Taxing and Regulating College and University Endowments: The Literatures Perspective

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Taxing and Regulating College and University
Endowments The Literatures Perspective

• Mark J. Cowan
• Boise State University
• ATA Midyear Meeting
• Memphis, Tennessee
• Feb. 22, 2008

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The Issue

• College and university endowments have recently
  experienced record investment returns
• Despite the increased earnings, payout rates have
  remained steady
• Fiscal 2006 Return 15.3
• Fiscal 2006 Payout Rate 4.6
• Fiscal 2007 Return 17.2
• Fiscal 2007 Payout Rate 4.6
• Tuition Rates have increased
• gt 6 average increase 2007-2008

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The Issue

• Colleges and universities are accused of
  hoarding their endowment earnings
• September of 2007 Senate Finance Committee
  Hearing on Endowmentsdiscussed
• Mandating a minimum payout
• Taxing endowment earnings
• January of 2008 Senators Baucus and Grassley
  sent a letter to 136 Colleges and Universities
  with endowments of 500 million or more,
  requesting details on
• Endowment investment payout policies
• Tuition and financial aid policies

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Issues Considered

• No specific proposals are currently before
  Congress
• The paper considers two general possibilities
• Taxing endowment earnings under the Unrelated
  Business Income Tax (UBIT)
• Mandating a minimum payout requirement based on
  the current payout requirements that apply to
  private foundations

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Approach to the Issues

• Missing from the debate over endowments the
  theoretical underpinning of our current tax
  treatment of educational institutions
• What does the rich literature about tax exempt
  organizations teach about how we should treat the
  current issues surrounding endowments?
• The paper reviews the endowment issue in light of
  the literature on
• The rationales for granting tax exempt status to
  educational institutions
• The rationales underlying the Unrelated Business
  Income Tax (UBIT)
• The rationales underlying the private foundation
  rules

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Background

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Private vs. Public Institutions

• Private institutions exempt from tax under
  Section 501(a) as 501(c)(3) organizations
• Public institutions exempt from tax because they
  are part of a state government
• Endowments of public institutions are normally
  held in separate 501(c)(3) organizations
• Re avoid state restrictions on spending
• Re maintain the privacy of donations
• Example When I donate to Boise State
  University, my donation goes to the Boise State
  University Foundation (a 501(c)(3) organization)
  to support BSU not to the state of Idaho

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Private vs. Public Institutions

• Public institutions have had to turn to private
  funding (via endowments) in light of reduced
  state support
• Both private and public institutions are subject
  to UBIT in the same manner
• Bottom line the policy issues associated with
  endowments are generally the same for both
  private and public institutions

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Section 501(c)(3) Organizations

• Must be organized and operated exclusively
  i.e., primarily for religious, charitable,or
  educational purposes
• Note that educational is a purpose separate
  from charitable
• Colleges and universities benefit society by
  providing education, not necessarily by helping
  the poor
• Colleges and universities have historically NOT
  been held to a community benefit, alms for the
  poor standard

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Inurement

• To attain and maintain tax exempt status, the
  organizations net earnings may not inure to the
  benefit of private shareholders or individuals
• ANY inurement is grounds to revoke the tax
  exemption
• Backed up by INTERMEDIATE SANCTIONS in Section
  4958
• Excise tax on excess compensation
• 25 tax on excess benefit applied to the person
  receiving the benefit
• If the excess benefit is not returned, a 200 tax
  applies
• 10 tax on organization managers that
  participated in providing the excess benefit
  (capped at 20,000)
• These rules provide a check on using endowments
  to pay excess compensation to institution
  executives

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UBIT

• Colleges and universities are taxed (at the
  corporate tax rates) on income from
• A trade or business,
• Regularly carried on
• That is unrelated to the exempt mission of the
  organization (other than to provide funds to use
  in the organizations mission)
• UBIT looks to the source of the funds not the
  destination of the funds

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UBIT

• Applies to both private and public institutions
• Many exceptions protect much of the income earned
  by colleges and universities
• Passive income such as interest, dividends,
  capital gains, real property rents, and royalties
  
• 52 billion of endowment earnings in fiscal 2006
• Forgone revenue of 18 billion

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Endowments

• Made up of restricted (by donor) funds,
  self-restricted funds, and unrestricted funds
• Many funds in endowments are not restricted in
  the legal sense
• Separate accounts are established for specific
  purposes (a scholarship, an endowed
  professorship, a center, a support fund for a
  particular department)
• All accounts are invested as one pool of funds
  with earnings allocated to individual accounts

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Endowments

• Historically, endowments invested in bonds and
  other conservative investments
• Today, endowments invest in higher risk vehicles
• Hedge funds
• Venture capital firms
• Emerging Market Equities
• Returns have been impressive, but endowment
  managers expect a downturn in the current year

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A Sampling of Endowments
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Hansmanns Endowment Study (1990)

• Reviewed the various reasons for endowment
  accumulation, e.g.,
• To maintain intergenerational equity
• To main liquidity in the face of short term and
  long term financial shocks
• Hansmann took issue with all the given reasons
  for endowment accumulation and criticized
  endowment practices at Yale
• Concluded that endowments should not be forced to
  pay out a specified percentage of their assetsit
  may lead to unproductive spending
• The threat of government control can encourage
  colleges and universities to manage their
  endowments more effectively

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Rationales for Tax Exemption

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Theories of Tax Exemption

• Subsidy Theories
• Traditional Public Benefit Subsidy Theory
• Capital Subsidy Theory
• Donative Theory (Hall Colombo) (see paper)
• Income Measurement Theory

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Traditional Public Benefit Subsidy Theory

• The tax system provides a subsidy to nonprofits
• Nonprofits provide services to society the
  government is not able or willing to provide
• A subsidy is granted to stimulate private
  nonprofits without subjecting them to government
  control
• Lack of government control is a key part of the
  tax exemption regime
• Allows for innovation and flexibility in the
  nonprofit sector
• Efficiency may suffer, efforts may be wasted, but
  in the end progress comes from freedom
• This hands off view of tax exemption seems to
  have been lost in the debate over endowments

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Capital Subsidy Theory

• Hansmann (1981)
• Tax exemption remedies difficulties nonprofits
  have in raising capital
• Nonprofits must rely on retained earnings (e.g.
  endowments) rather than borrowings or equity
• A tax would reduce nonprofits access to capital

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The Subsidy Theories and Endowments

• Traditional public benefit subsidy theory
• Importance of lack of control
• As long the institution is providing education,
  it should be entitled to run its affairs
  (including its endowment) as it deems appropriate
  
• Capital subsidy theory
• Exemption helps colleges and universities to
  accumulate endowments as a source of capital
• A tax would be inconsistent with this theory
• Bottom Line The subsidy theories of tax
  exemption do not support a tax on endowment income

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Income Measurement Theory

• Bittker Rahdert (1976)
• Tax exemption is not a subsidy
• Tax exemption is granted because the activity of
  a nonprofit does not produce income as defined
  in the tax law
• Endowment income is income under the tax law,
  but it cannot be viewed in isolation since our
  income tax is on NET income

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Rationales for UBIT

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Unfair Competition

• The stated reason for enacting UBIT
• Raising revenue to finance the Korean War was
  also a stated reason
• New York University School of Law and their
  ownership of the C.F. Mueller Company
• Little evidence that that unfair competition
  would be a real problem sans UBIT (Bittker
  Rahdert)
• Overall, not a generally accepted rationale for
  UBIT
• Even if it were, passive income such as endowment
  income does not raise unfair competition issues

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Efficiency Rationale Part 1

• Hansmann (1989)
• Part 1 of Efficiency Rationale UBIT encourages
  nonprofits to invest in a diverse portfolio of
  stocks (not taxed) instead of wholly owned
  businesses (taxed)
• Without UBIT, nonprofits might
• Invest more in wholly owned businesses (stifling
  diversification)
• Invest in many wholly owned businesses (leading
  to inefficient conglomeration)

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Efficiency Rationale Part 1

• Application to Endowments
• Endowments involve passive investments that are
  diversified and do not lead to conglomeration
• With passive income and business income on the
  same tax footing, colleges and universities might
  invest in more wholly owned businesses, stifling
  diversification or leading to conglomeration

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Efficiency Rationale Part 2

• Part 2 of Efficiency Rationale UBIT prevents a
  wasted subsidy In the absence of UBIT,
  nonprofits
• Would not use their tax exempt status to lower
  their prices and undercut for-profit competition
• Would charge the same prices as their for-profit
  competitors any cost savings would be used up in
  inefficient operations
• Nonprofits have no shareholders to hold them
  accountable for inefficient operations
• Application to Endowments
• Endowments are being invested efficiently--there
  is no wasted subsidy involved

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Efficiency Rationale Part 3

• Part 3 of Efficiency Rationale In the absence of
  UBIT, nonprofits would be able to invest in
  wholly-owned businesses
• This could lead to over-saving
• Application to Endowments
• Endowments may already be over-saving
• Extension of UBIT to endowment income may dampen
  over-savingbut Hansmann does not go so far as to
  suggest an extension of UBIT

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Old Line/Political Function Rationale

• Stone (2005)
• UBIT taxes income that looks bad
• UBIT exempts income that is traditional
• Income from noodle companies taxable
• Income from passive investments exempt

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Old Line/Political Function Rationale

• Application to Endowments
• Per this theory, passive income should not be
  taxed
• But if endowments get too large and endowment
  income gets too significantthen such income may
  look bad and call for taxation
• It appears we have not yet reached this point

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Private Foundations

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Overview of Private Foundations

• Private Foundations Section 501(c)(3)
  organizations that get most of their support from
  limited sources
• A family
• An individual
• A company
• Operating foundations run a charity
• Non-operating foundations dont have charitable
  operations they make grants to other charitable
  organizations

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Overview of Private Foundations

• All Section 501(c)(3) organizations are
  considered private foundations unless they meet
  an exception
• Private colleges and universities are NOT private
  foundations
• Section 501(c)(3) organizations supporting public
  colleges and universities are (normally) NOT
  classified as private foundations
• Section 509(a)(1)

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Minimum Distribution Requirement

• Private foundations are subject to many special
  rules and restrictions
• Most important here Minimum Distribution
  Requirement (Section 4942)
• Must spend at least 5 of the net fair market
  value of their assets on charitable purposes
• Failure to do so results in excise taxes on the
  undistributed amount (30 at first)
• The minimum distribution rules do not apply to
  operating foundations

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Rationales for Minimum Distribution Requirements

• No clear, reasonable rationale has been
  identified
• Possible explanation lack of accountability
• Private foundations have substantial resources
  and enjoy tax exemption but
• They are only accountable to donors
• Once the principal donors are gone, there are few
  constituents the organization must answer to
• A minimum distribution requirement ensures that a
  private foundation is at least engaged in a
  minimum amount of charitable work

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Rationales for Minimum Distribution Requirements

• Sinister explanation (Bittker Rahdert)
• Private foundations have too much independence
  and thus too much power
• Private foundations may tread on toes that
  belong to government officials
• The regulatory regime imposed on private
  foundations keeps them in line

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Rationales for Minimum Distribution Requirements

• Whatever the merits of the minimum distribution
  requirements, they should not be applied outside
  of the private foundation context (Bittker
  Rahdert)
• Abuses may take place there may be
  inefficiencies
• But this does not justify applying the onerous
  private foundation rules to other Section
  501(c)(3) organizations

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Colleges and Universities vs. Private Foundations

• Colleges and universities look like private
  foundations because of their accumulating
  endowments
• But Colleges and universities are ACCOUNTABLE to
  a vast array of constituents

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Colleges and Universities vs. Private Foundations

• Colleges and universities must answer to
• Students
• Faculty
• Staff
• Alumni
• The surrounding community
• Accreditation agencies (at the institutional and
  program levels)
• Federal guidelines regarding financial aid for
  students
• State governments (state institutions)
• DONORS

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Colleges and Universities vs. Private
Foundations Accountability to Donors

• Colleges and universities must raise money
• Even well-endowed institutions continue to raise
  money
• Harvard must explain why it needs despite its
  large endowment
• Capital campaigns must be specific about the
  use of funds
• Bottom line the institution must be accountable
  if it wants to raise funds
• This includes being accountable for the optimal
  use of its endowment

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Developments

• Harvard, Yale, Dartmouth and others have tapped
  their endowments to offer expanded student aid
• Investment returns may not be as impressive in
  2008
• Issue may fade as colleges respond to the threat
  of congressional action and investment returns
  decline

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Lessons from the Literature

• Colleges and universities have a mission to
  educate, not necessarily to serve the less
  fortunate
• Taxation or regulation of endowments would be
  inconsistent with our current understanding of
  the rationales underlying
• The tax exemption for colleges and universities
• UBIT
• The private foundation regime
• Major critic of endowments (Hansmann) does not
  advocate regulation
• These perspectives are missing from the current
  debate over endowments

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Is It Time to Rethink the Tax Treatment of
Colleges Universities?

• While the literature does not support taxation or
  regulation of endowments, perhaps it may be time
  to discuss fundamental changes to the tax exempt
  system
• Should we rethink exemptions for colleges and
  universities?
• What does charity mean?
• What does education mean?
• Should the rules allowing restricted gifts be
  reformed?
• Should the rules regarding charitable deductions
  be reformed?
• These questions go well beyond the narrow issue
  of endowments
• Until we fundamentally re-imagine the tax
  treatment of nonprofits, Congress should avoid
  piecemeal reformssuch as taxing and regulating
  endowments

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Comments/Questions?

• markcowan_at_boisestate.edu