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Firm Seeks Clarification of Terms in Proposed College Excise Tax Regs

OCT. 1, 2019

Firm Seeks Clarification of Terms in Proposed College Excise Tax Regs

DATED OCT. 1, 2019
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October 1, 2019

Ms. Melinda Williams
Ms. Amber L. MacKenzie
Internal Revenue Service
CC:PA:LPD:PR (REG-106877-18), Room 5203
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

Re:REG-106877-18

Dear Ms. Williams and Ms. MacKenzie:

Thank you for the opportunity to provide comments regarding the excise tax based on the investment income of certain private colleges and universities under Section 4968.1 This letter addresses three discrete issues set forth in the notice of proposed rulemaking published in REG-106877-18 on July 3, 2019 (the “Proposed Regulations” or “NPRM”), each of which is discussed in greater detail below:

1. The Phrase “Students Attending” Should Include All Students Enrolled in and Taking One or More Courses. The proposed definition of “student” in Prop. Reg. §53.4968-1(a)(3)(i) is unduly limiting. Nothing in Section 4968 justifies excluding those enrolled in and taking courses at an educational institution, but not pursuing a degree or certification, from treatment as “students attending” for purposes of Section 4968. The definition of “student” should include all those enrolled in and taking courses at the institution, including continuing education, executive education, and distance learners (on a full-time-equivalent basis).

2. The Term “Related Organizations” Should Exclude Ordinary and Split-Interest Trusts. The Proposed Regulations should follow the legal principle that ordinary and split-interest trusts are merely contractual arrangements and not “organizations” for tax purposes.

3. Partnerships and Taxable Corporations Should Be Excluded From “Related Organizations.” The concept of related organizations was included in the statute as an anti-abuse tool. The statute does not provide with specificity the criteria for determining which “organizations” are considered related organizations. In developing these criteria, the Treasury Department and IRS should recognize that nothing is served from an anti-abuse perspective by including partnerships and taxable corporations within the scope of related organizations. These entities should be excluded from related organizations in order to increase administrability and economic coherence.

Comment 1 : The Phrase “Students Attending” Should Include All Students Enrolled in and Taking One or More Courses

An applicable educational institution is subject to the Section 4968 excise tax if, among other requirements, it has more than 500 tuition-paying students. Section 4968(b)(2) explains how to count “students attending” an applicable educational institution as follows: “the number of students of an institution (including for purposes of determining the number of students at a particular location) shall be based on the daily average number of full-time students attending such institution (with part-time students taken into account on a full-time student equivalent basis).”

The statutory rule for counting students considers only the amount of time students spend at the institution; it does not distinguish students from non-students based on other factors such as the subject matter they are studying, or for what purpose they are studying. The plain language meaning of the word “student” is unambiguous — a student is simply “one who studies,” especially “one who attends a school.” See Student, Merriam-Webster Dictionary (11th Ed. 2012). When a statutory term is clear on its face, it is improper to impose an alternative meaning. See Stauffer v. IRS, 124 AFTR 2d 2019 (1st Cir. 2019) (looking to dictionary definition of term where not defined in the statute, and rejecting attempt to impose a more limited construction without statutory authority for doing so); Mayo Clinic v. U.S., 124 AFTR 2d 2019-5448 (D. Minn. 2019) (regulation that adds requirements beyond the bounds of statutory authority invalid, with reference to dictionary definitions of key terms). There is nothing in the statute implying that alternative, and more restrictive, interpretations of the word “student” were intended.

The NPRM, however, adds a substantial additional condition to be considered a “student attending” the institution: the individual must be seeking a degree or other “recognized educational credential” from the institution. The imposition of such an additional condition has no statutory basis and would exclude many bona fide students, such as members of the local community permitted to enroll in courses, employees of the institution taking courses to increase job skills or opportunities, distance learners, and participants in executive education programs. Each of these individuals, to the extent they have enrolled in and are taking academic courses, whether in person or virtually, can fairly be regarded as a “student attending” the institution, within the meaning of the statute, yet may be excluded on account of the additional condition adopted by the NPRM.

For its restrictive interpretation of “students attending” the institution, the NPRM draws from a separate statute altogether, relying not on Section 4968 but on the description of an “eligible student” in Section 484(a)(1) of the Higher Education Act (“HEA”) as well as Section 25A(b) of the Code (which provides for the American Opportunity Tax Credit (“AOTC”)). That reliance, however, is misplaced for the reasons discussed below.

Congress designed the HEA and AOTC using the restrictive standard for “eligible student” in order to achieve a specific policy objective, namely to limit the class of individuals who are eligible for certain Federal grants, loans, and tax credits to those who are “enrolled in a degree, certification or other program . . . leading to a recognized educational credential at an institution. . . .” Section 484(a)(1) of the HEA and Section 25A(b) of the Code do not purport to define who is a “student” at all — rather, they describe which subset of students are “eligible students” for purposes of the specific benefits provided under the HEA and the AOTC statutes. In those cases, Congress made a clear and express decision to include only some students, not all students, as eligible for those benefits.

By contrast, Congress identified the class of individuals who are counted for purposes of Section 4968 to be all of the “students attending” the applicable educational institutions, without further criteria. There is no reason to infer that when Congress used the term “students attending” an institution in Section 4968 it really meant the more restrictive eligibility standard under the HEA and AOTC. If Congress had intended to impose these additional eligibility requirements, it knew how to do so. See Mayo Clinic v. U.S., 124 AFTR 2d 2019-5448, 5454 (D. Minn. 2019) (observing that if Congress had intended for the term “educational organization” to include an additional “primary-function” requirement, “it had an excellent chance to say so but elected not to.”)

A closer parallel to Section 4968 is provided by the Family Educational Rights and Privacy Act (FERPA). Under that statute, the term “student” generally means “any individual who is or has been in attendance at an educational agency or institution and regarding whom the agency or institution maintains education records.” (Emphasis added.) Regulations issued by the Department of Education define “attendance” to include “[a]ttendance in person or by paper correspondence, videoconference, satellite, Internet, or other electronic information and telecommunications technologies for students who are not physically present in the classroom.” See 34 CFR § 99.3. Similarly, under Section 25A(f)(1)(A) of the Code, the Lifetime Learning Credit is available for certain tuition and fees required for “attendance” at eligible educational institutions. IRS guidance provides that for purposes of the Lifetime Learning Credit, “an eligible student is a student who is enrolled in one or more courses at an eligible educational institution.” There is no requirement that the student must be seeking a degree, or even taking a course for credit, nor any requirement that a student's attendance be physical as opposed to virtual.

In other words, both FERPA and the Lifetime Learning Credit are based statutorily on “attendance” at an educational institution, and guidance in both cases has confirmed that nothing beyond a student's enrollment and attendance — whether in-person or virtual — is required to trigger their application. Similarly, Section 4968 is based on “students attending” an educational institution, and should be interpreted by guidance in a manner similar to FERPA and the Lifetime Learning Credit.

Moreover, an indication that the HEA and the AOTC are not appropriate analogues for interpreting “student attending” for purposes of Section 4968 is the extent to which the NPRM has to struggle to adapt the HEA and AOTC eligibility criteria to fit Section 4968, including eliminating students accepted for enrollment and re-including less-than-half-time students. In particular, the fact that less-than-half-time students are expressly included in the Section 4968 student count is significant. Many students attend school less than half-time, and a significant portion of those less-than-half-time students are students not working towards a degree or credential. While these students are excluded from eligibility under the HEA and the AOTC, these students “attending” the institution are counted by Section 4968 on a full-time-equivalent basis. By including part-time (including less-than-half-time) students on a full-time-equivalent basis, Congress in Section 4968 signaled its intention for the student count to be captured broadly (and measured proportionately).

If Treasury and the IRS adopt the broader definition of “students attending” an institution and reject the unduly narrow definition in the Proposed Regulations, the total student count for certain applicable educational institutions may well increase, thereby reducing the institution's assets-per-student ratio, and potentially enabling some institutions to fall under the threshold for application of the excise tax. But that is an entirely reasonable result because all students taking classes — regardless of whether they are seeking degrees — require financial resources of the college or university to support them, and so it is appropriate to include them all (on a full-time-equivalent basis) when calculating the assets-per-student threshold for purposes of applying the excise tax on endowment income. Moreover, a rule that counts individual students only if the individual is seeking a recognized educational credential could have unintended consequences, as it would create an incentive for institutions to focus their resources on increasing enrollment of credential-seeking students at the expense of non-credential students (potentially compromising the educational opportunities provided to online and other nontraditional students, which many institutions view as a vital part of their charitable mission). It may also create an incentive for institutions to create new forms of educational credentials merely to increase the student count.

To avoid these distorting effects, the Treasury Department should give effect to the plain language of the statute, by confirming the student count to include (on a full-time-equivalent basis) all individuals enrolled in and taking one or more courses at the institution, whether in person or virtually, like the interpretation of similar language under FERPA and the AOTC.

Comment 2: The Term “Related Organization” Should Exclude Ordinary Trusts and Split-Interest Trusts.

To prevent institutions from circumventing the income or asset test of Section 4968 by placing the institution's assets in a separate entity, Congress included “related organization” rules under Section 4968(d)(2). That section provides:

(2) RELATED ORGANIZATION. For purposes of this subsection, the term 'related organization' means, with respect to an educational institution, any organization which —

(A) controls, or is controlled by, such institution,

(B) is controlled by 1 or more persons which also control such institution, or

(C) is a supported organization (as defined in section 509(f)(3)), or an organization described in section 509(a)(3), during the taxable year with respect to such institution.

(Emphasis added).

Ordinary and split-interest trusts should be excluded from the scope of these “related organization” provisions for a variety of reasons. As discussed in a separate set of comments that the higher education community is submitting, the anti-abuse concerns that underlie the related organization provisions are not present with respect to ordinary and split-interest trusts because such trusts are controlled by their trustees, not by their charitable beneficiaries. Those comments also detail the considerable practical and compliance difficulties that educational institutions would confront if required to treat all trusts as “related organizations” given that in many cases the charitable beneficiary is unaware of the existence of the split-interest trust until it begins to receive distributions from it.

Separately from those concerns, as the plain language of the statute indicates (see the highlighted phrasing above), for any person or entity to be considered a “related organization,” that person or entity has to be an organization in the first place. If an entity is not an organization, it cannot be a related organization, irrespective of control. Thus, in the case of trusts, the definition of “related organizations” should follow the legal principle that ordinary and split-interest trusts are merely contractual arrangements, not organizations.

Treas. Reg. §301.7701-4(b) describes certain “business trusts” as “organizations,” where “the real character of the organization” is such that “the organization is more properly classified as a business entity.” Where such a trust is described in Section 501(a) (a tax-exempt trust), that trust is treated, at least for purposes of those sections of the Code relating to tax exemption, as an “organization.” Section 4947(a)(1) supports this view, stating that a fully charitable trust (as opposed to a split-interest trust) “shall be treated as an organization described in section 501(c)(3)” even if it does not receive a determination of exempt status from the Service. (Emphasis added.)

By contrast, an ordinary or split-interest trust is merely a contractual relationship, whereby one party (the trustee) holds property as a fiduciary for the benefit of another. The definition of an ordinary “trust” in Treas. Reg. §301.7701-4(a) acknowledges the distinction between business trusts and ordinary trusts, describing the latter as “an arrangement . . . whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries.” The Regulations go on to say that “an arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.” Ordinary trusts taxed under the rules of Subchapter J of the Code, and split-interest trusts described in Section 4947(a)(2) such as charitable remainder trusts and charitable lead trusts, are not described as “organizations,” but are instead described simply as “trusts.”

The Proposed Regulations should follow the distinction between business trusts and ordinary trusts that Section 512(b)(13) itself follows. For purposes of defining related organizations, Section 512(b)(13) construes “organizations” as excluding ordinary taxable trusts. Moreover, Section 512(b)(13) describes controlling entities (the tax-exempt entities potentially subject to unrelated business income tax) as “organizations” regardless of their form, but deliberately uses the broader term “entities” rather than the more narrow “organizations” in describing the controlled entities potentially receiving a tax benefit from the payments in question. The anti-avoidance provision of Section 512(b)(13)(F) uses the even broader term “persons.” Had Congress intended to include assets and income from all related trusts, it could easily have said so, using the broader term “person or entity” rather than the more narrow term “organization.”

Accordingly, to the extent the Proposed Regulations follow Section 512(b)(13) for purposes of defining Related Organizations under Section 4968, they should also follow the distinction among different kinds of trust arrangements under that section, with the result that ordinary and split-interest trusts should not be considered “related organizations” for purposes of Section 4968.

Comment 3: Partnerships and Taxable Corporations Should Be Excluded From “Related Organizations”

As noted above, the policy consideration for including assets and income from related organizations under Section 4968 is evidently to prevent the avoidance of the excise tax through use of holding structures. That is, educational institutions should not be permitted to avoid Section 4968 tax by holding assets in structures that, as compared to direct ownership, represent a difference in form but not substance.

This concern, however, is not applicable with respect to investments held through partnerships or taxable corporations. The asset value of those investments is fully captured in the value of the educational institution's partnership or stock interest. The income of these investments is already appropriately treated because, in the case of a partnership, the income will flow through and be included in the educational institution's net investment income, and in the case of a taxable corporation, the income will already be subject to corporate income tax (and when distributed to the educational institution will be included in net investment income).

Accordingly, there is no purpose served by treating partnerships and taxable corporations as within the scope of the term “related organizations.” Moreover, the inclusion of partnerships and taxable corporations may at a minimum create complexity or, worse yet, unintended and unreasonable economic outcomes (such as double tax, and/or inclusion of income and assets that belong to unrelated third parties). While there may be other approaches to mitigate those concerns (as we understand other members of the higher education community have proposed), the most direct approach is simply to exclude partnerships and taxable corporations from treatment as related organizations.

Even with such an exclusion for partnerships and taxable corporations, the related organization provision of the statute would continue to have meaning, as it would remain applicable to tax-exempt organizations. Other comments from members of the higher education community will likely address the criteria for those organizations, and will not be repeated here.

The exclusion of partnerships and taxable corporations may be viewed as inconsistent with the NPRM's reliance on Section 512(b)(13) as it applies to partnerships and taxable corporations. Section 512(b)(13), however, is not an appropriate analogy here. The reason for regarding certain partnerships and taxable corporations as controlled organizations for purposes of Section 512(b)(13) is specific to that section and does not apply to Section 4968. The purpose of Section 512(b)(13) is to prevent UBTI from being eroded by housing an unrelated activity in a subsidiary that pays deductible interest, rents, or royalties that are excludable from the tax-exempt parent's income. It is necessary, in that context, to regard partnerships and taxable corporations as controlled entities in order to achieve the goal of Section 512(b)(13), because otherwise exempt organizations could put an income generating business into a partnership or taxable corporation, where the organization benefits on a current basis from the funds generated by the business but income that would otherwise be taxed goes untaxed to the extent of interest, rent or royalties paid to the parent. By contrast, it is not necessary to regard partnerships or taxable corporations as controlled entities in order to prevent circumvention of Section 4968 tax, for the reasons discussed above. The treatment of partnerships and taxable corporations under Section 512(b)(13), therefore, should not be determinative of their treatment under Section 4968.

* * *

I hope that these comments are helpful to you as you formulate proposed regulations under Section 4968 and would be happy to speak with you or provide further clarification or input on the information discussed above. Thank you for your consideration.

Sincerely yours,

Alexander L. Reid
Morgan, Lewis & Bockius LLP
Washington, DC

Copy to:
Treasury
David Kautter, Assistant Secretary for Tax Policy
Elinor Ramey, Attorney-Advisor, Office of Tax Policy
Krishna Vallabhaneni, Tax Legislative Counsel

Internal Revenue Service
Janine Cook, Deputy Associate Chief Counsel, Tax Exempt & Government Entities
Victoria Judson, Associate Chief Counsel, Tax Exempt & Government Entities
Tamara Ripperda, Commissioner of Tax Exempt and Government Entities
Charles Rettig, Commissioner of IRS

FOOTNOTES

1 Unless otherwise indicated, “Section” refers to the Internal Revenue Code of 1986, as amended.

END FOOTNOTES

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