Proposed Tax on Endowment Income Would Mean Difficult Choices for Many Schools

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College and university leaders are paying close attention to the tax plans moving through the Senate and House.  As currently written, both proposals would levy a 1.4% tax on net investment income earned during the tax year for private colleges and universities. The House version proposed the tax be applied to schools with assets of at least $250,000 per student and a minimum of 500 students. A last minute amendment to the Senate version raised that threshold to those that have assets of $500,000 per student. Assets would include mainly endowment funds and potentially other financial holdings such as cash reserves.

We don’t yet know all the details of the taxation, so we cannot gauge the exact impact at this early stage, of course. But what is certain is that an enactment of these tax proposals would reduce the amount of endowment proceeds that the affected schools would have available to put toward their missions.

In fact, with this tax, some institutions will likely face the difficult choice of (a) spending less going forward on their mission-based programs, such as scholarships or research, in order to preserve the perpetual nature of the endowment – or (b) continuing to fund programs at current levels, increasing the risk that the value and longevity of the underlying assets would be eroded over time.

The tax would take some endowments into new territory when it comes to how they invest, not just spend. These schools are accustomed to focusing on maximizing their investment returns to sustain their endowment support of students, faculty and programs. Tax planning is a new concept for them, since they have always been non-taxable institutions because of their nonprofit status; the tax would force them to approach investing strategies from a taxable perspective for the first time.

How the tax is imposed is important as well.  As the proposal currently stands, the tax would be levied on investment income, which is not calculated in the same way as investment returns.  The appreciation or depreciation from unrealized capital gains is a major component of investment return.  Net investment income, on the other hand, includes realized capital gains as well as interest, dividends, rent, and royalties, minus the expenses incurred in earning the income, such as investment oversight costs.

Institutions could (and sometimes do) incur realized capital gains in years when investment returns are negative since the amount of realized gains is based on the difference between the aggregate sale value of securities and the initial cost basis (which could be from several years prior).  That means institutions’ endowments could be eroded even more when returns are negative but investment income is positive.

It’s worth noting that there is currently a net investment income tax for private foundations. They are subject to a tax of 2% of total net investment income, which can be reduced to 1% in certain circumstances.  The new tax plan proposes revising that to 1.4%, the same as the proposed tax on selected private colleges and universities.

To get a sense of the magnitude of the proposed net investment income tax on selected private higher education institutions, we looked at data reported by a group of private foundations (whose tax forms are already set up to capture net investment income figures) in their 2015 returns. If the tax had been 1.4% instead of 2%, the tax liability would have been about 9 basis points of their long-term investment pool. While we can’t be certain of how the affected colleges and universities would be impacted, it’s reasonable to expect a similar liability for the higher education institutions. For some perspective, an institution with a $1 billion endowment and a 9 basis point tax liability would have $900,000 of endowment resources diverted away from students and mission-related support.

Colleges and universities should continue to monitor the tax legislation situation closely. If the tax on net investment income passes into law, many schools will have to take steps – including some likely painful ones – to adjust.