectual property that has been donated or sold to the institution will not be considered assets used directly to fulfill exempt purposes. The final regulations include detailed examples of assets considered to be used and not used directly in carrying out an institution's exempt purposes.

Reasonable cash balance

Educational institutions are permitted to treat the reasonable cash balance needed to cover operations as an asset used directly in carrying out exempt purposes. The proposed regulations contained a safe harbor for determining a "reasonable cash balance" based on 1.5% of the FMV of an institution's non-charitable use assets. The final regulations permit an organization to calculate a reasonable cash balance using any reasonable method and replaces the safe harbor in the proposed regulations with a different one based on three months of operating expenses allocable to the organization's program services.

Assets of related organizations

The final regulations state that any asset of a related organization used directly in carrying out the institution's exempt purpose should be excluded from IRC Section 4968(b)(1)(D). The final regulations also provide that an asset of a related organization that is treated as an asset of the educational institution will be considered to be used directly in carrying out exempt purposes if: (1) the related organization is described in IRC Section 501(c)(3), and (2) the asset is being used directly in carrying out the related organization's exempt purpose.

Net investment income

The final regulations eliminate cross references to regulations under IRC Section 4940(c) to define net investment income for IRC Section 4968 purposes and instead require use of specific rules under IRC Section 4968 that are similar to those under IRC Section 4940(c) but are geared more specifically to educational institutions. The final regulations also provide that net investment income generally is the amount by which the sum of gross investment income and capital gain net income exceeds allowable deductions, and is determined by applying IRC Section 103 (interest on certain governmental obligations) and IRC Section 265 (expenses and interest relating to exempt income).

Gross investment income

The proposed regulations requested comments on whether specific types of income should be excluded from gross investment income under IRC Section 4968 because taxing those types of income would not achieve the congressional intent behind IRC Section 4968.

Commenters recommended that interest should be excluded if derived from loans to students and faculty, housing rentals to students and faculty, royalties stemming from exempt functions, programmatic activities, and endowment funds used as tuition replacement. Reflecting most of these suggestions, the final regulations provide that gross investment income generally means income from interest, dividends, rents, payments with respect to securities loans (IRC Section 512(a)(5)) and royalties — but not including such income to the extent that is included in computing the tax imposed by IRC Section 511. The final regulations exclude from gross investment income:

• Interest income from student loans that the educational institution or a related organization makes to students of the educational institution in connection with the students' attendance at the institution
• Rental income from the institution's or a related organization's provision of housing for faculty and staff if the housing is provided contingent on their roles as faculty or staff
• Royalty income derived from patents, copyrights and other intellectual and intangible property to the extent those assets resulted from the work of students or faculty in their work with the applicable educational institution

Royalties flowing from trademarks on the institution's name or logo, as well as from intellectual property that has been donated to or purchased by the institution, are not excluded.

The final regulations expressly provide that deductions permitted from gross investment income generally include all ordinary and necessary expenses, including operating 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 this income.

Consistent with IRC Section 4940(c), the final regulations provide that the following modifications must be taken into account in determining allowable deductions:

• A depreciation deduction is allowed on the basis of the straight-line method under IRC Section 168(b)(3) and without regard to IRC Section 168(b)(1) and (2).
• A depletion deduction is allowed, determined without regard to IRC Sections 613 and 613A.
• Basis used for purposes of calculating the deduction allowed for depreciation or depletion is the basis determined under the rules of part II of subchapter O of chapter 1 of the Code, subject to certain modifications.
• The deduction for expenses paid or incurred in any tax year for the production of gross investment income, earned as an incident to a charitable function, cannot be greater than the income earned from the charitable function includible as gross investment income for the tax year.

Capital gains and losses

The proposed regulations require an applicable educational institution to use the donor's basis to calculate gain on the sale or other disposition of a lifetime gift of property. The final regulations reflect comments the IRS received in providing that:

• Capital gain net income from the sale or exchange of property that an institution uses for its exempt purpose is disregarded for the portion of the property used for the exempt purpose.
• Any appreciation in the value of donated property occurring before it was donated is disregarded.
• Capital losses may be carried over but not carried back.

Related organizations

The final regulations provide definitions and special rules regarding related organizations. The final regulations exclude from the definition of a related organization:

• Foreign and domestic taxable corporations and taxable trusts
• Charitable remainder trusts
• Partnerships, S corporations and other pass-through entities, any income of which flows to the educational institution

Employee benefit plans.Under the final regulations, the determination of whether assets held by or related to an educational institution's employee benefit plan are considered assets of the institution is based on whether the arrangement is considered to be a funded or nonfunded plan. A financing vehicle (e.g., grantor trust) used in connection with unfunded plans is considered a related organization for IRC Section 4968(d) purposes, and its assets are treated as belonging to the educational institution.

Decedents' estates.The final regulations provide that a decedent's estate is not considered a related organization, but any estate assets that are transferred to the institution are considered the school's assets upon receipt.

Control

The final regulations separately define control for organizations that: control an educational institution; are controlled by an educational institution; and are controlled by one or more persons who also control the educational institution.

The final regulations generally provide that an educational institution controls a nonstock organization if the institution (or at least one of its managers, directors, officers, trustees or employees) can:

• Appoint or elect more than 50% of the nonstock organization's governing body
• Require the nonstock organization to make an expenditure, or prevent an expenditure
• Require the nonstock organization to perform any act that significantly affects its operations, or prevent the nonstock organization from performing such an act

Similar rules apply to determine if an educational institution is controlled by a nonstock organization.

An organization is controlled by one or more persons that also control the institution if more than 50% of the members of the governing body of the other organization are directly or indirectly controlled by persons that comprise 50% or more of the governing body of the educational institution. The final regulations also include some complex rules for determining control of or by a trust.

To avoid any unintended results from using the downward attribution principles of IRC Section 318(a)(3), the final regulations apply the principles of IRC Section 318(a)(2) for purposes of determining stock ownership in a corporation, but do not apply IRC Section 318(a)(3). Another addition to the final regulations includes the clarification that undesignated assets should not be treated as intended or available for the educational institution unless affirmatively designated or appropriated for the institution or made available for it to draw upon at will.

Assets and income of supporting organizations

The final regulations maintain the rules in the proposed regulations that generally require assets and income of a supporting organization of an educational institution to be treated as the assets and income of that educational institution for purposes of IRC Section 4968, with an exception for entities that were Type III supporting organizations with respect to an educational institution on December 31, 2017.

Applicability date

Although the final regulations will apply to tax years of educational institutions that begin after the date TD 9917 is published in the Federal Register, no date for this anticipated publication has yet been set.

Implications

The final regulations generally follow those proposed in mid-2019 with a few changes based on the comments received by the IRS.

Educational institutions otherwise meeting the requirements of IRC Section 4968 should review their inventory of intangible assets to determine if those assets can be included in the definition of exempt assets and therefore excluded from the educational institution's asset base. Similarly, educational institutions should review and thoroughly document whether they can establish a reasonable method to determine a reasonable cash balance, including the calculation of three months of operating expenses, to further increase the amount that is excluded from the asset base.

While the final regulations eliminate cross-references to regulations under IRC Section 4940(c) and create new terms to define net investment income for IRC Section 4968 purposes, organizations must still be cognizant of some IRC Section 4940(c) language to determine their gross investment income. Educational institutions should review all calculations of gross investment income, capital gain net income and their allowable deductions to accurately determine their IRC Section 4968 liability.

Educational institutions must be aware of the changes to the definitions of control, attribution and constructive ownership under IRC Section 318(a)(2). Educational institutions will have to review the applicability of each definition of control based on their particular relationships with other organizations.

Lastly, educational institutions will need to determine if all the assets and income of their supporting organizations must be treated as assets and income of the educational institution, or if an exception could apply.

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

———————————————
RELATED RESOURCES

— For more information about EY's Exempt Organization Tax Services group, visit us here.

———————————————