Comments Address Scope of Exempt Use Assets for Excise Tax Purposes

EXEMPT PURPOSE ASSET DEFINTION

Section 4968 imposes a 1.4% excise tax on the net investment income of an “applicable educational institution.” For these purposes, the term “applicable educational institution” generally includes colleges and universities (other than state colleges and universities) that have at least 500 tuition-paying students during the preceding taxable year, more than 50% of which are located in the U.S., and “the aggregate fair market value of the assets of which at the end of the preceding taxable year (other than those assets which are used directly in carrying out the institution's exempt purpose) is at least $500,000 per student of the institution.”¹

Section 4968 does not provide any further guidance on which assets are considered “assets which are used directly in carrying out the institution's exempt purpose.” The Conference Report specifically states that it is “intended that the Secretary promulgate regulations to carry out the intent of the provision, including regulations that describe . . . assets that are used directly in carrying out the educational institution's exempt purpose.” A footnote to the Conference Report (and repeated in the General Explanation of Public Law 115-97 prepared by the Joint Committee on Taxation) observes that “[a]ssets used directly in carrying out the institution's exempt purpose include, for example, classroom buildings and physical facilities used for educational activities and office equipment or other administrative assets used by employees of the institution in carrying out exempt activities, among other assets.”²

The legislative history makes clear that a variety of assets can fall within the definition of “assets which are used directly in carrying out the institution's exempt purpose” (referred to herein as “exempt use assets” or “exempt purpose assets”). Consistent with this legislative history, we believe it is appropriate to look to section 4942 and the accompanying regulations as a starting point for defining the scope of exempt purpose assets for purposes of section 4968, with certain modifications to account for key differences between colleges and universities subject to section 4968 and private foundations subject to section 4942.

“Exempt Purpose Assets” under Section 4942

Section 4942 imposes an excise tax on private non-operating foundations that fail to spend a minimum amount of their non-charitable assets annually. In order to calculate a this minimum distributable amount for a year, the foundation must calculate its “minimum investment return” and then deduct certain amounts. The “minimum investment return” is essentially equal to 5% of the “aggregate fair market value of all assets of the foundation other than those which are used (or held for use) directly in carrying out the foundation's exempt purpose.”³

Regulations under section 4942 define assets used (or held for use) directly in carrying out a foundation's exempt purposes as assets that are “actually used by the foundation in the carrying out of the charitable, educational, or other similar purpose which gives rise to the exempt status of the foundation” and assets owned by the foundation with respect to which the foundation “establishes to the satisfaction of the Commissioner that its immediate use for such exempt purpose is not practical (based on the facts and circumstances of the particular case) and that definite plans exist to commence such use within a reasonable period of time.”⁴ To illustrate, the regulations provide that exempt purpose assets include, but are not limited to(1) administrative assets, such as office equipment and supplies which are used by employees or consultants of the foundation, to the extent such assets are devoted to and used directly in the administration of the foundation's exempt activities; (2) real estate or the portion of a building used by the foundation directly in its exempt activities; (3) physical facilities used in such activities, such as paintings or other works of art owned by the foundation which are on public display, fixtures and equipment in classrooms, research facilities and related equipment which under the facts and circumstances serve a useful purpose in the conduct of such activities; (4) any interest in a functionally related business (which includes any trade or business which is not an unrelated trade or business) or in a program-related investment; (5) any property leased by a foundation in carrying out its exempt purpose at no cost (or at a nominal rent) to the lessee or for a program-related purpose, such as the leasing of renovated apartments to low-income tenants at a low rental as part of the lessor foundation's program for rehabilitating a blighted portion of a community; and (6) the reasonable cash balances necessary to cover current administrative expenses and other normal and current disbursements directly connected with the foundation's exempt activities.⁵ For these purposes, a reasonable cash balance is generally deemed to be 1.5% of the fair market value of all of the foundation's assets included in determining minimum investment return (without regard to the cash balance itself), less any acquisition indebtedness. A foundation may treat this 1.5% reasonable cash balance as an exempt use asset whether or not it actually held this amount as cash during the year. A foundation is permitted to exclude more than 1.5% if it satisfies the IRS that the extra amounts are necessary for payment of foundation expenses.⁶

Assets held for investment purposes, such as stocks, bonds, notes, endowment funds, or leased real estate are not treated as exempt purpose assets even though the income from such assets is used to carry out such exempt purpose. The value of a building that is used both for exempt purposes and for management of investment assets must be apportioned between assets used for investment purposes and assets used for exempt purposes. A foundation is permitted to make a reasonable allocation and, if the exempt use represents 95% or more of the total use of the property, all of the property may be treated as exempt use.⁷

Additionally, the regulations under section 4942 exclude certain additional assets from the calculation of minimum investment return. These assets are generally assets in which the private foundation does not have a current possessory interest, including future interests, assets of an estate not yet distributed, interests in any trust created and funded by another person, and any pledge to the foundation of money or property (whether or not the pledge may be legally enforced).⁸

Private operating foundations described in section 4942(j)(3) are not subject to the tax imposed on the undistributed income of a private foundation under section 4942(a) and (b). To qualify as a private operating foundation, an organization must meet an income test and one of three alternative tests (an assets test, an endowment test, or a support test), which, together, are intended to ensure that the foundation engages primarily in direct charitable programs and activities rather than making grants to other charitable organizations.

“Exempt Purpose Assets” under Section 4968

We believe that it would be appropriate to interpret the scope of exempt purpose assets under section 4968 no more narrowly than under section 4942. In fact, we believe that there are key differences between educational organizations subject to section 4968 and private non-operating foundations subject to section 4942 that mandate a broader interpretation of the concept for purposes of section 4968 than for purposes of section 4942.

Private foundations are typically grantmaking organizations that achieve their exempt purposes by making disbursements to other tax-exempt organizations. Colleges and universities, on the other hand, seek to achieve their charitable purposes not by making distributions to other charitable organizations, but by engaging in educational and research activities themselves.⁹ Recognizing the status of most private foundations as grantmaking organizations, the regulations under section 4942 treat as exempt purpose assets the reasonable cash balances necessary to cover the foundation's current administrative expenses and other normal and current disbursements directly connected with the foundation's exempt activities.¹⁰ The regulations therefore permit a grantmaking private foundation to treat as exempt purpose assets certain amounts to be disbursed to grantees. The IRS should clarify that, similarly, section 4968 permits colleges and universities to treat as exempt purpose assets reasonable cash balances needed by an institution to cover expenses for its educational and research functions.

Given that colleges and universities are more similar to private operating foundations than private non-operating foundations, we believe it would be appropriate to calculate the reasonable cash balance amount in a manner similar to the calculation used by all private operating foundations that requires this type of operating entity to make “qualifying distributions” (distributions for the active conduct of activities that constitute the foundation's exempt purpose) equal in value to “substantially all” (85%) of the lesser of its adjusted net income and 5% of its net investment assets. We believe the calculation of this “income test,” designed specifically for operating entities, serves as an appropriate proxy for the reasonable cash balances needed to cover a college or university's expenses for its educational and research functions. IRS guidance should make clear that, for section 4968 purposes, a reasonable cash balance should be deemed to be 4.25% of the institution's net investment assets, consistent with the calculation of the private operating foundation “income test.”

In addition, we believe it is appropriate in the context of colleges and universities to treat assets contributed subject to donor-imposed restrictions requiring them to be expended within a reasonable period of time (i.e., not donor-restricted assets that must be maintained in perpetuity pursuant to the terms of the gift) as exempt purpose assets. Thus, for example, a gift from a donor that must, pursuant to the terms of the gift, be expended for the construction of a new building within the next five years would be treated as an exempt purpose asset. This treatment of certain temporarily restricted assets is consistent with the definition of assets that “are used (or held for use) directly in carrying out a foundation's exempt purpose.” Specifically, the regulations under section 4942 acknowledge that assets that may not be used immediately by a foundation may be treated as exempt purpose assets where definite plans exist to commence such use within a reasonable period of time. We believe that donor-restricted assets subject to a requirement that they be expended within a timeframe of approximately five years should be treated as exempt purpose assets for purposes of section 4968.

Finally, we note that the IRS exercised its regulatory authority under section 4942 to exclude certain assets in addition to assets used (or held for use) directly in carrying out the foundation's exempt purpose for purposes of calculating a foundation's minimum investment return. The IRS should exercise its regulatory authority under section 4968 to likewise exclude such assets from the determination whether the per-student asset threshold has been met. In requiring a determination of an organization's non-exempt asset base, both section 4942 and section 4968 are intended to identify the resources the organization has available for use in non-charitable endeavors, including for investment. The regulations under section 4942 properly recognize that the nonpossessory interests private foundations may hold in assets (including future interests, and interests in trusts, estates and pledges) do not give foundations control over the underlying assets and therefore do not permit the foundation to use such assets for non-charitable purposes. The same is true for colleges and universities in the context of section 4968. The IRS therefore should exercise its regulatory authority under section 4968 to exclude nonpossessory interests in assets from the asset base used to calculate whether the per-student threshold has been met in the same manner as such interests are excluded under section 4942.