# Guidance on the Determination of the Section 4968 Excise Tax Applicable to Certain Colleges and Universities > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2020-20933 ## Record - **Collection:** Federal Register - **Document type:** Rule - **Published:** October 15, 2020 - **Citation:** 85 FR 65526 ## Text 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. 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 § 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. 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. 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 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 § 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 § 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 § 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 § 1.25A-2(b) would not address the commenter's concerns. Further, § 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 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. 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. 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 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 § 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. 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 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 § 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 § 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 § 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 § 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 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 § 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 § 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 § 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 § 53.4940-1(c) through (f), with certain modifications. Specifically, § 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 § 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 § 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 § 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 § 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 § 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 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 § 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 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 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 § 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 § 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 § 53.4940-1(e)(1)(i), § 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 § 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 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 § 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 § 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 § 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 § 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 § 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 § 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 § 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 § 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 § 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 § 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 § 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 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 § 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. 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 § 1.170A-1(b) and the value on the date of donation is determined under the valuation rules of § 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. 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 § 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. 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 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 [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2020-20933. Public record. Not legal advice.