The OBBBA Higher Education Endowment Tax Could Divert Colleges From Their Core Mission And Encourage Tax Sheltering

The reconciliation bill passed by House Republicans (the One Big Beautiful Bill Act (OBBBA)) now being considered in the Senate would significantly expand the scope and amount of tax collected on the net investment income (NII) from endowments of certain colleges and universities. As a result, colleges subject to the tax increase will have less funding available to educate students, especially poorer members of their student populations. In addition, the higher rates contemplated in the OBBBA will exacerbate incentives for affected institutions to avoid the tax using a range of tax avoidance strategies, further adding to tax code complexity and potentially detracting from universities' core mission.

How the NII tax would work

The proposed NII tax resembles the existing 1.4 percent tax rate imposed by the 2017 Tax Cuts and Jobs Act (TCJA) on a select group of colleges. However, the House bill would extend the tax to a larger group, following a tiered structure based on the per-student endowment amount. Tax rates would range from 1.4 percent of NII for endowments of $500,000 to $750,000 per student, up to 21 percent for those with $2 million or more per student. The Senate bill would also follow a tiered structure, but its top rate would be 8 percent.

NII includes interest, dividends, rents, securities loans, and royalties. However, it excludes accrued capital gains until the assets are sold, as well as the implicit return on ownership of real estate (essentially the rent saved by owning rather than leasing land and buildings). Additionally, NII does not include operating income, such as tuition and other fees.

The bill also includes an additional income tax on teaching international students. It achieves this by subtracting international students from the denominator used to calculate the count of endowment per student, pushing more institutions over the threshold for a zero or lower tax rate.

The risk of greater tax sheltering

Taxes on capital income derived from specific assets are among the most complex aspects of tax law, partly because investors can often rearrange their portfolios and conduct other transactions to legally evade these taxes. For example, portfolio managers can find assets whose returns, for one reason or another, are less likely to be taxed.

Colleges and universities affected by the proposed NII tax employ savvy portfolio managers. The endowment tax and its proposed increase provide strong incentives for educational institutions and potential donors to participate in various activities to mitigate it. Here are a few possibilities:

Easy: Portfolio reshuffling

• Convert dividend-paying stocks into non-dividend-paying alternatives, such as transferring equity holdings to corporations that reinvest earnings instead of distributing dividends.

• Convert mutual fund and certain stock holdings into tax-advantaged exchange-traded funds (ETFs) and other investment funds.

• Borrow against the endowment when cash is needed, instead of realizing endowment income.

• Leverage debt, using the endowment as collateral, reduce NII by deductible interest, and then purchase assets whose returns are in the form of accrued gains.

Moderately difficult: Business adjustments

• Transform reserves into net real estate equity, which does not generate investment income.

• Establish lower or zero interest rates on any institutional student loans offered (since that interest is subject to being included as investment income and taxed) and fund the loss in income with lower direct scholarships funded from tax-sheltered assets.

• Pay bills in advance using taxable reserves and invest additional funds in assets yielding nontaxable returns.

• If an endowment’s structure allows, convert money that might have gone into endowment into any reserves that don’t count as endowment (to decrease the amount of endowment per student, the measure that determines the tax rate).

• Enroll fewer international students and engage in fewer international student exchanges.

Complicated: New donor-college arrangements

• Encourage donors to create trusts and other vehicles (e.g., donor-advised funds) that hold assets, with returns designated now or later for the college. This effectively transforms annual income from endowments (now held privately) into annual donations.

• Some individuals likely will choose to delay contributions by keeping assets with nontaxable returns until death, thereby reducing the combined overall tax burden that both the donor and the college would pay on the income.

  • While from the donor's perspective, these options might maximize the donation's value, they would likely be suboptimal from the college’s standpoint due to the greater uncertainty surrounding the donation and its timing.

• Avoid counting revocable pledges as part of the endowment total or encourage reliable donors to make oral rather than formal pledges (so as to move into a lower tax rate bracket based on the size of the endowment per student).

Highly Complex: Long-run institutional reorganization

• Establish independent scholarship funds or supporting charities to maintain endowments, separating them and, if necessary, their trustees from the college or university.

• Eliminate tuition for all but 499 students (to meet the tax requirement, the school must have 500 tuition-paying students) and increase fees for dormitory housing and other living necessities.

• Do not add endowed centers (or divest from some educational activities) to reduce endowment per student, but encourage their establishment nearby with separate boards.

To protect the assets that support the education of their students, colleges and universities have strong incentives to participate in various activities to reduce the impact of a higher tax on their endowment income. Congress could respond to such strategies by adding more laws and regulations. But, just as with the businesses and individuals, the tax planning industry would likely counter with new approaches, resulting in an even more elaborate mix of rules and regulations.

Ultimately, fewer resources would be available to students, especially those who would benefit the most from support. It is hard to argue that any of this leads to educational reform.

*Sandy Baum is a Senior Fellow at the Urban Institute; Jill S. Manny is the Executive Director of the National Center on Philanthropy and the Law and Professor of Law at New York University. This column was first published in Tax Vox on June 19.