Tax code Section 4968, which was added by the Tax Cuts and Jobs Act (TCJA), imposes an excise tax of 1.4% on the net investment income of certain private colleges and universities with large endowments valued at $500,000 or more per student. On June 28, 2019, the Treasury Department and the Internal Revenue Service released proposed regulations providing guidance for determining the new excise tax. The guidance was much needed, as most colleges and universities that are subject to the tax—referred to in the statute as “applicable educational institutions” (AEIs)—will have to make their first payments of Section 4968 excise taxes in November. Unfortunately, the proposed regulations provide these AEIs with relatively little guidance on how to calculate the tax.
Section 4968 taxes AEIs on their “net investment income” (NII) and defines NII only by stating that it “shall be determined under rules similar to the rules of section 4940(c).” (Section 4968(c).) Section 4940(c) defines NII for purposes of the excise tax on such income earned by private foundations. In defining NII for purposes of Section 4968, the proposed regulations unfortunately do little more than parrot the statute, merely cross-referencing Section 4940(c) and the regulations thereunder, with some minor modifications. By mostly limiting the guidance to these cross-references, the proposed regulations provide AEIs with virtually no additional guidance on the question of how to determine NII. In particular, they neglect to take into account meaningful differences between the operations of a college or university and a typical private foundation. In addition, the proposed regulations fail to recognize the many ways investment activity has changed over the nearly 50 years since the proposed regulations under Section 4940 were issued—in particular, the increased amount of investment activity conducted through partnerships and the issues such investments raise. Consequently, the proposed regulations raise more questions than they answer.
This article reviews what questions the proposed regulations under Section 4968 do and do not answer for AEIs attempting to determine their NII for the first time and highlights areas where AEIs will have to reach positions in the absence of clear guidance over the next several months. In Part 2 of this two-part series, the authors explain deductions and the treatment of related organizations.
As a general matter, the proposed regulations provide that an AEI may deduct against GII and capital gain net income all of its “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 such income . . . .” (Section 4940(c)(3)(A).) Such expenses include depreciation, subject to several modifications. First the straight-line method of depreciation must be used instead of accelerated depreciation methods. (Treas. Reg. Section 53.4940-1(e)(2)(i).) Second, even if the AEI has not previously taken depreciation deductions with respect to depreciable property in tax years beginning before Dec. 31, 2017, the AEI still must reduce its basis in such property by an amount equal to straight-line depreciation for purposes of taking deductions against NII in subsequent tax years. (Treas. Reg. Section 53.4940-1(e)(2)(iii).) Third, if the AEI has actually taken depreciation deductions in excess of the straight-line method in prior tax years (for example, against UBTI), the basis used in taking subsequent depreciation deductions must reflect this excess depreciation. Finally, in contrast to the rule used for calculating capital gain (discussed above), for purposes of determining depreciation deductions, the AEI may not use a basis that has been “stepped up” to December 2017 FMV. These principles apply equally to cost depletion.
Other expenses specifically mentioned in the proposed regulations (by cross-reference) as deductible against GII are the allocable portion of salaries and other compensation, outside professional fees, interest, and rents and taxes on property used. (Treas. Reg. Section 53.4940-1(e)(1)(i).) Charitable contribution deductions, net operating loss deductions, and certain other statutory deductions (e.g., dividends received deductions) are specifically disallowed. (Treas. Reg. Section 53.4940-1(e)(1)(iii).) More generally, tax code Section 4940(c)(1) states that—except to the extent inconsistent with the provisions of tax code Section 4940—NII “shall be determined under the principles of subtitle A.” This arguably suggests that deductions taken against GII and capital gain net income are limited to deductions permissible under subtitle A and that restrictions on such deductions in subtitle A—such as those under tax code Section 163(j) (restricting interest deductions), tax code Section 263 (disallowing deductions for certain capital expenditures), and tax code Section 274 (disallowing deductions for certain entertainment and other expenses)—may also apply.
Expenses Incurred Incident to a Charitable Function
The regulations under tax code Section 4940 contain a special rule for “gross investment income earned as an incident to a charitable function.” (Treas. Reg. Section 53.4940-1(e)(2)(iv).) This rule provides that the “deduction for expenses paid or incurred in any taxable year for the production of gross investment income earned as an incident to a charitable function shall be no greater than the income earned from such function which is includible as gross investment income for such year.” The same regulations also contain the following example illustrating this rule: “where rental income is incidentally realized in 1971 from historic buildings held open to the public, deductions for amounts paid or incurred in 1971 for the production of such income shall be limited to the amount of rental income includible as gross investment income for 1971.”
The regulations under tax code Section 4940 do not define “charitable function” (or “incident to a charitable function”) for these purposes (and no authorities of which the authors are aware have expounded upon its meaning to any significant degree). The most significant authority on this rule is a TAM from 1980, in which the IRS ruled that expenses allocable to a student loan program were not deductible in calculating NII to the extent such expenses exceeded interest income from the loans. (TAM 8047007.) In doing so, the IRS rejected the taxpayer’s argument that the phrase “incident to a charitable function” applies “only when income derived from an exempt activity is minor or inconsequential.”
No guidance exists on how broadly or narrowly a single “charitable function” should be defined and how to determine whether one or many charitable functions exists. The issue of how to draw lines between separate “charitable functions” may not have come up previously because relatively few private foundations would have GII earned incident to a charitable function from multiple sources. AEIs, by contrast, will almost certainly be earning such income from many sources. For example, an AEI might, in a single year, earn royalties from research patents, rents from leasing dormitories, and interest from student loans. As a result, AEIs will need to determine where to draw the lines between GII that is incident to a charitable function and income that is not, and whether all GII from a charitable function may be aggregated along with associated expenses.
If NII for each charitable function needs to be determined separately, AEIs will need guidance on how to separate charitable functions. For example, is educating students one “charitable function,” meaning that an AEI may aggregate all GII earned and associated expenses incurred in serving that purpose? Or does an AEI need to treat each separate activity (for example, student housing v. faculty housing) or even each separate item of property (for example, each dormitory or each item of intellectual property) as a separate “function”? As Treasury and the IRS have discovered in trying to develop guidance on how to determine whether one trade or business is separate from another for purposes of another provision enacted as part of tax reform (tax code Section 512(a)(6)), drawing such lines is no easy task.
Because the proposed regulations make no effort to explain how the “charitable function” limitation should apply to AEIs’ unique circumstances, AEIs will have to determine their NII in the absence of clear guidance on the limitation.
Tax code Section 4968 provides that NII of any “related organization” of an AEI is generally to be treated as NII of the AEI. (Section 4968(d)(1).) A related organization is defined in the statute as including any organization that controls or is controlled by the AEI, is controlled by one or more persons that control the AEI, or is a supporting or supported organization described in tax code Section 509(a)(3) or tax code Section 509(f)(3), respectively, of the AEI. (Section 4968(d)(2).) As indicated by Notice 2018-55, the proposed regulations provide that overall net losses from sales or other dispositions of property by one related organization (or by the AEI) reduce (but not below zero) overall net gains from sales or other dispositions by other related organizations (or by the AEI). (Prop. Treas. Reg. Section 53.4968-1(b)(3)(v).)
A detailed discussion of related organizations is beyond the scope of this article, but two points in particular merit discussion: namely, whether any of the NII of taxable related organizations must be included in an AEI’s NII and the scope of the exceptions to taking into account the NII of related organizations.
Taxable Related Organizations
The proposed regulations define related organizations as including not only other nonprofit, tax-exempt organizations, but also taxable organizations. Specifically, the proposed regulations provide that an AEI “controls” (and is thus related to) a stock corporation, partnership, or trust, if it owns (either directly or indirectly by applying the principles of tax code Section 318) more than 50% of the corporation’s stock (by vote or value), the partnership’s profits or capital interests, or the trust’s beneficial interests. However, taxing an AEI on the NII of a controlled taxable corporation, partnership, or non-exempt trust makes little sense for the reasons described below.
In the case of a controlled taxable corporation, any investment income earned by the corporation will already be taxed under tax code Section 11 and then would be taxed again as NII if and when it is paid to the AEI as a dividend. There does not appear to be any justification for taxing it a third time as NII when it is earned by the controlled corporation.
In the case of a partnership, the AEI will already have been taxed on its proportionate share of NII derived from its partnership interests regardless of whether or not it controls the partnership. Taxing the AEI on the share of NII earned by (and, in the case of taxable partners, taxed to) other partners in the partnership just because the AEI’s profits or capital interests exceed 50% would similarly have no justification.
As for trusts in which an AEI has a beneficial interest, including charitable remainder trusts, charitable lead trusts, and other charitable trusts, it makes little sense to treat as the NII of the AEI any income that is taxed to the trust or distributed (and, in the case of taxable beneficiaries, taxed) to beneficiaries of the trust other than the AEI, regardless of whether the AEI’s beneficial interests exceed 50%. For purposes of avoiding double-counting, it is also worth noting that Treas. Reg. Section 53.4940-1(d)(2) (cross-referenced in the tax code Section 4968 proposed regulations) provides that income from a split-interest trust generally retains its character in the hands of the distributee private foundation, meaning that a split-interest trust’s distributions to an AEI of GII would be included in an AEI’s NII.
The inequity of taxing AEIs on the NII of taxable entities is noted in the preamble, which states that “[s]ince the net investment that a taxable entity provides to an applicable educational institution has already been taxed under section 1, the Treasury Department and the IRS do not consider it consistent with congressional intent to tax the income again under section 4968.” (84 Fed. Reg. 31,795, 31,801.) However, the proposed regulations themselves do not provide operative language to implement this principle. In addition, the reference to “section 1” in this sentence in the preamble is confusing. It appears that Treasury and the IRS may have intended to refer to “chapter 1,” which would capture both tax code Section 1 (imposing tax on trusts and individuals) and tax code Section 11 (imposing tax on corporations). Until further guidance on the question is issued, AEIs will have to determine the extent to which they feel comfortable disregarding the NII of related taxable organizations.
Exceptions to the Related Organization Rule
Tax code Section 4968 contains two notable exceptions to the rule that AEIs take into account the NII of related organizations.
First, tax code Section 4968 provides that no amount of NII will be taken into account with respect to more than one AEI. (Section 4968(d)(1)(A).) Accordingly, if an organization is a related organization to more than one AEI, its NII should be allocated between the AEIs. With respect to how the allocation should be made, the proposed regulations say only that “[s]uch allocation must be made in a reasonable manner, taking into account all facts and circumstances, and must be used consistently across all related organizations.” (Prop. Treas. Reg. Section 53.4968-1(c)(2)(ii)(A).)
Second, tax code Section 4968 provides that, with respect to organizations that are related to an AEI by virtue of controlling the AEI or being controlled by one or more persons that control the AEI (i.e., a “brother/sister” relationship) (Section 4968(d)(1)(B)), the NII of the related organization is only taken into account by the AEI if it is “intended or available for the use or benefit of” the AEI. This “use or benefit” exception is not available, however, for organizations that are “controlled by” AEIs. Curiously, the proposed regulations define “control” in a manner that could be interpreted as rendering all “brother/sister” corporations of an AEI as “controlled by” the AEI and therefore ineligible for the “use or benefit” exception. In particular, the proposed regulations instruct AEIs to apply the principles of tax code Section 318 in determining the ownership of any entity, and those principles—specifically tax code Section 318(a)(3)(C)—suggest that an AEI controls an entity with which it has a brother-sister relationship. This appears to be an inadvertent “glitch” resulting from the drafters’ borrowing their definition of control from tax code Section 512(b)(13) and will hopefully be fixed in final guidance.
The “use or benefit” exception is also not available to supporting organizations of an AEI. Although the statute does not expressly provide a transition or grandfather rule, the proposed regulations provide that supporting organizations that were “Type III” supporting organizations (Type III SOs) to the AEI as of Dec. 31, 2017, also qualify for the “use or benefit” exception. (Prop. Treas. Reg. Section 53.4968-1(c)(3)(ii).) Accordingly, with respect to such Type III SOs, the proposed regulations provide that only the NII intended or available for the use and benefit of, or otherwise fairly attributable to, the AEI are taken into account. An AEI may determine whether the NII of such a Type III SO is intended or available for the use and benefit of, or otherwise fairly attributable to, the AEI using “any reasonable method.” The proposed regulations note that treating all the distributions received from the Type III SO as NII of the AEI each year will be deemed a reasonable method.
The tax code Section 4968 proposed regulations are the first proposed regulations to be issued under the new Code provisions enacted as part of the TCJA that are specifically applicable to tax-exempt organizations. (Tax code Sections 4960, 512(a)(6), and 512(a)(7).) Although providing some welcome guidance, these regulations leave many of the most difficult questions presented by tax code Section 4968 unanswered. With respect to NII, they do little beyond citing to the regulations under tax code Section 4940 with minor modifications, which taxpayers reasonably would have looked to anyway. Worse, in doing so, the proposed regulations make little effort to take into account the significant differences between the operations of a university and a typical private foundation and changes over the past 50 years in how tax-exempt organizations invest their assets, nor do they reflect any serious consideration of how an AEI should apply the basis step-up rule in the case of a partnership investment.
Hopefully, affected universities will provide Treasury and the IRS with the comments they need to make substantial improvements in the final regulations that would, at a minimum, exclude GII and capital gains from exempt-use assets and provide AEIs with a practical approach for determining how to exclude pre-Dec. 31, 2017, appreciation in partnership assets from capital gain net income.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Preston J. Quesenberry is a managing director and Randall S. Thomas is a senior manager in the exempt organizations group of KPMG LLP’s Washington National Tax office. The authors are grateful for the insightful comments and suggestions provided by Ruth M. Madrigal, a principal in the exempt organizations group of Washington National Tax.
The information in this article is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230 because the content is issued for general informational purposes only. The information contained in this article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP.