Memo on Net Investment Income Forwarded to Treasury

MEMO ON NET INVESTMENT INCOME

Definition of “Net Investment Income”

IRC section 4968 states that net investment income for purposes of IRC section 4968 shall be determined “under rules similar to the rules of section 4940(c).” By using the term “similar to” and not expressly incorporating the rules under IRC section 4940, Congress indicated its understanding of the material differences between private foundations subject to excise tax under IRC section 4940 and colleges and universities subject to excise tax under IRC section 4968 and that it is therefore inappropriate to treat colleges' and universities' income and deductions exactly the same as the income and deductions of private foundations. For the reasons set forth below, we believe that the rules under IRC section 4968 should track the rules under IRC section 4940 in many respects, but that, in order to account for the material differences between private foundations and colleges and universities, the rules under IRC section 4968 must diverge from the rules under IRC section 4940 in several key ways.

Similarities to Exempt Operating Foundations

As a threshold matter, universities are much more akin to exempt operating foundations (described in IRC section 4942(j)(3)), which are entirely exempt from taxation under IRC section 4940, than they are to other private foundations subject to the tax. This similarity means that if one were to apply rules “similar to” the rules of IRC section 4940, including the exclusion for exempt operating foundations from taxation under that IRC section, one could argue that colleges and universities should not be subject to excise tax at all. Although Congress likely did not intend such an outcome when adopting IRC section 4968, the comparison is instructive for understanding the basis upon which the definition of net investment income as it applies to colleges and universities should deviate from the way it applies to private foundations. By including the words “similar to” in IRC section 4968, Congress clearly contemplated that there would be differences in the application of the tax between private foundations, on the one hand, and colleges and universities, on the other.

Exempt operating foundations are private foundations that engage in direct charitable activities (rather than passive grant-making activities) and meet certain requirements relating to the sources of their historical support and the composition of their boards and management. An exemption from IRC section 4940 excise tax for exempt operating foundations was enacted as part of the Deficit Reduction Act of 1984, at which time the Joint Committee on Taxation explained the reason for the exception as follows:

The enactment of the exception for exempt operating foundations therefore clearly shows Congress's awareness that imposition of an excise tax on net investment income can depress the direct charitable activities that would otherwise be conducted and evidences a Congressional intent to facilitate direct charitable activities by allowing for an exemption from excise tax for organizations directly engaging in such charitable activities. Given the backdrop of past Congressional action with respect to exempt operating foundations, we believe subjecting the net investment income of universities and colleges is illogical and inconsistent. The exemption of exempt operating foundations from the net investment income excise tax supports the position that colleges and universities should not be subject to IRC section 4968 excise tax at all.

However, to the extent a portion of the net investment income of colleges and universities, unlike exempt operating foundations, is subject to excise tax under IRC section 4968, at a minimum an exception should be made for income derived from the activities of colleges and universities that most closely resemble those of exempt operating foundations, namely colleges' and universities' educational and research functions. These functions, which form the basis of the organizations' tax exemption, are much more comparable to the direct charitable activities of exempt operating foundations that Congress intended to support and facilitate through enactment of the exempt operating foundation exception to IRC section 4940 than they are to the passive grant -making activities of other private foundations that remain subject to excise tax under IRC section 4940. Given the mandate that IRC section 4968 follow rules “similar to” the rules of IRC section 4940, the rules under IRC section 4968 should reflect the vast operational differences between colleges and universities, on the one hand, and passive grant-making private foundations on the other, as well as the broader policy judgments incorporated into IRC section 4940, including the decision to support and facilitate direct charitable activities of organizations engaging in such activities. As a result, the rules under IRC section 4968 should exempt income derived through the exercise of colleges' and universities' educational and research functions from the definition of “net investment income.” Such income should include, without limitation, the following items of income: (1) interest on loans provided as part of the educational functions of colleges and universities; (2) rent from dormitories and other student and faculty housing provided as part of the educational functions of colleges and universities; (3) gain from the sale of property and equipment used for programmatic purposes that are part of the educational or research functions of colleges and universities; (4) revenue derived from copyrights and patents developed as part of the educational or research functions of colleges and universities; (5) investment income attributable to assets subject to donor-imposed restrictions requiring the income to be used for purposes that are part of the educational or research functions of colleges and universities, including the provision of scholarships; and (6) any other income from programmatic activities that are part of the educational or research functions of colleges and universities.

Gifts of Appreciated Property

The taxation of capital gains and losses presents a particularly problematic issue under IRC section 4968 and a concrete example of why the rules of IRC section 4940 cannot simply be incorporated wholesale into the IRC section 4968 context given the vast operational differences between colleges and universities, on the one hand, and passive grant-making private foundations on the other. Under IRC section 4940, net investment income includes a foundation's “capital gain net income,” which is generally equal to the excess of capital gains over capital losses realized with respect to any capital asset, subject to certain exclusions and modifications.² Such capital gain net income would generally include any gain realized on the sale of appreciated property received as a gift. As noted above, however, private foundations subject to tax under IRC section 4940 are generally passive grant-making organizations. Such foundations have the ability to dispose of appreciated property by making a grant of such appreciated property instead of selling such appreciated property and making a grant in cash. The regulations under IRC section 4940 make clear that a foundation distributing appreciated property in the form of a grant that is a “qualifying distribution” (as most grants by private foundations are) does not realize any capital gain net income as a result of such distribution.³ In other words, by making a grant of the appreciated property, the private foundation can avoid being subject to the IRC section 4940 excise tax on any appreciation. The recipient of such a distribution would generally be a public charity, which could sell the property without being required to pay tax on the property's appreciation (as public charities are not subject to tax under IRC section 4940 and the sale of the appreciated property likely would not give rise to unrelated business taxable income).

The rules under IRC section 4940 thus enable passive grant-making private foundations to avoid taxation of gain on appreciated property by making grants of the appreciated property to charitable organizations, which in turn can use the proceeds from the disposition of such property for their charitable activities without being subject to tax. Unlike passive grant-making private foundations, colleges and universities subject to IRC section 4968 must fund substantial operations in order to engage directly in their charitable mission, i.e., teaching thousands of students through theory and practice, housing and feeding those students, and advancing knowledge for the betterment of society through scientific and other research. This entails enormous administrative and operational complexities, such as developing and maintaining housing, dining halls, museums, laboratories, patient care facilities, institutes, programs and the like.

Unlike private foundations that can make grants of appreciated property received as gifts, universities either use such gifts directly in their charitable activities or, more often, liquidate the gifts and use the proceeds immediately to fund the university's charitable activities or to provide longstanding if not perpetual support through the university's endowment investments. Universities cannot avoid the recognition of net investment income (and resulting imposition of tax under IRC section 4968) simply by making a grant of appreciated property in the manner private foundations can. In order for the rules under IRC section 4968 to operate in a manner “similar to” the rules under IRC section 4940, the rules under IRC section 4968 should therefore provide for a general exception excluding from the definition of “net investment income” any appreciation in an asset. While we believe the ability of private foundations to eliminate excise tax on any appreciation of property by making grants of such property would justify excluding any appreciation in property from excise tax under IRC section 4968, we believe at a very minimum it calls for an exclusion of appreciation in property received by gift existing at the time the property is received. This is not only because the gain was generated even before the university received the gift, but in contrast to private foundations (which typically receive gifts from a handful of closely related donors), colleges and universities subject to IRC section 4968 receive a high volume of contributions from a wide range of donors from whom obtaining cost basis information could be extraordinarily burdensome, an important distinction that would support a different application of the excise tax.