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INSIGHT: The University Excise Tax and Net Investment Income—Proposed Regulations Dodge the Hard Questions—Part 1

Oct. 8, 2019, 1:01 PM

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 tax code Section 4968 excise taxes in November. Unfortunately, the proposed regulations provide these AEIs with relatively little guidance on how to calculate the tax.

Tax code 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).” (Tax code Section 4968(c).) Tax code Section 4940(c) defines NII for purposes of the excise tax on such income earned by private foundations. In defining NII for purposes of tax code Section 4968, the proposed regulations unfortunately do little more than parrot the statute, merely cross-referencing tax code 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 tax code 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 tax code 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. Part 1 of this two-part series outlines what income is included in net investment income.


Tax code Section 4940(c) and, by cross-reference, tax code Section 4968, define NII as: (1) gross investment income (GII); plus (2) “capital gain net income”; less (3) any such income that is unrelated business taxable income (UBTI); less (4) deductions of ordinary and necessary expenses paid or incurred for the production or collection of GII or for the management, conservation, or maintenance of property held for the production of such income. This part considers each of these elements of NII in that order and discusses the limited guidance that the proposed regulations provide to AEIs with respect to computing each of them.

Gross Investment Income

Tax code Section 4940(c)(2) defines GII as the gross amount of income from interest, dividends, rents, royalties, and payments with respect to securities loans, but not including any UBTI and not including any interest earned on tax-exempt bonds. Pursuant to changes made by the Pension Protection Act of 2006, tax code Section 4940(c)(2) further provides that GII includes “income from sources similar to those in the preceding sentence.” (Pub. L. No. 109-280, Section 1221(a)(1).) In addition, the regulations under tax code Section 4940(c) provide that GII takes into account “interest, dividends, rents, and royalties derived from assets devoted to charitable activities.” (Treasury Regulation Section 53.4940-1(d)(1).)

While recognizing the regulations’ provisions relating to assets devoted to charitable activities (exempt-use assets), AEIs and practitioners expected that Treasury and the IRS would use the “similar to” language in tax code Section 4968(c) and Congress’s focus on “endowment” assets in enacting tax code Section 4968 as authority to exclude from GII income derived from at least some such “exempt-use assets.” From a policy perspective, Treasury and the IRS could have justified such a carve-out by acknowledging the obvious distinction between private foundations, most of which are grantmaking entities with little in the way of income-producing operating assets, and AEIs, almost all of which employ such operating assets as a substantial part of furthering their exempt purposes.

However, the proposed regulations do not include any carve-out for exempt-use assets. Rather, the proposed regulations just cross-reference the regulations under tax code Section 4940 that subject investment income derived from exempt-use assets to tax. If Treasury and the IRS stick with this approach in the final regulations, GII could encompass a much broader swath of income than most AEIs were anticipating—that is, more than just income from endowments. Examples of income that AEIs could have to include in GII include interest on student loans, rents from dormitories and faculty housing, rents from leasing university facilities for various events, and royalties earned from research activities, college athletics, and use of the school name and logo.

Treasury and the IRS seem to recognize that differences between private foundations and AEIs and the Congressional intent underlying tax code Section 4968 may require that income from exempt-use assets be excluded from GII, as they requested comments on whether “specific types of income should be excluded” from GII because taxing those types of income “would not achieve the congressional intent in enacting section 4968.” (84 Fed. Reg. 31,795, 31,800 (July 3, 2019).) In particular, Treasury and the IRS asked commenters to explain why the specific characteristics of certain types of income would “warrant deviating from the rules provided in section 4940 and the regulations thereunder.” In explaining why a type of income should be excluded, commenters are also asked to “state specifically how the proposed exclusion is still ‘similar to’ the rules of section 4940(c).” The preamble suggests below-market interest received on student loans as a possible example of excludible income and requests comments on any “particular factors that distinguish room and board payments from students living in a dormitory from rental income that institutions receive,” including “whether any of the arrangements include the signing of leases” and “the various amounts charged by a college or university related to provision of housing and meals.”

The question about “distinguishing factors” in the preamble has many AEIs considering whether the payments they receive from students for dormitory use may be differentiated from “rents” within the meaning of tax code Section 4940. Unfortunately, neither tax code Section 4940 nor the regulations thereunder (much less the proposed regulations under tax code Section 4968) contain any definition of the term “rents.” That said, most universities will be able to draw numerous distinctions between their dormitories and typical space that is leased for occupancy. For one, as the preamble itself suggests, student housing in dormitories provided by colleges and universities does not typically involve a lease agreement between the student and college or university.

Moreover, landlord-tenant laws do not typically apply to student dormitories. In addition, students commonly receive services in connection with their dormitory use that tenants do not usually receive from landlords. This distinction might be seen as especially relevant given that the rules governing UBTI disqualify payments as “rents from real property” when the occupant receives services “other than those usually or customarily rendered in connection with the rental of rooms or other space for occupancy only.” (Treas. Reg. Section 1.512(b)-1(c)(5).) Further, dormitory use often has a mandatory dimension absent in typical landlord-tenant relationships. For example, some AEIs require certain students (e.g., freshman) to live on campus and assign these students dormitories and roommates.

These and other distinguishing factors should matter in determining whether to classify payments for dorm rooms as “rents,” notwithstanding the lack of any definition of that term for purposes of tax code Section 4940 or tax code Section 4968. The uncertainty is magnified by the fact that GII includes not only “rents” but also “income from sources similar to” rents, with the meaning of “sources similar to” also undefined. Notwithstanding this uncertainty, AEIs will need to determine their position on whether payments for dorm rooms are or are not GII over the next couple of months.

Even if AEIs determine that payments for dorms are rents that have to be included in GII, this inclusion may not actually increase NII if the deductible expenses associated with the dorms equal or exceed those rents. However, making this determination for dorms and other exempt-use assets is likely to significantly increase administrative headaches, as it will require AEI tax departments to track and allocate expenses more rigorously than they may have had to do in the past.

One final thing to note about rents includible in GII is that they are not necessarily limited to rents from real property, but also may include rents from personal property. As a general rule, most rents from personal property are included in UBTI, which means they would be excluded from GII on that basis. But if an AEI considers any personal property rents to not be UBTI because, for example, the rentals are substantially related to the AEI’s educational purposes (e.g., rentals of lab attire for chemistry students) or are primarily for the convenience of students or employees, those rents could still be included in GII based on the rules in the proposed regulations. Taxing AEIs on this income would be an unexpected, and arguably unintended, application of a tax that ostensibly targets the “endowment” income of AEIs.

Capital Gain Net Income

In addition to GII, NII includes capital gain net income, which consists of capital gains less any capital losses, with no capital loss carryovers or carrybacks and no ability to use excess capital losses against GII in the same tax year. (Tax code Section 4940(c)(4); Treas. Reg. Sections 53.4940-1(f)(1); 53.4940-1(f)(3).) Capital gain net income does not include any gain or loss taken into account in computing UBTI.

Sale of Exempt-Use Assets

While capital gains and losses on the disposition of exempt-use assets were once excluded from NII, amendments to tax code Section 4940 in 2006 (Pension Protection Act of 2006, Pub. L. No. 109-280, Section 1221(b)) and 2007 (Tax Technical Corrections Act of 2007, Pub. L. No. 110-172, Section 3(f)) changed this, so that tax code Section 4940 now applies to “capital gains and losses from the sale or other disposition of assets used to further an exempt purpose.” However, the regulations under tax code Section 4940 have not been amended to reflect this change and still state that there “shall be taken into account only capital gains and losses from the sale or other disposition of property held by a private foundation for investment purposes … .” (Treas. Reg. Section 53.4940-1(f)(1).) As the proposed regulations under tax code Section 4968 cross-reference not only the regulations under tax code Section 4940 but also tax code Section 4940(c) for purposes of determining capital gain net income, and the regulations under tax code Section 4940 are obviously out of date, it appears that capital gain net income may include both gain realized on the sale of investment assets and gain from the disposition of exempt-use assets. Accordingly, to the surprise of AEIs and practitioners that expected tax code Section 4968 to tax investment income from endowments, the proposed regulations could tax gain from an AEI’s disposition of classroom buildings and other exempt-use assets if they are adopted without change.

Basis for Calculating Gain

To determine capital gain net income, AEIs will naturally need to know their basis in the assets they sell. More than a year ago, in Notice 2018-55, Treasury and the IRS made clear that tax code Section 4968 would not tax AEIs on any appreciation in property (that is, over the property’s adjusted basis) that occurred before Dec. 31, 2017, nine days after tax code Section 4968 was enacted and the day before tax code Section 4968 went into effect for calendar-year AEIs. The proposed regulations implement this basis “step-up” contemplated by Notice 2018-55 by simply cross-referencing Treas. Reg. Section 53.4940-1(c) through (f) and substituting “Dec. 31, 2017” as the applicable date. (Prop Treas. Reg. Section 53.4968-1(b)(2), (3).)

In making this substitution, the proposed regulations clarify several points implicitly made by Notice 2018-55. For one, by cross-referencing the regulations under tax code Section 4940, the proposed regulations make clear that, for purposes of calculating capital gain under tax code Section 4968, the basis of an asset will be the greater of:

  • The basis as determined and adjusted under normal basis rules, modified by: (1) using the straight-line method of depreciation; (2) not using percentage depletion described in tax code Section 613; and (3) without regard to tax code Section 362(c) (relating to the basis for certain contributions to capital) (henceforth “Normal Section 4940 Basis”), or

  • In the case of an asset held on Dec. 31, 2017, and continuously thereafter until disposition, the fair market value (FMV) as of Dec. 31, 2017 (Dec. 31, 2017 FMV), plus or minus all adjustments after Dec. 31, 2017, using the normal basis rules subject to the same modifications applicable in determining Normal tax code Section 4940 Basis. (Treas. Reg. Section 53.4940-1(f)(2)(i)(A).)

In addition, the cross-referencing in the proposed regulations establishes that basis “stepped up” to Dec. 31, 2017 FMV should not be used for purposes of determining a loss. Rather, for losses, an AEI should use the Normal tax code Section 4940 Basis. (Treas. Reg. Section 53.4940-1(f)(2)(ii).)

Partnership Investments and Transition Issues

Although the basis step-up and other NII rules described above may have worked well for stock investments held by private foundations in 1969, AEIs, which now earn much of their NII through investment vehicles taxed as partnerships for federal income tax purposes, will encounter particular challenges in computing NII attributable to partnership investments. As a general matter, partnerships do not report their investment income to partners on Schedule K-1 in a uniform matter and often such income is aggregated in ways that will present challenges to AEIs in calculating their NII. Perhaps nowhere will these challenges be more significant than with respect to capital gain net income, though inconsistent reporting of GII and other issues will likely arise as well.

Inside vs. Outside Basis Step-Up

In the case of partnership interests owned by an AEI, Notice 2018-55 was silent regarding whether the basis step-up to Dec. 31, 2017 FMV was limited to the AEI’s basis in its partnership interests or, rather, could also be extended to a partnership’s basis in its assets. The proposed regulations address this question by providing that if an AEI held a partnership interest (including through one or more tiers of partnerships) on Dec. 31, 2017, and continuously thereafter, and the partnership held assets on Dec. 31, 2017, and continuously thereafter to the date of disposition, the partnership’s basis in those assets with respect to the AEI for purposes of determining the AEI’s share of gain upon a sale or disposition of the assets is not less than the Dec. 31, 2017 FMV plus or minus all adjustments after Dec. 31, 2017, using the normal basis rules subject to the same modifications applicable in determining Normal Section 4940 Basis. (Prop. Treas. Reg. Section 53.4968-1(b)(3)(iv).) The proposed regulations also state that “[t]o avail itself of this special partnership basis rule, an institution must obtain documentation from the partnership to substantiate the basis used.”

While this rule was presumably intended to address AEIs’ concerns regarding inside basis in partnership assets, it presents such an amorphous standard that AEIs presumably have flexibility in determining precisely what documentation represents a reasonable attempt to comply with the substantiation requirement, especially given that a strict reading of the requirement would appear to be unadministrable. For example, even if an AEI-partner could obtain the Dec. 31, 2017 FMV of all of the assets owned by a partnership and all lower-tier partnerships—a lofty goal in itself—the AEI would also need asset-level information annually. An AEI will typically receive a Schedule K-1 for the relevant tax year that reports only the aggregate net capital gain (or loss) on the partnership assets sold during the tax year (without indicating whether those assets were owned by the partnership on Dec. 31, 2017), and the AEI could do nothing with only this aggregate number and the Dec. 31, 2017 FMV of the partnership’s assets.

At a minimum, the partnership would also need to inform the AEI as to which specific assets (identified so that they could be linked to a particular Dec. 31, 2017 FMV) were sold and for what amounts. In addition, if the disposition of an asset resulted in a loss (or the Normal Section 4940 Basis in the asset was higher than Dec. 31, 2017 FMV at the time of a disposition resulting in a gain), the partnership would also need to provide the AEI with the Normal Section 4940 Basis at the time of disposition, which may not be the same as the partnership’s own basis in the asset if the partnership was not using the straight-line method of depreciation or was taking percentage depletion.

Moreover, if any portion of the gains reported on the Schedule K-1 were UBTI, the partnership generally would (at least if the AEI were using a Dec. 31, 2017 FMV basis for any of the sold assets) need to provide the AEI with the amount of UBTI generated by the disposition of each asset, as well as the basis of these assets at the time of the sale. This information would appear necessary for the AEI to determine what portion of the UBTI was attributable to appreciation prior to Dec. 31, 2017 (which would presumably not be used to offset NII) and what portion was attributable to appreciation after Dec. 31, 2017 (which could be excluded from NII).

Further, to apply the proposed regulations, the partnership would need to provide all of this information for its own assets and those of lower-tier partnerships—or provide alternative computations of capital gain specifically for the AEI based on this information—not only for 2018, but for every year thereafter until all of the assets held on Dec. 31, 2017, are sold. In addition, most partnerships would be doing all of this additional work for at most a handful of AEIs in the absence of any provisions that require partnerships to provide this information. As a result, it is unclear how Treasury and the IRS can reasonably expect that AEIs would be able to obtain this information from partnerships—especially in the case of Schedules K-1 for the 2018 calendar year, most of which have already been issued.

Accordingly, in light of Congress’s intent that AEIs not be taxed on any appreciation in property that occurred before Dec. 31, 2017, Treasury and the IRS will have to devise a more administrable rule if they expect any consistency in how AEIs step up the basis of assets held by partnerships. In the meantime, over the upcoming months, AEIs will have to determine what methodologies they are comfortable with in excluding capital gains being reported to them on Schedules K-1.

2018 Partnership Income

Most AEIs use a fiscal-year end of June 30 and receive Schedules K-1 from at least some calendar-year partnerships. The Schedules K-1 issued by such partnerships for 2018 covered six months for which tax code Section 4968 was not in effect for fiscal-year AEIs (January 1 to June 30) and six months for which it was in effect (July 1 to December 31). Given this, some AEIs have questioned whether the NII reflected on a 2018 Schedule K-1 earned before July 1, 2018, is subject to tax code Section 4968.

While the proposed regulations do not address this question, existing guidance suggests an unfavorable answer. Tax code Section 4968(a) imposes an excise tax on an AEI’s NII “for the taxable year.” Tax code Section 706(a) provides that “[i]n computing the taxable income of a partner for a taxable year, the inclusions required by section 702 and section 707(c) with respect to a partnership shall be based on the income, gain, loss, deduction, or credit of the partnership for any taxable year of the partnership ending within or with the taxable year of the partner.” (See also Treas. Reg. Section 1.706-1(a).) Reading these provisions together, an AEI most likely computes its NII for its tax year ending June 30, 2019, based on items reported for the tax year of the partnership issuing the Schedule K-1 ending within the tax year ending on June 30, 2019—which, for a calendar-year partnership, would be the 2018 calendar year.

Donated Assets

The preamble to the proposed regulations and the proposed regulations’ cross-reference to the tax code Section 4940 regulations make relatively clear that when an AEI acquires an asset by gift, Treasury and the IRS are currently contemplating that the AEI’s basis will be the donor’s basis (except that if the basis is greater than the FMV of the asset at the time of the gift, then the basis will be FMV at the time of the gift for purposes of determining a loss). (Tax code Section 1015; 84 Fed. Reg. 31,795, 31,800; Treas. Reg. Section 53.4940-1(f)(2).) Many AEIs will not have obtained information regarding their donor’s basis in the past and may encounter difficulty obtaining it in the future.

Even though individual donors who make gifts of non-cash assets to AEIs of more than $500 are required to report their basis to the IRS on Form 8283, the Form 8283 is not required to be presented to the AEI for signature for publicly traded securities, contributions of $5,000 or less, and certain other categories of assets. (See Treas. Reg. Section 1.170A-16(c), (d)(1), (d)(2).) And even when a Form 8283 is provided to an AEI for signature, the donor often will not have completed the line stating the basis in the asset at the time the AEI receives the form. Further, the AEI may not receive the Form 8283 in time to compute its capital gain on the sale of the asset for purposes of paying and reporting NII.

The tax code Section 4940 regulations cross-referenced in the proposed regulations instruct AEIs that if “the facts necessary to determine the basis of property in the hands of the donor or the last preceding owner by whom it was not acquired by gift are unknown … then the original basis to such foundation of such property shall be determined under the rules of [Treas. Reg. Section] 1.1015-1(a)(3).” (Treas. Reg. Section 53.4940-1(e)(2)(iii).) Tax code Section 1015(a) and the accompanying regulation under Treas. Reg. Section 1.1015-1(a)(3) contain an unusual rule that shifts the ultimate burden of determining the carryover basis in a donated asset from the donee to the IRS. In particular, these provisions state that if the donee does not know the facts necessary to determine the donor’s basis or that of the last preceding owner, it is the IRS that must, if possible, obtain the facts from the donor or last preceding owner, or any other person cognizant of such facts. If the IRS cannot obtain those facts, the donor’s basis (or that of the last preceding owner) equals the property’s FMV as determined by the IRS as of the date or approximate date at which, according to the best information that the IRS can obtain, the property was acquired by the donor (or last preceding owner).

In assessing the IRS’s responsibility under tax code Section 1015(a), at least one court has made clear that if the IRS has a difficult time obtaining the necessary basis information, it cannot simply assume that basis is zero. In James E. Caldwell & Co. v. Commissioner, 234 F.2d 660 (6th Cir. 1956), the U.S. Court of Appeals for the Sixth Circuit reversed the Tax Court’s holding permitting the IRS to substitute a basis of zero for purposes of determining gain on the disposition of property acquired by gift where it was “impossible” to determine the FMV of the property at the time the donor acquired it. The Caldwell court held that if the donee cannot establish the donor’s actual basis and the IRS is unable to make a finding of FMV pursuant to the statutory mandate in tax code Section 1015(a), neither gain nor loss is realized on the donee’s sale of the property.

Perhaps anticipating these difficulties, the preamble asks for comments on a potential “special rule” noted in the proposed regulations—a rule that would exclude any appreciation in a gift of donated property that occurred before the date of receipt by the AEI. (84 Fed. Reg. 31,795, 31,800.) Under this rule, the basis of any donated asset would presumably be stepped up to FMV as of the time of the gift and an AEI would only be taxed on gain generated during its ownership of an asset. The IRS also requested comments on how such a special rule would be consistent with the statutory language of tax code Section 4968. The only relevant language in tax code Section 4968 is that NII “shall be determined under rules similar to the rules of section 4940(c).” The law is clear that private foundations use carryover basis from donors when computing their net capital gain under tax code Section 4940(c). However, AEIs are arguably distinguishable from private foundations in that they typically receive donations from many donors, while private foundations typically receive donations from only a handful of donors that are often intimately involved with the foundation. As a result, gathering basis information from donors will be a much more onerous task for AEIs than it would be for a private foundation.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

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.

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