Alert December 21, 2017

Changes on the Horizon for Colleges and Universities Under Tax Reform Legislation

Summary

On December 20, 2017, Congress sent a major tax reform bill (the Act) to President Trump for signature. Once signed, the Act will result in significant changes for many institutions of higher education. Notably, new excise taxes will be imposed on excess executive compensation and investment income of highly endowed private colleges and universities. In addition, the legislation modifies certain provisions relating to unrelated business taxable income, eliminates the charitable deduction for college athletic seating event rights and repeals the exclusion from income of interest on advance refunding bonds. On a positive note, many of the highly publicized proposed provisions relating to education were not included in the final bill.

Excise Tax Imposed on Excess Executive Compensation. Under the Act, an excise tax of 21% is imposed on an applicable tax-exempt organization if it pays compensation in excess of $1,000,000, or certain severance payments, to its covered employees. This excise tax provision is applicable to any organization exempt under Code Sections 501(a), 115(1), or 527, and exempt farmers’ cooperatives. The organization, and not the covered employee, is responsible for payment of the excise tax.

A covered employee is defined as (1) one of the five highest compensated employees of the tax-exempt entity for the taxable year, or (2) any employee who was a covered employee of the entity (or any predecessor) for a preceding taxable year beginning after December 31, 2016. Once an employee qualifies as a covered employee, the excise tax provisions apply to that person for so long as the organization continues to compensate the covered employee. Accordingly, the employee remains a covered employee even in subsequent taxable years when the employee is no longer one of the five highest compensated employees of the tax-exempt entity.

The excise tax is applicable to remuneration paid in excess of $1,000,000 in a taxable year. Whether compensation has exceeded $1,000,000 is generally calculated in accordance with Code Section 3401(a) and includes any remuneration paid to the covered employee by a related organization. Remuneration includes all amounts no longer subject to a substantial risk of forfeiture, even if such amounts have not yet been paid to the covered employee. It specifically includes amounts that are vested but not yet paid under Code Section 457(f)(3)(B). There is a specific exclusion from the definition of remuneration for payments to qualified providers for the performance of medical or veterinary services.

The excise tax is also imposed on “excess parachute payments” that are paid to a covered employee (assuming such individual is also a “highly compensated employee” within the meaning of Section 414(q)) in excess of such employee’s base amount of compensation. The Act defines parachute payments as payments that (1) are contingent upon the covered employee’s separation from service with the employer, and (2) have an aggregate present value that equals or exceeds three times the covered employee’s “base amount.” A covered employee’s base amount is calculated by applying rules similar to those set forth in Code Section 280G, which generally provide that a covered employee’s base amount is the individual’s average income from the organization over the five-year period immediately preceding the year in which the separation from employment occurs. Payments made under or to a 403(b) annuity contract or 457(b) plan are not considered parachute payments, and again there is an exception for payments for the performance of medical or veterinary services.

Excise Tax Based on Investment Income of Private Colleges and Universities. Certain private colleges and universities will be subject to a new excise tax on the net investment income of their endowments. Private foundations have long been subject to an excise tax on their net investment income at a rate of either one or two percent. The Act imposes a similar excise tax on certain private colleges and universities. Experts have speculated that the legislation will affect approximately 30 colleges nationwide, although the number could increase.

The Act will impose an excise tax of 1.4% on the net investment income of applicable educational institutions. These are private colleges and universities that (1) have at least 500 students during the preceding taxable year, (2) have over 50% of their students located in the United States; and (3) have assets of at least $500,000 per student at the end of the preceding taxable year (excluding those assets used directly in carrying out the institution’s exempt purpose).

  • Number of Students. The number of students at an institution is based on the daily average number of full-time students attending the institution, with part-time students taken into account on a full-time student equivalent basis.
  • Assets and Net Investment Income. The net investment income will be determined under rules similar to the private foundation rules under Section 4940(c) of the Code. For purposes of determining whether an institution meets the assets-per-student threshold and determining net investment income, the assets and net investment income of related organizations will be treated as the assets and net investment income of the institution, except that (1) no such amount is taken into account with respect to more than one educational institution; and (2) unless the related organization is controlled by the institution or is a supporting organization with respect to the institution, assets and investment income that are not intended or available for the use or benefit of the educational institution are not taken into account.

    An organization is considered related to the institution if the organization (1) controls, or is controlled by, the institution; (2) is controlled by one or more persons that control the institution; or (3) is a supported organization of the institution.

The Joint Explanatory Statement issued by the House and Senate Committee of Conference seems to acknowledge that additional guidance will be necessary to clarify the calculation of assets and net investment income. The Statement notes that it is intended that the Secretary of the Treasury promulgate regulations to carry out the intent of the provision, including regulations that describe: (1) assets that are used directly in carrying out the educational institution’s exempt purpose; (2) the computation of net investment income; and (3) assets that are intended or available for the use or benefit of the educational institution.

Effective date: Taxable years beginning after December 31, 2017.

ADDITIONAL LEGISLATION OF INTEREST:

  • UBTI Separately Computed for Each Trade or Business ActivityUnder a new addition to the unrelated business taxable income (UBTI) rules, any organization with more than one unrelated trade or business must compute its UBTI separately with respect to each such trade or business and can no longer use a deduction from one unrelated trade or business to offset income from another.  

    Effective date: Taxable years beginning after December 31, 2017.

     
  • UBTI Increased by Amount of Certain Fringe Benefit Expenses for Which Deduction is Disallowed. UBTI now includes any expense paid or incurred by a tax-exempt organization for transportation fringe benefits, parking facilities used in connection with qualified parking, or any on-premises gym or other athletic facility. This does not apply to the extent the amount paid or incurred is deductible under Code Section 274 or is directly connected with an unrelated trade or business which is regularly carried on by the organization. The provision is intended to mirror a companion provision for taxable entities, which changes the deductibility of certain fringe benefits.  

    Effective date: amounts paid or incurred after December 31, 2017.

     
  • Denial of Charitable Deduction for College Athletic Seating Event RightsAn individual can no longer take a charitable deduction for a payment to an institution of higher education in exchange for which the individual receives the right to purchase tickets or seating at an athletic event.  Prior law allowed the individual to treat 80% of such payment as a charitable contribution.  

    Effective date: Taxable years beginning after December 31, 2017.

     
  • Advance Refunding Bonds Repealed. Although the legislation does not make changes regarding private activity bonds, it repeals the exclusion from income of interest on advance refunding bonds. Advance refunding bonds are refunding bonds (bonds used to pay principal, interest or redemption price on a prior bond issue) that are issued more than 90 days before the redemption of the refunded bond.  

    Effective date: Advance refunding bonds issued after December 31, 2017.

     
  • Johnson Amendment Remains in EffectThe highly contentious revisions to the “Johnson Amendment” were not included in the final legislation. The Johnson Amendment prohibits 501(c)(3) organizations from participating or intervening in any political campaign on behalf of or in opposition to any candidate for public office. Republicans may still seek to repeal the Johnson Amendment in another context.
  •  
  • Many Proposed Education Provisions Not Included in Final LegislationMany of the House-proposed provisions relating to education did not make it into the final legislation. These include the proposed: (1) repeal of the Lifetime Learning Credit and modifications to the American Opportunity credit; (2) repeal of the deduction for student loan interest; (3) repeal of the deduction for qualified tuition and related expenses; (4) repeal of the exclusion for interest on the United States savings bonds used for higher education expenses; (5) repeal of the exclusion for educational assistance programs; and (6) repeal of the exclusion for qualified tuition reductions. The proposed repeal of exclusion for qualified tuition reduction was sharply opposed by graduate students and others in higher education as it would have taxed tuition waivers received by graduate students.