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Picture a mad scramble at wealthy private colleges and universities in the days after the Republican tax reform plan passed Congress, as officials scurried to find ways to dodge or minimize the new excise tax on their endowments.
With the legislation kicking in for taxable years starting after Dec. 31, there would have been little time to lose. The tax reform package places an annual 1.4 percent excise tax on net investment income at an estimated several dozen colleges and universities. Specifically, the tax will apply to institutions with at least 500 students and net assets of $500,000 per student. That includes some of the nation's wealthiest colleges, such as Harvard, Stanford and Princeton Universities, but also some that fall under the tax in large part because they have relatively small student bodies, such as Claremont McKenna College.
It also includes colleges with unique missions and circumstances that don't fit the generic picture of a college and its endowment. Kentucky's Berea College uses its substantial per-student endowment to enable it to not charge tuition and was the center of legislative maneuvering as the bill passed. Cooper Union has a per-student endowment of more than $500,000 only because it owns the $675.6 million Chrysler Building in New York City -- which represented more than 80 percent of Cooper Union's endowment value in 2016.
Picture the chaos as money managers and business officers frantically ran simulations to determine which changes would limit their tax bills. Can portfolios be sold so that the gains on top-performing assets are realized before they are taxed? Can donations be redirected so that they will not go into funds exposed to taxation? Should colleges on the edge of the bill’s $500,000-per-student cutoff enroll a few more students to drive down the average value of their assets? Should those with slightly more than 500 students try to cut enrollment next year so as to drop below that limit?
Then ignore that scene, because it’s pure fiction.
To be sure, college and university leaders are asking their business offices what the excise tax will mean for them. Tax policy tends to distort behavior, after all. But the immediate reaction to the college investment income excise tax looks less like a movie scene depicting stock market panic and more like experts reading, squinting and scratching their heads.
Most are unsure exactly how the endowment tax will affect colleges’ and universities’ behavior, especially in the short term. There are, they say, simply too many lingering unknowns about how the letter of the law will be translated into practice.
“We are expecting the Treasury Department to have to take some steps to help with some of the definitions,” said Liz Clark, director of federal affairs at the National Association of College and University Business Officers. “A lot is going to rest on the definition of assets used directly in carrying out the educational institutions’ exempt purpose, as well as the definition of net investment income.”
Clark was referring to specific language in the bill. It says net investment income will be taxed, but it remains unclear how, specifically net investment income is to be calculated. The bill also carves out some assets from being used to calculate the $500,000-per-student limit asset trigger -- those "assets which are used directly in carrying out the institution’s exempt purpose" -- but experts don’t know exactly which assets will end up being exempt.
They’re accounting questions that seem simple at first glance. But few things are simple when it comes to accounting -- or university endowments, which are often made up of a dizzying assortment of individual funds, restricted for different uses and invested in a variety of asset classes spanning bonds, public stocks, venture capital, real estate and commodities.
The excise tax isn’t even necessarily limited to endowments. While it’s been referred to publicly as an endowment tax, the bill does not use that term. It refers to an “excise tax based on net investment income,” experts pointed out.
Definitions were fluid enough in the run-up to the bill’s passage that few were able to agree on estimates of how many institutions will be subject to the tax. A National Association of Independent Colleges and Universities list included the Weill Cornell Medical College as being subject to the tax, only for Cornell University to say that its medical college’s endowed funds have long been counted toward a unified university endowment and would not be affected by the tax.
Elsewhere, consulting firm Ithaka S&R posted a long discussion about why particular methods of tabulating enrollment can change which institutions are exempt under the bill’s 500-student limit. The bill says that the number of students "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)." But Ithaka S&R pointed out that the Integrated Postsecondary Education Data System "collects both fall FTE and 12-month FTE, but it’s unclear which method the provision recommends." It also notes that several of the institutions that appear to be subject to the tax enroll only graduate students and may consider themselves part of another campus instead of stand-alone institutions -- like Weill Cornell Medical College.
The bottom line: taxing university earnings is new territory for the federal government, and tax planning is a new subject for much of private, nonprofit higher education.
Some precedent exists for taxing other nonprofit organizations’ investment income. Private foundations are already subject to an excise tax based on their investment income. Some of the language in the excise tax for private colleges and universities appears designed to mirror the law for private foundations. But colleges and universities can be vastly more complex operations than foundations, so investment managers are urging caution.
“We’re trying to provide some estimates and think about what the implications might be in terms of the cost of the tax,” said Tracy Filosa, head of the enterprise advisory practice at asset manager Cambridge Associates. “But we’re estimating that based on some experience with private foundations, not knowing exactly how it’s going to apply to higher ed.”
For private foundations, it generally has made sense to continue pursuing the highest possible long-term rates of return, Filosa said. The benefits of those returns tend to outweigh tax savings that could be realized by shifting investment strategies to minimize tax burden.
Still, each institution will face its own specific scenarios.
“I think people are looking at their balance sheets and thinking about how that asset calculation will be calculated and thinking about what net investment income looks like,” Filosa said. “You want to make sure you’re making the right moves and not moving too early on something you don’t have the right information on.”
Colleges and universities could start exploring certain types of financial arrangements in the near future. Some split-interest agreements, like charitable remainder trusts, can have third parties holding assets from donors and making regular payments to colleges and universities. Theoretically, some of those arrangements could allow an institution to receive regular income from assets without having to carry those assets on its books, where they would be subject to taxation.
Again, though, the effectiveness of that strategy hinges on regulations that are yet to be revealed. Certain experts predict final tax regulations will address split-interest agreements. Robert Spencer, a director at Huron Consulting Group, is one of them. He and his colleagues have also written that colleges and universities should be evaluating their potential tax liability and assessing their investing, spending and foundation strategies in wake of the tax bill’s passage.
Pending final regulations, colleges and universities could also end up shifting some of their fund-raising and assets into buildings instead of endowments, Spencer said. Or they could explore converting gifts to holdings that do not generate investment income.
More broadly, Spencer wonders if the relatively limited tax voted on in December could be a precursor to broader taxation of colleges’ investment holdings.
“Could this be an entry into this taxable market?” he said. “Thinking ahead, does this open the door for more types of taxation? There may be strategies not even thinking about this current law, but thinking forward.”
In other words, institutions that aren’t going to be subject to the tax are paying attention. That will be particularly true of institutions that just miss the tax’s cutoffs, said Tony Ialeggio, chief marketing officer at the asset manager Commonfund.
“I think it's probably a good assumption that certain schools that are on the border will be very aware of this on a go-forward basis and will be looking for advice from their lawyers and accountants,” he said.
There is widespread disagreement over just how deeply a 1.4 percent excise tax on net investment income will cut into budgets at wealthy colleges and universities. Take a theoretical $1 billion endowment and assume an annual return of 8 percent. The tax bill would come out to about $1.1 million.
Adding $1 million in costs could cause some institutions to cut back on student aid. Debby Kuenstner, who has managed Wellesley College’s $2 billion endowment since 2009, told WGBH On Campus Radio that a third of the college’s endowment income goes toward scholarships.
“A million dollars is serious money to us,” she told WGBH. “This is a tax bill that says, let’s invest less as a country in education, and let’s hope that those corporations that we give a big tax cut to are going to invest as wisely.”
In an email to Inside Higher Ed, Kuenstner said Wellesley would explore strategies going forward.
“Drilling down into individual strategies is another serious endeavor that Wellesley will undertake,” she wrote. “We will need to consider the after-tax return of different approaches, and how those approaches will support Wellesley’s commitment to a generous financial aid policy that enables us to enroll a socioeconomically diverse student body -- and maintain one of the lowest net prices among the country’s leading liberal arts colleges.”
Berea College -- the college in Kentucky that uses its endowment to avoid charging tuition -- has also estimated it would owe an average bill of more than $1 million per year under the new excise tax. The financial loss would probably force the college to turn away promising students, the college's president, Lyle Roelofs, recently wrote in an opinion piece for The Courier-Journal in Louisville.
Others believe taxing endowments could actually push wealthy colleges and universities to invest more in education instead of competing for prestige by stashing funds away in ever-growing endowments.
“The tax at the margin shifts the incentive away from saving and toward spending,” said Thomas Gilbert, a professor of finance at the University of Washington. “That’s a basic economic argument.”
Gilbert is critical of universities padding large endowments and routing them into what he sees as risky investments in hopes of eye-popping returns. In November, he and his fellow University of Washington finance professor Christopher Hrdlicka co-authored an op-ed in The Wall Street Journal arguing a tax on endowment investment income would help higher ed.
The piece prompted American Council on Education President Ted Mitchell to write a letter replying that endowments are supposed to generate stable and perpetual funding for colleges and universities. A tax on endowments transfers money from higher ed institutions to the federal government, Mitchell wrote.
Gilbert maintains his argument today, however. Colleges are less likely to chase high returns if those returns are taxed, he says. That means they are less likely to use risky investment strategies that can result in higher returns. But safer investments also mean more reliable funding that doesn’t evaporate with stock market crashes, as happened to many institutions in the Great Recession. And fewer investments mean more educational spending that directly benefits students.
“You generate a high expected return, yeah, you’re going to end up paying the tax,” Gilbert said. “This makes the rate of return from investing in the financial markets less attractive. You’re going to get 1.4 percent less. If I lower the net rate of return from saving a dollar, then what does it do? It makes saving less attractive.”
Gilbert does worry that the per-student limits in the Republican tax reform package will encourage some institutions to take extreme steps to avoid the tax, say, by finding ways to keep their endowment value at $499,999 per student.
Universities on the brink of tipping over the tax's per-student limits are publicly acknowledging that they are likely to have to pay it in the future. Take the case of two Chicago-area research powerhouses, the University of Chicago and Northwestern University. Some analyses point to the University of Chicago having to pay the tax but Northwestern coming in just below the per-student cutoff. Others have questioned those calculations, and even officials for the universities told the Chicago Tribune they aren't sure whether they will have to pay the tax next year. But Northwestern anticipates having to pay the tax "if not next year then in later years," a spokesman told the Tribune.