Since this blog was published there have been further developments related to the Tax Cuts and Jobs Act. Please see our post Tax Cuts and Jobs Act: CPI Plus More for our latest thinking.
With the Senate's passage of its version of a comprehensive tax bill early Saturday morning, the enactment of sweeping new tax reform legislation by the end of the calendar year 2017 seems increasingly more likely. Still, the Senate version of the bill varies in some substantive ways from the House version, and both must be reconciled before the President can sign a bill into law.
What is certain is that if passed, the change in the U.S. tax law will have a broad impact for most filers – corporations, individuals and tax-exempt institutions, including colleges and universities, private foundations and public charities. Importantly, while legislators on Capitol Hill over the last several years have focused their attention on the largest endowments and most elite colleges and universities, the tax bills as currently drafted are broader, and have the potential to impact a far wider group of tax-exempt organizations.
Certainly, large tax-exempt organizations are still a target of legislators, and one of the potential tax changes is the proposed excise tax on large educational endowments.
Excise Tax on Large Educational Endowments
Under the Senate bill for private colleges and universities with assets of at least $500,000 per student and at least 500 tuition-paying students, there is a proposed new excise tax of 1.4% on net investment income. We expect this could impact 25-30 colleges and universities. The House version of the bill has broader applicability than the Senate version. Of course, the devil is in the details of any tax bill, and governing boards will have to understand the myriad of impacts that might apply if the legislation is adopted. Some examples include the following:
- Assets – While the current draft legislation defines assets as the “aggregate fair market value of assets (other than those assets used directly in carrying out the institution’s exempt purposes),” it is unclear if certain restricted endowed pools will be included in this definition.
- Net Investment Income – Because of its reference to a well-established Internal Revenue Code section, the definition of net investment income for this purpose appears clear; it includes interest, dividends and realized gains – the same definition in Internal Revenue Code 4940(c) as currently applied to private foundations. That Code section excludes unrealized gains.
- Effective Date – For institutions with large unrealized gains, the effective date of the legislation is important. Both the House and Senate versions state: “The amendments made by this section shall apply to taxable years beginning after December 31, 2017.” For those institutions with June tax/fiscal year-ends, we believe this to mean that it will be effective in the taxable year beginning July 1, 2018, with the implication that gains realized on or prior to June 30, 2018 may not be subject to this excise tax.
Beyond the Excise Tax
Importantly, while most of the press attention has focused on the proposed excise tax on large educational endowments, the House and Senate bills include proposals that may impact tax-exempt organizations of all sizes and types, including:
Expanded application of unrelated business taxable income (UBTI) – the Senate version of the bill includes language that would prohibit a tax-exempt organization from using the losses from one unrelated activity to offset the income from a different, profitable unrelated activity.
Elimination of two-tier excise tax structure for private foundations – the House version of the bill eliminates the two-tier excise tax structure, replacing it with a single excise tax of 1.4 percent. While this would serve to simplify the current structure, The Joint Committee on Taxation estimates this will result in additional tax liability of $500 million over ten years.
Standard deductions – both House and Senate versions propose doubling the standard deduction, which could have the effect of fewer filers itemizing deductions. Estimates are that this would reduce the number of itemizers from about 1 in 3 taxpayers to about 1 in 20. The Tax Policy Center released a study in November that estimates this would decrease charitable giving by $12.3 – $19.7 billion in 2018.
Student debt – the House bill would eliminate a deduction on interest paid on student loans, making the cost of higher education higher for many students. The elimination of this deduction as an “above the line” deduction would be particularly impactful since it would affect most student loan borrowers – not just those who itemize. Eliminating it would mean that, over the next decade, the cost of student loans for borrowers would increase by roughly $24 billion according to The Joint Committee on Taxation. Other provisions of the proposed bill, such as the reduction in certain tax credits for tuition, as well as language which would treat employer-provided tuition payments as taxable income, would put further pressure on the affordability of college for students.
Tax-exempt bonds – The House bill would repeal the federal income tax exemption for interest earned on all private activity bonds, which include certain tax-exempt bonds currently issued by 501(c)(3) organizations. The impact would be higher borrowing costs for hospitals, colleges and universities, because the interest earned on private activity bonds they issue after December 31, 2017 will no longer qualify for an exemption from federal income tax.
Executive compensation – Both bills would impose on a tax-exempt organization a new 20 percent excise tax on annual compensation in excess of $1 million paid to any of its five highest paid employees.
UBTI is gross income derived from (1) a trade or business (2) that is regularly carried on and (3) that is not substantially related to the performance of tax-exempt functions. Certain debt financed income is also taxable for an exempt organization, such as interest or dividends from debt financed investments. UBTI is taxed at corporate or trust rates. Most tax exempt organizations can have UBTI from direct activities as well as through investments. For example, in the case of a college, common UBTI activities include outside advertising in a sports arena or publication, or athletic and parking facilities provided to alumni or the general public. Also, alternative investments, including limited partnerships, can generate UBTI from ordinary income flowing through the underlying trade or business activity as well as income from debt financed investments.
Assessing the Impact on Your Institution
Tax-exempt institutions have had to manage the impact of tax legislation and tax liability for decades. This is likely to increase if the proposed changes become law. The proposals working through the legislative process in Washington will require continued scrutiny and analyses by governing boards and staff – particularly given the breadth of the changes and the potential for significant impacts across the tax-exempt sector.
What is clear to us at Commonfund is that the tax-exempt ecosystem, of which endowed asset pools are just a part, is likely to become more complex. As such, it is particularly important that financial and operating metrics – which may be impacted by tax changes – be viewed as inputs to investment policy design. For example, among colleges and universities, the impacts of tax changes on the following metrics will be important to study:
Net tuition revenue
Tuition discount rates
The percentage of restricted versus unrestricted endowment
Debt issuance and capacity
Gift flow and gifts as a percentage of endowment
Tuition and endowment support of the operating budget
Effective spending rates
Tax-exempt organizations provide critical functions and benefits to society, which is why they have been afforded tax-exempt status. Understandably, many in the sector are concerned that the proposed legislation – already impactful as it currently stands – could lead to even more significant taxation down the road, with the potential to negatively impact the ability of these institutions to fulfill their missions. As a result, we encourage governing boards of tax-exempt organizations to study the potential impact of the bill and to engage with their elected officials to assure that any bill that becomes law does not result in unintended consequences.
Important Disclosure: Importantly, the information above should not be considered tax or legal advice as Commonfund is not qualified to provide such advice, and we encourage you to consult with your tax and/or legal advisors for their perspective on how the proposed changes might impact you.