Final regulations on the TCJA endowment tax

The final regulations adopt the proposed regulations issued in 2019 (which incorporated the provisions of Notice 2018-55 that provided early guidance on the new tax imposed by the TCJA) as modified in response to comments provided. Highlights of the changes follow:

• The term “student” is defined as a person enrolled in and attending a course for academic credit from the institution and who is being charged tuition at a rate that is commensurate with the tuition rate charged to students enrolled for a degree. This definition clarifies the term under the proposed regulations.
• A student is considered “tuition-paying” after taking into account grants made directly from the educational institution or by the federal, state, or local government.
• The definition of "gross investment income" has been revised to exclude 1) interest income from a student loan; 2) rental income from student housing and from faculty and staff housing if the housing is provided contingent on the residents’ roles as faculty or staff of the institution; and 3) royalty income that is derived from patents, copyrights, and other intellectual property and intangible property to the extent those assets resulted from the work of student(s) or faculty member(s) in their capacities as such with the institution.
• A deduction from gross investment income is allowed for all the 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 such income, determined with modifications (including straight-line depreciation and depletion).
• Trademarks on an institution’s logo or name and intellectual property donated or sold to the institution are not assets used directly for the institution’s exempt purposes.
• A cash balance necessary to cover current operating and administrative expenses and other disbursements directly connected with the institution’s exempt activities may be determined by any reasonable method. One such method would be to calculate an amount equal to three months of operating expenses allocable to program services.
• Specific rules under Section 4968 that are similar to the rules of Section 4940(c) but that are more tailored to educational institutions are included. (This is in response to comments that a cross-reference to the Section 4940(c) regulations to define net investment income did not adequately account for differences between a private foundation and an educational institution.)
• Rules for determining capital gain net income are clarified by providing that 1) capital gain net income from the sale or exchange of property used by an institution for its exempt purpose is disregarded for the portion of the property that is used for the exempt purpose; 2) any appreciation in the value of donated property that occurred prior to the date of its donation to the institution is disregarded; and 3) capital loss carryovers are allowed, but capital loss carrybacks are not.
• Rules for institutions to determine net investment income with respect to partnership interests are clarified:
  • The final rules retain the general rule for assets (other than partnership interests) allowing a step-up in basis for assets held as of Dec. 31, 2017, and continuously thereafter to the date of disposition (including through partnerships) to their fair market value with certain adjustments.
  • The final rules adopt a special rule for assets held through partnerships. For each partnership interest an institution held on Dec. 31, 2017, the institution may determine an unadjusted step-up amount that is equal to the excess, if any, of the fair market value of such partnership interest on that date, over the adjusted tax basis of such partnership interest on that date. In addition, the final regulations require an institution to reduce its distributive share of capital gain net income from a partnership by the lesser of 1) the institution’s share of applicable capital gain from such partnership, 2) one-third of the institution’s unadjusted step-up for such partnership, or 3) the institution’s adjusted step-up for such partnership.
• The definition of “related organization” excludes taxable corporations and certain taxable trusts whether foreign or domestic, as well as partnerships, S corporations, or other pass-through entities if any portion of income flows through to the institution.

The final regulations are effective for tax years beginning after their publication in the Federal Register, which is still pending as of the date of this article. According to the preamble to the final regulations, for tax years beginning on or before the date the final regulations are published in the Federal Register, institutions will be treated as in compliance if they use a reasonable, good faith interpretation of the statute.

The changes in the final regulations, while not dramatic, could make a difference in who owes the tax and how much they owe. Educational institutions should work with their tax advisers to evaluate the final regulations and their potential impact. Institutions subject to the Section 4968 excise tax, and those close to the threshold for being subject to the tax, should review their net investment income tracking methods and revise them, if necessary, to comply with the final regulations. As institutions are analyzing the effect of the final rules, they should consider filing an amended Form 4720, “Return of Certain Excise Taxes on Charities and Other Persons Under Chapters 41 and 42 of the Internal Revenue Code,” to incorporate favorable provisions of the rules.