Treasury Receives Reasons for Stepped-Up Basis for Endowments

Legal Arguments in Support of an Initial Basis Step-Up for Assets Held by “Applicable Educational Institutions” on Effective Date of Section 4968

Section 4968 imposes a 1.4% tax on the “net investment income” of certain private universities and colleges for each taxable year beginning after 2017.¹ Pursuant to new Section 4968(c), “net investment income” is to be calculated under rules “similar to” the rules of Section 4940(c), which imposes a tax on the net investment income of Section 501(c)(3) organizations classified as “private foundations.” The following discussion provides a brief analysis of several sources of support for an initial basis step-up in connection with the imposition of the Section 4968 excise tax.

• Section 4940(c), which is specifically cross-referenced in Section 4968, provides an initial basis step-up. Section 4968(c) states that “net investment income,” for purposes of section 4968, “shall be determined under rules similar to the rules of section 4940(c).” Section 4940(c)(4)(B) provides a basis step-up as of the effective date of the legislation, stating that the basis for determining gain on property held by a private foundation on the date the Section 4940 excise tax became effective and continuously through the date of disposition of the property “shall be deemed to be not less than the fair market value of such property on December 31, 1969,” the date on which the provision went into effect. In fact, if the basis otherwise computed exceeds the fair market value of the property on December 31, 1969, the higher basis is used in computing taxable gain. Treasury Regulations § 53.4940-1(f)(2)(i). The plain language of Section 4968(c) incorporates the “net investment income” determination rules of Section 4940(c). Furthermore, we believe that the wording of Section 4968 — providing that “net investment income” is to be determined under rules “similar to” the rules of Section 4940(c) — provides the Department of the Treasury and the IRS with the authority to issue regulations providing for an initial basis step-up. To exclude the application of Section 4940(c)(4)(B), adjusted to reflect the effective date of Section 4968, while applying the remaining provisions of Section 4940(c) would be inconsistent with the plain meaning of the statute.

  • The IRS has ruled that an initial basis step-up is provided for Section 4940 purposes when a public charity converts to a private foundation. In Private Letter Ruling 9852023 (Sept. 28, 1998), the IRS addressed a situation where a public charity expected to undertake certain transactions that would result in its being classified as a private foundation. Specifically, the organization sought guidance on the adjusted basis of stock, the gain on sale of which would be subject to tax under Section 4940(a) following the entity's conversion to a private foundation. The IRS noted that if the assets were sold while the entity qualified as a public charity described in Section 509(a)(3), the gain would not be subject to any federal income or excise tax. However, market conditions prevented the sale of certain of the assets before the entity ceased to be a public charity, presenting the entity with “the prospect of paying a two percent (2 percent) excise tax on its net capital gain, mostly earned while it was a public charity.” Noting that “[t]he Code and the regulations are silent on this type of circumstance,” the IRS relied on its understanding of the legislative intent behind the initial basis step-up rule for assets of public charities that were owned on December 31, 1969 and Rev. Rul. 76-424 (described below) in holding that the adjusted basis of the stock at issue “will be equal to fair market value at the time [the entity] ceases to be a public charity.” Private colleges and universities subject to the newly-enacted Section 4968 excise tax are in an analogous position to public charities that convert to private foundation status, warranting an equitable application of the initial basis step-up rule.

• Retroactive applicability of Section 4968 leads to inequitable outcomes and a possible violation of the Takings Clause. In Revenue Ruling 76-424, 1976-2 C. B. 367, the IRS explained that the purpose of the initial basis step-up provided in Section 4940(c)(4)(B) was “. . . to avoid taxing appreciation of property prior to the enactment of the taxing statute.” This initial basis step-up is consistent with the objective of ensuring that Fifth Amendment Takings Clause principles are not violated as a result of imposing retroactive taxes. Furthermore, the legislative history of Section 7805, which authorizes the Secretary to issue regulations, suggests that limiting the permissible retroactive effect of a ruling or regulation reflected Congress's view that retroactive application could cause “inequitable results.”

  • Retroactive application of statutes or regulations is generally intended to counter abusive transactions. The sales of assets that are likely to be affected by the imposition of the Section 4968 excise tax occur in the ordinary course of investing endowment assets. These are not tax-motivated transactions, and the parties involved therefore could not have anticipated the imposition of a liability on these transactions.

  • The Supreme Court has determined that the imposition of substantially disproportionate liability can violate the Takings Clause. In Eastern Enterprises v. Apfel, 524 U.S. 498 (1998), the plurality opinion applied a three-part test for regulatory takings to a retroactive liability for health benefits imposed on a coal mining company. Under the test, a reviewing court must consider “the economic impact of the regulation on the claimant,” “the extent to which the regulation has interfered with distinct investment-backed expectations,” and “the character of the governmental action.” The Court stated that it must make an inquiry into basic notions of “justice and fairness,” noting that if “severe retroactive liability [is imposed] on a limited class of parties that could not have anticipated the liability, and the extent of that liability is substantially disproportionate to the parties' experience,” the liability will violate the Takings Clause. Based on the Eastern Enterprises test, if Section 4968 is interpreted as requiring that affected institutions pay tax on appreciation of property that occurred prior to enactment of the statute and, consequently, that they create books and records based upon historical costs that are unknown upon the imposition of such tax, the liability arguably violates the Takings Clause.

• An initial basis step-up has been provided in an analogous situation. Blue Cross and Blue Shield organizations were made taxable by the Tax Reform Act of 1986 (the “1986 Act”). Section 1012(c)(3)(A)(ii) of the 1986 Act provided that, for purposes of determining gain or loss, the adjusted basis of any asset held as of the date on which the organization became taxable “shall be treated as equal to its fair market value as of such day.” The conference report reveals that this basis adjustment was provided “because the confrees [sic] believe that such formerly tax-exempt organizations should not be taxed on unrealized appreciation or depreciation that accrued during the period the organization was not generally subject to income taxation.” H.R. Conf. Rept. 841, 99^th Cong., 2d Sess. II-350 (1986). This clear statement of intent reveals that legislators sought to avoid creating tax obligations due to changes in the value of property that took place before the organization was subject to income taxation. Although the legislative history of Section 4968 does not directly address the step-up in basis of newly-taxable property, its incorporation of the Section 4940(c) basis determination rules achieves the same end.

---

COMPLIANCE BURDENS ARISING FROM TAXATION OF BUILT-IN GAINS

BACKGROUND

Section 4968 imposes a 1.4% tax on the “net investment income” of certain private universities and colleges for each taxable year beginning after 2017.¹ Pursuant to new Section 4968(c), “net investment income” is to be calculated under rules “similar to” the rules of Section 4940(c), which imposes a tax on the net investment income of Section 501(c)(3) organizations classified as “private foundations.” The following discussion provides a brief discussion of the compliance burdens and retroactive aspects of this tax unless an initial basis step-up is permitted in connection with the imposition of the new Section 4968 excise tax.

COMPLIANCE BURDEN

The Trump Administration issued Executive Order 13789² that directed the Secretary of the Treasury to review all significant tax regulations promulgated on or after January 1, 2016 and identify the ones that (1) “impose an undue financial burden on United States taxpayers,” (2) “add undue complexity to the federal tax laws,” or (3) “exceed the authority of the Internal Revenue Service.” It is difficult to see how a carryover basis rule under Section 4968 is consistent with the policies expressed in Executive Order 13789.

The financial burden that a carryover basis would impose on universities is “undue” in the sense that it unfairly punishes these organizations by imposing financially burdensome requirements and additional complexity. Unless the guidance for section 4968 does not require cost basis calculations for assets acquired prior to enactment, the guidance will clearly fail the executive order tests. Some of larger universities have commented that they believe it will take them over 36,000 man hours to review Form K-1s issued to them by investment funds to “try” to determine historical basis. On average, it is estimated that all Form K-1s issued over at least a seven to a ten-year period will need to be located and reviewed in an attempt to calculate original cost basis.³ Even mid-sized endowments will have over 100 Form K-1s received per year.⁴ A Big Four accounting firm also quoted fees in excess of $1 million to attempt to compile basis records for one university. In addition to the issues with fund investments, there are even greater issues with donated assets. There was no need track basis of donated assets, so no records would exist. Universities might be able to determine acquisition date and use the fair market value at that date as a proxy for basis, but even determining acquisition date may be difficult in situations where there have been multiple gifts over a period of years. Finally, for some donated assets, the gifts may span back over decades and thus determining valuation even if an acquisition date is found will still be very difficult.

Unless step-up in basis is permitted, similarly situated taxpayers will likely have different tax results based upon how each institution essentially attempts to mark-to-market their investment assets prior to the end of their current fiscal years. The fallacy of not permitting a step-up in basis for all taxpayers is that certain institutions will avoid taxation of built-in gains through such transactions while others will be taxed on such gains. Tax policy should not favor such differences in treatment. Also, such tax policy will encourage universities to hold highly appreciated assets longer solely because they had built-in gains prior to the enactment of this tax.

Several universities have argued that the burden imposed by requiring a pre-effective date documentation requirement would be severe for all taxpayers subject to the new tax, regardless of tax sophistication, and would exceed any the perceived benefits for tax administration. Requiring retroactive creation of records which were not mandated to be maintained would be a substantial deviation from past practice in similar circumstances and would compel universities to build expensive new systems to satisfy requirements to compute cost basis prior to the effective date. Universities do not believe that they should have to expend time and resources designing and building systems to comply with rules that may ultimately be modified under the Executive Order to alleviate undue burdens of compliance.