Analysis: IRS Issues New 1.4 Percent University Endowment Income Tax

On Friday, June 28th, 2019, the Internal Revenue Service released the proposed guidelines for higher education institutions required to pay a new tax on their endowments as outlined under the 2017 Tax Cuts and Jobs Act (TCJA). The 1.4 percent excise tax on net investment income targets universities with at least 500 tuition-paying students and with assets of $500,000 per student. The proposed rules define how colleges and universities calculate the number of full-time students and offer guidance about what income and assets are subject to the tax. These regulations are estimated to impact between 25 to 40 institutions. 

On Dec. 22, 2017, the Tax Cuts and Jobs Act was signed into law by President Trump. Its passing represented the most significant change to the U.S. tax code in decades and contained several provisions affecting higher education, including:

• A new, unprecedented tax on the endowments of some private colleges and universities;
• A limit on the state and local tax (SALT) deduction; and
• The application of the unrelated business income tax (UBIT). 

Initially, many of the questions involving the law’s impact on private colleges and universities were left unanswered. Now, after more than a year of uncertainty, the newly released guidelines shed some light on what effect the 1.4 percent excise tax on endowments will have on the nation’s wealthiest private colleges and universities. 

Analysis:  

Many colleges and universities across the country maintain endowments, a collection of tax-exempt donations and investments used to pay for salaries, research, financial aid, and other expenses. Reporting for 2018 from the Indiana University Lilly Family School of Philanthropy showed that just under half of all spending from university endowments goes to support financial aid.

The 58-page draft rules of the 1.4 percent excise tax are assigned to qualifying private colleges and universities, some of the same guidelines that govern private foundations. Under the proposed guidelines, colleges and universities, like private foundations, would be taxed on interest, dividends, and rental income. As a result, colleges that provide student loans would be taxed on the interest the loans yield, and money received from renting facilities would be considered taxable income. Profits earned from running a hospital, clubs, and alumni organizations may also qualify under the new tax guidelines. According to the nonpartisan Joint Committee on Taxation, the tax will raise about $200 million a year. The revenue from the tax would offset corporate tax cuts. 

According to research published in 2018 by the Federal Reserve Bank of Cleveland, colleges may behave strategically to avoid paying the new tax. For example, colleges with low enrollments may reduce enrollment levels even further to push their total enrollment below the 500 student threshold. Other schools may increase enrollment or make it appear so to decrease their endowment assets per student.  Although the new guidelines provide some insights into which schools may be affected, there remains much uncertainty about its impact. The study mentioned above also stated that because the $500,000 assets per student measure will not be indexed for inflation, institutions currently unaffected could find themselves under the new guidelines in years to come.  

How Will These Proposals Affect Philanthropy? 

A recent study’s estimates of giving for 2018-2025 indicated that up to 2.6 million fewer households are likely to donate each year, and charitable giving could decrease by $19.1 billion annually due to the passage of TCJA. While the 1.4 percent excise tax currently affects a relatively small number of institutions, the tax transfers money from higher education institutions to the federal government. It thereby dilutes the ability of higher education endowment to fulfill its mission.  With foundations and corporations counting for 30 percent and 15 percent, respectively, of the total charitable support donated annually to higher education institutions, college and university leaders are concerned that the new tax could deter donors and drain vital funds.

Opposition

Substantial opposition has already come from many Ivy League colleges stating that the new regulations will likely deprive colleges of revenue or drive up students’ costs. The potentially affected colleges and universities include Harvard, Yale, Stanford, Princeton, and other liberal arts colleges with sizable endowments such as Iowa’s Grinnell College, Williams College in Massachusetts, and Swarthmore College in Pennsylvania.  

Representative Tom Reed, the New York Republican who proposed the endowment tax, has suggested giving institutions more exceptions in exchange for spending more on financial aid for middle-income students and disclosing information about fees paid to outside investment managers.  

The proposed guidelines are subject to change and are now open for a 90-day public comment period. The IRS seeks comments from colleges and universities on whether student loan interest, rental income, and other assets should be exempt from taxation. The American Council on Education (ACE), an organization representing up to 50 higher-education associations, has been involved in efforts opposing the tax with continuous letters of opposition sent to the Ways and Means Committee since the proposal of the tax bill in 2017 and will also file comments on the proposed rules. Public comments are due to the IRS by October 1, 2019.