[Federal Register Volume 85, Number 200 (Thursday, October 15, 2020)]
[Rules and Regulations]
[Pages 65526-65564]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-20933]



[[Page 65525]]

Vol. 85

Thursday,

No. 200

October 15, 2020

Part IV





Department of the Treasury





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Internal Revenue Service





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26 CFR Part 53





Guidance on the Determination of the Section 4968 Excise Tax Applicable 
to Certain Colleges and Universities; Final Rule

  Federal Register / Vol. 85 , No. 200 / Thursday, October 15, 2020 / 
Rules and Regulations  

[[Page 65526]]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 53

[TD 9917]
RIN 1545-BO75


Guidance on the Determination of the Section 4968 Excise Tax 
Applicable to Certain Colleges and Universities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations for determining the 
excise tax applicable to the net investment income of certain private 
colleges and universities. The regulations affect certain private 
colleges and universities.

DATES: 
    Effective Date: These regulations are effective on October 14, 
2020.
    Applicability Date: For date of applicability, see Sec.  53.4968-4.

FOR FURTHER INFORMATION CONTACT: Melinda Williams at (202) 317-6172 or 
Amber Mackenzie at (202) 317-4086 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    This document amends the Foundation and Similar Excise Tax 
Regulations (26 CFR part 53) by adding final regulations under section 
4968 of the Internal Revenue Code (Code). Section 4968 was added to the 
Code by section 13701 of Public Law 115-97 (131 Stat. 2054, 2167-68 
(2017)), commonly referred to as the Tax Cuts and Jobs Act (TCJA). 
Section 4968(a) imposes on each applicable educational institution, as 
defined in section 4968(b)(1), an excise tax equal to 1.4 percent of 
the institution's net investment income, determined under section 
4968(c). Further, section 4968(d) treats a portion of certain assets 
and net investment income of certain related organizations as assets 
and net investment income of the educational institution.
    Section 4968(b)(1) defines the term ``applicable educational 
institution'' as an eligible educational institution (as defined in 
section 25A(f)(2)) that, during the preceding taxable year, had at 
least 500 tuition-paying students, more than 50 percent of whom were 
located in the United States, that is not a state college or university 
as described in the first sentence of section 511(a)(2)(B), and that 
had assets (other than those assets used directly in carrying out the 
institution's exempt purpose) the aggregate fair market value of which 
was at least $500,000 per student of the institution.
    Section 4968(b)(2) provides that, for purposes of section 
4968(b)(1), the number of students of an institution (including for 
purposes of determining the number of students at a particular 
location) is 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.
    Section 4968(c) provides that, for purposes of section 4968, ``net 
investment income'' is determined under rules similar to the rules of 
section 4940(c).
    Section 4968(d)(1) provides that, for purposes of determining the 
aggregate fair market value of an educational institution's assets not 
used directly in carrying out its exempt purpose,\1\ and for purposes 
of determining an institution's net investment income, the assets and 
net investment income of any related organization with respect to the 
institution are treated as assets and net investment income, 
respectively, of the educational institution, with two exceptions. 
First, no such amount is to be taken into account with respect to more 
than one educational institution. Second, unless such organization is 
controlled by such institution or is a supporting organization 
described in section 509(a)(3) with respect to such institution for the 
taxable year, assets and net investment income that are not intended or 
available for the use or benefit of the educational institution are not 
taken into account.
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    \1\ Section 4968(d)(1) erroneously cross references section 
4968(b)(1)(C). The correct cross reference should be to section 
4968(b)(1)(D). See Joint Committee on Taxation, ``General 
Explanation of Public Law 115-97'' (JCS-1-18), December 2018, at 
290, n. 1357.
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    Section 4968(d)(2) provides that the term ``related organization,'' 
with respect to an educational institution, means any organization 
that: (1) Controls, or is controlled by, such institution; (2) is 
controlled by one or more persons that also control such institution; 
or (3) is a supported organization (as defined in section 509(f)(3)), 
or a supporting organization (as described in section 509(a)(3)), 
during the taxable year with respect to the educational institution.
    The Conference Report for the TCJA, H. Rept. 115-466, 115th Cong., 
1st Sess., December 15, 2017 (Conference Report), at 555, states ``It 
is intended that the Secretary promulgate regulations to carry out the 
intent of the provision,'' including regulations that describe: (1) 
Assets that are used directly in carrying out an educational 
institution's exempt purpose; (2) the computation of net investment 
income; and (3) assets that are intended or available for the use or 
benefit of an educational institution.
    In June 2018, the Department of the Treasury (Treasury Department) 
and the IRS issued Notice 2018-55, 2018-26 I.R.B. 773, to provide 
interim guidance on certain issues related to the application of the 
tax imposed by section 4968. Specifically, Notice 2018-55 stated that, 
in the case of property held on December 31, 2017, and continuously 
thereafter to the date of its disposition, the Treasury Department and 
the IRS intended to propose regulations stating that basis for purposes 
of determining gain (but not loss) is deemed to be not less than the 
fair market value of such property on December 31, 2017, plus or minus 
all adjustments after December 31, 2017, and before the date of 
disposition, consistent with the regulations under section 4940(c). 
Notice 2018-55 additionally stated that the Treasury Department and the 
IRS expected the proposed regulations to provide that losses from sales 
or other dispositions of property generally would be allowed only to 
the extent of gains, with no capital loss carryovers or carrybacks, and 
that losses from sales or other dispositions of property by related 
organizations will be allowed to offset overall net gains from other 
related organizations or the applicable educational institution.
    On July 3, 2019, the Treasury Department and the IRS published a 
notice of proposed rulemaking in the Federal Register (REG-106877-18, 
84 FR 31795) that contained proposed regulations regarding the 
requirements of section 4968, including the manner for determining the 
excise tax applicable to the net investment income of certain private 
colleges and universities. The proposed regulations incorporated the 
provisions set forth in Notice 2018-55. The proposed regulations also 
provided definitions for several of the terms necessary for an 
educational institution to determine whether the section 4968 excise 
tax is applicable to it, including the terms ``student,'' ``tuition-
paying,'' ``located in the United States,'' and ``assets used directly 
in carrying out an institution's exempt purpose.'' Eighteen comments 
were received in response to the proposed regulations, one of which was 
the collective comment of forty educational institutions likely to be 
subject to this excise tax. No public hearing was requested or held.
    After consideration of the comments received, the proposed 
regulations

[[Page 65527]]

under section 4968 are adopted as final regulations as modified by this 
Treasury Decision. The major areas of comment and the revisions to the 
proposed regulations are discussed in the Summary of Comments and 
Explanation of Revisions. Eight commenters voiced objections to the 
Code section itself. No regulatory response to these comments is 
appropriate. Accordingly, these comments are not discussed in the 
Summary of Comments and Explanation of Revisions. All comments are 
available for public inspection at www.regulations.gov or on request.

Summary of Comments and Explanation of Revisions

    These final regulations provide guidance on the tax imposed by 
section 4968 and the entities that are subject to the tax.

1. Applicable Educational Institution

    Section 4968(b)(1) defines the term ``applicable educational 
institution,'' in part, as an eligible educational institution defined 
in section 25A(f)(2). Consistent with the statute, the proposed 
regulations provided that the term ``applicable educational 
institution'' means any eligible educational institution (as defined in 
section 25A(f)(2) and Sec.  1.25A-2(b)): (1) That had at least 500 
tuition-paying students attending the institution during the preceding 
taxable year; (2) more than 50 percent of whose tuition-paying students 
are located in the United States; (3) that is not described in the 
first sentence of section 511(a)(2)(B) (relating to state colleges and 
universities); and (4) the aggregate fair market value of the assets of 
which at the end of such preceding taxable year (other than those 
assets that are used directly in carrying out the institution's exempt 
purpose) is at least $500,000 per student attending the institution.
    Two commenters addressed the definition of applicable educational 
institution. The first commenter recommended that the final regulations 
provide additional guidance to clarify that separate, but affiliated, 
educational institutions that are under common control (for example, 
within the same university system) should be aggregated for purposes of 
determining the number of students used in both the 500-student and the 
$500,000-per-student tests. These final regulations do not adopt this 
recommendation, because both section 4968(b)(1) and section 25A(f)(2) 
refer to individual institutions and neither contains any provisions 
for aggregating affiliated institutions for purposes of determining the 
number of students at an institution. The only aggregation in section 
4968 is the requirement to treat certain assets and net investment 
income of related organizations as the assets and net investment 
income, respectively, of the institution.
    The second commenter stated that, for purposes of defining 
``eligible educational institution,'' the final regulations should not 
include a reference to the regulations at Sec.  1.25A-2(b) and should 
use only the statutory definition contained in section 25A(f)(2). 
Section 1.25A-2(b) provides that an eligible educational institution 
means, in general, a college, university, vocational school, or other 
postsecondary educational institution that is described in section 481 
of the Higher Education Act of 1965 (20 U.S.C. 1088) as in effect on 
August 5, 1997 (generally all accredited public, nonprofit, and 
proprietary postsecondary institutions) that (1) is participating in a 
Federal financial aid program under title IV of the Higher Education 
Act of 1965 or (2) is certified by the Department of Education as 
eligible to participate in such a program but chooses not to 
participate.
    The commenter explained that there are several educational 
institutions whose organizational documents and mission prohibit them 
from applying for or receiving Federal funds (including accepting funds 
as part of a student Federal financial aid program under Title IV of 
the Higher Education Act of 1965). The commenter asked that 
applicability of section 4968 be determined based on the actions of an 
institution rather than by a Department of Education certification that 
is focused on whether the students of an institution can claim an 
individual tax credit under section 25A for expenses to attend the 
institution, which the commenter sees as being incompatible with both 
the terms of section 25A and the mission of such institutions.
    Although the Treasury Department and the IRS appreciate the 
position of the commenter, section 4968 expressly defines applicable 
educational institution by reference to section 25A(f)(2). Section 
25A(f)(2) provides that the term ``eligible educational institution'' 
means an institution that is described in section 481 of the Higher 
Education Act of 1965 (20 U.S.C. 1088), as in effect on the date of the 
enactment of section 25A, and that ``is eligible to participate in a 
program under title IV of such Act.''
    If the final section 4968 regulations did not include a reference 
to Sec.  1.25A-2(b), an educational institution would still be 
``eligible to participate in a program under title IV of such Act'' as 
long as it satisfied all of the requirements of that Act even if it 
chose not to participate in such a program and even if it was not 
certified by the Department of Education as eligible to participate in 
such a program. Thus, deleting the reference to Sec.  1.25A-2(b) would 
not address the commenter's concerns. Further, Sec.  1.25A-2 was 
adopted in 2002, and Congress is presumed to have been aware of the 
regulations when section 4968 was enacted. Congress did not express any 
intent in the legislative history of section 4968 for the regulations 
under section 25A to be disregarded for purposes of defining eligible 
educational institution. In addition, it would be very difficult for 
the Treasury Department and the IRS to provide in the regulations under 
section 4968 that the IRS is following a definition of eligible 
educational institution that is consistent with the statutory language 
of section 25A(f)(2) without also incorporating the regulations under 
section 25A unless there was specific language in section 4968 with 
which the regulations were in conflict, and that is not the case here. 
Lastly, the Treasury Department and the IRS understand that the number 
of educational institutions that do not participate in the Federal 
programs provided in the Higher Education Act or that are not certified 
as eligible to participate in the programs is very small, and it would 
be burdensome for the IRS to follow one definition of eligible 
educational institution for purposes of section 25A and another under 
section 4968 when both provisions are dependent on section 25A(f)(2).
    Thus, these final regulations adopt the definition of applicable 
educational institution as proposed.

2. Student

    The proposed regulations defined ``student,'' based in part on 
section 25A(b)(3) and the Higher Education Act, as a person enrolled in 
a degree, certification, or other program (including a program of study 
abroad approved for credit by the eligible educational institution at 
which such student is enrolled) leading to a recognized educational 
credential at an eligible educational institution, and who is not 
enrolled in an elementary or secondary school.
    The proposed regulations also provided that the number of students 
of an educational institution (including for purposes of determining 
the number of students at a particular location) is based on the daily 
average number of full-time students attending such institution (with 
part-time students taken into account on a full-time

[[Page 65528]]

student equivalent basis). Under the proposed regulations, the 
standards for determining part-time students, full-time students, full-
time equivalents, and daily average are determined by each educational 
institution. However, the standards may not be lower than the 
applicable standards established by the Department of Education under 
the Higher Education Act of 1965 (20 U.S.C. 1088), as amended.
    Three commenters addressed the proposed definition of ``student,'' 
stating that section 4968 does not define the term student but it does 
provide that, for purposes of determining the number of students of an 
institution, an educational institution must determine the daily 
average number of full-time students attending the institution, with 
part-time students taken into account on a full-time student equivalent 
basis. Two of these commenters recommended that the definition should 
include all students attending the institution even if not enrolled in 
a degree, certification, or other program leading to a recognized 
educational credential, stating that section 4968 includes students 
that are taking a less-than half time load and that many of those 
students are not seeking a degree. The commenters stated that the 
definition of student for purposes of the Lifetime Learning Tax Credit 
(LLTC) \2\ or the Family Educational Rights and Privacy Act (FERPA) \3\ 
is broader than the definition that applies for purposes of the Higher 
Education Act and the American Opportunity Tax Credit,\4\ which defines 
those eligible for student loans, and thus is more consistent with and 
thus appropriate for purposes of section 4968. In addition, two 
commenters recommended against a definition based on a recognized 
educational credential, questioning who would decide what constitutes 
such a credential and whether this would allow potential manipulation 
by the educational institutions. One other commenter suggested 
retaining the standard in the proposed regulations.
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    \2\ The Lifetime Learning Credit, found in section 25A(c), 
provides a tax credit equal to 20 percent of up to $10,000 of 
``qualified tuition and related expenses'' paid by the taxpayer 
during the taxable year to acquire or improve job skills. Section 
25A(f)(1) defines qualified tuition and related expenses as tuition 
and fees required for enrollment or attendance at an eligible 
educational institution for courses of instruction at such 
institution.
    \3\ The Family Educational Rights and Privacy Act (FERPA) (20 
U.S.C. 1232g; 34 CFR part 99) is a Federal law that protects the 
privacy of student education records. It defines the term 
``student'' as any individual who is or has been in attendance at an 
educational agency or institution, including at elementary and 
secondary school levels, and regarding whom the agency or 
institution maintains education records.
    \4\ The American Opportunity Tax Credit, found in section 
25A(b), provides a tax credit equal to the sum of 100 percent of so 
much of the qualified tuition and related expenses paid by the 
taxpayer during the taxable year (for education furnished to the 
eligible student during any academic period beginning in such 
taxable year) as does not exceed $2,000, plus 25 percent of such 
expenses so paid as exceeds $2,000 but does not exceed $4,000. 
Section 25A(b)(3) defines an eligible student for purposes of the 
American Opportunity Tax Credit as a student who meets the 
requirements of section 484(a)(1) of the Higher Education Act of 
1965 (20 U.S.C. 1091(a)(1)), as in effect on the date of the 
enactment of section 25A, and is carrying at least \1/2\ the normal 
full-time work load for the course of study the student is pursuing.
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    The Treasury Department and the IRS agree that section 4968 does 
not expressly state that a person must be enrolled in a degree, 
certification, or other program to be considered a student. However, 
section 4968 does require that a student be attending the institution: 
``. . . the number of students of an institution . . . 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 Treasury Department and the IRS have concluded that the 
definition of student provided in FERPA is overly broad, as it 
includes, for example, individuals who previously attended the 
educational institution.
    However, the LLTC, which provides a tax credit based on certain 
tuition and fees required ``for the enrollment or attendance of'' an 
individual at an eligible educational institution ``for courses of 
instruction of such individual at such institution'' does provide a 
useful analogy, as it refers to a person who is enrolled, attending, 
and paying qualified tuition to an institution for courses of 
instruction at such institution.
    Whereas the LLTC includes a requirement that the purpose of the 
course must be to acquire or improve job skills of the individual, the 
Treasury Department and the IRS have determined that it would be more 
appropriate and administrable instead to require that the course be 
taken for academic credit. Whereas neither an applicable educational 
institution nor the IRS is likely to know whether a course is taken to 
acquire or improve job skills of the individual, it should be easy to 
determine whether a course was taken for academic credit. Furthermore, 
anyone taking a course for academic credit is using the school's 
resources to receive the specific time and attention of the school's 
faculty for his or her individual instruction. Thus, it is appropriate 
to include taking a course for academic credit as a component of the 
definition of student for purposes of section 4968.
    However, under the definition, a student, whether full time or part 
time, must be charged tuition at a rate that is commensurate with the 
rate charged to students enrolled for a degree. The Treasury Department 
and the IRS have concluded that this is necessary for a part-time 
student to be considered as attending the institution on an 
``equivalent basis'' to a full-time student.
    Thus, these final regulations define the term ``student'' for 
purposes of section 4968 as a person who is enrolled and attending a 
course for academic credit from the institution and who is being 
charged tuition at a rate that is commensurate with the tuition rate 
charged to students enrolled for a degree. No inference is to be drawn 
from this definition with regard to the definition of student for other 
purposes, including for purposes of applying section 25A.
    These final regulations also adopt the portion of the definition of 
``student'' found in the proposed regulations providing that the number 
of students of an educational institution (including for purposes of 
determining the number of students at a particular location) is based 
on the daily average number of full-time students (with part-time 
students taken into account on a full-time student equivalent basis). 
The standards for determining whether a student attends part-time or 
full-time and for calculating full-time equivalents and the daily 
average number of full-time students are determined by each educational 
institution. However, the standards may not be lower than the minimum 
applicable standards established by the Department of Education under 
the Higher Education Act of 1965 (20 U.S.C. 1088), as amended.

3. Tuition-Paying

    The proposed regulations provided that the term ``tuition-paying'' 
means the payment of any tuition or fees required for the enrollment or 
attendance of a student for a course of instruction at an eligible 
educational institution. The proposed regulations stated that this does 
not include any separate payment for supplies or equipment required 
during a specific course once a student is enrolled in and attending 
the course or the payment of room and board or other personal living 
expenses. In addition, the proposed regulations provided that whether a 
student is ``tuition-paying'' is determined after taking into account 
any scholarships provided directly by the educational institution and 
any work study programs operated directly by the

[[Page 65529]]

educational institution; however, scholarship payments provided by 
third parties, even if administered by the institution, are considered 
payments of tuition on behalf of the student.
    Three commenters discussed the meaning of ``tuition-paying.'' One 
commenter expressed a concern that smaller educational institutions 
might modify their financial aid programs to offer fewer partial 
scholarships and more full scholarships to fall under the threshold of 
having 500 tuition-paying students. The Treasury Department and the IRS 
have determined that a modification to the regulations for this purpose 
is not necessary because any definition of tuition-paying may lead to 
this result and because the same definition of tuition-paying should 
apply regardless of the size of the institution.
    Another commenter recommended that a student should be considered 
``tuition-paying'' regardless of the source of tuition funds, except 
that an eligible educational institution that does not charge tuition 
to any student would not be considered to have any tuition-paying 
students. These final regulations do not adopt this suggestion because 
the statute does not refer to tuition ``charged,'' rather it refers to 
tuition ``paid.''
    The third commenter asked whether the term ``scholarships'' in the 
proposed regulations was intended to include Pell Grants and other 
forms of Federal and state student financial aid as well as non-
governmental grants made on behalf of students, recommending that these 
grants from government and non-government sources not be treated as the 
payment of tuition on behalf of students. The Treasury Department and 
the IRS agree that grants or scholarships made by Federal, state, and 
local governments should be disregarded when determining whether a 
student is tuition-paying. Grants or scholarships made by Federal, 
state, and local governments generally are governed by legislation, are 
intended to make a college education more affordable for all potential 
students, and generally are based on criteria that the government sets 
(such as a determination of financial need), applied without regard to 
which educational institution the student attends or the cost of the 
education. Pell Grants and other Federal grants are awarded and 
administered by the Department of Education, which determines each 
student's financial need and eligibility for the grant. Finally, almost 
all educational institutions, whether private or public, use Federal 
and state grants to offset the cost of tuition, and therefore it would 
be fundamentally unfair to include these government grants as payment 
of tuition by or on behalf of a student in determining whether an 
educational institution is liable for the excise tax imposed by section 
4968.
    Thus, these final regulations adopt the definition of ``tuition-
paying'' found in the proposed regulations, which concluded that 
scholarships awarded by the institution are not tuition ``paid'' on 
behalf of the student, whereas scholarships from third parties 
essentially are payments of the student's tuition, but add that whether 
a student is tuition-paying is also determined after taking into 
account grants made by the Federal government or any state or local 
government.

4. Located in the United States

    The proposed regulations provided that the term ``located in the 
United States'' refers to the location of a student, and that a student 
is considered to have been located in the United States if the student 
resided in the United States for at least a portion of the time the 
student attended the institution during the educational institution's 
preceding taxable year.
    The preamble to the proposed regulations provided three examples 
relating to whether a student is considered to have been located in the 
United States. In the first example, a student who attended an 
educational institution in the preceding taxable year and who is a 
citizen of a foreign country is considered to have been a student 
located in the United States if the student resided in the United 
States for at least a portion of the time the student attended the 
educational institution in the preceding taxable year. In the second 
example, a student attending the educational institution in the 
preceding taxable year who was studying abroad in a foreign country is 
considered to have been a student located in the United States if the 
student resided in the United States for at least a portion of the time 
the student attended the educational institution. The third example 
illustrates that, if a student did not reside in the United States for 
any portion of the time the student attended the educational 
institution during the preceding taxable year, then that student would 
not be considered to have been located in the United States for 
purposes of section 4968(b)(1)(B). The proposed regulations asked for 
comments on whether further guidance is needed relating to whether a 
student is considered to have been located in the United States in a 
preceding taxable year.
    One commenter addressed the definition of ``located in the United 
States.'' This commenter recommended that each institution be permitted 
to determine whether a student is located in the United States using 
any reasonable approach, as long as it was consistently used. However, 
the commenter said that the approach would have to consider students 
who spend substantial time in the United States attending classes as 
located in the United States.
    The proposed rule contemplated that educational institutions could 
determine whether a student resided in the United States for at least a 
portion of the time that the student attended the institution during 
the institution's preceding taxable year using any reasonable method, 
but these final regulations make that explicit. The final regulations 
otherwise maintain the rule as proposed.

5. Assets Used Directly in Carrying Out an Institution's Exempt Purpose

a. In General
    To be included in the definition of applicable educational 
institution under section 4968(b)(1), an institution must have assets 
(other than those assets that are used directly in carrying out the 
institution's exempt purpose) the aggregate fair market value of which 
is at least $500,000 per student. The phrase ``assets that are used 
directly in carrying out the institution's exempt purpose'' is not 
defined in section 4968, but a similar phrase is used in section 4942.
    For purposes of section 4942, a private foundation must determine 
its minimum investment return as part of its calculation of its 
distributable amount for any taxable year. Minimum investment return is 
defined in section 4942(e) as five percent of the excess 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,'' over the acquisition indebtedness 
with respect to such assets.
    Because section 4968 contains a phrase similar to the language used 
in section 4942 (other than the omission of the parenthetical ``(or 
held for use)''), the proposed regulations generally followed Sec.  
53.4942(a)-2(c) for purposes of determining whether an educational 
institution's assets are used directly in carrying out the 
institution's exempt purpose, but not including any assets that would 
be considered ``held for use'' for section 4942 purposes.

[[Page 65530]]

    More specifically, the proposed regulations provided that an asset 
is used directly in carrying out an institution's exempt purpose only 
if the asset is actually used by the institution in carrying out its 
exempt purpose. Whether an asset is used directly by the institution to 
carry out its exempt purpose must be determined based on all the facts 
and circumstances. If property is used for an exempt purpose and for 
other purposes, and the exempt use represents 95 percent or more of the 
total use, the property is considered to be used exclusively for an 
exempt purpose. If the exempt use of such property represents less than 
95 percent of the total use, the institution must make a reasonable 
allocation between exempt and nonexempt uses.
    The proposed regulations included examples of assets that are used 
directly in carrying out an institution's exempt purpose, stating that 
they include, but are not limited to: (1) Administrative assets, such 
as office equipment and supplies used by the institution directly in 
the administration of its exempt activities; (2) real estate or the 
portion of any building used by the institution directly in its exempt 
activities; (3) physical property such as paintings or other works of 
art owned by the institution that are on public display, fixtures and 
equipment in classrooms, research facilities and related equipment 
that, under the facts and circumstances, serve a useful purpose in the 
conduct of the institution's exempt activities; (4) the reasonable cash 
balances necessary to cover current administrative expenses and other 
normal and current disbursements directly connected with the 
educational institution's exempt activities (and, for this purpose, the 
proposed regulations provided a safe harbor for determining a 
reasonable cash balance: The portion of an educational institution's 
actual cash balances at the end of a year that does not exceed 1.5 
percent of the fair market value of the institution's non-charitable 
use assets, determined without regard to any reduction for reasonable 
cash balances); and (5) any property the educational institution leases 
to other persons at no cost (or at a nominal rent) to the lessee in 
furtherance of the institution's exempt purposes.
    The proposed regulations also provided the following examples of 
assets not considered to be used directly in carrying out an 
institution's exempt purpose: (1) Assets that are held for the 
production of income or for investment (for example, stocks, bonds, 
interest-bearing notes, endowment funds, or leased real estate), even 
if the income from such assets is used to carry out such exempt 
purpose; and (2) property (such as offices) used for the purpose of 
managing the institution's endowment funds.
    The proposed regulations asked for comments on whether the use of 
the principles of the section 4942 regulations creates any concerns. 
Commenters asked that the final regulations expand the list of assets 
considered used directly in carrying out an institution's exempt 
purpose to include those that are ``held for use'' as well as including 
certain intangible assets and certain assets of functionally related 
businesses. Commenters also addressed how to calculate a reasonable 
cash balance that would be considered used directly in carrying out an 
institution's exempt purpose. In addition, commenters asked whether an 
asset of a related organization that is treated as an asset of an 
educational institution by section 4968(d) can be considered used 
directly by the institution in carrying out its exempt purpose.
b. Assets That Are Held for Use
    One commenter asked that the proposed regulations be expanded to 
include as assets ``used directly in carrying out the institution's 
exempt purpose'' assets that are ``held for use'' to carry out such 
purposes, stating that there is no legislative history suggesting that 
Congress specifically intended to not include the ``held for use'' 
language contained in section 4942.
    Because assets held for use could include a much broader category 
of assets, such as portions of an endowment fund set aside in some 
formal or informal way for an exempt purpose, the Treasury Department 
and the IRS have concluded that the category of assets used directly 
for an institution's exempt purposes should not be so expanded, 
especially because the statutory language of section 4968 does not 
include the ``(or held for use)'' parenthetical language that appears 
in section 4942. Accordingly, these final regulations do not adopt the 
commenter's suggestion.
c. Intangible Assets
    One commenter requested that the final regulations permit 
intangible assets, in appropriate cases, to be treated as used directly 
in carrying out an institution's exempt purpose. The Treasury 
Department and the IRS agree that, in certain circumstances, intangible 
assets may be treated as used directly in carrying out an institution's 
exempt purpose. Thus, these final regulations provide that, to the 
extent that royalty income would be excluded from net investment income 
as described in part 6.a.iii. of this Summary of Comments and 
Explanation of Revisions, the patents, copyrights, and other 
intellectual property and other intangible property generating such 
royalty income are treated as assets used directly by the institution 
in furtherance of its exempt purposes. These final regulations also 
provide that trademarks on an institution's logo or name and 
intellectual property donated or sold to the institution are not assets 
used directly for the institution's exempt purposes.
d. Certain Assets of Functionally Related Businesses
    The preamble to the proposed regulations asked for comments on 
whether and how educational institutions use functionally related 
businesses in conducting their operations and whether functionally 
related businesses should be explicitly included or excluded as 
examples of exempt use assets in the final regulations. One commenter 
requested that the final regulations provide that non-financial assets 
used in a functionally related business be considered assets used 
directly in carrying out an educational institution's exempt purpose. 
The commenter stated that university theatres that produce plays, 
student newspapers with circulation revenue or ad sales income, or 
similar activities that operate as legally separate businesses while 
buttressing the educational mission of an educational institution are 
examples of functionally related businesses. The commenter recommended 
that assets, including intangible assets, of such a functionally 
related business be considered to be used directly in furthering the 
educational institution's exempt purpose. The commenter further 
recommended, however, that working capital or other financial resources 
relating to such a functionally related business should be considered 
assets not used directly in furthering the educational institution's 
exempt purpose.
    The Treasury Department and the IRS agree that, in certain 
circumstances, certain assets of functionally related businesses may be 
treated as used directly in carrying out an institution's exempt 
purpose. However, the Treasury Department and the IRS note that the 
concept of a functionally related business is relevant only for private 
foundations with respect to the excise taxes imposed under sections 
4942 and 4943. Thus, instead of providing a special rule for a non-
financial asset of

[[Page 65531]]

an activity of an educational institution, or of a related organization 
with respect to the educational institution, that meets the definition 
of a functionally related business found in Sec.  53.4942(a)-
2(c)(3)(iii), the general rule is that an educational institution 
evaluates each asset based on all the facts and circumstances to 
determine whether the asset is used directly in furthering the 
institution's exempt purpose applies.
e. Reasonable Cash Balance
    The proposed regulations recognized that, for section 4942 
purposes, an amount equal to 1.5 percent of the fair market value of a 
private foundation's non-charitable use assets (i.e., assets not 
actually used by an institution in carrying out its exempt purpose), 
determined without regard to the reduction for the reasonable cash 
balance, is deemed to be a ``reasonable cash balance'' that is excluded 
from the asset base used in calculating a private foundation's minimum 
investment return under section 4942(e). For consistency with the 
section 4942 rules, the proposed regulations proposed to adopt the same 
definition as a safe harbor and asked for comments on whether, in light 
of the differences between the exempt activities and valuation date(s) 
of a private foundation and an educational institution, a different 
percentage or other measurement should be used as a reasonable cash 
balance at the end of the taxable year.
    Two commenters stated that the 1.5 percent safe harbor should not 
be included in the final regulations, because there is a significant 
difference between the activities, and thus the need for cash for 
operating expenses, of a private foundation and an educational 
institution. The commenters indicated that the operating expenses of a 
private foundation whose exempt activity is awarding grants, and even 
of an operating private foundation, generally are substantially less 
than the salaries, maintenance, and other operating expenses of an 
educational institution with expansive physical facilities and human 
resources for conducting education and research.
    One commenter stated that educational institutions affected by the 
excise tax under section 4968 vary widely in size and focus, and that 
their methods for the delivery of educational services--which are the 
drivers of operating expenses and corresponding cash outflow and 
timing--vary widely. This commenter also mentioned that some 
institutions have a summer session with a lower attendance (therefore 
requiring fewer resources) as compared to their traditional fall or 
spring sessions, and thus may have a lower cash balance at the end of 
their taxable year, which generally falls in the middle of summer on 
June 30th or July 31st. This commenter also stated that ratings 
agencies might downgrade the credit rating of some institutions based 
on their having cash on hand of only 1.5 percent of the value of non-
exempt use assets, and that bond proceeds for exempt projects must be 
held in liquid assets. One commenter also stated that the amount 
required for the reasonable cash needs of the institution should 
include funds for the expenses of its educational and research 
functions as well as cash reserves for special projects and bond 
covenants. Both commenters recommended that the final regulations 
instead permit educational institutions to determine their own 
reasonable cash needs as of the end of the taxable year, based on the 
particular facts and circumstances of that institution.
    The Treasury Department and the IRS note that the 1.5 percent safe 
harbor in proposed Sec.  53.4968-1(a)(4)(ii)(D) was merely a safe 
harbor and did not prevent an educational institution from establishing 
under the general facts and circumstance rule of proposed Sec.  
53.4968-1(a)(4)(i) that another cash balance was reasonably necessary 
to cover its current administrative expenses and other normal and 
current disbursements directly connected with its exempt purposes. 
However, in recognition that commenters did not find the safe harbor 
useful, these final regulations instead provide a different safe harbor 
that is based on the specific expenses incurred by each educational 
institution. Specifically, these final regulations provide that a 
reasonable cash balance may be determined by any reasonable method, and 
that one such method would be to calculate an amount equal to three 
months of operating expenses allocable to program services, calculated 
by dividing annual functional expenses allocable to program services 
(2019 Form 990, Part IX, line 25, column (B), or the corresponding line 
provision of any successor Form 990) by four. Alternatively, a larger 
amount may be a reasonable cash balance for this purpose if, under the 
facts and circumstances, a larger amount is established to be necessary 
to cover administrative expenses and other normal disbursements 
directly connected with the institution's exempt activity.
f. Assets of Related Organizations
    One commenter noted that section 4968(d) treats certain assets of 
related organizations with respect to an educational institution as 
assets of the educational institution, and that section 4968(b)(1)(D) 
requires the educational institution to determine whether, at the end 
of the preceding taxable year, the aggregate fair market value of its 
assets (other than those assets that are used directly in carrying out 
the institution's exempt purpose) is at least $500,000 per student of 
the institution. This commenter suggested that, in counting the assets 
of a related organization for this purpose, any asset of the related 
organization that is used directly in carrying out the educational 
institution's exempt purpose should be excluded from section 
4968(b)(1)(D). In addition, the commenter asked how to apply the ``used 
directly in carrying out the institution's exempt purpose'' test in the 
case of a related organization with exempt purposes differing from 
those of the educational institution.
    The Treasury Department and the IRS agree with these comments. 
Therefore, these final regulations provide that an asset of a related 
organization that is treated as an asset of the educational institution 
(in accordance with section 4968(d) and Sec.  53.4968-3(c)) and is used 
directly in carrying out the educational institution's exempt purpose 
is considered used directly by the institution in carrying out its 
exempt purpose. These final regulations further provide that an asset 
of a related organization that is treated as an asset of the 
educational institution is considered to be used directly in carrying 
out the educational institution's exempt purpose if (1) the related 
organization is described in section 501(c)(3) and (2) the asset is 
being used directly in carrying out the related organization's exempt 
purpose.
    For example, under this rule, if an educational institution 
controls (as described in part 7.b.ii of this Summary of Comments and 
Explanation of Revisions) a nonprofit nonstock organization that is a 
museum, then section 4968(d)(1)(B) would treat all of the museum's 
assets as assets of the educational institution, regardless of whether 
the assets are earmarked or restricted for the benefit of, or otherwise 
fairly attributable to, the educational institution, and even if they 
are specifically earmarked or restricted for another entity or for 
unrelated purposes or are otherwise not fairly attributable to the 
educational institution. However, when for purposes of section 
4968(d)(1)(D) the educational institution values its assets (other than 
those used directly in carrying out the institution's exempt purpose) 
at the end of the preceding taxable year, the educational institution 
could exclude any museum

[[Page 65532]]

asset, such as artwork, that is being used directly in carrying out the 
museum's exempt purpose, even if such use does not directly carry out 
the educational institution's exempt purpose. (The Treasury Department 
and the IRS note that the general rule found in Sec.  53.4968-
1(b)(5)(iii) that neither assets that are held for the production of 
income or for investment nor property (such as offices and equipment) 
used for the purpose of managing funds are considered used directly in 
carrying out an exempt purpose. Thus, a related organization whose 
exempt purpose is grantmaking generally will have few assets considered 
to be used directly in carrying out the educational institution's 
exempt purpose.)
g. Valuation of Assets Not Used Directly in Carrying Out an 
Institution's Exempt Purpose
    The proposed regulations provided that, for purposes of valuing an 
educational institution's non-exempt use assets, the institution should 
use rules similar to the rules of section 4942(e) and Sec.  53.4942(a)-
2(c)(4), with two modifications. First, the phrase ``educational 
institution'' is substituted for ``private foundation'' or 
``foundation'' every place they appear. Second, an institution will 
have to make such adjustments as are reasonable and necessary to obtain 
the fair market value of non-exempt use assets as of the last day of 
the valuation taxable year, rather than any other time(s) required by 
the section 4942 regulations. The proposed regulations also requested 
comments on valuing assets using the principles of section 4942, as 
modified by this special timing rule. No comments were received. 
Accordingly, the proposed rule is adopted without substantive changes.
6. Net Investment Income
    For taxable years beginning after December 31, 2017, section 
4968(a) imposes a 1.4 percent excise tax on the net investment income 
of an applicable educational institution (as defined in section 
4968(c)), and on certain amounts of net investment income of certain 
related organizations, as described in section 4968(d) and Sec.  
53.4968-3. Section 4968(c) provides that net investment income is 
determined under rules similar to the rules of section 4940(c). 
Accordingly, the proposed regulations provided that an applicable 
educational institution generally must calculate net investment income 
under the rules of section 4940(c) and Sec.  53.4940-1(c) through (f), 
with certain modifications.
    Specifically, Sec.  53.4968-1(b)(3) of the proposed regulations (1) 
substituted ``applicable educational institution'' for ``private 
foundation'' or ``foundation'' each place they appear; (2) did not 
apply the rule in Sec.  53.4940-1(d)(3), because it is narrowly focused 
on section 302 stock redemptions by corporations that are disqualified 
persons and is not applicable to colleges and universities; (3) 
substituted ``December 31, 2017'' for ``December 31, 1969'' every place 
that it occurs to determine the basis of assets held on December 31, 
2017, for purposes of determining gain upon the sale or exchange of an 
asset held on December 31, 2017 in calculating the excise tax; (4) 
applied the special basis rule to assets held in partnerships as of 
December 31, 2017, as well; and (5) allowed overall net losses from 
sales or other dispositions of property by one related organization or 
by the applicable educational institution to reduce (but not below 
zero) overall net gains from such sales or other dispositions by other 
related organizations or by the applicable educational institution.
    Several commenters requested that the final regulations further 
tailor those rules to take into account differences between a private 
foundation subject to section 4940 and an educational institution, 
including differences in funding sources, use of funds, structure, 
governance, and oversight. In response, as discussed further in the 
following paragraphs of this part 6, these final regulations omit the 
use of a cross reference to the regulations under section 4940(c) to 
define net investment income for purposes of section 4968. Instead, 
these final regulations prescribe specific rules under section 4968 
that are similar to the rules of section 4940(c) but that are more 
tailored to educational institutions.
    In particular, following the regulations under section 4940(c), the 
final regulations provide, as further described in this part 6, that 
net investment income generally is the amount by which the sum of the 
gross investment income and the capital gain net income exceeds the 
allowable deductions. Also consistent with section 4940(c)(5) and Sec.  
53.4940-1(c)(2), net investment income is determined by applying 
section 103 (relating to interest on certain governmental obligations) 
and section 265 (relating to expenses and interest relating to tax-
exempt income). Finally, consistent with section 4940(c)(1) and Sec.  
53.4940-1(c)(1), net investment income is determined under the 
principles of subtitle A of the Code except to the extent inconsistent 
with the Code or regulations.
a. Gross Investment Income
    The proposed regulations noted that section 4968 does not expressly 
provide that the tax on net investment income is limited to net 
investment income derived from assets that are not used directly in 
carrying out an applicable educational institution's exempt purpose. 
This lack of a limitation is in contrast to the specific language in 
section 4968(b)(1)(D) that excludes assets used directly in carrying 
out an institution's exempt purpose in determining whether the 
educational institution is an applicable educational institution. 
Instead, section 4968(c) provides that net investment income is 
determined under rules similar to the rules of section 4940(c).
    To implement this provision, the proposed regulations proposed to 
adopt by cross reference the rules provided in section 4940(c) and the 
regulations thereunder, including Sec.  53.4940-1(d)(1), which 
specifies that ``gross investment income'' means the gross amounts of 
income from interest, dividends, rents, royalties (including overriding 
royalties), and capital gain net income received by a private 
foundation from all sources, but does not include such income to the 
extent included in computing the tax on unrelated business taxable 
income imposed by section 511. Under this definition, consistent with 
specific language in Sec.  53.4940-1(d), interest, dividends, rents, 
and royalties derived from assets devoted to an educational 
institution's exempt activities would be includible in gross investment 
income. Therefore, for example, under the proposed regulations, 
interest received on a student loan would have been includible in 
income for purposes of section 4968.
    The proposed regulations requested comments on whether specific 
types of income should be excluded from gross investment income under 
section 4968 because taxing those types of income would not achieve the 
congressional intent in enacting section 4968. Commenters recommended 
excluding interest from student and faculty loans, rental income from 
student and faculty housing, royalty income from exempt functions, 
income from programmatic activities, and income from endowment funds if 
the income is used as a tuition replacement fund.
    These final regulations adopt most of these recommendations. These 
final regulations specify that, consistent with section 4940(c), gross 
investment income generally means the gross amounts of income from 
interest, dividends, rents, payments with respect

[[Page 65533]]

to securities loans (as defined in section 512(a)(5)), and royalties, 
but not including any such income to the extent it is included in 
computing the tax imposed by section 511. Gross investment income also 
includes income from sources similar to those in the preceding 
sentence. In general, gross investment income includes the items of 
investment income described in Sec.  1.512(b)-1(a).
    However, in response to comments and consistent with the overall 
purpose of section 4968, these final regulations exclude from the 
definition of gross investment income (1) interest income from a 
student loan that was made by the applicable educational institution or 
a related organization to a student of the applicable educational 
institution in connection with the student's attendance at the 
institution; (2) rental income from the provision of housing by the 
applicable educational institution or a related organization to 
students of the applicable educational institution and from housing for 
faculty and staff if the housing is provided contingent on their roles 
as faculty or staff of the applicable educational institution; and (3) 
royalty income that is derived from patents, copyrights, and other 
intellectual property and intangible property to the extent those 
assets resulted from the work of student(s) or faculty member(s) in 
their capacities as such with the applicable educational institution. 
However, neither royalty income from trademarks on the institution's 
logo or name nor royalty income from intellectual property donated or 
sold to the institution is excluded from gross investment income under 
this rule).
i. Interest From Student Loans
    The proposed regulations noted that the regulations under section 
4940(c) specifically include student loan interest as gross investment 
income. However, recognizing that student loans provided directly by an 
applicable educational institution to its students can be seen as 
helping the applicable educational institution fulfill its mission of 
educating its students, and that, unlike private foundations, colleges 
and universities educate students and charge tuition as part of their 
primary exempt activities, the preamble to the proposed regulations 
asked whether student loans provided by an applicable educational 
institution to its students arguably can be viewed as a form of 
deferred tuition which will be paid when the student enters the 
workforce.
    The preamble to the proposed regulations suggested distinguishing 
the interest on a student loan from investment interest by reference to 
the interest rate. If the interest is at a market (or higher) rate, it 
would be difficult to distinguish the interest on the student loan and 
interest on assets acquired for investment purposes. However, if the 
interest rate is set at a substantially below-market rate, the 
difference between the market interest rate and the interest rate on 
the student loan might be viewed as similar to a scholarship from the 
educational institution to the student. Under these circumstances, the 
remaining, below-market rate interest income might be considered 
distinguishable from income derived from assets acquired primarily for 
investment purposes. Finally, the preamble to the proposed regulations 
asked for comments on how a rule based on interest rates could be 
addressed to avoid administrative challenges for both the IRS and 
taxpayers in determining the relevant market-rate and an acceptable 
lower rate, and in adjusting to rate changes during the course of the 
loan.
    Four commenters recommended excluding all interest income from 
loans to students from gross investment income, stating that loans made 
by colleges and universities to students are not offered with the 
intent of earning investment income for the institution, but are 
instead made to assist students who have gaps in funding and need 
financial assistance to complete their educations. Many of these 
student loans are need-based loans to low-income students who would not 
qualify for other programs or commercial loans. In addition, most of 
the student loans made by educational institutions are made on terms, 
taken as a whole, that are more favorable than similar commercial 
student loans. These better terms include lower interest rates, fixed 
interest rates, deferred or delayed repayment periods, low or no 
origination fees, relaxed eligibility requirements, and more flexible 
repayment plans than loans that are offered on the open market.
    In response to these comments, these final regulations exclude from 
gross investment income interest income from a student loan that was 
made by the applicable educational institution (or a related 
organization of the institution) to a student of the institution in 
connection with the student's attendance at the institution.
    While most of the student loans made by educational institutions 
(or their related organizations) may be made on terms, taken as a 
whole, that are more favorable than similar commercial student loans, 
many of those favorable terms are not centered on interest rates. For 
example, unlike commercial loans, no collateral or demonstrations 
regarding future income are required. Therefore, an exception based on 
whether terms are more favorable than commercial loans would be unduly 
burdensome to administer and these final regulations do not include 
such a requirement.
    One commenter recommended extending this reasoning to faculty 
loans, which in many circumstances are provided in order to give an 
educational institution a competitive edge in attracting talented 
educational professionals. In most cases, this type of financing is an 
alternative to providing housing directly, the income or loss from 
which the commenter also recommended excluding. However, the commenter 
noted that there are nuances with respect to the types of faculty loans 
that may be provided by an educational institution that may warrant 
disparate treatment, and that an examination of all of the facts and 
circumstances (such as the resources of the borrowers, interest rate 
charged, availability of credit in the local area, and scope and extent 
of the program) would be necessary to determine whether a particular 
loan was effectively a substitute for bank financing and thus really an 
investment vehicle that should be considered to produce gross 
investment income.
    These final regulations do not exclude interest on loans to faculty 
from gross investment income. Although loans to faculty might 
indirectly benefit students by attracting better faculty, so does 
paying faculty higher salaries. Some loans provide a substitute for 
bank financing for a faculty member to purchase a residence that then 
becomes an asset of the faculty member. All loans to faculty, even if 
on favorable terms as part of a compensation package in order to 
attract such faculty, are substantially different from loans to 
students which may be viewed as effectively representing deferred 
tuition. Furthermore, interest income received on loans to faculty is 
more difficult to distinguish from other interest income that is 
includible under section 4940(c), such as interest income at the 
applicable Federal rate on a loan to acquire a luxury home. While 
certain loans, such as one to allow faculty to secure appropriate 
housing that otherwise would not be attainable by faculty, might 
qualify as supporting the institution's exempt purposes, a similar loan 
in other circumstances might not. The difference would be heavily 
dependent upon interest rates, the local real estate market, and other 
facts and circumstances. Thus, in accord with the

[[Page 65534]]

language in section 4968(c) that net investment income for section 4968 
purposes should be similar to the rules of section 4940(c), the final 
regulations under section 4968 do not exclude interest income on loans 
other than loans to students in connection with their attendance at the 
educational institution.
ii. Rental Income From Student, Faculty, and Staff Housing
    The proposed regulations also noted that colleges and universities 
offer various types of housing (such as dormitories or apartments) for 
use by students, non-students (for example, during the summer), and 
faculty. The preamble to the proposed regulations requested comments on 
the differences, if any, among the housing arrangements, whether any of 
the arrangements include the signing of leases, the various amounts 
charged by a college or university related to provision of housing and 
meals, and particular factors that distinguish room and board payments 
from students living in a dormitory from rental income that 
institutions receive.
    Five commenters recommended excluding income from student housing 
from gross investment income. These commenters stated that student 
housing is provided by educational institutions to their students for 
the purpose of furthering the students' education, rather than to 
create an investment return to the institution. On-campus housing 
provides a sense of community and creates non-classroom opportunities 
for students to engage with individuals with a similar academic focus 
as well as those with diverse perspectives and backgrounds, which 
promotes informal learning and development of social skills. It also 
facilitates studying and attending classes on campus, provides students 
with the full breadth of campus security services, and provides 
convenient access to campus dining halls. Many educational institutions 
require students to live in on-campus housing for one or more years. 
Further, several factors distinguish student housing from other rental 
properties that institutions may own. For example, typical residential 
rental agreements provide secure and exclusive access to a specific 
property for the tenant's use, and the tenant has the right to 
continuous occupancy and use of the specified space over the term of 
the lease. In contrast, students sign a contract for housing, but 
typically do not sign leases. They are assigned a space, within a room 
often shared by at least one other individual, frequently a stranger. 
Residence halls and student apartments or houses are typically not 
available year-round, but only during academic terms. For example, that 
housing might close over certain holidays and during breaks between 
semesters. Housing space normally is contingent on enrollment at the 
educational institution, and students that withdraw from the 
institution must vacate their rooms. Students are subject to specific 
housing rules and codes of conduct while in student housing, often 
including a prohibition on cooking. Residence halls also typically 
include the presence of a resident advisor, who is available 24 hours a 
day and may monitor the students' behavior. Guest access to student 
residences often is monitored or restricted.
    The Treasury Department and the IRS agree that income received from 
the housing of current students of an educational institution is 
distinguishable from other types of traditional rental income, and 
these final regulations exclude such income from gross investment 
income, whether the housing is provided to the educational 
institution's students by the institution or a related organization of 
the institution.
    Two commenters further recommended that rental income from faculty 
and staff housing also should be excluded from net investment income, 
stating that faculty and staff housing is a critical strategic resource 
used by universities to recruit and retain exceptional personnel. The 
commenters note that the provision of faculty and staff housing allows 
faculty and staff to live closer to campus, which not only is a 
convenience for such individuals but also allows them to more fully 
participate in the campus experience, contributing to a vibrant and 
dynamic residential and academic campus. Two commenters mentioned that 
housing rental prices generally are not set based on market rates but 
on actual cost, and many institutions operate housing at a loss, 
although it would be administratively burdensome to determine a 
theoretical market rate for each housing unit as well as to break out 
the income and expenses related to each housing unit.
    The Treasury Department and the IRS agree that rental income from 
housing provided to an institution's faculty and staff can be 
distinguished from other types of rental income if the housing is 
provided contingent on their capacities as faculty or staff (for 
example, if the rental agreement contains a provision that the person 
must be currently employed as faculty or staff of the applicable 
educational institution). Thus, these final regulations exclude such 
income from gross investment income, whether the housing is provided to 
the educational institution's faculty or staff by the institution or a 
related organization of the institution. These final regulations do 
not, however, exclude rental income from other persons, or from former 
faculty or staff.
    Two commenters recommended that rental income from dormitories and 
other student housing that is made available to students and 
nonstudents alike for educational programs and camps open to the public 
that are outside of the institution's academic year, particularly 
during the summer months, also be excluded from gross investment 
income. These final regulations do not adopt this suggestion. Such 
income may, depending on the circumstances, constitute unrelated 
business taxable income and be excluded from section 4968 for that 
reason. For example, if the income is from leasing to third parties 
that conduct summer camps and programs at the institution and the 
institution provides substantial personal services with respect to the 
rented facilities, it likely is unrelated business taxable income. 
Furthermore, the leasing of student housing to third parties for the 
operation of camps and programs run by third parties is not materially 
distinguishable from typical rental income. Also, if the summer camp or 
program is not operated by the educational institution, then the 
educational institution does not control who is staying in the housing 
and the housing is not necessarily provided for the benefit of the 
institution's current students or to contribute directly to achieving 
its educational purpose. However, the Treasury Department and IRS note 
that rental income from dormitories and other housing provided to 
current students that extends through the summer months (such as 
graduate student housing) would meet the exception for housing provided 
to students and would be excluded from gross investment income.
iii. Royalty Income From Exempt Functions
    Two commenters asked that royalty income derived from educational 
and research activities conducted by an applicable educational 
institution be excluded from the institution's gross investment income. 
The commenters stated that universities conduct research as part of the 
pursuit of knowledge by faculty and students rather than for the 
purpose of earning income. Both commenters stated that royalties 
derived from research that is directly conducted by students, faculty, 
and researchers is

[[Page 65535]]

distinguishable from the royalty income earned by most private 
foundations because private foundations receiving royalty income 
``normally'' have passive holdings in intellectual property that was 
not developed by the private foundations. (One commenter clarified that 
royalty income earned from ``passive investments'' was not intended to 
be included in this proposed exception for purposes of section 4968.)
    Both commenters represented that it would be a significant 
administrative burden to capture all expenses and costs allocable to 
such royalty income, including expenses incurred in applying for, 
obtaining, and defending a patent and in developing and negotiating 
license agreements during the life of the patent, and both commenters 
estimated that such annual expenses would equal or exceed the annual 
gross investment income from such royalties.
    The Treasury Department and the IRS agree that applicable 
educational institutions produce intellectual property as part of the 
pursuit of knowledge by faculty and students. These activities 
generally are not engaged in for profit and they are not passive 
investment activity. Instead, these activities are integral to an 
educational institution's exempt purposes. As a result, these final 
regulations exclude certain royalties generated by such educational and 
research activities from gross investment income for purposes of 
section 4968.
    Specifically, these final regulations exclude from gross income 
royalty income that is derived from patents, copyrights, and other 
intellectual property and intangible property to the extent those 
assets resulted from the work of student(s) or faculty member(s) in 
their capacities as such with the applicable educational institution. 
However, neither royalty income from trademarks on the institution's 
logo or name nor royalty income from intellectual property donated or 
sold to the institution is excluded from gross investment income under 
this rule.
iv. Income From Programmatic Activities
    Two commenters recommended excluding any income derived by an 
educational institution from the conduct of its core educational and 
research activities (that is, programmatic activities) from gross 
investment income. The commenters stated that taxing income that is 
derived directly from a college or university's exempt purpose is 
inconsistent with the intent of section 4968, which is intended to tax 
investment income. However, one commenter did not include any specific 
examples of types of income that would be gross investment income 
derived from the conduct of an applicable educational institution's 
core educational and research activities, and the other commenter gave 
as examples tuition, museum or gym admission fees, and income from a 
related business, such as a campus bookstore--none of which would be 
included in the definition of gross investment income under the 
proposed regulations.
    The Treasury Department and the IRS note that private foundations 
may earn gross investment income in the conduct of their exempt 
activities, but that such income is explicitly considered gross 
investment income by section 4940(c) and Sec.  53.4940-1(d). The 
preamble to the proposed regulations specifically asked commenters, 
when commenting on whether specific types of income should be excluded 
from gross investment income under section 4968 because taxing those 
types of income would not achieve the congressional intent in enacting 
section 4968, to state specifically how any such proposed exclusion 
would still be ``similar to'' the rules of section 4940(c) and the 
specific characteristics of each type of such income that would warrant 
deviating from the rules provided in section 4940 and the regulations 
thereunder. Furthermore, it is unclear what types of income, other than 
student loan interest, rental income from certain housing, and certain 
royalty income, otherwise would be gross investment income earned in 
the conduct of an applicable educational institution's exempt 
activities. Accordingly, other than the exclusions listed in part 
6.a.i., ii., and iii., these final regulations do not include an 
exclusion from gross investment income for income earned in the conduct 
of an applicable educational institution's exempt activities.
v. Excluding Income on Endowment Funds if the Income Is Used as a 
Tuition Replacement Fund
    One commenter recommended excluding income from endowment funds 
from gross investment income if the income is used as a tuition 
replacement fund for all of the applicable educational institution's 
students.
    Section 4968(c) provides that, for purposes of section 4968, net 
investment income is determined under rules similar to the rules of 
section 4940(c). Neither section 4968(c) nor 4940(c) provide an 
exclusion from net investment income for the income from an 
institution's endowment fund, regardless of what the income is 
ultimately used for. Thus, these final regulations do not exclude the 
income from an institution's endowment fund (however defined) from 
gross investment income, even if the income from the endowment fund is 
used as a tuition replacement fund.
b. Deductions
i. In General
    As stated in part 6.a of this Summary of Comments and Explanation 
of Revisions, the proposed regulations provided that an institution 
generally must calculate net investment income under rules similar to 
the rules of section 4940(c). The proposed regulations proposed to 
adopt this approach, incorporating by cross reference the provisions of 
Sec.  53.4940-1(c) through (f), with certain modifications. These final 
regulations delete the use of a cross reference to the regulations 
under section 4940(c) and instead prescribe specific rules that are 
similar to the rules of section 4940.
    Thus, consistent with section 4940(c) and Sec.  53.4940-1(e)(1)(i), 
Sec.  53.4968-2(c)(1)(i) of these final regulations explicitly states 
that there is allowed as a deduction from gross investment income all 
the ordinary and necessary expenses, including operating expenses, paid 
or incurred for the production or collection of gross investment income 
or for the management, conservation, or maintenance of property held 
for the production of such income, determined with the modifications 
described in part 6.b.ii of this Summary of Comments and Explanation of 
Revisions.
    An applicable educational institution's operating expenses related 
to its gross investment income may include compensation of officers, 
other salaries and wages of employees, outside professional fees, 
interest, and rental payments and taxes upon property used in the 
applicable educational institution's operations other than in its 
exempt activities. An applicable educational institution's operating 
expenses that are incurred both for investment and exempt purposes, 
such as salaries for officers or other employees, must be allocated 
between the investment and exempt activities of that institution on 
some reasonable basis. Similarly, consistent with Sec.  53.4940-
1(e)(1)(iii), in cases in which only a portion of property produces, or 
is held for the production of, income subject to the section 4968 
excise tax, and the remainder of the property is used for other 
purposes, the expenses are apportioned between the taxable and other 
uses. Furthermore, to

[[Page 65536]]

the extent an applicable educational institution's expenses are taken 
into account in computing the tax imposed by section 511, they are not 
deductible for purposes of computing the tax imposed by section 4968.
    Consistent with Sec.  53.4940-1(e)(1)(iii), no amount is allowable 
as a deduction to the extent it is paid or incurred for purposes other 
than the production or collection of gross investment income as 
determined for section 4968 purposes, or for the management, 
conservation, or maintenance of property held for the production of 
such income. Thus, for example, the charitable deduction prescribed 
under section 170 or 642(c), the net operating loss deduction 
prescribed under section 172, and certain special deductions for 
corporations under sections 241 through 250 prescribed under part VIII 
of subchapter B of chapter 1 of the Code (part VIII of subchapter B) 
are not allowable as a deduction in determining section 4968 net 
investment income. Taxes imposed under section 4968 are not paid or 
incurred for the production or collection of gross investment income.
ii. Modifications
    Consistent with section 4940(c) and Sec.  53.4940-1(e)(2), these 
final regulations provide that the following modifications must be made 
in determining deductions otherwise allowable under these final 
regulations, as explained in part 6.b.i of this Summary of Comments and 
Explanation of Revisions.
    First, consistent with section 4940(c)(3)(B)(i) and Sec.  53.4940-
1(e)(2)(i), a depreciation deduction is allowed, but only on the basis 
of the straight line method provided in section 168(b)(3) and without 
regard to paragraphs (1) and (2) of section 168(b).
    Second, consistent with section 4940(c)(3)(B)(ii) and Sec.  
53.4940-1(e)(2)(ii), a depletion deduction is allowed, but such 
deduction is determined without regard to sections 613 and 613A, 
relating to percentage depletion.
    Third, consistent with Sec.  53.4940-1(e)(2)(iii), basis to be used 
for purposes of calculating the deduction allowed for depreciation or 
depletion is the basis determined under the rules of part II of 
subchapter O of chapter 1 of the Code (part II of subchapter O), 
subject to the previously described modifications for calculating 
depreciation and depletion, and without regard to Sec.  53.4968-2(d)(2) 
(relating to the basis for determining gain for property held on 
December 31, 2017, and continuously thereafter to the date of 
disposition, discussed in part 6.c of this Summary of Comments and 
Explanation of Revisions) or section 362(c) (relating to certain 
contributions to capital). Thus, an applicable educational institution 
must reduce the cost or other substituted or transferred basis by an 
amount equal to the straight-line depreciation or cost depletion, 
without regard to whether the institution deducted such depreciation or 
depletion during the period prior to its first taxable year beginning 
after December 31, 2017. However, in cases in which an applicable 
educational institution has previously taken depreciation or depletion 
deductions in excess of the amount which would have been taken had the 
straight line or cost method been employed, such excess depreciation or 
depletion also is taken into account to reduce basis. If the facts 
necessary to determine the basis of property in the hands of the donor 
or the last preceding owner by whom it was not acquired by gift are 
unknown to a donee applicable educational institution, then the 
institution's original basis in such property is determined under the 
rules of Sec.  1.1015-1(a)(3).
    One commenter requested that the step-up rule for calculating gain 
upon the disposition of assets held on December 31, 2017 (discussed 
later in this Summary of Comments and Explanation of Revisions) also 
apply for purposes of calculating depreciation and depletion, stating 
that educational institutions, which are more likely than private 
foundations to hold on to depreciable assets, otherwise may be 
motivated to engage in self-help by selling assets they own and 
purchasing similar use assets in order to obtain depreciation 
deductions based on the current fair market value basis. These final 
regulations do not adopt such a rule because it would be contrary to 
section 4940(c) and applicable educational institutions do not seem to 
be distinguishable from private foundations on this issue.
    Fourth, consistent with Sec.  53.4940-1(e)(2)(iv), the deduction 
for expenses paid or incurred in any taxable year for the production of 
gross investment income, as determined for section 4968 purposes, 
earned as an incident to a charitable function can be no greater than 
the income earned from such function which is includible as gross 
investment income for such year. For example, where rental income is 
incidentally realized in a year from historic buildings held open to 
the public, deductions for amounts paid or incurred in that year for 
the production of such income is limited to the amount of rental income 
includible as gross investment income for the year.
c. Capital Gains and Losses
    The proposed regulations contained three special rules relating to 
capital gains and losses. First, consistent with Notice 2018-55, the 
proposed regulations substituted ``December 31, 2017'' for ``December 
31, 1969'' each place it appears in Sec.  53.4940-1(c)-(f), to provide 
a step-up in basis (if any) for purposes of calculating gain upon the 
sale or other disposition of assets held on December 31, 2017, and 
continuously thereafter to the date of disposition.
    Second, in response to a comment received in response to Notice 
2018-55, the proposed regulations provided that, if an applicable 
educational institution held an interest in a partnership (including 
through one or more tiers of partnerships) on December 31, 2017, and 
continuously thereafter, and the partnership held assets on December 
31, 2017, and continuously thereafter to the date of disposition, the 
partnership's basis in its assets with respect to the applicable 
educational institution for purposes of determining the applicable 
educational institution's share of gain upon sale or other disposition 
of the assets by the partnership will not be less than the fair market 
value of such asset on December 31, 2017, plus or minus all adjustments 
as provided under Sec.  53.4940-1(f)(2)(i) after December 31, 2017, and 
before the date of disposition. The proposed regulations stated that, 
to avail itself of this special partnership basis rule, an institution 
must obtain documentation from the partnership to substantiate the 
basis used.
    Third, the proposed regulations provided that, for purposes of 
Sec.  53.4940-1(f), overall net losses from sales or other dispositions 
of property by one related organization (or by the applicable 
educational institution) reduce (but not below zero) overall net gains 
from such sales or other dispositions by other related organizations 
(or by the applicable educational institution).
    The preamble to the proposed regulations stated that, consistent 
with the requirement in section 4968(c) to calculate net investment 
income under rules similar to the rules under section 4940(c), the 
proposed regulations generally followed the rules for determining gain 
upon the sale or other disposition of property that have been used for 
section 4940(c) purposes since 1969. The preamble further stated that 
section 4940(c)(1) provides that, except to the extent inconsistent 
with the provisions of section 4940, net investment income is 
determined under the principles of subtitle A. Subtitle A

[[Page 65537]]

encompasses all of the income tax provisions (sections 1 through 1564) 
of the Code, including the basis rules in section 1015 (basis of 
property acquired by gift generally is the donor's basis). Accordingly, 
under the proposed regulations, an applicable educational institution 
generally must calculate gain on the sale or other disposition of a 
lifetime gift of property using the donor's basis. However, the 
preamble to the proposed regulations requested comments on whether a 
special rule excluding from capital gain net income any appreciation in 
a gift of donated property that occurred before the date of receipt by 
the applicable educational institution should be included under the 
final regulations and how a special rule excluding from gain such pre-
donation appreciation would be consistent with the statutory language 
of section 4968.
    Commenters addressed several aspects of the proposed rules for 
capital gain net income, including the taxation of capital gain net 
income on the sale of exempt use property; capital gain net income on 
the sale of donated property; the step-up rule for assets held in a 
partnership on December 31, 2017; and whether capital loss carryovers 
should be allowed.
    In response to these public comments and as discussed in in more 
detail in part 6.c.i through iii of this Summary of Comments and 
Explanation of Revisions, these final regulations provide that (1) 
capital gain net income from the sale or exchange of property used by 
an institution for its exempt purpose is disregarded for the portion of 
the property that is used for the exempt purpose; (2) any appreciation 
in the value of donated property that occurred prior to the date of its 
donation to the institution is disregarded; and (3) capital loss 
carryovers are allowed but not capital loss carrybacks.
    Consistent with section 4940(c)(4)(A) and (D) and the proposed 
regulations, these final regulations also provide that in determining 
capital gain net income for purposes of the tax imposed by section 
4968, no gain or loss from the sale or other disposition of property is 
taken into account to the extent that such gain or loss is taken into 
account for purposes of computing the tax imposed by section 511.
i. Capital Gain Net Income on Sale of Exempt Use Property
    Two commenters recommended excluding from capital gain net income 
gain from the sale of exempt use property. One of the commenters stated 
that exempt use property is excluded from section 4968(b)(1)(D)'s 
calculation for determining the applicability of section 4968, and that 
it would thus be inconsistent to tax the educational institution on the 
sale of such property. This commenter also stated that taxing income 
that is derived directly from a college or university's exempt purpose 
assets is inconsistent with the intent of section 4968, which is aimed 
at investment income. The other commenter said that the proposed 
regulation's reference to Sec.  53.4940-1(f)(1) suggested such a 
result, but asked that the final regulations clarify this reading.
    Section 4940(c)(4)(A) was amended in 2006 \5\ to provide that 
``there shall not be taken into account any gain or loss from the sale 
or other disposition of property to the extent that such gain or loss 
is taken into account for purposes of computing the tax imposed by 
section 511.'' By implication, section 4940(c)(4)(A) thus provides that 
all gain or loss from the sale or other disposition of any and all 
property, other than any gain or loss that is taken into account for 
purposes of computing the tax imposed by section 511, is taken into 
account for purposes of section 4940(c).\6\
---------------------------------------------------------------------------

    \5\ The amendments to section 4940(c)(4)(A) were made by the 
Pension Protection Act of 2006, Public Law 109-280, and the Tax 
Technical Corrections Act of 2007, Public Law 110-172 (which 
conformed the language of section 4940(c)(4)(A) to the 2006 JCT 
Technical explanation).
    \6\ According to the JCT Technical explanation (JCX-38-06), the 
reason for amending section 4940(d)(4)(A) in 2006 and 2007 was that 
section 4940(c) does not provide for the blanket exclusion of gain 
or loss from the sale or other disposition of assets used for exempt 
purposes that was provided in the section 4940 regulations. Section 
53.4940-1(f)(1)), which has not been updated to reflect the 
amendments made in 2006 and 2007, provides that ``there shall be 
taken into account only capital gains and losses from the sale or 
other disposition of property held by a private foundation for 
investment purposes'' and ``gains and losses from the sale or other 
disposition of property used for the exempt purposes of the private 
foundation are excluded.'' (Emphasis added.) Although the section 
4940 regulations, which have not been revised since 1992, have not 
been revised to reflect the changes to section 4940(c)(4)(A) made in 
2006 and 2007, the current statute is clear that capital gain net 
income includes (and is intended to include) gain from property used 
by a private foundation for exempt purposes.
---------------------------------------------------------------------------

    Section 4968(c) provides that net investment income for purposes of 
section 4968 is determined under rules similar to the rules of section 
4940(c). Section 4940(c) was specifically amended in 2006 and 2007 to 
provide that capital gain net income is no longer limited only to 
property that was held for investment purposes and, instead, extends to 
all property held by a private foundation, including property used for 
exempt purposes. The only exceptions to this general rule are for ``any 
gain or loss from the sale or other disposition of property to the 
extent that such gain or loss is taken into account for purposes of 
computing the tax imposed by section 511'' and for certain like-kind 
exchange-type dispositions. See Section 4940(c)(4)(A) and (D).
    However, educational institutions as a general matter own more 
tangible property and more different types of tangible property used in 
the performance of their exempt purposes than a typical private 
foundation. Further, constantly changing and growing student 
populations, as well as new developments and innovations and needs in 
education and research, requires educational institutions to 
continually reevaluate their needs for property and possibly to replace 
or upgrade certain property. This process is likely to result in the 
need to sell assets in order to best serve the educational 
institution's exempt purposes. For instance, property such as 
residential and educational buildings, libraries, laboratories, and 
information technology assets often are sold as needs change. Income 
from such sales generally is reinvested in acquiring upgrades or 
replacements for that property, and therefore is integral to the 
performance of the exempt function of the institution, rather than for 
an investment purpose. Accordingly, these final regulations exclude 
from capital gain net income the gain from the sale or exchange of 
exempt use property for the portion of the property that is used for 
the exempt purpose.
ii. Capital Gain Net Income From the Sale of Donated Property
    Five commenters responded to the proposed regulations' request for 
comments on the calculation of capital gain net income from the sale of 
donated property, all recommending that any appreciation that occurred 
prior to an institution's receipt of the donated property be excluded 
from such gain. The commenters stated that the purpose of section 4968 
is to tax institutions on their own net investment income, not to tax 
donations, and that it would thus be inequitable to tax applicable 
educational institutions on the appreciation in value that occurred 
before the donee institution received the donation of a capital asset. 
Commenters also stated that donated property normally is not actually 
retained and held as an investment; instead, applicable educational 
institutions typically sell donated property as soon as possible. Thus, 
the gain upon sale of donated property often is attributable to the 
appreciation that occurred before the institution received the 
property.

[[Page 65538]]

    Three commenters noted that, although a private foundation must use 
the donor's transferred basis in computing any gain from the sale of 
donated property, a private foundation has the option of making gifts 
of appreciated property to section 501(c)(3) public charities by 
funding their grants in kind, resulting in no excise or income tax 
being imposed on either organization when the property eventually is 
sold. These commenters stated that it would be difficult for applicable 
educational institutions to take advantage of this strategy. One 
commenter opined that private foundations generally are able to time 
their sales to offset losses more efficiently than educational 
institutions can. The commenter asserted that the substantially higher 
operational expenses of an educational institution sometimes require 
that institution to sell a donated asset upon receipt. The commenter 
also opined that, because these donated assets are not retained for 
investment purposes, they do not produce net investment income.
    All commenters stated that the requirement to obtain a donor's 
basis information will be administratively burdensome. Unlike private 
foundations, which typically receive donations from a small number of 
known donors, applicable educational institutions receive a large 
number of donations from a wide variety of donors. In many cases, 
institutions will be unable to determine (or verify) the transferred 
basis under section 1015 of the donated property. Further, the 
commenters stated, requesting donors to provide their basis information 
could negatively affect an applicable educational institution's 
relationships with donors.
    One commenter stated that applicable educational institutions could 
work around this issue by encouraging donors to donate any appreciated 
property to a donor advised fund that then could sell the property and 
contribute the cash proceeds to the institution.
    The Treasury Department and the IRS agree that the differences 
between applicable educational institutions and private foundations 
with respect to donations of property justify a rule under section 4968 
that is different from the treatment found in section 4940(c) for the 
treatment of the capital gain net income of property donated to a 
private foundation. In addition, such a rule will increase 
administrability for both taxpayers and the IRS by removing the 
requirement to determine the donor's basis of the donated property. 
Furthermore, it will avoid placing different applicable educational 
institutions receiving stock of equal value but with different bases in 
different positions with regard to the computation of their respective 
net investment income merely from receiving the donated property.
    Accordingly, these final regulations provide that any appreciation 
in the value of donated property that occurred prior to the date of 
donation to the applicable educational institution is disregarded in 
calculating gain for purposes of section 4968. This special rule does 
not, however, change the transferred basis of the donated property; 
thus, an applicable educational institution must obtain the transferred 
basis of donated property under section 1015 for purposes of claiming a 
loss upon its sale or other disposition or for purposes of calculating 
depreciation or depletion.
    One commenter requested that the final regulations recognize that a 
college or university that disposes of contributed property at the 
first reasonable opportunity is not holding such property for 
investment purposes and, accordingly, exclude all of the proceeds from 
the sale of such contributed property from capital gain. The same 
commenter suggested a safe harbor under which property disposed of 
within 30 days of receipt would be treated as having been disposed of 
at the first reasonable opportunity. These final regulations do not 
adopt either suggestion, because there is no analog in section 4940(c) 
or in any other provision of the Code. Furthermore, any cut off would 
be arbitrary and there is no justification for why one day versus 
another day should not result in the recognition of gain. While these 
final regulations disregard any appreciation that occurred prior to an 
institution's receipt of the donated property, appreciation that occurs 
after an institution's receipt of the donated property is included in 
net investment income. For consistency with the rules applicable to 
charitable deductions, the date of donation is determined under the 
timing rules of Sec.  1.170A-1(b) and the value on the date of donation 
is determined under the valuation rules of Sec.  1.170A-1.
iii. Capital Loss Carryovers
    One commenter requested that capital loss carryovers be allowed. 
This commenter represented that a private grant-making foundation, to 
the extent it has satisfied its minimum distribution requirements, can 
easily curtail its spending (and the realization of capital gains while 
converting investment assets to cash) by issuing fewer or smaller grant 
awards to manage its section 4940 tax liability. The commenter 
contrasted such a foundation with an educational institution that 
typically has a large operating budget with significant 
nondiscretionary expenses related to employees and infrastructure and 
must find ways to meet its ongoing cash needs, which may involve 
selling investments at particular times that may not be advantageous 
from an investment or tax perspective.
    Although section 4940(c) explicitly allows losses from sales or 
other dispositions of property only to the extent of gains from such 
sales or other dispositions, and does not allow capital loss carryovers 
or carrybacks, the commenter represented that, given the differences 
between private foundations and educational institutions, the allowance 
of capital loss carryovers is necessary to achieve outcomes for 
educational institutions under section 4968 that are ``similar to'' the 
outcomes for private foundations under section 4940(c).
    The Treasury Department and the IRS acknowledge that there are 
various and notable differences between private foundations subject to 
section 4940(c) and educational institutions in their missions, 
functions, and operating expenses. Therefore, based on a general 
understanding, as further informed by commenters, of the way 
educational institutions manage both their substantial, 
nondiscretionary operating expenses in furthering their exempt purposes 
and their investment activities, these final regulations allow the use 
of capital loss carryovers.
    Accordingly, these final regulations adopt the rule in the proposed 
regulations that overall net losses from sales or other dispositions of 
property by one related organization (or by the applicable educational 
institution) reduce (but not below zero) overall net gains from such 
sales or other dispositions by other related organizations (or by the 
applicable educational institution). In addition, these final 
regulations adopt the rule in the proposed regulations that, should 
overall net losses from sales or other dispositions of property exceed 
gains from sales or other dispositions of such property during the same 
taxable year, such excess may not be deducted from gross investment 
income in any taxable year, nor may such excess be used to reduce gains 
in prior taxable years. However, the final regulations provide that 
capital loss carryovers are allowed and may be deducted from capital 
gains in a future year.

[[Page 65539]]

d. Basis
    These final regulations provide rules for determining basis or a 
substitute for basis (in the context of section 4968) for purposes of 
determining (1) gain from the sale or other disposition of property 
other than a partnership interest; (2) a distributive share of gain 
from the sale or other disposition of an asset held in a partnership; 
(3) gain on the sale of a partnership interest; and (4) loss.
i. Basis for Purposes of Determining Gain From the Sale or Other 
Disposition of Property Other Than a Partnership Interest
    Consistent with the proposed regulations and with section 4940(c), 
these final regulations provide that the basis for purposes of 
determining gain from the sale or other disposition of property (other 
than a partnership interest) is generally the greater of (1) fair 
market value of the property on December 31, 2017, plus or minus all 
adjustments after December 31, 2017, and before the date of its 
disposition under the rules of part II of subchapter O, provided that 
the property was held by the applicable educational institution on 
December 31, 2017, and continuously thereafter to the date of its 
disposition, or (2) basis as determined under the rules of part II of 
subchapter O, subject to the three modifications described at the 
beginning of part 6.b.ii. of this Summary of Comments and Explanation 
of Revisions (referring to the modifications relating to deductions 
against gross investment income). See parts 6.d.ii. and 6.e. of this 
Summary of Comments and Explanation of Revisions for special rules 
regarding determining a distributive share of capital gain from the 
sale or other disposition of an asset held in a partnership and on the 
sale of a partnership interest.
ii. Basis for Purposes of Determining a Partner's Distributive Share of 
Gain From the Sale or Other Disposition of an Asset Held in a 
Partnership and Gain From the Sale or Other Disposition of a 
Partnership Interest
    The proposed regulations provided that if an applicable educational 
institution held an interest in a partnership (including through one or 
more tiers of partnerships) on December 31, 2017, and continuously 
thereafter, and the partnership held an asset on December 31, 2017, and 
continuously thereafter to the date of disposition by the partnership, 
the partnership's basis in such asset (for purposes of determining the 
applicable educational institution's share of gain upon sale or other 
disposition of that asset) is not less than the fair market value of 
such asset on December 31, 2017, plus or minus all adjustments as 
provided under Sec.  53.4940-1(f)(2)(i) after December 31, 2017, and 
before the date of disposition.
    Four commenters addressed the requirement in the proposed 
regulations that, for purposes of applying this rule, an applicable 
educational institution must obtain documentation from the partnership 
to substantiate the basis used. The commenters stated that, while an 
applicable educational institution can obtain documentation to 
establish its basis in its partnership interest (outside basis) as of 
December 31, 2017, obtaining documentation to establish its share of 
the basis of each partnership asset (inside basis) would be extremely 
burdensome and that an asset-by-asset determination of gain might, 
therefore, not be possible.
    The commenters stated that applicable educational institutions 
often hold interests in hundreds of partnerships, many with numerous 
investors, that may involve multiple tiers of flow-through entities, 
and that applicable educational institutions generally are passive 
investors in these partnerships. Commenters stated that it would be 
very difficult, if not impossible, for applicable educational 
institutions to obtain the required basis documentation from all the 
partnerships, especially because there is no requirement for 
partnerships to provide such documentation and because reporting from 
partnerships generally is done on an aggregate basis and not on an 
asset-by-asset basis. Commenters added that many partnerships may not 
even be aware that their partners include an applicable educational 
institution.
    The commenters recommended that the substantiation rule in the 
proposed regulations be removed and that an applicable educational 
institution instead be allowed to determine the amount of built-in gain 
in the applicable educational institution's share of partnership assets 
using any reasonable method. Two commenters recommended a method, 
described in part 6.e. of this Summary of Comments and Explanation of 
Revisions, that would use the difference between fair market value and 
outside basis of a partnership interest on December 31, 2017, to 
approximate the amount of cumulative built-in gain in an applicable 
educational institution's share of partnership assets on such date.
    The Treasury Department and the IRS recognize the problem described 
by commenters with regard to the proposed substantiation rule and agree 
that another approach for determining the amount of built-in gain in 
partnership assets solely for purposes of applying section 4968 would 
be appropriate in alleviating the problem. Accordingly, these final 
regulations remove the proposed substantiation rule and eliminate the 
need to determine a step-up in a partner's share of bases in 
partnership assets for purposes of section 4968. As a result, the bases 
of partnership assets on December 31, 2017, are not stepped up for 
purposes of section 4968. Rather, for purposes of determining an 
applicable educational institution's share of gain upon the sale or 
other disposition of an asset held in a partnership, these final 
regulations provide that the applicable educational institution's basis 
in each partnership asset generally is determined under the rules of 
subchapter K of chapter 1 of the Code (subchapter K), but also provide 
a method, more fully described in part 6.e. of this Summary of Comments 
and Explanation of Revisions, which generally enables an applicable 
educational institution to offset its distributive share of capital 
gain net income from partnership asset dispositions by a portion of the 
built-in gain in the applicable educational institution's interest in 
the partnership as of December 31, 2017.
    These final regulations provide a similar rule for determining an 
applicable educational institution's gain upon the sale or other 
disposition of all or a portion of a partnership interest.
iii. Basis for Purposes of Calculating Loss
    Consistent with the proposed regulations and with section 4940(c), 
for purposes of determining loss from the sale or other disposition of 
property, basis is determined under the rules of part II of subchapter 
O, subject to the modifications of part 6.b.ii. of this Summary of 
Comments and Explanation of Revisions (referring to the modifications 
relating to depreciation and depletion deductions against gross 
investment income). For purposes of determining loss from the sale or 
other disposition of a partnership interest, basis is determined under 
the rules of subchapter K.
e. Special Rules Regarding Partnership Interests and Partnership Assets
    As described in part 6.d.ii. of this Summary of Comments and 
Explanation of Revisions, commenters stated that it would be very 
difficult, if not impossible, for institutions to obtain the basis 
documentation necessary to apply the partnership asset basis step-up 
rule provided in the proposed regulations.

[[Page 65540]]

As an alternative, two commenters recommended a method that would use 
the difference between the fair market value and outside basis of an 
applicable educational institution's partnership interest on December 
31, 2017, to approximate the difference between the fair market value 
and inside basis of, and thus the amount of built-in gain in, the 
applicable educational institution's share of partnership assets on 
such date. The commenters stated that the difference between fair 
market value and tax basis of an applicable educational institution's 
partnership interest on December 31, 2017, generally should reflect the 
amount of the applicable educational institution's built-in gain in its 
share of the partnership's assets on such date, and that, because 
educational institutions should know the fair market values and tax 
bases of their partnership interests on December 31, 2017, they should 
be able to calculate the built-in gain in their partnership interests 
as of December 31, 2017.
    Specifically, the commenters recommended that an applicable 
educational institution should be allowed to offset the distributive 
share of partnership capital gain net income after December 31, 2017, 
allocated by a partnership by the amount of the built-in gain the 
applicable educational institution had in its partnership interest, 
determined as of December 31, 2017. Under the commenters' approach, an 
applicable educational institution would determine its built-in gain in 
a partnership interest as of December 31, 2017, and then not report any 
capital gain allocated from that partnership after December 31, 2017, 
as being subject to section 4968 until the cumulative amount of such 
excluded gain equals the amount of built-in gain in the interest. The 
commenters recommended that this rule be applied on a partnership-by-
partnership basis and be available to reduce the amount of an 
applicable educational institution's capital gain net income on a 
first-recognized basis.
    For the reasons described in part d.ii of this Summary of Comments 
and Explanation of Revisions, these final regulations adopt an approach 
that is similar to the approach recommended by the commenters in regard 
to determining an applicable educational institution's distributive 
share of gain allocated from a partnership (partnership asset 
disposition rule), as well as adding a partnership interest disposition 
rule. These final regulations provide that, for each partnership 
interest an applicable educational institution held on December 31, 
2017, the applicable educational institution may determine an 
unadjusted step-up amount that is equal to the excess, if any, of the 
fair market value of such partnership interest on December 31, 2017, 
over the adjusted basis of such partnership interest on December 31, 
2017. Then, for purposes of computing net investment income for taxable 
years beginning after December 31, 2017, an applicable educational 
institution will reduce its distributive share of capital gain net 
income from such partnership by the least of (1) the applicable 
educational institution's share of applicable capital gain from such 
partnership (that is, both short-term and long-term capital gain for 
the first taxable year after December 31, 2017, but only long-term 
capital gains and losses for subsequent years because short-term 
capital gains and losses in such years could not have been included in 
the amount of outside built-in gain as of December 31, 2017); (2) one-
third of the applicable educational institution's unadjusted step-up 
for such partnership; or (3) the applicable educational institution's 
adjusted step-up for such partnership (which, in general, is its 
unadjusted step-up reduced by any capital gain that was previously 
excluded pursuant to the partnership asset disposition rule or the 
partnership interest disposition rule described in this paragraph).
    These final regulations do not apply the capital gain net income 
reduction rule on a first-recognized basis, as recommended by the 
commenters. The excess of fair market value over tax basis of a 
partnership interest on December 31, 2017, may reflect built-in gain in 
partnership assets that would not be included in net investment income 
for purposes of section 4968--for example, ordinary income property. 
Additionally, application of the rule to offset all first-recognized 
capital gain net income in determining the educational institution's 
net investment income could provide a benefit to applicable educational 
institutions that would be inconsistent with the purpose of section 
4968 by permitting a reduction in capital gain net income subject to 
section 4968 that is attributable to a partnership asset both acquired, 
and disposed of, after December 31, 2017. Accordingly, these final 
regulations adopt a middle ground position that spreads the exclusion 
without burdensome asset-by-asset matching by providing that the 
maximum amount of an applicable educational institution's capital gain 
net income from a partnership that may be excluded in any given year 
cannot exceed one-third of the applicable educational institution's 
unadjusted step-up for such partnership.
    Commenters did not provide a recommendation for coordinating the 
partnership asset disposition rule with a partnership interest 
disposition rule. However, consistent with permitting an applicable 
educational institution to offset its distributive share of capital 
gain net income from partnership asset dispositions, these final 
regulations also provide a capital gain net income reduction rule in 
the context of a sale or other disposition of all or a portion of a 
partnership interest. These final regulations provide that, for 
purposes of computing net investment income, an applicable educational 
institution reduces the amount of its capital gain net income upon the 
sale or other disposition of all or a portion of a partnership interest 
by an amount that bears the same relation to the applicable educational 
institution's adjusted step-up for such partnership as the fair market 
value of the transferred portion of the interest bears to the fair 
market value of the applicable educational institution's entire 
interest in such partnership before the sale or other disposition.

7. Related Organizations

    Section 4968(d)(1) provides, in part, that the assets and net 
investment income of any related organization with respect to an 
educational institution are to be treated as assets and net investment 
income, respectively, of the educational institution. To determine 
which assets of a related organization are included by section 
4968(b)(1)(D) for a particular year, an educational institution 
determines which organizations are related organizations, as defined in 
section 4968(d)(2), as of the end of the educational institution's 
preceding taxable year, and values the relevant assets on that date. To 
determine the amount of net investment income of a related organization 
that is included by the applicable educational institution in 
calculating the tax imposed by section 4968(a) for a particular taxable 
year, an applicable educational institution determines which 
organizations are related organizations, as defined in section 
4968(d)(2), as of the end of that taxable year of the applicable 
educational institution and includes the net investment income from 
each related organization's tax year that ends with or within that same 
taxable year of the applicable educational institution. If an 
organization becomes a related organization within the applicable 
educational institution's taxable year

[[Page 65541]]

and remains a related organization as of the end of the taxable year, 
then the applicable educational institution includes the organization's 
net investment income for the portion of the year that it was a related 
organization, using any reasonable method.
    The statute provides two exceptions to the rules for including 
assets and net investment income of a related organization as assets 
and net investment income of the educational institution: (1) No such 
amount is to be taken into account with respect to more than one 
educational institution, and (2) unless the related organization is 
controlled by the institution or is described in section 509(a)(3) 
(relating to supporting organizations) with respect to the institution 
for the taxable year, assets and net investment income that are not 
intended or available for the use or benefit of the institution are not 
to be taken into account by it. Section 53.4968-3 of these final 
regulations provides definitions and special rules relating to related 
organizations.
a. Definition of Related Organization
    Under section 4968(d)(2), the term ``related organization'' means, 
with respect to an educational institution, any organization that (1) 
controls the educational institution; (2) is controlled by the 
educational institution; (3) is controlled by one or more persons that 
also control the educational institution; (4) is a supported 
organization (as defined in section 509(f)(3)) with respect to the 
educational institution during the taxable year; or (5) is a supporting 
organization (as described in section 509(a)(3)) with respect to the 
educational institution during the taxable year.
    The first three categories of related organizations require control 
of an organization, but the statute does not define the term 
``control.'' Furthermore, whether the educational institution is the 
controlling or controlled entity matters because if the related 
organization controls the educational institution, or is controlled by 
one or more persons that also control the educational institution, then 
assets and net investment income of the related organization that are 
not intended or available for the use or benefit of the educational 
institution are not taken into account. In contrast, if a related 
organization is controlled by an educational institution, then all the 
assets and net investment income of the related organization are taken 
into account by the educational institution, with the exception that 
the same assets are not taken into account by more than one educational 
institution.
    The proposed regulations provided a definition of control derived 
from section 512(b)(13)(D) and the regulations thereunder, consistent 
with the definition of control contained in Notice 2019-09, ``Interim 
Guidance Under Section 4960'' (2019-04 I.R.B. 403), and requested 
comments on whether there were any circumstances in which this proposed 
definition of control should be modified in the context of section 
4968.
    Specifically, the proposed regulations defined control as: (1) In 
the case of a corporation, ownership (by vote or value) of more than 50 
percent of the stock of the corporation; (2) in the case of a 
partnership, ownership of more than 50 percent of the profits interests 
or capital interests in such partnership; (3) in the case of a trust 
with beneficial interests, ownership of more than 50 percent of the 
beneficial interests in the trust; or (4) in the case of a nonprofit 
organization or other organization without owners or persons having 
beneficial interests (nonstock organization), including a governmental 
entity, (a) more than 50 percent of the directors or trustees of the 
educational institution or nonstock organization are either 
representatives of, or are directly or indirectly controlled by, the 
other entity or (b) more than 50 percent of the directors or trustees 
of the nonstock organization are either representatives of, or are 
directly or indirectly controlled by, one or more persons that control 
the educational institution. For this purpose, a ``representative'' 
means a trustee, director, agent, or employee, and ``control'' includes 
the power to remove a trustee or director and designate a new trustee 
or director. Finally, the proposed regulations stated that section 318, 
which contains rules for determining constructive ownership of stock, 
applies for purposes of determining ownership of stock in a 
corporation, and similar principles apply for purposes of determining 
ownership of an interest in any other entity.
    Commenters stated generally that use of the proposed definition of 
``control'' would result in educational institutions' being required to 
take into account assets and net investment income that the educational 
institutions do not actually control and that they will never receive 
because the assets and income actually belong to unrelated third 
parties. The commenters also stated that such a rule is inconsistent 
with Congressional intent to include assets and income of related 
organizations only when the educational institution actually has 
control over the use of the related organization's assets and net 
investment income, and would not address Congressional concerns that 
educational institutions might attempt to avoid the section 4968 excise 
tax by holding assets in structures that, as compared to direct 
ownership, represent a difference in form but not substance.
    More specifically, commenters stated that entities under common 
control with an educational institution could be deemed to be 
controlled by the educational institution, contrary to reality and thus 
inappropriately inflating the net investment income of the educational 
institution. In addition, the commenters stated that including 
controlled taxable entities, partnerships, split interest trusts, and 
employee benefit plans as related organizations for purposes of section 
4968 would lead to double or triple taxation.
    Parts 7.a.i. through v. of this Summary of Comments and Explanation 
of Revisions address entities that commenters recommended disregarding 
in applying the related organization provisions of section 4968(d): 
Taxable corporations; partnerships and other pass-through entities; 
certain trusts; employee benefit plans; and decedent's estates. Part 
7.b of this Summary of Comments and Explanation of Revisions describes 
the rules for determining whether an educational institution will be 
considered to ``control'' an entity that is not disregarded for 
purposes of section 4968(d). Part 7.c of this Summary of Comments and 
Explanation of Revisions addresses the application of the rule that 
assets and net income of a controlled entity will be treated as the 
assets and net income of only one educational institution. Part 7.d of 
this Summary of Comments and Explanation of Revisions addresses the 
application of the rule that assets and net investment income of 
certain related organizations that are not intended or available for 
the use or benefit of an educational institution are not taken into 
account by the institution.
i. Taxable Corporations
    The preamble to the proposed regulations stated that, because the 
net investment income that a taxable entity distributes or transfers to 
an educational institution has already been taxed, the Treasury 
Department and the IRS did not consider it consistent with 
Congressional intent to tax the income again under section 4968. 
Furthermore, with regard to the assets of a taxable corporation that is 
a related organization, the educational institution likely already has 
included the value of the shares of the corporation's stock that it 
owns in its non-exempt use assets; however, the stock value may differ

[[Page 65542]]

from the value of the taxable corporation's underlying assets. The 
proposed regulations requested comments on how to account for this 
difference without double-counting the assets, as well as more general 
comments on the treatment of taxable entities that may be related 
organizations for purposes of section 4968.
    Commenters agreed that educational institutions should not be 
required to take into account the net investment income of a related 
organization that is a taxable entity, stating that this would result 
in double, and sometimes triple, taxation (U.S. Federal income tax at 
the entity level on the taxable entity's income; section 4968 tax on 
any payments of net investment income by a taxable entity to the 
educational institution; and section 4968 tax on the net investment 
income of the controlled taxable entity that is treated as the 
institution's income under section 4968(d)). Furthermore, the 
commenters said that the value of the educational institution's 
holdings in the taxable entity would already be reflected on the 
educational institution's books, and, if the educational institution 
owned more than 50 percent, but less than 100 percent, of the taxable 
entity, the proposed definition would attribute to the institution 
income and assets that actually belong to unrelated third parties.
    To prevent this multiple taxation of a taxable entity's net 
investment income and to prevent overcounting of a taxable entity's 
assets, these final regulations exclude from the definition of 
``related organization'' a taxable corporation and, as described in 
part 7.a.iii. of this Summary of Comments and Explanation of Revisions, 
taxable trusts, in each case whether foreign or domestic.
    The Treasury Department and the IRS note that any investment-type 
income that is paid to an educational institution by a taxable entity 
(such as interest on money loaned by the institution to the taxable 
entity) is included in net investment income for purposes of section 
4968(c) in the same manner as any other such investment-type income 
received by an institution from any other entity, regardless of whether 
the other entity is or is not controlled by the institution. In 
addition, for purposes of section 4968(b)(1)(D), the value of the 
educational institution's interest in a taxable entity is based on the 
fair market value of the interest on the last day of the preceding 
taxable year, rather than on the book value of the interest reflected 
on the educational institution's books and records.
ii. Partnerships and Other Pass-Through Entities
    Commenters stated that the proposed regulations' definition of 
control of partnerships (i.e., that ownership of more than 50 percent 
of the profits interest or capital interest in a partnership would 
result in the educational institution's being deemed to control the 
partnership), likewise would result in double taxation (section 4968 
tax on the net investment income that is allocated to the educational 
institution by the partnership and section 4968 tax on the net 
investment income of the partnership that is treated as the 
institution's income under section 4968(d)), which is inconsistent with 
the principles of subchapter K. Furthermore, the value of the 
educational institution's interest in the partnership already would be 
reflected on the educational institution's books, and, if the 
educational institution owns more than 50 percent, but less than 100 
percent, of the profits interest or capital interest in such 
partnership, the proposed definition would attribute to the institution 
income and assets that actually belong to other partners, including 
unrelated third parties.
    One commenter stated that an educational institution often is a 
limited partner in an investment partnership and asked that the final 
regulations provide that an educational institution that is a limited 
partner in a partnership not be treated as controlling the partnership 
for purposes of section 4968. This commenter added that, even if an 
educational institution served as the general partner of a partnership, 
it would have limited powers to change equity holders' entitlements to 
the partnership income and thus would not control all of the income or 
assets of the partnership.
    To prevent double taxation of a partnership's net investment income 
and overcounting of its assets, these final regulations exclude from 
the definition of ``related organization'' a partnership, S 
corporation, or other pass-through entity a portion of whose income 
flows through to the educational institution.
    The Treasury Department and the IRS note that any net investment 
income that flows through to an educational institution is included in 
that institution's net investment income for purposes of section 
4968(c). In addition, for purposes of section 4968(b)(1)(D), the value 
of an educational institution's partnership interest is the fair market 
value of the institution's partnership interest on the last day of the 
preceding taxable year, rather than the book value of that interest 
carried on the educational institution's books and records.
iii. Certain Trusts
    Multiple commenters stated that the proposed regulations' 
definition of control of trusts, which provided that ownership of more 
than 50 percent of the beneficial interests in a trust results in an 
educational institution being deemed to control the trust, would lead 
to inequitable results. In particular, commenters recommended excluding 
split-interest trusts described in section 4947(a)(2) from the 
definition of related organization, stating that, with respect to 
charitable remainder trusts, an educational institution generally is 
not able to receive any benefit, and cannot use assets in the trust, 
until the termination of the interests of the income beneficiaries 
(which may be decades into the future). This is true even if the value 
of the educational institution's interest in the trust exceeds 50 
percent of the present value of all beneficial interests in the trust. 
In addition, even though it is unlikely that an educational institution 
would receive any income from such a trust while the grantor is alive, 
income paid from a split-interest trust is not considered net 
investment income for purposes of section 4940(c) (see Notice 2004-35), 
and it seems inconsistent to treat income that would not be net 
investment income if it were received directly from the trust to be 
treated as net investment income when not received from the trust. 
Further, it seems inequitable and contrary to Congressional intent to 
tax an educational institution on income that is paid to the grantor or 
other non-charitable beneficiary during the grantor's lifetime. 
Finally, it would be difficult for an educational institution to obtain 
information about the income of a split-interest trust, as there is 
currently no Federal requirement for a split-interest trust to report 
this information to its remainder beneficiary(ies).
    One commenter recommended that the final regulations provide that a 
charitable remainder trust is within the control of the institution 
only if the institution (1) has a vested remainder interest of at least 
50 percent of all actuarial interests in the trust, (2) serves as the 
trustee of the trust, and (3) under the terms of the trust document, 
has the right as trustee to make distributions from the trust to itself 
as a charitable organization.
    The Treasury Department and the IRS considered whether the present 
value of an educational institution's share of the remainder assets of 
a charitable

[[Page 65543]]

remainder trust should be included as assets of the institution for 
purposes of the $500,000-of-assets-per-student test in section 
4968(b)(1)(D), given that such assets can demonstrate creditworthiness 
and because money is fungible. However, the Treasury Department and the 
IRS have determined that, for ease of administrability for both 
educational institutions and the IRS, and in view of the risk that, as 
a result of market forces, the remainder eventually received by the 
educational institution could be significantly less than its present 
value each year, an educational institution will not count the assets 
of a charitable remainder trust as its own assets until the educational 
institution actually becomes entitled to those assets at the 
termination of the interest of the income beneficiary. If this were not 
the rule, an educational institution would have to determine annually 
its share of the fair market value of the assets of each charitable 
remainder trust for which the educational institution is a remainder 
beneficiary, even though the educational institution might not know it 
had a remainder interest in all cases, the educational institution's 
remainder interest could be given to another charity in some instances, 
and the educational institution might not receive its remainder 
interest if the trust's investment returns turn out to be insufficient 
for the trust to possess any assets at the termination of the interests 
of the income beneficiaries. An educational institution similarly would 
have difficulty determining such a trust's net investment income. 
Therefore, these final regulations provide that a charitable remainder 
trust is not considered to be a related organization for purposes of 
section 4968(d).
    An educational institution will not be a remainder beneficiary of a 
charitable lead trust. Instead, some portion of the trust's income is 
payable currently to one or more charities for a term, after which the 
remaining assets of the trust will be payable to noncharitable 
beneficiaries. Thus, an educational institution does not have any right 
to or interest in the principal or remainder of such a trust. As an 
income beneficiary of a charitable lead trust, any income payable 
currently to an educational institution will be included in the 
institution's net investment income for the current year. (This is true 
whether the trust is a grantor trust (whose income is taxed to the 
deemed owner of the trust and for which there is no current income tax 
deduction for the current distribution to charity) or a nongrantor 
trust (whose income is taxed to the trust itself, subject to a 
charitable deduction).) Thus, because the assets of a charitable lead 
trust are not available to the educational institution, and its net 
investment income is already included in the educational institution's 
assets and net investment income as received, the final regulations 
exclude charitable lead trusts from the definition of a related 
organization.
    In addition, because there are only limited circumstances in which 
the educational institution would have sufficient control over a trust 
to justify treating the trust as a related organization, the final 
regulations also exclude all other taxable trusts from the definition 
of a related organization except to the extent the educational 
institution is deemed to control the trust, as provided in part 
7.b.ii.B of this Summary of Comments and Explanation of Revisions.
iv. Employee Benefit Plans
    Commenters stated that various retirement and benefit plans 
(including but not limited to section 403(b), section 457, voluntary 
employees' beneficiary associations (VEBAs) under section 501(c)(9), 
and defined benefit plans), should be excluded from the definition of 
related organization for purposes of section 4968(d), stating that the 
beneficiaries of these plans are employees of the educational 
institutions and it was not the intent of Congress to tax the 
investment income of these entities. One commenter also asked that 
other assets that are set aside or dedicated by an educational 
institution to pay for the institution's commitment to provide certain 
employee benefits be excluded from the definition of related 
organization.
    These final regulations base the determination of whether assets 
held by or related to an employee benefit plan of an educational 
institution are considered assets of the educational institution on 
whether the arrangement is considered to be a funded or nonfunded plan. 
An employer's obligation to pay an employee benefit generally is 
considered to be ``funded'' when the assets are set aside from the 
employer exclusively to provide for the employees' benefits in a manner 
that the assets are no longer subject to claims of the employer's 
general creditors and may not revert back to the employer's general 
assets for use by the employer. See Sproull v. Commissioner, 16 T.C. 
244 (1951), aff'd per curiam, 194 F.2d 541 (6th Cir. 1952). For 
example, contributions to the section 501(a) trust of a section 401(a) 
qualified retirement plan are considered to fund the obligation to 
provide employees' future retirement benefits. Similarly, a section 
403(b)(1) annuity contract or amounts held in a section 403(b)(7) 
custodial account are considered to ``fund'' the obligation to pay 
employees' section 403(b) retirement benefits. In each of these cases, 
the assets held in the trust, contract, or account are considered to be 
set aside to ``fund'' the employer's benefit obligation and are not 
treated as assets of the employer. Further, amounts held in a section 
419(e) welfare benefit fund (including a VEBA) are set aside to provide 
welfare benefits for employees, are not subject to the claims of 
general creditors, and would not be treated as assets of the employer 
or as assets of a related organization.
    In contrast, plans under section 457 are unfunded because funds are 
not set aside for the purpose of providing benefits to plan 
participants in a manner that would result in a ``funded'' obligation 
to provide benefits under the plan. Under section 457(b)(6), assets 
held pursuant to an eligible deferred compensation plan, including 
amounts held in a grantor trust, must remain solely the property and 
rights of the employer and would be subject to the claims of the 
employer's general creditors. See Sec.  1.457-8(b)(2). Similarly, 
amounts set aside by an eligible employer intended to pay for benefits 
under an ineligible section 457(f) plan, including assets set aside in 
a grantor trust, are treated as assets of the employer and subject to 
the claims of the employer's general creditors. Accordingly, assets set 
aside and held by an educational institution, including in a grantor 
trust, to be used to pay the employees' benefits under an educational 
institution's section 457(b) or section 457(f) plan are considered 
assets of the educational institution. As a result, these final 
regulations provide that a grantor trust or other financing vehicle 
used in connection with these unfunded plans is a ``related 
organization'' for purposes of section 4968(d), and its assets will be 
treated as the assets of the educational institution. The Treasury 
Department and the IRS note that, because assets in an unfunded plan 
are available to the employer just like any other assets, they are not 
considered ``used directly in carrying out the institution's exempt 
purpose'' for purposes of section 4968(b)(1)(D).
    Other unfunded employee benefits, such as a typical health flexible 
spending arrangement (health FSA) or accrued leave cashout program, 
have no related grantor trust or other financing vehicle but instead 
use the employer's general assets as a source of payment. Any general 
assets that are used to satisfy benefit obligations are

[[Page 65544]]

considered assets of the employer. Thus, if the employer is an 
educational institution or is a related organization with regard to an 
educational institution, such assets are considered to be assets of the 
educational institution, and no special rule is needed in the 
regulations.
    Solely for purposes of determining the status of an employee 
benefit plan as a funded or unfunded arrangement, an educational 
institution and all of its related organizations are treated as a 
single sponsor and payor of the benefits.
v. Decedents' Estates
    A few commenters asked that the final regulations clarify that 
decedents' estates are not ``related organizations'' under section 
4968(d). Commenters stated that, because a decedent's estate is a 
separate legal entity created at a person's death, it should not be 
considered a related organization under section 4968(d), and, in any 
case, an educational institution would not be in a position to control 
a decedent's estate. The Treasury Department and the IRS agree, and to 
eliminate any question for purposes of section 4968, these final 
regulations provide that a decedent's estate is not a related 
organization. However, the Treasury Department and the IRS note that 
any assets of an estate that ultimately are transferred to an 
educational institution will be considered the educational 
institution's assets upon receipt by the institution.
b. Control
    As stated in part 7.a of this Summary of Comments and Explanation 
of Revisions, the first three categories of related organizations 
described in section 4968(d)(2) require the presence of an element of 
control to exist for an organization to be considered to be ``related'' 
to an educational organization, but the statute does not define the 
term ``control.'' The proposed regulations provided a definition of 
control based on section 512(b)(13)(D) and the regulations thereunder 
and requested comments on whether there are any circumstances in which 
this definition of control should be modified in the context of section 
4968.
    Commenters asserted that the proposed definition of control would 
lead to unintended and undesirable results. For example, commenters 
stated that the downward attribution rules of section 318 would cause 
all brother/sister organizations of an educational institution to be 
considered to be controlling each other and that an educational 
institution controlled by a church could be deemed to own all the 
assets of the church or the assets of another, unrelated church just 
because the two churches were invested in the same investment 
partnership.
    The proposed regulation's definition of control did not 
differentiate between an educational institution's control of another 
organization or another organization's control of an educational 
institution. The Treasury Department and the IRS recognize that the 
types of entities that would be deemed to control an educational 
institution under the proposed rule are likely to be very different 
from those that would be controlled by an educational institution. In 
addition, the direction of control matters for purposes of determining 
whether all the assets and net investment income of a related 
organization are attributable to the educational institution or whether 
only the assets and net investment income that are intended or 
available for the use or benefit of the educational institution are 
attributable to the educational institution. Accordingly, these final 
regulations provide separate rules for the different relationships that 
may exist. Specifically, these final regulations, among other things, 
separately define control for organizations that control an educational 
institution, that are controlled by an educational institution, and 
that are controlled by one or more persons that also control an 
educational institution, and do not apply the downward attribution 
rules of section 318.
i. Controls Such Institution
    The Treasury Department and the IRS anticipate that most applicable 
educational institutions are set up as nonstock organizations, but to 
cover all circumstances, these final regulations set out rules for 
control of various types of organizational forms.
    Generally, an organization will be considered to control an 
educational institution if the organization owns (by vote or value) 
more than 50 percent of the stock or membership interest of the 
educational institution.
    In the case of any educational institution that does not have stock 
or membership interests, the other organization will be considered to 
control an educational organization if the other organization (or one 
or more of its managers, directors, officers, trustees, or employees, 
acting only in their capacities as representatives of the organization) 
can (1) appoint or elect (which must include the power to remove and 
replace) more than 50 percent of the members of the educational 
institution's governing body (such as directors, officers, or 
trustees), or otherwise has an ongoing power to appoint or elect more 
than 50 percent of such members with reasonable frequency; (2) require 
the educational institution to make an expenditure (or prevent the 
educational institution from making an expenditure); or (3) require the 
educational institution to perform any act that significantly affects 
its operations (or prevent it from performing such an act). Such 
control includes control by aggregating votes or positions of authority 
(including by veto power) but applies regardless of the method by which 
the control is exercised or exercisable.
    As discussed in part 7.d of this Summary of Comments and 
Explanation of Revisions, an educational institution generally does not 
take into account assets and net investment income of a related 
organization that controls the educational institution unless the 
assets and net investment income of the related organization are 
intended or available for the use or benefit of the educational 
institution. However, if a related organization both controls the 
educational institution as described in this paragraph and is also a 
supporting organization described in section 509(a)(3) during the 
taxable year with respect to the educational institution, as described 
in part 7.b.iv of this Summary of Comments and Explanation of 
Revisions, then the rule that attributes the largest amount of assets 
and net investment income of the related organization to the 
educational institution must be applied.
ii. Is Controlled by Such Institution
    The Treasury Department and the IRS have determined that only tax-
exempt corporations, certain trusts, and nonstock organizations 
controlled by an educational institution should be considered 
controlled related organizations with respect to an educational 
institution for purposes of determining an educational institution's 
assets and net investment income under section 4968(d)(1).
    As discussed in part 7.d of this Summary of Comments and 
Explanation of Revisions, if an educational institution controls an 
organization under this definition, then it must take into account all 
the assets and net investment income of the controlled related 
organization, except as provided in parts 7.b.ii.B (relating to certain 
controlled trusts), 7.c (relating to no amount being taken into account 
with respect to more than one educational institution), 7.d.iii 
(relating to certain organizations that were Type III supporting 
organizations with respect to an educational institution on December

[[Page 65545]]

31, 2017), and 7.d.iv (relating to when assets used directly in 
carrying out a related organization's exempt purpose are considered to 
be used directly in carrying out the educational institution's exempt 
purpose) of this Summary of Comments and Explanation of Revisions.
A. Tax-Exempt Corporations
    No comments were received relating to the proposed rule for control 
of tax-exempt corporations. Thus, these final regulations retain the 
proposed rule and provide that a tax-exempt corporation is controlled 
by an educational institution if the educational institution owns (by 
vote or value) more than 50 percent of the voting and nonvoting stock 
or membership interest of the tax-exempt corporation.
B. Trusts
    As discussed in part 7.a.iii of this Summary of Comments and 
Explanation of Revisions, several commenters stated that the proposed 
rule for control of trusts, which provided that control of a trust with 
beneficial interests means ownership of more than 50 percent of the 
beneficial interests in the trust, would not appropriately capture 
trusts that are controlled by the educational institution within the 
generally accepted meaning of that term. Commenters stated that the 
trustee of a trust does not control a trust in a way that is relevant 
for purposes of section 4968, because the trustee is required to 
administer the trust in accordance with, and to the extent of the 
trustee's duties and powers as determined by, the terms of the trust 
and applicable law. One commenter suggested that, given the limited 
roles of the trustee and the beneficiary, an educational institution 
should be considered to control a trust only if the educational 
institution is both a beneficiary and a trustee with the discretionary 
power to make current distributions of the trust's income and/or 
principal to itself, pursuant to the terms of the trust.
    The Treasury Department and the IRS agree with commenters that a 
control rule for trusts based on an educational institution having a 
more than 50 percent beneficial interest leads to unintended results. 
However, the Treasury Department and the IRS believe that the 
commenter's recommended rule is too narrow and could allow an 
educational institution to transfer endowment assets into a trust that 
it would not be considered to control under the recommended rule, but 
that it did control in substance.
    The Treasury Department and the IRS acknowledge that the concept of 
control does not comport well with trusts. Possibly the only person 
with control over a trust is a person with the power to revoke the 
trust; even the trustee's ``control'' is limited by the provisions of 
the trust instrument and applicable law. In attempting to construct a 
replacement for the control rule for trusts to be used in the context 
of section 4968, the Treasury Department and IRS identified the four 
specific circumstances under which a trust should be deemed to have a 
relationship with the educational institution that is sufficiently 
similar to that generally intended by the concept of control. However, 
in two of these circumstances, these final regulations recognize that 
the deemed control is only with regard to some of the assets of the 
trust; consequently, in the third and fourth circumstances explained in 
the subsequent paragraphs, only a portion of the trust is considered to 
be a related organization and only some of the assets and net 
investment income are attributed to the educational institution.
    The first circumstance is where the educational institution is the 
sole permissible trust beneficiary. In this circumstance, several 
factors would be irrelevant, such as the identity of the trustee, the 
timing and standards for making trust distributions, and the donors to 
the trust. To prevent the existence of another trust beneficiary, 
whether purely discretionary or with only a minimal interest in the 
trust, from being used to avoid this rule, the test refers to the 
educational institution being ``substantially'' the sole trust 
beneficiary.
    A second circumstance is where the trust is a pooled income fund 
described in sections 642(c)(3) and 642(c)(5). Although a certain 
portion of the net income of the fund is payable on a current basis to 
the donors to the fund, the fund is managed by the educational 
institution, the educational institution is the sole remainderman of 
the fund, and a portion of the fund becomes payable to the educational 
institution as each donor's interest expires. Given the different times 
(generally based on the date of death of individual donors) when 
portions of the trust principal will become payable to the educational 
institution, and the control of the fund by the educational 
institution, the Treasury Department and the IRS have determined that 
it is appropriate to deem a pooled income fund described in sections 
642(c)(3) and 642(c)(5) to be controlled by that institution.
    A third circumstance is where the trust has been funded with assets 
of the educational institution. If, and only to the extent that, the 
trust's funding consisted of assets contributed to the trust by the 
educational institution (or by a person controlled by the educational 
institution), the Treasury Department and the IRS concluded that the 
trust's assets and net income should be attributed to the educational 
institution.
    Finally, the Treasury Department and the IRS concluded that any 
portion of a trust that the educational institution (or a person 
controlled by the educational institution) can demand or cause to be 
distributed to the educational institution (or a person controlled by 
the educational institution) should be attributed to the educational 
institution.
    Therefore, these final regulations provide that a trust is a 
related organization, and an educational institution is deemed to 
control that trust, only: (1) If the educational institution is 
substantially the sole permissible trust beneficiary or appointee of 
both income and principal, whether or not the timing of distributions 
is subject to the trustee's discretion; (2) if the trust is a pooled 
income fund described in section 642(c)(3) and (5); (3) if, but only to 
the extent that, the assets of the trust were contributed to the trust 
by the educational institution (or by a person controlled by the 
educational institution, as determined under these regulations); or (4) 
if, but only to the extent that, the educational institution (or a 
person controlled by the educational institution, as determined under 
these regulations) has the right to demand (or can otherwise cause) a 
distribution of principal from the trust to the educational institution 
(or a person controlled by the educational institution).
    For purposes of this definition, a person is controlled by an 
educational institution if the educational institution has the power to 
remove and replace such person or otherwise controls the person under 
one of the tests in Sec.  53.4968-3(b)(2)(i), (ii), or (iii), with 
similar principles applying for purposes of determining control of any 
other form of entity.
C. Nonstock Organizations
    One commenter objected to the proposed rule for control of nonstock 
organizations, stating that the portion of the rule that is based on 
directors or trustees of the educational institution being 
representatives of the other organization often incorrectly determines 
which entity controls the other, as the presence of common directors or 
trustees alone is not determinative of control. The commenter stated 
that the

[[Page 65546]]

representatives test from the proposed regulations could be especially 
devastating to hierarchical religious organizations using corporation 
sole or similar structures, which have neither directors nor trustees. 
If one made a natural extension of the proposed rule by treating the 
incumbent officer of a ``corporation sole'' as a sole director or 
trustee, hierarchical religious organizations could be affected because 
an ecclesiastical officeholder could not be on the board of any 
educational institution without causing that religious organization to 
be deemed to be controlled by that educational institution. The 
commenter stated that control tests found in other sections of the Code 
relating to tax-exempt organizations, such as the control tests found 
in sections 507, 509, 4911, 4941, 4942, and 4943, would be more 
relevant and appropriate for purposes of section 4968. For example, 
these tests include the power to cause a certain act, often acting 
solely in the capacity of foundation manager.
    The Treasury Department and the IRS agree that a modified version 
of control for nonstock organizations that is based on the power of the 
educational institution (or one or more of its managers, directors, 
officers, trustees, or employees acting only in the capacity as a 
representative of the educational institution) to cause (or prevent) a 
certain act would also appropriately reflect control by the educational 
institution over the nonstock organization.
    Thus, these final regulations provide that an educational 
institution controls a nonstock organization if the educational 
institution (or one or more of its managers, directors, officers, 
trustees, or employees acting only in those capacities) can (1) appoint 
or elect (which must include the power to remove and replace) more than 
50 percent of the members of the nonstock organization's governing body 
(such as directors, officers, or trustees), or otherwise has the 
ongoing power to appoint or elect more than 50 percent of such members 
with reasonable frequency; (2) require the nonstock organization to 
make an expenditure (or prevent the organization from making an 
expenditure); or (3) require the nonstock organization to perform any 
act that significantly affects its operations (or prevent it from 
performing such an act). Such control includes control by aggregating 
votes or positions of authority (including by veto power) but applies 
regardless of the method by which the control is exercised or 
exercisable.
iii. Is Controlled by One or More Persons That Also Control Such 
Institution
    The proposed regulations provided a rule relating to control of a 
nonstock organization by one or more persons that also control an 
educational institution, finding control if more than 50 percent of the 
directors or trustees of the nonstock organization are directly or 
indirectly controlled by one or more persons that control the 
educational institution.
    In recognition that the other organization might be other than a 
nonstock organization, these final regulations provide a separate rule 
for organizations that are controlled by one or more persons that also 
control such institution. Under these final regulations, an 
organization is controlled by one or more persons that also control the 
educational institution if more than 50 percent of the members of the 
governing body of the other organization is directly or indirectly 
controlled by persons that comprise more than 50 percent of the members 
of the governing body of the educational institution.
    As discussed in part 7.d of this Summary of Comments and 
Explanation of Revisions, an educational institution does not take into 
account assets and net investment income of a related organization that 
is controlled by one or more persons that also control the educational 
institution unless the assets and net investment income are intended or 
available for the use or benefit of the educational institution. 
However, if a related organization is both (1) controlled by one or 
more persons that also control the educational institution, as 
described in this part 7.b.iii, and also is (2) controlled by the 
educational organization, as described in part 7.b.ii of this Summary 
of Comments and Explanation of Revisions or is also a supporting 
organization described in section 509(a)(3) during the taxable year 
with respect to the educational institution, as described in part 
7.b.iv of this Summary of Comments and Explanation of Revisions, then 
the rule that attributes the largest amount of assets and net 
investment income of the related organization to the educational 
institution must be applied.
    Nevertheless, the exceptions allowing certain assets and net 
investment income to not be taken into account described in parts 
7.b.ii.B (relating to certain controlled trusts), 7.c (relating to no 
amount being taken into account with respect to more than one 
educational institution), 7.d.iii (relating to certain organizations 
that were Type III supporting organizations with respect to an 
educational institution on December 31, 2017), and 7.d.iv (relating to 
when assets used directly in carrying out a related organization's 
exempt purpose are considered to be used directly in carrying out the 
educational institution's exempt purpose) of this Summary of Comments 
and Explanation of Revisions, continue to apply.
iv. Supporting Organizations Described in Section 509(a)(3)
    Section 4968(d)(2)(C) includes within the definition of related 
organization any supporting organization (as described in section 
509(a)(3)) during the taxable year with respect to the educational 
institution.
    One commenter noted that a Type I supporting organization \7\ 
controlled by a community foundation that supports a class of entities 
that includes an educational institution within the class should be 
considered to be a Type I supporting organization only ``with respect 
to'' the controlling community foundation and not ``with respect to'' 
an educational institution. The commenter suggested that an 
organization be considered a supporting organization with respect to 
the educational institution only if the supporting organization meets 
the organizational, operational, and relationship tests with respect to 
the educational institution, considered in isolation. The Treasury 
Department and the IRS agree that a section 509(a)(3) organization is a 
supporting organization ``with respect to'' an educational institution 
only if the supporting organization meets the organizational, 
operational, and relationship tests with respect to the educational 
institution, and have clarified this point in these final regulations.
---------------------------------------------------------------------------

    \7\ Organizations described in section 509(a)(3) are known as 
``supporting organizations.'' Supporting organizations achieve their 
public charity status by providing support to one or more 
organizations described in section 509(a)(1) or (2), which, in this 
context, are referred to as ``supported organizations.'' To be 
described in section 509(a)(3), an organization must satisfy several 
tests, including having one of three ``relationships'' with one or 
more supported organizations. A supporting organization that is 
operated, supervised or controlled by one or more supported 
organizations is known as a ``Type I'' supporting organization. A 
supporting organization that is supervised or controlled in 
connection with one or more supported organizations is known as a 
``Type II'' supporting organization. A supporting organization that 
is operated in connection with one or more supported organizations 
is known as a ``Type III'' supporting organization.
---------------------------------------------------------------------------

    The commenter further suggested that an organization be deemed to 
be described in section 509(a)(3) with respect to an educational 
institution only if (1) it is described in section

[[Page 65547]]

509(a)(3); (2) it bears a Type I, Type II, or Type III relationship to 
the educational institution; and (3) substantially all, or at least a 
majority, of its activities are for the benefit of, perform the 
functions of, or carry out the purposes of the educational institution 
or other public charities controlled by the educational institution. 
The Treasury Department and the IRS disagree with this reading because 
a supporting organization may be a supporting organization (as 
described in section 509(a)(3) and the regulations under section 
509(a)(3)) with respect to the educational institution, despite the 
fact that less than a majority of its activities are for the benefit 
of, perform the functions of, or carry out the purposes of the 
educational institution or other public charities controlled by the 
educational institution. Thus, these final regulations do not adopt 
this recommendation.
    The commenter noted that a supporting organization that is not a 
supporting organization ``with respect to'' an educational institution 
may still be related to the institution under one of the other tests, 
and that a Type I or Type II supporting organization with respect to 
the educational institution may be considered both a supporting 
organization with respect to the educational institution described in 
section 4968(d)(2)(C) and an organization controlled by the educational 
institution described in section 4968(d)(2)(A) or an organization 
controlled by one or more persons that also control the educational 
institution described in section 4968(d)(2)(B). The Treasury Department 
and the IRS agree, but in cases in which an organization is a related 
organization with respect to an educational institution on more than 
one basis, if one of the bases is that the organization is either 
controlled by the educational institution as described in part 7.b.ii 
of this Summary of Comments and Explanation of Revisions, or is a 
supporting organization (as described in section 509(a)(3)) with 
respect to the educational institution during the taxable year, then 
the rule that attributes the largest amount of assets and net 
investment income of the related organization to the educational 
institution must be applied.
v. Constructive Ownership
    The proposed regulations provided that the principles of section 
318 apply for purposes of determining ownership of stock in a 
corporation and that similar principles apply for purposes of 
determining ownership in any other entity.
    Commenters noted that section 318 provides rules for attribution 
from entities under section 318(a)(2) (upward attribution) and to 
entities under section 318(a)(3) (downward attribution). In general, 
under upward attribution, (1) partners in a partnership are each 
considered to own a proportionate share of stock owned by or for the 
partnership; (2) beneficiaries of a trust are each considered to own a 
proportionate share of stock owned by or for the trust based on their 
actuarial interests in the trust; and (3) a person that owns stock 
representing 50 percent or more of the value of a corporation is 
considered to own a proportionate share of the stock owned by or for 
such corporation. In general, under downward attribution, partnerships 
and trusts are considered to own stock owned by or for their partners 
and beneficiaries, respectively, and corporations are considered to own 
stock owned by or for a person that owns stock representing 50 percent 
or more of the value of the corporation. Commenters noted that 
application of the downward attribution rules can lead to an 
institution being deemed to control an organization that it does not 
actually control.
    The Treasury Department and the IRS agree with commenters that 
application of the principles of section 318(a)(3) may lead to 
unintended results. Thus, these final regulations provide that the 
principles of section 318(a)(2) apply for purposes of determining 
ownership of stock in a corporation, and similar principles apply for 
purposes of determining ownership of interests in any other entity.
c. Assets and Net Income Treated as Assets and Net Income of Only One 
Educational Institution
    As noted at the beginning of this part 7, section 4968(d)(1) 
provides, in part, that for purposes of determining the aggregate fair 
market value of an institution's assets and its net investment income, 
the assets and net investment income of all related organizations with 
respect to the educational institution are treated as assets and net 
investment income, respectively, of the educational institution. 
However, section 4968(d)(1)(A) provides an exception under which no 
such amount is taken into account with respect to more than one 
educational institution.
    In order to effectuate the exception contained in section 
4968(d)(1)(A), the proposed regulations provided that, in any case in 
which an organization is a related organization with respect to more 
than one educational institution, the assets and net investment income 
of the related organization must be allocated among the educational 
institutions as to which the organization is a related organization. 
The proposed regulations provided that such allocation must be made in 
a reasonable manner, taking into account all facts and circumstances, 
and must be consistently applied across all related organizations. The 
Treasury Department and the IRS requested comments on whether more 
specific guidance is required concerning the allocation of a related 
organization's assets and net investment income among multiple 
educational institutions being supported by the same related 
organization, and if so, what such additional guidance should be 
provided. One commenter agreed with the proposed regulation, saying 
that any reasonable methodology that takes into account all facts and 
circumstances and is applied consistently across all related 
organizations is appropriate for purposes of avoiding double-counting 
of related organizations' assets and income. Thus, these final 
regulations adopt the proposed rule and add that the allocation must be 
consistently applied.
d. Assets and Net Investment Income of Related Organizations
    For purposes of attributing assets and net investment income of 
related organizations to educational institutions, section 
4968(d)(1)(B) provides that, unless a related organization is 
controlled by the educational institution or is a supporting 
organization described in section 509(a)(3) with respect to such 
institution for the taxable year, assets and net investment income of 
the related organization that are not intended or available for the use 
or benefit of the educational institution are not taken into account.
    Put another way, if a related organization (1) controls the 
educational institution (but is not described in section 509(a)(3) with 
respect to the educational institution for the taxable year as 
described in part 7.b.iv of this Summary of Comments and Explanation of 
Revisions), (2) is controlled by one or more persons that also control 
such institution (but is neither controlled by the educational 
institution as described in part 7.b.ii of this Summary of Comments and 
Explanation of Revisions nor is described in section 509(a)(3) with 
respect to the educational institution), or (3) is a supported 
organization (as defined in section 509(f)(3)) with respect to the 
educational institution during the

[[Page 65548]]

taxable year, then the related organization's assets and net investment 
income are taken into account as assets and net investment income of 
the educational institution only to the extent the assets and net 
investment income are intended or available for the use and benefit of 
the educational institution.
    However, if a related organization either (1) is controlled by the 
educational institution or (2) is a supporting organization described 
in section 509(a)(3) with respect to such institution for the taxable 
year, then all the assets and net investment income of the related 
organization are considered assets and net investment income of the 
educational institution, except as provided in parts 7.b.ii.B (relating 
to certain controlled trusts), 7.c (relating to an exception under 
which no such amount is taken into account with respect to more than 
one educational institution), 7.d.iii (relating to certain 
organizations that were Type III supporting organizations with respect 
to an educational institution on December 31, 2017), and 7.d.iv 
(relating to when assets used directly in carrying out a related 
organization's exempt purpose are considered to be used directly in 
carrying out the institution's exempt purpose) of this Summary of 
Comments and Explanation of Revisions.
i. Related Organizations That Control the Educational Institution, Are 
Controlled by One or More Persons That Also Control the Educational 
Institution, or Are Supported Organizations (as Defined in Section 
509(f)(3)) With Respect to the Educational Institution During the 
Taxable Year
    As discussed in part 7.d of this Summary of Comments and 
Explanation of Revisions, the assets and net investment income of 
certain related organizations are taken into account only to the extent 
that they are intended or available for the use and benefit of the 
educational institution. In determining which assets and net investment 
income are considered ``intended or available for the use and benefit 
of'' the educational institution, the Conference Report states, ``[f]or 
example, assets of a related organization that are earmarked or 
restricted for (or fairly attributable to) the educational institution 
would be treated as assets of the educational institution, whereas 
assets of a related organization that are held for unrelated purposes 
(and are not fairly attributable to the educational institution) would 
be disregarded.'' H. Rept. 115-466, 115th Cong., 1st sess., at 555 
(December 15, 2017).
    The proposed regulations provided that when an educational 
institution is determining which assets and net investment income are 
``intended or available for the use or benefit of'' the educational 
institution, the educational institution must make an allocation 
between those assets and net investment income that are intended or 
available for the use and benefit of the educational institution and 
those not intended or not available for the use and benefit of that 
educational institution. Such allocation must be made in a reasonable 
manner, taking into account all facts and circumstances, and must be 
consistently applied across all related organizations.
    One commenter agreed with this approach, stating that it is 
reasonable to permit an educational institution to take into account 
its own unique facts and circumstances and use any reasonable method to 
allocate the assets and net investment income.
    The preamble to the proposed regulations further explained that 
assets and net investment income of such a related organization are 
intended or available for the use and benefit of an educational 
institution if such assets and net investment income are specifically 
earmarked or restricted for the benefit of, or are otherwise fairly 
attributable to, the educational institution. Conversely, assets and 
net investment income of a related organization are not intended or 
available for the use and benefit of an educational institution if such 
assets and net investment income are specifically earmarked or 
restricted for another entity or for unrelated purposes or otherwise 
are not fairly attributable to that educational institution.
    The preamble to the proposed regulations requested comments on 
situations in which an organization's assets or net investment income 
is not specifically earmarked or restricted for the benefit of any 
particular organization but otherwise is fairly attributable to the 
educational institution or to another organization. For example, the 
proposed regulations asked whether, absent any earmarking or 
restriction, total distributions from a related organization to an 
educational institution in one taxable year should establish a 
presumption for section 4968 purposes that at least an equal amount is 
fairly attributable to that educational institution for the following 
taxable year, absent demonstrated facts and circumstances supporting 
attribution of a lesser amount.
    One commenter stated that, because earmarked and restricted funds 
are subject to legally binding requirements that the assets must be 
used solely for the designated recipient, such funds are a clear 
example of assets ``intended for'' a particular organization. In 
contrast, internal board decisions to allocate funds to certain 
purposes do not typically convert funds into restricted funds because 
the board still has authority to reverse its previous decision without 
obtaining any outside consent. However, the commenter noted that 
certain assets that have been affirmatively designated for use by an 
educational institution could be ``intended for'' the institution, and 
thus ``fairly attributable,'' even if not subject to a binding 
restriction. This commenter recommended that the unrestricted, 
undesignated assets of a related organization will not be treated as 
intended or available for the educational institution unless they have 
been affirmatively designated or appropriated for the educational 
institution or made available for the educational institution to draw 
upon at will; in other words, if they have been approved and directed 
by the related organization for use by the educational institution. 
These final regulations adopt this recommendation.
    A few commenters said that total distributions from a related 
organization to an educational institution in one taxable year should 
not establish a presumption for section 4968 purposes that at least an 
equal amount is fairly attributable to the educational institution for 
the following taxable year. One commenter recommended creating a 
rebuttable presumption based upon an average of distributions from the 
related organization over a number of years. Another commenter noted 
that there is no need to estimate possible future distributions because 
the excise tax under section 4968 is based on data that is known at the 
time the annual return is being prepared, so the exact amount of 
distributions do not have to be estimated. This commenter stated that 
if such a presumption did apply, it should be rebuttable based on facts 
showing that the previous year's amounts distributed were for special 
projects and not ``intended or available for'' the educational 
institution the following year. In response to the comments, these 
final regulations do not include a presumption based on previous 
distributions.

[[Page 65549]]

ii. Related Organizations That Are Controlled by the Educational 
Institution or That Are Supporting Organizations (as Described in 
Section 509(a)(3)) With Respect to the Educational Institution During 
the Taxable Year
    If a related organization (1) is controlled by an educational 
institution, as described in part 7.b.ii of this Summary of Comments 
and Explanation of Revisions, or (2) is a supporting organization (as 
defined in section 509(a)(3) and described in part 7.b.iv of this 
Summary of Comments and Explanation of Revisions) with respect to the 
educational institution during the taxable year, then the assets and 
net investment income of the related organization must be taken into 
account as assets and net investment income of the educational 
institution, regardless of whether the assets and net investment income 
are earmarked, restricted for the benefit of, or otherwise are fairly 
attributable to that educational institution, and even if they are 
specifically earmarked or restricted for another entity or for 
unrelated purposes or otherwise are not fairly attributable to that 
educational institution. However, the special rule in section 
4968(d)(1)(A) continues to apply, preventing the assets and net 
investment income of the related organization from being taken into 
account by more than one educational institution. See part 7.c of this 
Summary of Comments and Explanation of Revisions. In addition, assets 
that are used directly for the related organization's exempt purpose 
are considered used directly in carrying out the educational 
institution's exempt purpose for purposes of section 4968(b)(1)(D), as 
described in parts 5.e and 7.d.iv of this Summary of Comments and 
Explanation of Revisions. There also is a special rule for related 
organizations that were Type III supporting organizations with respect 
to the educational institution on December 31, 2017, as described in 
part 7.d.iii of this Summary of Comments and Explanation of Revisions.
iii. Special Rule for Related Organizations That Were Type III 
Supporting Organizations With Respect to an Educational Institution on 
December 31, 2017
    In recognition that section 509(a)(3) Type III supporting 
organizations, unlike section 509(a)(3) Type I and Type II supporting 
organizations, are not directly or indirectly controlled by their 
supported organizations,\8\ and because educational institutions may 
not be able to get the needed information from their Type III 
supporting organizations on a timely basis, the proposed regulations 
provided a special rule for related organizations of an educational 
institution that were Type III supporting organizations with respect to 
an educational institution on December 31, 2017.
---------------------------------------------------------------------------

    \8\ As mentioned in footnote 9 of this preamble, there are three 
types of supporting organizations: Type I, Type II, and Type III. 
The relationship of a Type III supporting organization with its 
supported organization(s) is much more attenuated than the other two 
types.
---------------------------------------------------------------------------

    That special rule allowed an educational institution with a related 
organization that was a Type III supporting organization with respect 
to the educational institution on December 31, 2017, to take into 
account only the assets and net investment income of the related Type 
III supporting organization that are intended or available for the use 
and benefit of the educational institution, rather than the value of 
all of that organization's assets or amount of net investment income. 
The proposed regulations provided that an educational institution can 
determine whether the assets and net investment income of such a Type 
III supporting organization are intended or available for the use and 
benefit of the educational institution using any reasonable method. The 
proposed regulations set out one method for determining the amount of 
net investment income available to the educational institution that 
would be considered to be reasonable (i.e., using all the distributions 
received from a Type III supporting organization subject to this 
special rule as net investment income of the educational institution 
each year) and one method for determining assets available to the 
educational institution that would be considered to be reasonable 
(i.e., using the distributions received from a Type III supporting 
organization to calculate the percentage of the Type III supporting 
organization's total net income that was distributed to the educational 
institution, and using the same percentage to calculate the value of 
the underlying assets of the Type III supporting organization that are 
intended or available for the use and benefit of the educational 
institution each year). The proposed regulations requested comments on 
whether additional guidance pertaining to Type III supporting 
organizations was needed.
    One commenter stated that the safe harbor methods in the proposed 
regulations would in many cases lead to strange results, stating that 
the fact that a particular subsidiary makes a distribution to an 
educational institution in one year in no way implies that the 
educational institution has similar amounts available to it in future 
years, let alone to a corresponding portion of the related 
organization's entire asset base. The commenter suggested that only the 
amounts actually distributed or appropriated to the educational 
institution should be treated as intended or available for the 
educational institution.
    For consistency with the general rule for determining which assets 
and net investment income are considered ``intended or available for 
the use and benefit of'' an educational institution, and in response to 
the comment, these final regulations do not include the safe harbor 
method in the proposed regulations. Instead, these final regulations 
provide that a method using assets and net investment income of the 
Type III supporting organization (with respect to the educational 
institution as of December 31, 2017), that are specifically earmarked 
for an educational institution, are restricted for the benefit of an 
educational institution, and are otherwise fairly attributable to an 
educational institution (such as those that have been affirmatively 
designated or appropriated for the educational institution or made 
available for the educational institution to draw upon at will) will be 
deemed to be reasonable.
    Several commenters asked that the special rule for related 
organizations that were Type III supporting organizations with respect 
to the educational institution on December 31, 2017, be extended to 
cover all Type III supporting organizations. One asked that the special 
rule be extended to Type I and Type II supporting organizations, one 
asked that it be extended to split-interest trusts, and one asked that 
it cover all related organizations for which the educational 
institution lacks ``effective control.''
    Although the Treasury Department and the IRS have concluded that a 
transition rule with respect to entities that were Type III supporting 
organizations with respect to an educational institution on December 
31, 2017, is appropriate, extending this rule to other organizations 
would be contrary to the statute. In addition, the Treasury Department 
and the IRS have concluded that excluding certain categories of 
organizations from the definition of related organization, as described 
in part 7.a of this Summary of Comments and Explanation of Revisions, 
and explaining that a supporting organization must be described in 
section 509(a)(3) ``with respect to'' an educational institution during 
the

[[Page 65550]]

taxable year, as described in part 7.b.iv of this Summary of Comments 
and Explanation of Revisions, address most of the commenters' concerns.
iv. Interaction With Section 4968(b)(1)(D)
    As described in part 5.f of this Summary of Comments and 
Explanation of Revisions, these final regulations provide that an asset 
of a related organization that is treated as an asset of an educational 
institution by section 4968(d) and that is used directly in carrying 
out an educational institution's exempt purpose is considered to be 
used directly by the educational institution in carrying out its exempt 
purpose for purposes of section 4968(b)(1)(D). In addition, an asset of 
a related organization described in section 501(c)(3) that is treated 
as an asset of an educational institution by section 4968(d) and that 
is used directly in carrying out the related organization's exempt 
purpose is considered to be used directly by the educational 
institution in carrying out its exempt purpose for purposes of section 
4968(b)(1)(D).

8. Penalty Waiver

    One commenter asked that any penalties arising from underpayment of 
the excise tax for tax years prior to and including tax years in which 
final guidance is issued be waived. A waiver of penalties is beyond the 
scope of these regulations. In addition, these final regulations are 
not effective until the taxable year beginning after publication of the 
final regulations. Thus, applicable educational institutions will have 
up to a year to comply with the final regulations, and for prior 
taxable years applicable educational institutions can comply with the 
statute using a reasonable good faith interpretation.

Applicability Date

    These final regulations apply to taxable years of an educational 
institution beginning after October 15, 2020.

Special Analyses

    Executive Orders 12866, 13563, and 13771 direct agencies to assess 
costs and benefits of available regulatory alternatives and, if 
regulation is necessary, to select regulatory approaches that maximize 
net benefits (including potential economic, environmental, public 
health and safety effects, distributive impacts, and equity). Executive 
Order 13563 emphasizes the importance of quantifying both costs and 
benefits, of reducing costs, of harmonizing rules, and of promoting 
flexibility. The Executive Order 13771 designation for this regulation 
is regulatory.
    The final regulations have been designated by the Office of 
Management and Budget's (OMB) Office of Information and Regulatory 
Affairs (OIRA) as subject to review under Executive Order 12866 
pursuant to the Memorandum of Agreement (April 11, 2018) between the 
Treasury Department and OMB regarding review of tax regulations. OIRA 
has determined that the final rulemaking is significant and subject to 
review under Executive Order 12866 and section 1(b) of the Memorandum 
of Agreement. Accordingly, the final regulations have been reviewed by 
OMB.

I. Need for Regulation

    The Conference Report, at 555, states that Congress intended that 
the Secretary promulgate regulations to carry out the intent of section 
4968. These final regulations are in response to this congressional 
intent. The final regulations provide guidance for determining the 
excise tax applicable to the net investment income of certain private 
colleges and universities, as provided by the TCJA. The regulations are 
intended to clarify which educational institutions are subject to the 
excise tax under section 4968 (excise tax) and how net investment 
income is calculated for purposes of this excise tax.
    The Treasury Department and the IRS received 18 formal comments 
regarding these proposed definitions and rules, and there was a degree 
of taxpayer uncertainty as to whether the definitions of the various 
terms and whether the rules for computing net investment income would 
remain the same as those provided in the notice of proposed rulemaking.
    Pursuant to section 6(a)(3)(B) of Executive Order 12866, the 
following qualitative analysis provides further details regarding the 
anticipated impacts of the final regulations. The statute and the final 
regulations are briefly described in Part II of this Special Analyses 
section. The baseline used for the analysis is described in Part III. 
Part IV describes the types of entities affected by the proposed 
regulations. Part V provides a qualitative assessment of the potential 
economic effects, including the benefits and costs, of the proposed 
regulations compared to the baseline.

II. The Statute and the Final Regulations

    Section 4968 imposes a 1.4 percent excise tax on the net investment 
income of applicable educational institutions. Under the statute, an 
``applicable educational institution'' is an eligible educational 
institution (which is described in section 25A(f)(2)) that has at least 
500 tuition-paying students during the preceding taxable year, more 
than 50 percent of whom are located in the United States, that is not a 
state college or university, and the fair market value of the assets of 
which (other than those assets that are used directly in carrying out 
the institution's exempt purpose) is at least $500,000 per student at 
the end of the preceding taxable year. Under section 4968, net 
investment income is determined under rules ``similar to'' the rules of 
section 4940(c) (the rules for the calculation of the net investment 
income of private foundations). In addition, the statute contains a 
rule under which the assets and net investment income of related 
organizations generally are treated as the assets and net investment 
income of the educational institution.
    Section 4968 does not define the terms ``student,'' ``tuition-
paying student,'' or ``assets used directly in carrying out the 
institution's exempt purpose.'' Section 4968(c) states that, for the 
purposes of the excise tax in section 4968, net investment income is 
determined under rules ``similar to'' the rules of section 4940(c) but 
does not define what is meant by ``similar to.'' Section 4968 does not 
define the term ``control'' as it relates to the definition of a 
``related organization with respect to an educational institution.'' 
The final regulations provide general definitional guidance with 
respect to these and other terms and rules relevant to the 
implementation of the statute.

III. Baseline

    The Treasury Department and the IRS have assessed the benefits and 
costs of the final regulations relative to a no-action baseline 
reflecting anticipated Federal income tax-related behavior in the 
absence of these final regulations.

IV. Affected Entities

    One researcher used data from the Integrated Post-Secondary 
Education Data System (IPEDS) on endowment values at the end of the 
2015-2016 academic year and enrollment data to estimate the number of 
institutions at risk of having liability under this excise tax.\9\ 
Under the assumption that none of the assets in the endowment are for

[[Page 65551]]

exempt purposes, he estimates that 23 institutions are likely to be 
currently subject to tax. Using the same IPEDS data, another researcher 
estimated that in 2016, among four-year public and not-for-profit 
private institutions located in the United States with at least 500 
full-time equivalent students, and excluding endowments held at the 
university system level, there were 27 endowments worth at least 
$500,000 per student.\10\ These estimates do not take into account all 
of the provisions of the statute and regulations. For example, limiting 
this set of institutions to the not-for-profit private institutions 
subject to tax and excluding assets that are used for the institutions' 
exempt purpose would reduce the number of affected institutions. On the 
other hand, as both authors note, because the $500,000 per student 
threshold for the aggregate fair market value of assets (other than 
those assets which are used directly in carrying out the institution's 
exempt purpose) that in part determines whether the excise tax in 
section 4968 applies to an educational institution is not indexed for 
inflation, the number of institutions to which the excise tax in 
section 4968 applies is expected to increase over time. In addition, 
these studies did not consider assets held by related organizations; 
including such assets could increase the number of affected 
institutions.
---------------------------------------------------------------------------

    \9\ Levine, Phillip. ``The University Endowment Income Tax: Who 
Will Pay it and Why Was it Implemented?'', Econofact, January 25, 
2018, available at https://econofact.org/the-university-endowment-tax-who-will-pay-it-and-why-was-it-implemented, accessed April 29, 
2019.
    \10\ Hinrichs, Peter. ``College Endowments.'' Economic 
Commentary 2018-04 (May 17, 2018), Federal Reserve Bank of 
Cleveland, Table 1.
---------------------------------------------------------------------------

V. Economic Effects of the Final Regulations

    The Treasury Department and the IRS anticipate that the issuance of 
guidance pertaining to section 4968 will provide a marginal net 
economic benefit to the overall U.S. economy.
    The final regulations clarify a number of definitions related to 
the excise tax in section 4968. In the absence of guidance, affected 
taxpayers would have to calculate their tax liability without the 
definitions and clarifications provided by the final regulations, a 
situation that is generally considered more burdensome and could lead 
to greater conflicts with tax administrators. The final regulations 
make use of a number of existing statutory and regulatory provisions in 
defining students, tuition, exempt purpose, fair market value, net 
investment income and related organizations. Many taxpayers already 
will be familiar with these definitions. Thus, the Treasury Department 
and the IRS project that the final regulations will reduce taxpayer 
compliance burden relative to the no-action baseline, including in 
determining whether the excise tax applies to the institution and the 
computation of the excise tax. However, it is possible that the final 
regulations will have other economic effects based on the time needed 
to file the return as well as the costs of tax administration, 
including monitoring the compliance of taxpayers with the excise tax.
    The guidance provided in the final regulations also ensures that 
the excise tax liability is calculated similarly across taxpayers, 
avoiding situations where one taxpayer receives preferential treatment 
over another taxpayer for fundamentally similar economic activity. For 
example, in the absence of these final regulations, an educational 
institution may have uncertainty over whether it is subject to the 
excise tax under section 4968 and what assets are used in determining 
the net investment income for purposes of the excise tax under section 
4968. As a result, in the absence of guidance, similar institutions 
might take different positions and pay different amounts of tax, 
introducing economic inefficiency and inequity.
    Based on this analysis, the Treasury Department and the IRS 
anticipate the net economic contribution of the final regulations will 
be modest and will be positive relative to not issuing any such 
guidance and conditional on the relevant statutes. In the proposed 
regulations, the Treasury Department and the IRS requested comments on 
a number of aspects of the proposed regulations, which included 
comments on the economic effects, any behavioral changes caused, or the 
unintended costs and benefits of the regulations. The Treasury 
Department and the IRS did not receive any comments on these issues.

VI. Economic Analysis of Specific Provisions

    The regulations embody certain regulatory decisions that reflect 
the necessary exercise of regulatory discretion. These decisions 
specify more fully how section 4968 is to be implemented.

A. Clarifications of Definitions

    Consistent with the statute, the final regulations provide that the 
term ``applicable educational institution'' means any eligible 
educational institution: (1) That had at least 500 tuition-paying 
students attending the institution during the preceding taxable year; 
(2) with more than 50 percent of whose tuition-paying students are 
located in the United States; (3) that is not described in the first 
sentence of section 511(a)(2)(B) (relating to state colleges and 
universities); and (4) the aggregate fair market value of the assets of 
which at the end of such preceding taxable year (other than those 
assets that are used directly in carrying out the institution's exempt 
purpose) is at least $500,000 per student attending the institution.
    Many provisions of the final regulations clarify definitions 
related to the tax imposed by section 4968, minimizing the burdens 
entities bear to comply with the tax, and have little other economic 
impact. Clarifications reduce uncertainty, lower the effort required to 
infer which institutions are subject to the section 4968 tax and the 
potential for conflict if entities and tax administrators interpret 
provisions differently. Examples of clarifications include the 
definition of ``applicable educational institution,'' ``student,'' 
``tuition-paying,'' ``located in the United States,'' and ``assets.''
i. Definition of ``Student''
    The definition of ``applicable education institution'' relies on 
the definition of ``student.'' In section 25A(b)(3) and the Higher 
Education Act, a ``student'' is defined as a person enrolled in a 
degree, certification, or other program (including a program of study 
abroad approved for credit by the eligible educational institution at 
which such student is enrolled) leading to a recognized educational 
credential at an eligible educational institution, and who is not 
enrolled in an elementary or secondary school.
    The proposed regulations provided that the number of students of an 
educational institution (including for purposes of determining the 
number of students at a particular location) is 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). Under the proposed regulations, the standards for determining 
part-time students, full-time students, full-time equivalents, and 
daily average are generally determined by each educational institution.
    Two commenters recommended that the definition of ``student'' be 
expanded to include all students attending the institution even if not 
enrolled in a degree, certification, or other program leading to a 
recognized educational credential. One concern was that the term 
``recognized educational credential'' was ambiguous.
    The final regulations define the term ``student'' as a person who 
is enrolled and attending a course for academic credit from the 
institution and who is being charged tuition at a rate that is

[[Page 65552]]

commensurate with the tuition rate charged to students enrolled for a 
degree.
ii. Definition of ``Tuition-Paying''
    The proposed regulations provided that the term ``tuition-paying'' 
means the payment of any tuition or fees required for the enrollment or 
attendance of a student for a course of instruction at an eligible 
educational institution. The proposed regulations stated that this does 
not include any separate payment for supplies or equipment required 
during a specific course once a student is enrolled in and attending 
the course, or the payment of room and board or other personal living 
expenses. In addition, the proposed regulations provided that whether a 
student is ``tuition-paying'' is determined after taking into account 
any scholarships provided directly by the educational institution and 
any work study programs operated directly by the educational 
institution; however, scholarship payments provided by third parties, 
even if administered by the institution, are considered payments of 
tuition on behalf of the student.
    Commenters sought clarification on how scholarships from different 
sources counted toward tuition, given that the proposed regulations 
considered tuition after taking into account scholarships and work-
study programs offered directly from the institution. One commenter was 
specifically concerned with Federal and state financial aid and non-
governmental scholarships not paid by the institution. The final 
regulations do not count Federal, state, and local grants or financial 
aid as ``tuition,'' but do count grants and scholarships provided by a 
non-governmental party other than the particular educational 
institution as ``tuition.''
    In summary, ``tuition'' excludes payments made by or on behalf of 
the student by the institution or from any Federal, state, and local 
governmental sources. These clarifications in the final regulations 
will more easily allow institutions to determine the applicability of 
the statute.
iii. Definition of ``Located in the United States''
    The proposed regulations provided that the term ``located in the 
United States'' refers to the location of a student, and that a student 
is considered to have been located in the United States if the student 
resided in the United States for at least a portion of the time the 
student attended the institution during the educational institution's 
preceding taxable year.
    One commenter sought clarification on this definition, recommending 
that each institution be able to use any reasonable approach to 
consider which students are located in the United States, as long as it 
is consistently applied. The final regulations make explicit the 
commenter's suggestion.
iv. Clarifications of ``Assets Used Directly in Carrying Out an 
Institution's Exempt Purpose''
    The final regulations also provide clarification of ``assets used 
directly in carrying out an institution's exempt purpose.'' The 
definition of an asset counted for purposes of section 4968 rests on 
whether the asset is used for an exempt purpose. If an asset is used 
for both an exempt purpose and for other purposes, and the exempt use 
represents 95 percent or more of the total use, the property is 
considered to be used exclusively for an exempt purpose. If the exempt 
use of such property represents less than 95 percent of the total use, 
the institution must make a reasonable allocation between exempt and 
nonexempt uses. Non-exempt assets generally include assets held for the 
production of income or for investment and property used to manage the 
institution's endowment.
    A commenter recommended expanding the definition of exempt assets 
to include intangible assets and non-financial assets used in a 
functionally related business. Such functionally related businesses 
would be things like a school newspaper that generated ad revenue. The 
Treasury Department and IRS agreed that in certain circumstances these 
types of assets may be included in exempt assets.
    Another aspect of what is considered as assets held directly for an 
exempt purpose is a reasonable cash balance to carry out the 
institution's purpose. The proposed regulations recognized that an 
amount equal to 1.5 percent of the fair market value of the educational 
institution's non-charitable use assets (i.e., assets not actually used 
by an institution in carrying out its exempt purpose), determined 
without regard to the reduction for the reasonable cash balance, is 
deemed to be a ``reasonable cash balance'' that is excluded from the 
educational institution's asset base. These final regulations provide 
that a reasonable cash balance may be determined by any reasonable 
method and provide one example that would be deemed to be reasonable. 
The final regulations therefore increase the flexibility of educational 
institutions in establishing an appropriate reasonable cash balance.
    Commenters also requested clarification of the treatment of assets 
of organizations related to the educational institution. The final 
regulations provide that an asset of a related organization that is 
treated as an asset of the educational institution (in accordance with 
section 4968(d) and Sec.  53.4968-3(c)) and is used directly in 
carrying out the educational institution's exempt purpose is considered 
used directly by the institution in carrying out its exempt purpose. 
These final regulations further provide that an asset of a related 
organization that is treated as an asset of the educational institution 
is considered to be used directly in carrying out the educational 
institution's exempt purpose as long as (1) the related organization is 
described in section 501(c)(3) and (2) the asset is being used directly 
in carrying out the related organization's exempt purpose. Further 
discussion of ``related'' organizations is below.

B. Differences in Definition of ``Net Investment Income'' for 
Educational Institutions Versus Private Foundations

    Section 4968(a) imposes a 1.4 percent excise tax on the net 
investment income of an applicable educational institution and on 
certain amounts of net investment income of certain related 
organizations. Section 4968(c) provides that net investment income is 
determined under rules similar to the rules of section 4940(c). Section 
4940(c) defines net investment income for an excise tax on private 
foundations' net investment income.
    Several commenters requested that the Treasury Department and IRS 
further tailor these rules to take into account differences between a 
private foundation subject to section 4940 and an educational 
institution subject to section 4968, including differences in funding 
sources, use of funds, structure, governance, and oversight. The 
Treasury Department and IRS responded by tailoring the final 
regulations to define net investment income more specifically for 
educational institutions.
    Following the regulations under section 4940(c), the final 4968 
regulations provide that net investment income generally is the amount 
by which the sum of the gross investment income and the capital gain 
net income exceeds the allowable deductions. Commenters sought 
clarification and modification of what is included as ``gross 
investment income'' and ``capital gain net income.''

[[Page 65553]]

i. Gross Investment Income
    Commenters recommended clarifications and modification to what is 
included in gross investment income for purposes of section 4968. The 
final regulations specify that, consistent with section 4940(c), gross 
investment income generally means the gross amounts of income from 
interest, dividends, rents, payments with respect to securities loans, 
and royalties, but not including any such income to the extent it is 
included in computing the tax imposed by section 511.
    In response to commenters, the final regulations exclude from the 
definition of gross investment income interest income from a student 
loan made by an educational institution (or a related organization) to 
a student of the institution in connection with the student's 
attendance at the institution. Section 4940(c) specifically includes 
student loan interest as gross investment income. Commenters noted that 
loans made by colleges and universities to students are not offered 
with the intent of earning investment income for the institution.
    The final regulations also exclude from the definition of gross 
investment income rental income from the provision of housing to 
current students of the educational institution and from housing for 
faculty and staff if the housing is provided contingent on their roles 
as faculty or staff of the educational institution. The final 
regulations exclude from the definition of gross investment income 
royalty income that is derived from patents, copyrights, and other 
intellectual property and intangible property to the extent those 
assets were created by the institution's current students or faculty in 
their capacities as such. Commenters represented that it would be a 
significant administrative burden to capture all expenses and costs 
allocable to such royalty income. The Treasury Department and the IRS 
agree that applicable educational institutions produce intellectual 
property as part of the pursuit of knowledge by faculty and students. 
However, royalties from trademarks on the institution's logo or name, 
as well as royalties on property donated or sold to the educational 
institution, are not excluded from gross investment income under this 
rule.
ii. Capital Gains and Losses
    Commenters addressed several aspects of the proposed rules for 
capital gain net income, including the taxation of capital gain net 
income on the sale of exempt use property; capital gain net income on 
the sale of donated property; the step-up rule for assets held in a 
partnership on December 31, 2017; and whether capital loss carryovers 
should be allowed.
a. Capital Gain Net Income on Sale of Exempt Use Property
    In response to public comments, these final regulations provide 
that capital gain net income from the sale or exchange of property used 
by an institution for its exempt purpose is disregarded for the portion 
of the property that is used for the exempt purpose.
b. Capital Gain Net Income From the Sale of Donated Property
    Commenters recommended that any appreciation that occurred prior to 
an institution's receipt of the donated property be excluded from the 
calculation of capital gain net income from the sale of donated 
property. Private foundations subject to section 4940 are generally 
passive grant-making organizations that have the ability to dispose of 
appreciated property by making a grant of the property instead of 
selling the appreciated property and making a grant in cash. 
Educational institutions, on the other hand, nearly always immediately 
liquidate the gifts and use the proceeds to fund the institution's 
activities; they therefore cannot avoid the net investment income from 
the sale of appreciated property like private foundations. In response, 
these final regulations provide that any appreciation in the value of 
donated property that occurred prior to the date of donation to the 
applicable educational institution is disregarded in calculating gain 
for purposes of section 4968.
c. Basis for Purposes of Determining a Distributive Share of Gain From 
the Sale or Other Disposition of an Asset Held in a Partnership
    Commenters expressed concern with the proposed section 4968 rules 
proposing calculation of the basis of assets held in partnerships in 
which an educational institution owns an interest. Four commenters 
noted that it would be extremely burdensome for institutions to obtain 
documentation to establish their share of the basis of a particular 
partnership asset and that an asset-by-asset determination of gain, 
therefore, might not be possible.
    The Treasury Department and the IRS acknowledge the problem 
described by commenters. These final regulations provide a method, 
described in paragraph 6.e. of the Summary of Comments and Explanation 
of Revisions, which generally enables an applicable educational 
institution to offset its distributive share of capital gain net income 
from partnership asset dispositions by using the applicable educational 
institution's adjusted step-up for such partnership (described in 
paragraph 6.e of the Summary of Comments and Explanation of Revisions), 
if any, at the time of such partnership asset disposition.
    Specifically, the proposed regulations provided that, if an 
applicable educational institution held an interest in a partnership on 
December 31, 2017, and continuously thereafter, and the partnership 
held an asset on December 31, 2017, and continuously thereafter to the 
date of its disposition by the partnership, the applicable educational 
institution's basis in such asset (for purposes of determining the 
applicable educational institution's share of gain upon sale or other 
disposition of that asset) is not less than the fair market value of 
such asset on December 31, 2017, subject to all adjustments provided in 
the proposed regulations after December 31, 2017, and before the date 
of disposition.
d. Reduction of Capital Gain Net Income From a Partnership
    Commenters stated that it would be very difficult, if not 
impossible, for institutions to obtain the basis documentation that 
would have been required under the proposed regulations in order to 
apply the proposed partnership asset basis step-up rule. As an 
alternative, two commenters recommended a method that would use the 
difference between the fair market value and outside basis of an 
applicable educational institution's partnership interest on December 
31, 2017, to approximate the difference between the fair market value 
and inside basis of, and thus the amount of built-in gain in, the 
applicable educational institution's share of partnership assets on 
such date. The commenters stated that the difference between fair 
market value and tax basis of an applicable educational institution's 
partnership interest on December 31, 2017, should generally reflect the 
amount of the applicable educational institution's built-in gain in its 
share of the partnership's assets on such date, and that, because 
educational institutions should know the fair market values and tax 
bases of their partnership interests on December 31, 2017, they should 
be able to calculate the built-in gain in their partnership interests 
as of December 31, 2017.
    Specifically, the commenters recommended that an applicable 
educational institution should be

[[Page 65554]]

allowed to offset the distributive share of partnership capital gain 
net income after December 31, 2017, allocated by a partnership by the 
amount of the built-in gain the applicable educational institution had 
in its partnership interest, determined as of December 31, 2017. Under 
this approach, an applicable educational institution would determine 
its built-in gain in a partnership interest as of December 31, 2017, 
and then not report any capital gain allocated from that partnership 
after December 31, 2017, as being subject to section 4968 until the 
cumulative amount of such excluded gain exceeds the amount of built-in 
gain in the interest. The commenters recommended that this rule be 
applied on a partnership-by-partnership basis and be available to 
reduce the amount of an applicable educational institution's capital 
gain net income on a first-recognized basis.
    These final regulations adopt an approach that is similar to the 
approach recommended by the commenters. These final regulations provide 
that, for each partnership interest an applicable educational 
institution held on December 31, 2017, the applicable educational 
institution may determine an unadjusted step-up amount that is equal to 
the excess, if any, of the fair market value of such partnership 
interest on December 31, 2017, over the adjusted basis of such 
partnership interest on December 31, 2017. For purposes of computing 
net investment income for taxable years beginning after December 31, 
2017, an applicable educational institution will reduce its 
distributive share of capital gain net income from such partnership by 
the least of: (A) The applicable educational institution's share of 
applicable capital gain from such partnership (that is, both short-term 
and long-term capital gain for the first taxable year after December 
31, 2017, but only long-term capital gain for subsequent years because 
short-term capital gains could not have been included in the amount of 
outside built-in gain as of December 31, 2017); (B) one-third of the 
applicable educational institution's unadjusted step-up for such 
partnership; or (C) the applicable educational institution's adjusted 
step-up for such partnership (which, in general, is its unadjusted 
step-up reduced by any capital gain that previously was excluded 
pursuant to either this rule or the partnership interest sale rule 
described in paragraph 6.d.iii. of the Summary of Comments and 
Explanation of Revisions).
e. Capital Loss Carryovers
    A commenter represented that private foundations and educational 
institutions differ in their flexibility in regards to the treatment of 
sales of investments and operating budgets. Specifically, a private 
grant-making foundation, to the extent it has satisfied its minimum 
distribution requirements, can easily curtail its spending (and the 
realization of capital gains while converting investment assets to 
cash) by issuing fewer or smaller grant awards to manage its section 
4940 tax liability. The commenter contrasted such a foundation with an 
educational institution that typically has a large operating budget 
with significant nondiscretionary expenses related to employees and 
infrastructure and must find ways to meet its ongoing cash needs, which 
may involve selling investments at particular times that may not be 
advantageous from an investment or tax perspective.
    The Treasury Department and the IRS acknowledge the differences 
between private foundations subject to section 4940(c) and educational 
institutions in their missions, functions, and operating expenses. 
Based on these differences, these final regulations allow the use of 
capital loss carryovers consistent with the approach recommended by the 
commenter.

C. Related Organizations for Purposes of Net Investment Income and 
Assets

    Section 4968(d)(1) provides that the assets and net investment 
income of any related organization with respect to an educational 
institution are to be treated as assets and net investment income, 
respectively, of the educational institution. The statute provides two 
exceptions: (1) No such amount is to be taken into account with respect 
to more than one educational institution, and (2) unless the related 
organization is controlled by the institution or is a supporting 
organization (as described in section 509(a)(3)) with respect to the 
institution for the taxable year, assets and net investment income that 
are not intended or available for the use or benefit of the institution 
are not to be taken into account by that educational institution.
    Under section 4968(d)(2), the term ``related organization'' means, 
with respect to an educational institution, any organization that (1) 
Controls the educational institution; (2) is controlled by the 
educational institution; (3) is controlled by one or more persons that 
also control the educational institution; (4) is a supported 
organization (as defined in section 509(f)(3)) with respect to the 
educational institution during the taxable year; or (5) is a supporting 
organization (as described in section 509(a)(3)) with respect to the 
educational institution during the taxable year.
    The first three categories of related organizations require control 
of an organization, but the statute does not define the term 
``control.'' Furthermore, whether the educational institution is the 
controlling or controlled entity matters because, if the related 
organization controls the educational institution, or is controlled by 
one or more persons that also control the educational institution, then 
assets and net investment income of the related organization that are 
not intended or available for the use or benefit of the educational 
institution are not taken into account. In contrast, if a related 
organization is controlled by an educational institution, then all the 
assets and net investment income of the related organization are taken 
into account by the educational institution.
    Specifically, the proposed regulations defined control as: (1) In 
the case of a corporation, ownership (by vote or value) of more than 50 
percent of the stock of the corporation; (2) in the case of a 
partnership, ownership of more than 50 percent of the profits interests 
or capital interests in such partnership; (3) in the case of a trust 
with beneficial interests, ownership of more than 50 percent of the 
beneficial interests in the trust; or (4) in the case of a nonprofit 
organization or other organization without owners or persons having 
beneficial interests (nonstock organization), including a governmental 
entity, (a) more than 50 percent of the directors or trustees of the 
educational institution or nonstock organization are either 
representatives of, or are directly or indirectly controlled by, the 
other entity or (b) more than 50 percent of the directors or trustees 
of the nonstock organization are either representatives of, or are 
directly or indirectly controlled by, one or more persons that control 
the educational institution.
    The commenters sought clarifications and modifications of how 
related organizations are treated based around three major issues: (1) 
Control, (2) potential double taxation of certain types of related 
organizations, and (3) treatment of the assets of certain related 
organizations.
a. Control
    Commenters stated generally that use of the proposed definition of 
``control'' would result in educational institutions' being required to 
take into account assets and net investment income that

[[Page 65555]]

the educational institutions do not actually control and that they will 
never receive because the assets and income actually belong to 
unrelated third parties. The commenters also stated that such a rule is 
inconsistent with Congressional intent, and would not address 
Congressional concerns that educational institutions might attempt to 
avoid the section 4968 excise tax by holding assets in structures that, 
as compared to direct ownership, represent a difference in form but not 
substance.
    The final regulations provide separate rules for the different 
relationships that may exist and separately define control for 
organizations that (1) control an educational institution, (2) are 
controlled by an educational institution, and (3) are controlled by one 
or more persons that also control an educational institution.
b. Double Taxation of Certain Related Organizations
    Even if an educational institution controls certain types of 
related organizations, subjecting the assets or net investment income 
of these organizations to the section 4968 tax might result in double 
or triple taxation. In applying the related organization provisions of 
section 4968(d), commenters recommended disregarding taxable 
corporations and trusts, partnerships and pass-through entities, and 
split-interest trusts.
    Several types of entities that might be related organizations are 
taxed and then provide after-tax dollars to the educational 
institution. Counting these distributions toward the section 4968 tax 
might result in double taxation. The Treasury Department and the IRS do 
not consider it consistent with Congressional intent to tax the income 
again under section 4968. These final regulations exclude from the 
definition of ``related organization'' a taxable corporation and 
certain taxable trusts, in each case whether foreign or domestic.
    To prevent double taxation of a partnership's net investment income 
and overcounting of its assets, these final regulations exclude from 
the definition of ``related organization'' a partnership, S 
corporation, or other pass-through entity a portion of whose income 
flows through to the educational institution.
c. Treatment of Assets of Certain Related Organizations
i. Trusts
    With respect to trusts, commenters raised issues concerning 
``control'' and whether charitable remainder trusts should be counted 
as an asset of the educational institution, even if the educational 
institution is deemed to control the trust. Several commenters stated 
that the proposed rule for control of trusts, which provided that 
control of a trust with beneficial interests means ownership of more 
than 50 percent of the beneficial interests in the trust, would not 
lead an educational institution to control the trust within the 
generally accepted meaning of that term. Commenters stated that the 
trustee of a trust does not control a trust in a way that is relevant 
for purposes of section 4968, because the trustee is required to 
administer the trust in accordance with, and to the extent of the 
trustee's duties and powers as determined by, the terms of the trust 
and applicable law.
    The Treasury Department and the IRS acknowledge that the concept of 
control does not mesh well with trusts. In attempting to construct a 
replacement for the control rule for trusts to be used in the context 
of section 4968, the Treasury Department and IRS identified the 
circumstances under which a trust should be deemed to have a 
relationship with the educational institution that is sufficiently 
similar to that generally intended by the concept of control.
    These final regulations provide that a trust is a related 
organization, and an educational institution is deemed to control that 
trust, only: (1) If the educational institution is substantially the 
sole permissible trust beneficiary or appointee of both income and 
principal, whether or not the timing of distributions is subject to the 
trustee's discretion; (2) if the trust is a pooled income fund 
described in sections 642(c)(3) and 642(c)(5); (3) to the extent that 
the assets of the trust were contributed to the trust by the 
educational institution (or by a person controlled by the educational 
institution, as determined under these regulations); or (4) to the 
extent that the educational institution (or a person controlled by the 
educational institution, as determined under these regulations) has the 
right to demand (or can otherwise cause) a distribution of principal 
from the trust to the educational institution (or a person controlled 
by the educational institution). The final regulations clarify how to 
determine whether a person is controlled by an educational institution.
    With respect to split interest and charitable remainder trusts, 
commenters noted that an educational institution generally is not able 
to receive any benefit from, and cannot use assets in the trust, until 
the termination of the interests of the income beneficiaries (which may 
be decades into the future). This is true even if the value of the 
educational institution's interest in the trust exceeds 50 percent of 
the present value of all beneficial interests in the trust. Further, 
commenters noted it would be difficult for an educational institution 
to obtain information about the income of a split-interest trust, as 
there is currently no federal requirement for a split-interest trust to 
report this information to its remainder beneficiary(ies).
    With regard to charitable remainder trusts and split-interest 
trusts, even those that are administered by an educational institution, 
the Treasury Department and the IRS concluded that the assets and net 
investment income of such trusts should be included in the educational 
institution's assets and net investment income only as they are 
received by the educational institution. Any income from such trusts 
already is included in the educational institution's net investment 
income as it is received. A remainder interest held by an educational 
institution is deferred for a sometimes lengthy and sometimes 
indeterminate amount of time and is subject to market fluctuations that 
will affect (or could eliminate) the amount of any eventual 
distribution of principal to the educational institution.
    In addition, because there are only limited circumstances in which 
the educational institution would have sufficient control over a trust 
to justify treating the trust as a related organization, the final 
regulations also exclude all other taxable trusts from the definition 
of a related organization except to the extent the educational 
institution is deemed to control the trust.
ii. Employee Benefit Funds
    Commenters stated that various retirement and benefit plans should 
be excluded from the definition of related organization for purposes of 
section 4968(d), stating that the beneficiaries of these plans are 
employees of the educational institutions and it was not the intent of 
Congress to tax the investment income of these entities. Accordingly, 
these final regulations provide that an employee benefit fund is not a 
related organization for purposes of section 4968(d).
iii. Nonstock Organizations
    One commenter objected to the proposed rule for control of nonstock 
organizations, stating that the portion of the rule that is based on 
directors or trustees of the educational institution being 
representatives of the other organization often incorrectly determines 
which entity controls the

[[Page 65556]]

other, as the presence of common directors or trustees alone is not 
determinative of control.
    The Treasury Department and the IRS agree that a modified version 
of control for nonstock organizations that is based on the power of the 
educational institution (or one or more of its managers, directors, 
officers, trustees, or employees, acting only in that capacity) to 
cause (or prevent) a certain act would more appropriately reflect 
control by the educational institution over the nonstock organization.
    Thus, these final regulations provide that an educational 
institution controls a nonstock organization if the educational 
institution (or one or more of its managers, directors, officers, 
trustees, or employees acting only in that capacity) can (1) appoint or 
elect (which must include the power to remove and replace) more than 50 
percent of the members of the nonstock organization's governing body 
(such as directors, officers, or trustees), or otherwise can appoint or 
elect that majority with reasonable frequency; (2) require the nonstock 
organization to make an expenditure (or prevent the organization from 
making an expenditure); or (3) require the nonstock organization to 
perform any act that significantly affects its operations (or prevent 
it from performing such an act). Such control includes control by 
aggregating votes or positions of authority (including by veto power) 
but applies regardless of the method by which the control is exercised 
or exercisable.

Paperwork Reduction Act

    The collections of information contained in the final regulations 
will be submitted to the Office of Management and Budget for review in 
accordance with the Paperwork Reduction Act of (1995) (44 U.S.C. 
3507(d)). An agency may not conduct or sponsor, and a person is not 
required to respond to, a collection of information unless it displays 
a valid control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
return information are confidential, as required by 26 U.S.C. 6103.

A. Collections of Information Imposed by the Regulations

    The collection of information in these final regulations is in 
Sec. Sec.  53.4968-1(b)(2), (3), (4), and (5); 53.4968-2(d)(2)(ii) and 
(iii); and 53.4968-3(c) and (d)(2). The collection of information for 
Sec.  53.4968-1 is required to determine whether an educational 
institution is an applicable educational institution, as defined in 
section 4968(b). In particular, this collection of information includes 
definitions to enable educational institutions to determine what 
individuals constitute students of the educational institution, which 
students are tuition-paying, which students are located in the United 
States, and which assets of the educational institution are used 
directly in carrying out an institution's exempt purpose. The 
collection of information for Sec.  53.4968-2 is required to calculate 
net investment income as defined in section 4968(c). In particular, 
this collection of information includes determining an applicable 
educational institution's share of gain upon the sale or other 
disposition of a partnership asset. The collection of information for 
Sec.  53.4968-3 is required to determine the assets and net investment 
income of related organizations that are treated as assets and net 
investment income of applicable educational institutions, as defined in 
section 4968(d). In particular, this collection of information includes 
whether an organization is a supporting organization (as described in 
section 509(a)(3) of the Code) with respect to such institution 
(including whether the supporting organization is a Type I, Type II, or 
Type III), whether the related organization supports more than one 
educational institution, and determining the assets and net investment 
income of a related organization that are attributed to the educational 
institution.
    The excise tax for section 4968 is reported by timely filing a Form 
990, Return of Organization Exempt From Income Tax, and Form 4720, 
Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal 
Revenue Code, Schedule O, Excise Tax on Net Investment Income of 
Private Colleges and Universities. In 2016, the IRS released and 
invited comments on drafts of an earlier version of Form 4720 in order 
to give members of the public the opportunity to benefit from certain 
specific amendments made to the Code. The IRS received no comments on 
Form 4720 during the comment period. Consequently, the IRS made Form 
4720 available on December 9, 2016, for use by the public. The IRS is 
contemplating making additional changes to Form 4720 to accommodate new 
provisions provided for in the final regulations, such as for the 
allowance of capital loss carryovers. The IRS intends that the burden 
of the collections of information will be reflected in the burden 
associated with Form 4720, OMB approval number 1545-0047.

B. Burden Estimates

    The burden associated with Form 4720 is included in the aggregated 
burden estimates for OMB control number 1545-0047. The burden estimates 
in 1545-0047 relate to all filers associated with the Forms 990 and 
4720, and will in the future include, but not isolate, the estimated 
burden of the information collections associated with these final 
regulations.
    The expected burden estimates for this final rule are based on the 
information that is available to the IRS, and have been updated from 
the proposed regulations to include new provisions provided in the 
final regulations that reduce the record keeping burden for the private 
colleges and universities that are subject to the tax under section 
4968. The final regulations clarify that an educational institution may 
use any reasonable method for determining whether a student is located 
in the United States as long as that method is consistently applied, 
and that the educational institution may use any reasonable method to 
determine the reasonable cash balance necessary to cover current 
operating expenses, providing an example of a reasonable method. The 
final regulations also exclude several items of income from the 
definition of gross investment income, such as interest income from 
certain student loans, rental income from the provision of certain 
housing to students, faculty, and staff, and certain royalty income. 
The final regulations further disregard from the calculation of capital 
gains any gain from the sale or exchange of the portion of property 
that is used by an applicable educational institution for its exempt 
purpose and any appreciation in the value of donated property that 
occurred prior to the date of its donation. The final regulations 
provide an easier method for applicable educational institutions to 
substantiate interests and assets in partnership holdings. Finally, the 
final regulations exclude several types of organizations from the 
definition of ``related'' and adjust the definition of control for 
purposes of determining when an organization is related for purposes of 
section 4968.
    The expected burden for private colleges and universities that are 
subject to this rule as described in section 4968(b) is listed below:
    Estimated number of respondents: 40.
    Estimated average annual burden hours per response: 10 hours, 7 
minutes.

[[Page 65557]]

    Estimated total annual burden: $39,026 ($2017).
    Estimated frequency of collection: Annual.
    Accordingly, the new provisions in the final regulations reduced 
the estimated average annual burden hours per response by 22 hours, 20 
min, and the estimated total annual burden by $84,310 from the burdens 
estimated in the proposed regulations, which provided for an estimated 
40 number of participants, 32 hours and 27 minutes average burden hours 
per response, and $123,336 (2017) total annual burden.
    In the proposed regulations, the Treasury Department and the IRS 
requested comments on all aspects of information collection burdens 
related to the regulations, including estimates for how much time it 
would take to comply with the paperwork burdens described above for 
each relevant form and ways for the IRS to minimize the paperwork 
burden. The Treasury Department and the IRS did not receive any 
comments on these issues. Proposed revisions (if any) to the forms that 
reflect the information collections contained in these final 
regulations will be made available for public comment at https://apps.irs.gov/app/picklist/list/draftTaxForms.html and will not be 
finalized until after these forms have been approved by OMB under the 
PRA. Comments on these forms can be submitted at https://www.irs.gov/forms-pubs/comment-on-tax-forms-and-publications.

Regulatory Flexibility Act

    Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it 
is hereby certified that these final regulations will not have a 
significant economic impact on a substantial number of small entities. 
In the proposed regulations, the Treasury Department and the IRS 
invited comments on the impact this rule may have on small entities. 
The Treasury Department and the IRS did not receive any comments on 
this issue. As discussed elsewhere in this preamble, this rule merely 
provides definitions regarding the applicability of the section 4968 
excise tax to certain private colleges and universities and rules for 
calculating any tax that might be imposed. The requirements in this 
regulation fall only on educational institutions whose non-exempt 
assets have an aggregate fair market value of at least $500,000 per 
student of the institution and that have at least 500 tuition-paying 
students (for a minimum investment asset value of $250,000,000).
    The threshold established by the Small Business Administration for 
an educational institution to be considered a small entity is income 
from all sources exceeding $27.5 million. This final rule will not 
affect a substantial number of small entities. Only about 1.7 percent 
of four-year colleges and universities (less than 40 out of over 2,400 
institutions in the National Center for Education Statistics' 
Integrated Post-Secondary Education System Data for 2016) are expected 
to be affected by the tax. This is because at a modest 4 percent rate 
of return, the minimum endowment alone would generate income of $10 
million. To generate another $17.5 million in income would require 
receipts of $35,000 per student if the institution had only the minimum 
number of students, compared to average tuition and fees at a four-year 
private college or university, which was $39,529 in 2015-16. 
Accordingly, the Secretary certifies that this rule will not affect a 
substantial number of small entities.
    Pursuant to section 7805(f), the notice of proposed rulemaking was 
submitted to the Chief Counsel for the Office of Advocacy of the Small 
Business Administration for comment on its impact on small business (84 
FR 31795, July 3, 2019). No comments on the notice were received from 
the Chief Counsel for the Office of Advocacy of the Small Business 
Administration.

Congressional Review Act

    The Office of Management and Budget has determined that the final 
rule is not a ``major rule'' within the meaning of the Congressional 
Review Act (5 U.S.C. 801, et seq.).

Unfunded Mandates Reform Act

    Section 202 of the Unfunded Mandates Reform Act of 1995 requires 
that agencies assess anticipated costs and benefits and take certain 
other actions before issuing a final rule that includes any Federal 
mandate that may result in expenditures in any one year by a state, 
local, or tribal government, in the aggregate, or by the private 
sector, of $100 million in 1995 dollars, updated annually for 
inflation. The final regulations do not include any Federal mandate 
that may result in expenditures by state, local, or tribal governments, 
or by the private sector in excess of that threshold.

Executive Order 13132: Federalism

    Executive Order 13132 (entitled ``Federalism'') prohibits an agency 
from publishing any rule that has federalism implications if the rule 
either imposes substantial, direct compliance costs on state and local 
governments, and is not required by statute, or preempts state law, 
unless the agency meets the consultation and funding requirements of 
section 6 of the Executive order. The final regulations do not have 
federalism implications and do not impose substantial direct compliance 
costs on state and local governments or preempt state law within the 
meaning of the Executive order.

Drafting Information

    The principal authors of these regulations are Melinda Williams and 
Amber L. MacKenzie, Office of Associate Chief Counsel (Employee 
Benefits, Exempt Organizations, and Employment Tax). However, other 
personnel from the Treasury Department and the IRS participated in 
their development.

Statement of Availability of IRS Documents

    IRS Revenue Procedures, Revenue Rulings, Notices, and other 
guidance cited in this document are published in the Internal Revenue 
Bulletin (or Cumulative Bulletin) and are available from the 
Superintendent of Documents, U.S. Government Publishing Office, 
Washington, DC 20402, or by visiting the IRS website at http://www.irs.gov.

List of Subjects in 26 CFR Part 53

    Excise taxes, Foundations, Investments, Lobbying, Reporting and 
recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 53 is amended as follows:

PART 53--FOUNDATION AND SIMILAR EXCISE TAXES

0
Paragraph 1. The authority citation for part 53 continues to read, in 
part, as follows:

    Authority:  26 U.S.C. 7805.
* * * * *

0
Par. 2. Sections 53.4968-1 through 53.4968-4 are added to subpart K to 
read as follows:
Sec.
53.4968-1 Excise tax based on investment income of certain private 
colleges and universities.
53.4968-2 Net investment income.
53.4968-3 Related organizations.
53.4968-4 Applicability date.


Sec.  53.4968-1   Excise tax based on investment income of certain 
private colleges and universities.

    (a) Excise tax on the investment income of certain private colleges 
and universities. For taxable years beginning after December 31, 2017, 
section 4968 of the Internal Revenue Code (Code) imposes a tax equal to 
1.4 percent of the net investment income (as defined in

[[Page 65558]]

section 4968(c) and Sec.  53.4968-2) of an applicable educational 
institution (as defined in section 4968(b)(1) and paragraph (b)(1) of 
this section).
    (b) Definitions. The definitions in this paragraph (b) apply for 
purposes of section 4968 and Sec. Sec.  53.4968-1 through 53.4968-4.
    (1) Applicable educational institution. The term applicable 
educational institution means any eligible educational institution (as 
defined in section 25A(f)(2) of the Code and Sec.  1.25A-2(b) of this 
chapter)--
    (i) That had at least 500 tuition-paying students during the 
preceding taxable year;
    (ii) More than 50 percent of whose tuition-paying students are 
located in the United States;
    (iii) That is not described in the first sentence of section 
511(a)(2)(B) of the Code (relating to state colleges and universities); 
and
    (iv) The aggregate fair market value of the assets of which at the 
end of such preceding taxable year (other than those assets that are 
used directly in carrying out the institution's exempt purpose) is at 
least $500,000 per student.
    (2) Student. The term student means a person who is enrolled and 
attending a course for academic credit from the institution and who is 
being charged tuition at a rate that is commensurate with the tuition 
rate charged to students enrolled for a degree. The number of students 
of an educational institution (including for purposes of determining 
the number of students at a particular location) is based on the daily 
average number of full-time students (with part-time students taken 
into account on a full-time student equivalent basis). The standards 
for determining part-time students, full-time students, full-time 
equivalents, and daily average are determined by each educational 
institution. However, the standards may not be lower than the minimum 
applicable standards established by the Department of Education under 
the Higher Education Act of 1965 (20 U.S.C. 1088), as amended.
    (3) Tuition-paying--(i) In general. The term tuition-paying means 
the payment of any tuition or fees required for the enrollment or 
attendance of a student for a course of instruction at an educational 
institution. Tuition and fees do not include payment for supplies or 
equipment required during a specific course once a student is enrolled 
in and attending the course, or payment for room and board or other 
personal living expenses.
    (ii) Treatment of a comprehensive or bundled fee. If a student is 
required to pay a fee (such as a comprehensive fee or a bundled fee) to 
an educational institution that combines charges for tuition with 
charges for personal expenses such as room and board, the student is a 
tuition-paying student.
    (iii) Scholarships, grants, and work study programs. Whether a 
student is tuition-paying is determined after taking into account any 
scholarships and grants provided directly by the educational 
institution or by the Federal government or any state or local 
government, and after application of any work study programs operated 
directly by the institution. Scholarships and grants provided by non-
governmental third parties, even if administered by the institution, 
are considered payments of tuition on behalf of the student. 
Accordingly, a student will be considered a tuition-paying student if 
payment of tuition or a fee is required for the enrollment or 
attendance of the student for courses of instruction after the 
application of any scholarships offered directly by the institution, 
any work study program operated directly by the institution, and any 
grants and scholarships provided by the Federal government or any state 
or local government.
    (4) Located in the United States. A student is located in the 
United States if the student resided in the United States for at least 
a portion of the time the student attended the educational institution 
during the institution's preceding taxable year. Whether a student 
resided in the United States in any given year can be determined using 
any reasonable method, as long as that method is consistently applied.
    (5) Assets used directly in carrying out an institution's exempt 
purpose--(i) In general. Except as provided in paragraph (b)(5)(iv) of 
this section, an asset is used directly in carrying out an educational 
institution's exempt purpose only if the asset is actually used 
directly by the institution in carrying out its exempt purpose. Whether 
an asset is used directly by the institution to carry out its exempt 
purpose is determined based on all the facts and circumstances. If 
property is used for an exempt purpose and for other purposes, and the 
exempt use represents 95 percent or more of the total use, the property 
is considered to be used exclusively for an exempt purpose. If the 
exempt use of such property represents less than 95 percent of the 
total use, the institution must make a reasonable allocation between 
such exempt and nonexempt uses.
    (ii) Illustrations. Examples of assets that are used directly in 
carrying out an institution's exempt purpose include, but are not 
limited to, the following--
    (A) Administrative assets, such as office equipment and supplies 
used by the institution directly in the administration of its exempt 
activities;
    (B) Real estate or the portion of any building used by the 
institution directly in its exempt activities;
    (C) Physical property such as paintings or other works of art owned 
by the institution that are on public display (or held for public 
display), fixtures and equipment in classrooms, research facilities and 
related equipment that under the facts and circumstances serve a useful 
purpose in the conduct of the institution's exempt activities;
    (D) The reasonable cash balance, determined using any reasonable 
method, necessary to cover current operating and administrative 
expenses and other normal and current disbursements directly connected 
with the educational institution's exempt activities. For this purpose, 
a reasonable method would include calculating an amount equal to three 
months of operating expenses allocable to program services, calculated 
by dividing annual functional expenses allocable to program services by 
four. A larger amount may be a reasonable cash balance for this purpose 
if, under the facts and circumstances, a larger amount is established 
to be necessary to cover administrative expenses and other normal 
disbursements directly connected with the institution's exempt 
activity.
    (E) Any property the educational institution leases to other 
persons at no cost (or at a nominal rent) to the lessee in furtherance 
of the institution's exempt purposes; and
    (F) Patents, copyrights, and other intellectual property and 
intangible property to the extent that income from those assets is 
excluded from net investment income by Sec.  53.4968-2(b)(2)(iii).
    (iii) Assets not used directly. The following assets are examples 
of assets not used directly in carrying out an institution's exempt 
purpose--
    (A) Assets that are held for the production of income or for 
investment (for example, stocks, bonds, interest-bearing notes, 
endowment funds, or leased real estate not described in paragraph 
(b)(5)(ii)(E) of this section), even if the income from such assets is 
used to carry out such exempt purpose; and
    (B) Property (such as offices and equipment) used for the purpose 
of managing the institution's endowment funds.
    (iv) Assets of related organizations. An asset of a related 
organization that is treated as an asset of an educational

[[Page 65559]]

institution by section 4968(d) and Sec.  53.4968-3(c) and that is used 
directly in carrying out an educational institution's exempt purpose, 
or that is used directly in carrying out the exempt purpose of a 
related organization that is described in section 501(c)(3), is 
considered used directly by the educational institution in carrying out 
its exempt purpose.
    (v) Valuation of assets not used directly in carrying out an 
institution's exempt purpose--(A) In general. The values of assets not 
used directly in carrying out an educational institution's exempt 
purpose are determined under the rules of section 4942(e) and Sec.  
53.4942(a)-2(c)(4), as modified by paragraph (b)(5)(v)(B) of this 
section.
    (B) Modifications. In applying the rules of Sec.  53.4942(a)-
2(c)(4), an educational institution must--
    (1) Substitute ``educational institution'' for ``private 
foundation'' or ``foundation'' every place they appear; and
    (2) Make such adjustments as are reasonable and necessary to obtain 
the fair market value of any and all assets as of the last day of the 
preceding taxable year, rather than as of any other times permitted or 
required by Sec.  53.4942(a)-2(c)(4).


Sec.  53.4968-2   Net investment income.

    (a) Net investment income--(1) In general. For taxable years 
beginning after December 31, 2017, section 4968(a) of the Internal 
Revenue Code (Code) imposes a 1.4 percent excise tax on the net 
investment income (as defined in section 4968(c) and this section) of 
an applicable educational institution and on certain amounts of net 
investment income of certain related organizations, as described in 
section 4968(d) and Sec.  53.4968-3. For purposes of this section, net 
investment income is determined under rules similar to the rules of 
section 4940(c) of the Code. Thus, net investment income generally is 
the amount by which the sum of the gross investment income (as defined 
in paragraph (b) of this section) and the capital gain net income (as 
defined in paragraph (d) of this section) exceeds the deductions 
allowed by paragraph (c) of this section. Except to the extent 
inconsistent with the provisions of this section, net investment income 
is determined under the principles of subtitle A of the Code.
    (2) Tax-exempt income. For purposes of this section, net investment 
income is determined by applying section 103 of the Code (relating to 
State and local bonds) and section 265 of the Code (relating to 
expenses and interest relating to tax-exempt income).
    (b) Gross investment income--(1) In general. For purposes of this 
section and except as provided in paragraph (b)(2) of this section, the 
term gross investment income means the gross amounts of income from 
interest, dividends, rents, payments with respect to securities loans 
(as defined in section 512(a)(5) of the Code), and royalties, but not 
including any such income to the extent included in computing the tax 
imposed by section 511 of the Code. Such term also includes income from 
sources similar to those in the preceding sentence. In general, gross 
investment income includes the items of investment income described in 
Sec.  1.512(b)-1(a) of this chapter.
    (2) Exceptions. The following items of income are excluded from the 
definition of gross investment income:
    (i) Interest income from a student loan that was made by the 
applicable educational institution or a related organization to a 
student of the applicable educational institution in connection with 
the student's attendance at the institution;
    (ii) Rental income from the provision of housing by the applicable 
educational institution or a related organization to students of the 
applicable educational institution and from housing for faculty and 
staff if the housing is provided contingent on their roles as faculty 
or staff of the applicable educational institution; and
    (iii) Royalty income that is derived from patents, copyrights, and 
other intellectual property and intangible property to the extent those 
assets resulted from the work of student(s) or faculty member(s) in 
their capacities as such with the applicable educational institution. 
However, neither royalty income from trademarks on the institution's 
logo or name nor royalty income from intellectual property donated or 
sold to the institution is excluded from gross investment income under 
this rule.
    (c) Deductions--(1) In general. For purposes of computing net 
investment income--
    (i) There is allowed as a deduction from gross investment income 
all the ordinary and necessary expenses paid or incurred for the 
production or collection of gross investment income or for the 
management, conservation, or maintenance of property held for the 
production of such income, determined with the modifications set forth 
in paragraph (c)(2) of this section. Taxes paid or incurred under 
section 4968 are not paid or incurred for the production or collection 
of gross investment income. Allowable expenses include that portion of 
an applicable educational institution's operating expenses that is paid 
or incurred for the production or collection of gross investment 
income. An applicable educational institution's operating expenses 
include compensation of officers, other salaries and wages of 
employees, outside professional fees, interest, and rent and taxes on 
property used in the applicable educational institution's operations. 
Where an applicable educational institution's officers or employees 
engage in activities on behalf of the institution for both activities 
that generate net investment income and for activities that do not 
generate net investment income, compensation and salaries paid to such 
officers or employees must be allocated between the activities that 
generate net investment income and for activities that do not generate 
net investment income.
    (ii) Where only a portion of property produces, or is held for the 
production of, income subject to the section 4968 excise tax, and the 
remainder of the property is used for other purposes, the deductions 
allowed by this paragraph must be apportioned between the taxable and 
other uses.
    (iii) No amount is allowable as a deduction under this section to 
the extent it is paid or incurred for purposes other than those 
described in paragraph (c)(1)(i) of this section. Thus, for example, 
the charitable deductions prescribed under sections 170 and 642(c) of 
the Code; the net operating loss deduction prescribed under section 
172; and the special deductions prescribed under part VIII of 
subchapter B of chapter 1 of the Code are not allowable.
    (2) Deduction modifications. The following modifications must be 
made in determining deductions otherwise allowable under this paragraph 
(c):
    (i) The depreciation deduction is allowed, but only on the basis of 
the straight-line method provided in section 168(b)(3) and without 
regard to section 168(b)(1) and (2).
    (ii) The depletion deduction is allowed, but such deduction is 
determined without regard to sections 613 and 613A of the Code, 
relating to percentage depletion.
    (iii) The basis to be used for purposes of the deduction allowed 
for depreciation or depletion is the basis determined under the rules 
of part II of subchapter O of chapter 1 of the Code (part II of 
subchapter O), subject to the modifications found in paragraphs 
(c)(2)(i) and (ii) of this section (relating to depreciation and 
depletion), and without regard to Sec.  53.4968-2(d)(2) (relating to 
the basis for determining

[[Page 65560]]

gain for property held on December 31, 2017, and continuously 
thereafter to the date of disposition), or section 362(c) of the Code 
(relating to certain special basis rules regarding contributions of 
capital to corporations). Thus, an applicable educational institution 
must reduce the cost or other substituted or transferred basis by an 
amount equal to the straight-line depreciation or cost depletion, 
without regard to whether the applicable educational institution 
deducted such depreciation or depletion during the period prior to its 
first taxable year beginning after December 31, 2017. However, where an 
applicable educational institution has previously taken depreciation or 
depletion deductions in excess of the amount which would have been 
taken had the straight-line or cost method been employed, such excess 
depreciation or depletion also is taken into account to reduce basis. 
If the facts necessary to determine the basis of property in the hands 
of the donor or the last preceding owner by whom it was not acquired by 
gift are unknown to the applicable educational institution, then the 
original basis to the applicable educational institution of such 
property is determined under the rules of Sec.  1.1015-1(a)(3) of this 
chapter.
    (iv) The deduction for expenses paid or incurred in any taxable 
year for the production of gross investment income earned as an 
incident to a charitable function can be no greater than the income 
earned from such function which is includible as gross investment 
income for such year. For example, where rental income incidentally is 
realized in a year from historic buildings held open to the public, 
deductions for amounts paid or incurred in that year for the production 
of such income is limited to the amount of rental income includible as 
gross investment income for the year.
    (d) Capital gains and losses--(1) In general. In determining 
capital gain net income for purposes of the tax imposed by section 
4968--
    (i) Interaction with section 511. No gain or loss from the sale or 
other disposition of property is taken into account to the extent that 
such gain or loss is taken into account for purposes of computing the 
tax imposed by section 511.
    (ii) Sales or other dispositions of exempt use property. To the 
extent that property is used by the educational institution for its 
exempt purposes, capital gain from the sale or exchange of the portion 
of that property that is used by the educational institution for its 
exempt purposes is disregarded;
    (iii) Sales of donated property--(A) In general. Any appreciation 
in the value of donated property that occurred prior to the date of its 
donation to the institution is disregarded.
    (B) Date of donation. The date of donation is determined under the 
timing rules of Sec.  1.170A-1(b) of this chapter.
    (C) Value on the date of donation. The value of the donated 
property on the date of donation is determined under the valuation 
rules of Sec.  1.170A-1(c) of this chapter; and
    (iv) Capital losses. Net losses from sales or other dispositions of 
property by one related organization (or by the applicable educational 
institution) reduce (but not below zero) net gains from such sales or 
other dispositions by other related organizations (or by the applicable 
educational institution). Should overall net losses from sales or other 
dispositions of property exceed gains from sales or other dispositions 
of such property during the same taxable year, such excess may not be 
deducted from gross investment income in any taxable year, nor may such 
excess be used to reduce gains in prior taxable years. However, capital 
loss carryovers are allowed and may be deducted from capital gains in a 
future year.
    (2) Basis--(i) For purposes of calculating gain from the sale or 
other disposition of property other than a partnership interest. 
Subject to the modifications of paragraphs (c)(2)(i) and (ii) of this 
section (referring to the modifications relating to deductions against 
gross investment income) and without regard to section 362(c), the 
basis for purposes of determining gain from the sale or other 
disposition of property (other than a partnership interest) for 
purposes of determining capital gain net income for purposes of the tax 
imposed by section 4968 is the greater of--
    (A) Fair market value on December 31, 2017, plus or minus all 
adjustments after December 31, 2017, and before the date of disposition 
under the rules of part II of subchapter O, provided that the property 
was held by the applicable educational institution on December 31, 
2017, and continuously thereafter to the date of disposition, or
    (B) Basis as determined under the rules of part II of subchapter O.
    (ii) For purposes of determining a distributive share of gain from 
the sale or other disposition of a partnership asset. For purposes of 
determining an applicable educational institution's share of gain upon 
the sale or other disposition of a partnership asset, the applicable 
educational institution's basis in each such partnership asset 
generally is determined under the rules of subchapter K of chapter 1 of 
the Code (subchapter K). However, see paragraph (d)(3) of this section.
    (iii) For purposes of determining gain on the sale or other 
disposition of a partnership interest. For purposes of determining an 
applicable educational institution's gain upon the sale or other 
disposition of all or a portion of a partnership interest, the 
applicable educational institution's basis in such partnership interest 
is generally determined under the rules of subchapter K, subject to the 
special rules in paragraph (d)(3) of this section.
    (iv) For purposes of calculating loss. Subject to the modifications 
of paragraphs (c)(2)(i) and (ii) of this section (referring to the 
modifications relating to deductions against gross investment income) 
and without regard to section 362(c), basis as determined in paragraph 
(d)(2)(i)(B) of this section applies for purposes of determining loss. 
For purposes of determining loss from the sale or other disposition of 
a partnership interest, basis is determined under the rules of 
subchapter K.
    (3) Special rules regarding partnership interests and partnership 
assets--(i) Reduction of distributive share of capital gain net income 
from a partnership. For purposes of computing net investment income, an 
applicable educational institution reduces the amount of its 
distributive share of capital gain net income from a partnership by the 
least of--
    (A) The applicable educational institution's share of applicable 
capital gain (as defined in paragraph (d)(3)(iii)(A) of this section) 
from such partnership;
    (B) One-third of the applicable educational institution's 
unadjusted step-up (as defined in paragraph (d)(3)(iii)(B) of this 
section) for such partnership; or
    (C) The applicable educational institution's adjusted step-up (as 
defined in paragraph (d)(3)(iii)(C) of this section) for such 
partnership.
    (ii) Reduction of capital gain net income from a sale or other 
disposition of all or a portion of a partnership interest. For purposes 
of computing net investment income, an applicable educational 
institution reduces the amount of its capital gain net income upon the 
sale or other disposition of all or a portion of a partnership interest 
by an amount that bears the same relation to the applicable educational 
institution's adjusted step-up (as defined in paragraph (d)(3)(iii)(C) 
of this section) for such partnership as the fair market value of the 
transferred portion of the interest bears to the fair market

[[Page 65561]]

value of the applicable educational institution's entire interest in 
such partnership before the sale or other disposition.
    (iii) Definitions. For purposes of this section--
    (A) Applicable capital gain. For an applicable educational 
institution's first taxable year beginning after December 31, 2017, the 
term applicable capital gain means an applicable educational 
institution's share of both short-term and long-term capital gains and 
losses subject to section 4968 from a partnership. For subsequent 
taxable years, applicable capital gain does not include an applicable 
educational institution's share of short-term capital gains and losses 
subject to section 4968 from a partnership. For purposes of this 
paragraph, applicable capital gain is not less than zero.
    (B) Unadjusted step-up. An applicable educational institution 
computes an unadjusted step-up for each partnership interest it held on 
December 31, 2017. The unadjusted step-up for a partnership interest 
equals the excess, if any, of the fair market value of such partnership 
interest on December 31, 2017, over the adjusted basis of such 
partnership interest on December 31, 2017.
    (C) Adjusted step-up. An applicable educational institution 
computes an adjusted step-up for each partnership interest it held on 
December 31, 2017. The adjusted step-up for a partnership interest 
equals the unadjusted step-up for such partnership, reduced by the 
amount of any capital gain net income reduction pursuant to paragraphs 
(d)(3)(i) and (ii) of this section for such partnership.
    (4) Examples. The following examples illustrate paragraph (d)(3) of 
this section. Unless stated otherwise in the examples, partners have no 
tax items other than those listed in the example. With respect to 
partnerships, all allocations are in accordance with section 704(b) and 
the regulations under section 704(b) in part 1 of this chapter (Income 
Tax Regulations).
    (i) Example 1--(A) Facts. University (U), an applicable educational 
institution, is a partner in partnership PRS. On December 31, 2017, U's 
PRS interest had a fair market value of $130 and tax basis of $100. In 
2018, U's share of capital gain net income from PRS is $5, which is 
comprised of $20 of gain from the sale of capital asset X and ($15) of 
loss from the sale of capital asset Y. Further, such $5 of capital gain 
net income is applicable capital gain (as defined in paragraph 
(d)(3)(iii)(A) of this section).
    (B) Analysis. U has an unadjusted step-up (as defined in paragraph 
(d)(3)(iii)(B) of this section) for PRS of $30 ($130 fair market value 
- $100 tax basis on December 31, 2017). Pursuant to paragraph (d)(3)(i) 
of this section, for purposes of computing its net investment income, U 
reduces the amount of its capital gain net income from PRS by $5, which 
is the least of: U's share of applicable capital gain from PRS ($5); or 
one-third of U's unadjusted step-up for PRS ($10); or U's adjusted 
step-up for PRS ($30). Thus, U reduces its $5 of capital gain net 
income allocated from PRS by $5, resulting in U having $0 of capital 
gain net income in 2018 for purposes of section 4968. As a result, U's 
adjusted step-up for PRS for subsequent taxable years is reduced to $25 
($30 - $5) pursuant to paragraph (d)(4)(iii)(C) of this section. 
Pursuant to section 705, the $5 of gain allocated to U increases U's 
tax basis in its PRS interest to $105.
    (ii) Example 2--(A) Facts. The facts are the same as in paragraph 
(d)(4)(i)(A) of this section (Example 1). In 2019, U sells its entire 
interest in PRS for $130, which, immediately prior to the sale, had a 
tax basis of $105. As a result, U has $25 of capital gain from the sale 
of its PRS interest.
    (B) Analysis. Pursuant to paragraph (d)(3)(iii) of this section, 
for purposes of computing its net investment income, U reduces its 
capital gain net income resulting from the sale of its entire PRS 
interest by $25, which is the amount that bears the same relation to 
U's adjusted step-up for PRS ($25) as the fair market value of the 
transferred portion of PRS ($130) bears to the fair market value of the 
U's entire interest in PRS before the sale or other disposition ($130). 
Thus, U reduces its $25 of capital gain net income from the sale of its 
PRS interest by $25, resulting in U having $0 of capital gain net 
income in 2019 for purposes of section 4968.
    (iii) Example 3--(A) Facts. The facts are the same as in paragraph 
(d)(4)(i)(A) of this section (Example 1). In 2019, U's share of capital 
gain net income from PRS is $15, which is comprised of $15 of gain from 
the sale of capital asset Z. Further, such $15 of capital gain net 
income is applicable capital gain (as defined in paragraph 
(d)(3)(iii)(A) of this section).
    (B) Analysis. Pursuant to paragraph (d)(3)(i) of this section, for 
purposes of computing its net investment income, U reduces the amount 
of its capital gain net income from PRS by $10, which is the least of: 
U's share of applicable capital gain from PRS ($15); or one-third of 
U's unadjusted step-up for PRS ($10); or U's adjusted step-up for PRS 
($25, computed as $30 of unadjusted step-up, less $5 of capital gain 
net income reduced in 2018 pursuant to paragraph (d)(3)(i) of this 
section). Thus, U reduces its $15 of capital gain net income allocated 
from PRS by $10, resulting in U having $5 of capital gain net income in 
2019 for purposes of section 4968. As a result, U's adjusted step-up 
for PRS is reduced for subsequent taxable years to $15 ($25 - $10) 
pursuant to paragraph (d)(3)(iii)(C) of this section. Pursuant to 
section 705, the $15 of gain allocated to U increases U's tax basis in 
its PRS interest to $120.


Sec.  53.4968-3   Related organizations.

    (a) Definition of related organization--(1) In general. For 
purposes of section 4968(d) of the Internal Revenue Code (Code) and 
Sec. Sec.  53.4968-1 through 53.4968-4, except as provided in paragraph 
(a)(2) of this section, the term related organization means, with 
respect to an educational institution, any organization that--
    (i) Controls such institution;
    (ii) Is controlled by such institution;
    (iii) Is controlled by one or more persons that also control such 
institution;
    (iv) Is a supported organization (as defined in section 509(f)(3) 
of the Code) with respect to such institution during the taxable year; 
or
    (v) Is a supporting organization (as described in section 
509(a)(3)) with respect to such institution during the taxable year.
    (2) Organizations not considered related organizations. For 
purposes of section 4968(d) and Sec. Sec.  53.4968-1 through 53.4968-4, 
the term related organization does not include any organization that 
is--
    (i) A taxable corporation;
    (ii) A taxable trust, including a non-grantor charitable lead trust 
(except to the extent the trust is controlled by the educational 
institution as described in paragraph (b)(2)(ii) of this section);
    (iii) A grantor charitable lead trust;
    (iv) A charitable remainder trust;
    (v) A partnership, S corporation (as defined in section 1361(a)(1) 
of the Code), or other pass-through entity that is generally not 
subject to Federal income tax, the income of which is taxable to its 
partners or other interest holders; or
    (vi) A decedent's estate.
    (3) Employee benefit plans or arrangements. A trust or similar 
funding vehicle of an employee benefit plan or arrangement, such as a 
section 501(a) trust funding a section 401(a) qualified retirement 
plan, or an annuity contract funding a section 403(b) plan, or a 
section 419(e) welfare benefit fund

[[Page 65562]]

(including a voluntary employees' beneficiary association under section 
501(c)(9)) funding a welfare benefit plan, will not be treated as a 
related organization and its assets will not be treated as the assets 
of the educational institution or of a related organization. A trust or 
other funding vehicle of an unfunded employee benefit plan of an 
educational institution or a related organization, such as a grantor 
trust described in section 671 et seq., used in connection with a 
section 457(b) plan or an arrangement subject to section 457(f), will 
be treated as a related organization for purposes of section 4968(d) 
and its assets will be treated as the assets of the educational 
institution or of a related organization, but the assets are not 
considered ``used directly in carrying out the institution's exempt 
purpose'' for purposes of section 4968(b)(1)(D). For purposes of 
determining whether the employee benefit plan of an educational 
institution is funded or unfunded, the educational institution and all 
of its related organizations are treated as a single sponsor and payor 
of the benefits.
    (b) Control--(1) Controls such institution. For purposes of section 
4968(d) and Sec. Sec.  53.4968-1 through 53.4968-4, an organization 
controls an educational institution if--
    (i) The organization owns (by vote or value) more than 50 percent 
of the voting and non-voting stock or membership interest of the 
educational institution; or
    (ii) The organization (or one or more of its managers, directors, 
officers, trustees, or employees, acting only in those capacities) 
can--
    (A) Appoint or elect (which must include the power to remove and 
replace) more than 50 percent of the members of the educational 
institution's governing body (such as directors, officers, or 
trustees), or otherwise has the ongoing power to appoint or elect more 
than 50 percent of such members with reasonable frequency;
    (B) Require the educational institution to make an expenditure (or 
prevent the educational institution from making an expenditure); or
    (C) Require the educational institution to perform any act that 
significantly affects its operations (or prevent it from performing 
such an act).
    (2) Is controlled by such institution. For purposes of section 
4968(d) and Sec. Sec.  53.4968-1 through 53.4968-4, an organization is 
controlled by an educational institution:
    (i) Tax-exempt corporation. In the case of a corporation recognized 
as exempt from income tax under section 501(a), if the educational 
institution owns (by vote or value) more than 50 percent of the voting 
and nonvoting stock or membership interest of the corporation.
    (ii) Trust--(A) In general. In the case of a trust--
    (1) If the educational institution is substantially the sole 
permissible trust beneficiary or appointee of both income and 
principal, whether or not the timing of the distribution is subject to 
the trustee's discretion;
    (2) If the trust is a pooled income fund described in sections 
642(c)(3) and 642(c)(5);
    (3) If, but only to the extent that, the assets of the trust were 
contributed to the trust by the educational institution (or by a person 
controlled by the educational institution); or
    (4) If, but only to the extent that, the educational institution 
(or person controlled by the educational institution) has the right to 
demand (or can otherwise cause) a distribution of principal from the 
trust to the educational institution (or a person controlled by the 
educational institution).
    (B) Person controlled by the educational organization. For purposes 
of this paragraph (b)(2)(ii), a person is controlled by an educational 
institution if the educational institution has the power to remove and 
replace such person or otherwise controls the person under one of the 
tests described in Sec.  53.4968-3(b)(2)(i), (ii), or (iii), with 
similar principles applying for purposes of determining control of any 
other form of entity.
    (iii) Nonstock organization. In the case of a nonstock 
organization, if the educational institution (or one or more of its 
managers, directors, officers, trustees, or employees, acting only in 
those capacities) can--
    (A) Appoint or elect (which must include the power to remove and 
replace) more than 50 percent of the members of the organization's 
governing body (such as directors, officers, or trustees), or otherwise 
has an ongoing power to appoint or elect more than 50 percent of such 
members with reasonable frequency);
    (B) Require the organization to make an expenditure (or prevent the 
organization from making an expenditure); or
    (C) Require the organization to perform any act that significantly 
affects its operations (or prevent it from performing such an act).
    (3) Is controlled by one or more persons that also control such 
institution. For purposes of section 4968(d) and this section, an 
organization (other than one described in paragraph (a)(2) of this 
section) is controlled by one or more persons that also control the 
educational institution if more than 50 percent of the members of the 
governing body of the other organization are directly or indirectly 
controlled by persons that comprise more than 50 percent of the members 
of the governing body of the educational institution.
    (4) Constructive ownership. The principles of section 318(a)(2) 
(relating to ownership attribution from partnerships, estates, trusts, 
and corporations) apply for purposes of determining ownership of stock 
in a corporation, and similar principles apply for purposes of 
determining ownership of an interest in any other entity.
    (5) Method of control. Control includes control by aggregating 
votes or positions of authority (including by veto power), but applies 
regardless of the method by which the control is exercised or 
exercisable.
    (c) Organization described in section 509(a)(3) during the taxable 
year with respect to the educational institution. A section 509(a)(3) 
organization is a supporting organization with respect to an 
educational institution only if the supporting organization meets the 
organizational, operational, and relationship tests of section 
509(a)(3)(B) and Sec.  1.509(a)-4 of this chapter with respect to the 
educational institution.
    (d) Assets and net investment income of related organizations--(1) 
In general. A related organization's assets and net investment income 
are taken into account both in determining whether an institution is an 
applicable educational institution and in computing the net investment 
income of an applicable educational institution. For purposes of 
determining the aggregate fair market value of the assets and net 
investment income of an educational institution, the assets and net 
investment income of all related organizations are treated as the 
assets and net investment income, respectively, of the institution, 
unless an exception provided in paragraph (d)(2) of this section or the 
exception provided in Sec.  53.4968-1(b)(5)(iv) (relating to assets 
used directly in carrying out an exempt purpose) applies. In cases in 
which an organization is a related organization with respect to an 
educational institution under more than one definition of this Sec.  
53.4968-3, then the rule that attributes the largest amount of assets 
and net investment income of the related organization to the 
educational institution must be applied.
    (2) Exceptions. For purposes of section 4968 and this paragraph 
(d)(2)--

[[Page 65563]]

    (i) No amount is taken into account with respect to more than one 
educational institution. In determining the aggregate fair market value 
of the assets and net investment income of an educational institution, 
assets and net investment income of a related organization are not 
taken into account with respect to more than one educational 
institution. Thus, in any case in which an organization is a related 
organization with respect to more than one educational institution, the 
assets and net investment income of the related organization must be 
allocated between or among the educational institutions as to which the 
organization is a related organization, subject to paragraph (d)(2)(ii) 
of this section. The educational institution must make such allocation 
in a reasonable manner, taking into account all facts and 
circumstances, that is consistent across all related organizations.
    (ii) Assets and net investment income that are not intended or 
available for the use or benefit of the educational institution--(A) In 
general. Unless a related organization is controlled by the educational 
institution or is a supporting organization described in section 
509(a)(3) with respect to such institution for the taxable year, assets 
and net investment income of a related organization that are not 
intended or available for the use or benefit of the educational 
institution are not taken into account by that educational institution.
    (B) Determining whether assets and net investment income of a 
related organization are intended or available for the use or benefit 
of an educational institution. If a related organization controls the 
educational institution, is controlled by one or more persons that also 
control such institution (but is not described in section 509(a)(3) 
with respect to the educational institution for the taxable year), or 
is a supported organization (as defined in section 509(f)(3)) during 
the taxable year with respect to the educational institution, then the 
related organization's assets and net investment income are taken into 
account as assets and net investment income of the educational 
institution only to the extent the assets and net investment income are 
intended or available for the use or benefit of that educational 
institution. Assets and net investment income of a related organization 
are intended or available for the use or benefit of an educational 
institution if such assets and net investment income are specifically 
earmarked or restricted for the benefit of, or otherwise are fairly 
attributable to, the educational institution. For example, assets are 
fairly attributable to the educational institution if they have been 
affirmatively designated or appropriated for the educational 
institution or made available for the educational institution to draw 
upon at will. Conversely, assets and net investment income of a related 
organization are not intended or available for the use or benefit of an 
educational institution if such assets and net investment income are 
specifically earmarked or restricted for another entity or for 
unrelated purposes or otherwise are not fairly attributable to the 
educational institution. The assets and net investment income of a 
related organization must be allocated between those intended or 
available for the use or benefit of an educational institution and 
those not intended or not available for the use or benefit of that same 
educational institution. The educational institution must make such 
allocation in a reasonable manner, taking into account all facts and 
circumstances, that is consistent across all related organizations.
    (C) Related organizations that are controlled by the educational 
institution or that are supporting organizations (as described in 
section 509(a)(3)) with respect to the educational institution during 
the taxable year--(1) In general. If a related organization is 
controlled, as defined in paragraph (b)(2) of this section, by an 
educational institution, or is a supporting organization with respect 
to the educational institution during the taxable year, as defined in 
paragraph (c) of this section, the assets and net investment income of 
the related organization are taken into account as assets and net 
investment income of the educational institution regardless of whether 
those assets and net investment income are earmarked or restricted for 
the benefit of, or otherwise are fairly attributable to, the 
educational institution and even if they are specifically earmarked or 
restricted for another entity or for unrelated purposes or otherwise 
are not fairly attributable to the educational institution, subject to 
paragraph (d)(2)(ii)(C)(2) of this section. However, see Sec. Sec.  
53.4968-1(b)(2)(ii)(A)(3) and (4) regarding trusts that are controlled 
related organizations only to the extent assets of the trust were 
contributed to the trust by the educational institution (or by a person 
controlled by the educational institution), or only to the extent the 
educational institution (or person controlled by the educational 
institution) has the right to demand (or can otherwise cause) a 
distribution of principal from the trust to the educational institution 
(or a person controlled by the educational institution). See also Sec.  
53.4968-1(b)(5)(iv) for rules relating to when assets of a related 
organization are deemed to be used directly in carrying out the 
institution's exempt purpose.
    (2) Special rule for Type III supporting organizations with respect 
to an educational institution as of December 31, 2017. An educational 
institution with a related organization that was a Type III supporting 
organization with respect to the educational institution on December 
31, 2017, takes into account only the assets and net investment income 
of such Type III supporting organization that are intended or available 
for the use or benefit of, or otherwise are fairly attributable to, the 
educational institution, as described in paragraph (d)(2)(ii)(B) of 
this section. An educational institution may determine whether the 
assets and net investment income of such a Type III supporting 
organization are intended or available for the use or benefit of, or 
otherwise are fairly attributable to, the educational institution using 
any reasonable method. A method that attributes to an educational 
institution assets and net investment income of a supporting 
organization that specifically are earmarked for the educational 
institution, are restricted for the benefit of the educational 
institution, or otherwise are fairly attributable to the educational 
institution (such as those that have been affirmatively designated or 
appropriated for the educational institution or made available for the 
educational institution to draw upon at will) will be deemed to be 
reasonable.
    (3) Determining assets of related organizations. To determine which 
assets of a related organization are included by an educational 
institution under section 4968(b)(1)(D) for a particular year, an 
educational institution determines which organizations are related 
organizations, as defined in section 4968(d)(2) and Sec.  53.4968-3, as 
of the end of the educational institution's preceding taxable year, and 
values the relevant assets on that date.
    (4) Determining net investment income of related organizations. To 
determine the amount of net investment income of a related organization 
that is included by the applicable educational institution in 
calculating the tax imposed by section 4968(a) for a particular taxable 
year, an applicable educational institution determines which 
organizations are related organizations, as defined in section 
4968(d)(2) and Sec.  53.4968-3, as of the

[[Page 65564]]

end of that taxable year of the applicable educational institution and 
includes the net investment income from each related organization's 
taxable year that ends with or within that same taxable year of the 
applicable educational institution. If an organization became a related 
organization after the beginning of the applicable educational 
institution's taxable year, then the applicable educational institution 
includes the organization's net investment income for the portion of 
the year that the organization was a related organization, using any 
reasonable method.


Sec.  53.4968-4   Applicability date.

    The rules of Sec. Sec.  53.4968-1 through 53.4968-3 apply to 
taxable years of an educational institution beginning after October 15, 
2020.

Sunita Lough,
Deputy Commissioner for Services and Enforcement.
    Approved: September 4, 2020.
David J. Kautter,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2020-20933 Filed 10-14-20; 8:45 am]
BILLING CODE 4830-01-P