University Endowments Under Attach: Is Intervention Necessary?
by Jessica Sine
Table of Contents
I. Introduction
II. TAX EXEMPTION OF COLLEGES AND UNIVERSITIES
A. History
B. Current Tax Structure of Colleges and Universities
C. The Unrelated Business Income Tax (UBIT)
D. Intermediate Sanctions for Private Inurement
E. Lobbying Restrictions
III. UNIVERSITY ENDOWMENTS
A. Meaning and Scope of the Term “Endowment”
B. Donor-Imposed Restrictions
C. Investment Earnings
D. Summary
IV. RATIONALES BEHIND EXEMPTION
A. Tax-Base Theories and Income Measurement
B. The Subsidy Theory
C. Egalitarian Rationale
D. Externality Rationale
V. ATTACKS ON ENDOWMENTS AND UNIVERSTITY RESPONSE
A. Higher Education Costs In General
B. Elitism
C. Endowment Spending
D. The Current Economy
1. The Economic Crisis
2. Lack of Savings
VI. POTENTIAL SOLUTIONS
A. Minimum Payout Rates
B. Revocation of Tax-Exempt Status or Tax-Deductions
C. Wealthy Universities Reducing Tuition
D. Proportionate Approach
E. Transparency
VII. CONCLUSION
I.Introduction
The emphasis placed on higher education in recent years has caused the transformation of colleges from small, local schools emphasizing education to massive institutions with gargantuan budgets and endowments. Although there are a handful of proprietary institutions, such as the University of Phoenix and DeVry Institute (which represented about five percent of enrolled students in 1999-2000), higher education in the United States is generally provided by non-profit institutions.[1]
College and university endowments have grown exponentially over the last few decades. The combined endowment assets among America’s colleges and universities are astronomically high, and these assets produce tens of billions of dollars in annual earnings. Moreover, this income is almost entirely exempt from the federal income tax—meaning that the federal government surrenders billions in annual revenue each year. These amounts far exceed the estimated $6.6 billion dollar loss in tax revenues each year from charitable deductions for contributions to educational institutions.[2]
A barrage of recent criticism regarding university endowments has stemmed from the rapid increase in tuition and low endowment payout rates, coupled with the fact that endowment earnings have increased exponentially. Some lawmakers urge that such changes have run afoul to the original purpose behind tax-exempt status, and recent scrutiny regarding the activities of universities question whether tax-exemption is warranted in all cases.[3] Although the fire fueling this criticism has waned recently due to the shift in focus to the national economy, the issue remains un-resolved. The public policy implications at issue can be better understood after a closer analysis of the function and purpose of university endowments.
II.TAX EXEMPTION OF COLLEGES AND UNIVERSITIES
A.History
Nearly all schools established during the founding years of the United States had the primary objective of training ministers, and the tax exemption of educational institutions originated with the historic exemption for religious institutions.[4] The government continued to justify the tax exemption by concluding that freeing educational institutions from taxation would enable them to spend more on providing better education to students.[5] Exemptions for educational institutions have remained throughout the years, and today nearly every state has some provision, either constitutional or statutory, providing a tax exemption from state and local taxes for educational institutions.[6]
B.Current Tax Structure of Colleges and Universities
Although a distinction can be made between public and private universities, tax treatment with respect to university endowments for both public and private institutions are largely the same.[7] For an organization to qualify for § 501(c)(3) status, a nonprofit must be (among other requirements not relevant for purposes of this discussion):
[O]rganized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes…no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation…and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.[8]
Colleges and universities are also exempt from the accumulated earnings tax, a surcharge on income that is neither distributed nor necessary to support the reasonable needs or a corporation.[9] The purpose of the accumulated earnings tax is to encourage corporations to distribute income to shareholders in a timely manner. However, in contrast to taxable corporate entities, universities may allow endowments and other non-operating investments to accumulate without being subject to federal taxation.[10]
C.The Unrelated Business Income Tax (UBIT)
While colleges and universities are not typically subject to the federal income tax, they are subject to the unrelated business income tax (UBIT). The UBIT requires payment of the federal corporate tax on income earned from a trade or business that is regularly carried on and which is unrelated to the nonprofit’s tax-exempt mission.[11] In order for the trade or business to be exempt from the UBIT, there must be a causal relationship between the trade or business and the organization’s nonprofit mission. UBIT rules look to the source of the income rather than the ultimate provision of the funds. If the funds were generated by an unrelated business, and merely used to further the organization’s tax-exempt mission, they will be taxed.[12]
D.Intermediate Sanctions for Private Inurement
Sanctions for private inurement, which constrain the distribution of university funds, are one of the key distinctions between nonprofit and for-profit entities. A university can potentially lose its tax-exempt status if any of its earnings, regardless of amount, inure to benefit of a private individual.[13] For instance, if university employee were to receive a salary that exceeded fair market value of her services, that university would have violated the private inurement requirement.
Although revocation of tax-exempt status is possible, revocation is a very harsh penalty because it penalizes not just the recipient of such funds, but the entire university community. Congress enacted intermediate sanctions in 1996 to more narrowly focus the punishment for private inurement. In this situation, the intermediate sanction is essentially an excise tax on excess compensation to any “disqualified persons,” which can range from 10% to 200% of such excess benefit.[14]
E.Lobbying Restrictions
Universities are prohibited from participation in “substantial lobbying.”[15] Additionally, they are subject to an excise tax on any expenditures, or even potential revocation, for participation in any political campaign “on behalf of, or in opposition to, any candidate for public office.”[16]
III.UNIVERSITY ENDOWMENTS
A.Meaning and Scope of the Term “Endowment”
Many universities in the United States keep substantial financial reserves customarily referred to as endowments.[17] The term “endowment” is commonly used in the broader sense to refer to the total funds reserved by an institution, including those funds without restrictions on their use.[18] However, the narrower, legal meaning of endowment refers only to such funds that are subject to donor-imposed restrictions of their use. Therefore, as the common use of the term suggests, college and university endowment funds include not only those funds restricted as to use by donors, but also funds that are self-restricted, or earmarked, by the university itself(but not legally restricted) as well as entirely unrestricted funds.[19]
It is necessary to first understand the role behind the accumulation of endowment funds in order to determine what policy measures are sound. Those who criticize the university endowment structure regard an endowment as one giant “bank account.”[20] Colleges and universities maintain in defense that an endowment is much more complex, consisting of thousands of distinct accounts, each created for a specific purpose (such as a named scholarship, or a designated professorship).[21]
Both views are partially correct. While endowments are generally managed as one large investment pool, individual accounts are maintained with internal records for each designated use. The investment pool earns income as a whole, which is later divided and paid to the separate accounts after any fees are paid to staff. Each year, a predetermined amount of a designated fraction of the income of each account is spent for the objective of that account. For example, the income could be spent in the form of a scholarship check for a qualified student.[22] The university’s governing body or supporting organization generally establishes the payout rate and payout policy. Income that is not paid currently accumulates in the account for which it is allocated, and such accumulation both allows the account to preserve its value throughout the years and supplies a hedge against inflation.[23]
This financial cushion enables colleges and universities to function unlike the usual business when it comes to financial liquidity. Whereas the typical business must borrow a considerable portion of its financial needs in order to keep prices low and stay competitive in the marketplace, endowed universities are able to operate on capital surplus.[24] In addition, wealthy endowed universities are more likely to have the ability fully own their physical assets—unencumbered by debt—while continuing to amass large financial reserves.[25]
B.Donor-Imposed Restrictions
The laws governing the enforceability of donor-imposed restrictions are unique with respect to charitable educational organizations. The common law generally disallows perpetual restrictions on the use of property from being enforced. A broad exception has recognized for donor-imposed restrictions on gifts made to universities, even if the gift does not establish a formal charitable trust.[26] Therefore, a constraint on a donation to a university obliging the principal of that gift stay together perpetually, meaning that the gift be added to endowment, is currently enforceable. However, this exception is not fixed and has been the subject of much controversy. Its retention depends on the notion that endowments serve purposes that are important enough to justify such an exception.[27]
C.Investment Earnings
Colleges and universities are allowed to accumulate income under state law in a majority of states. Such accumulation, whether by the discretion of the trustees or by the mandate of the donor, is generally limited to the amount that is “reasonable or necessary” to achieve the university’s goals. While such limits have rarely been enforced to curtail a university’s endowment accumulation, they furnish the groundwork for intervention for excessive accumulation.[28]
Until quite recently, the annual investment earnings attributable to university endowments have increased to around 15 percent, while payout rates have remained relatively fixed at around 4 percent.[29] Meanwhile, tuition rates have skyrocketed. The disparity between these numbers has caused some to urge colleges and universities to stop “hoarding” their endowment income in order to limit tuition increases and provide more student aid.[30]
This increase (and recent decrease) in the value of endowments can be attributed to a result of a combination of risk taking and “stock market bonanza.”[31] Colleges and universities in recent years have invested significant portions of their assets on high-risk, high-return securities.[32] Generally speaking: the wealthier the university, the riskier the portfolio.[33] Until justthis year, average stock prices have continually increased over the last 25 years. The inflation-adjusted Dow Jones Industrial Average Index was five times higher at the close of 2007 than it was in 1982, even despite the dot-com bubble’s burst in 2000. Under such market conditions, “even the most passive portfolio manager” would have seen large returns.[34]
D.Summary
When selecting what portion of endowment earnings ought to be spent or reinvested, broad discretion is afforded to colleges and universities.[35] Furthermore, as mentioned above, endowments consist of various types of funds, including donor-restricted funds, self-restricted funds, and funds without restrictions.[36] Therefore, endowed funds have been accumulated largely as a result of university discretion, rather than by donor directive.[37]
A closer inquiry into the rationale behind university endowments could also serve to inform donors when deciding whether to impose restrictions on their gifts.[38] Moreover, public policy is more fully understood after considering the role and function of university endowments in comparison with other endowed non-profits. Private foundations, for instance, are required by federal tax law to spend at least 5% of their current investment asset value each year to discourage the accumulation of endowment funds.[39]
IV.RATIONALES BEHIND EXEMPTION
There are far too many theories explaining the exemption of higher educational institutions to be discussed currently, therefore, this paper will discuss only the most popular and most rational among them. The two most prominent lines of thinking fall into two general categories: tax-base theories and subsidy theories. Tax-base theories explain exemption as the result of an inability to find a reliable method to measure income, and therefore to assess and impose a tax, received and spent by nonprofit organizations. In contrast, as the name suggests, subsidy theories regard the exemption from taxation as an indirect subsidy of funds in the amount of the taxes not collected due to the exemption.[40] Two additional explanations for exemption are the egalitarian rationale and the externality rationale.
A.Tax-Base Theories and Income Measurement
Boris Bittker and George Rahdert’s renowned 1976 article on the nature of tax exemption provides a comprehensive analysis of tax-base theory, whereby the authors assert that the exemption from federal income tax results from fundamental problems encountered when attempting to accurately calculate the income earned by nonprofits.[41] However, Henry Hansmann has remarked more recently that income measurement is not difficult for the numerous nonprofit organizations (including institutions of higher education) that often operate much like their proprietary counterparts by drawing the majority of their income from the sale of goods or services.[42]
A growing number of educational institutions now have large professional staffs, complex, computerized methods of accounting, and generally operate more like commercial businesses. Therefore, whatever historic problems regarding income measurement that may have existed are rapidly disappearing today.[43] Many universities essentially “sell” education in the same manner that Sprint sells phone service, and students (“customers”) pay for the product. A significant portion of gross revenues of private universities comes from student tuition and sales.[44] The UBIT is a key example of the business-like operations of colleges and universities. Although it would seem ludicrous to provide Sprint with an across-the-board tax exemption, the exemptions given to private universities have rarely been questioned since our country’s birth.[45] This argument is strengthened by the fact that, while colleges and universities seem to be operating for profit, most of the expenses incurred by educational institutions fit squarely within the margins of deductible business expenses, such as salaries and maintenance, within Section 162 of the Internal Revenue Code.[46]
B.The Subsidy Theory
The subsidy theory in effect argues that by allowing educational institutions to conserve more funds to provide improved education and increase the potential for research, the government is actually reducing its financial burden by providing higher education.[47] Although the subsidy theory accurately explains the tax-exemption, policymakers and university leaders must ask whether it still justifies the exemption. As public subsidies to universities continue to grow, so does the power of the structures being subsidized.
A small majority of universities manage to consume the most attention and resources. This current structure has created an upper-tier of elite institutions that verge on becoming monopolies. The wealthiest of these institutions are incredibly well endowed, yet they continue to benefit from sweeping direct and indirect tax subsidies.[48] This raises an important policy question whether these subsidies be better invested differently, but still for higher education.
C.Egalitarian Rationale
One of the standard explanations offered for the steady rise of tuition rates is that there has been a steady increase in demand. Namely, colleges argue that the noticeable gap between incomes earned among college graduates compared with that of high school graduates has increased the demand for higher education, thereby raising the average price to attend college.[49]
The egalitarian model rationalizes that “universities can promote equal economic opportunity, high levels of intergenerational income mobility, and the American egalitarian ideal that “all men are created equal.” The egalitarian argument emphasizes the teaching, or instructional, element of higher education. While college graduates generally have a much larger earning potential than non-graduates, the high cost of college education (in addition to the loss of several years of income while in college) presents a kink in the higher education structure.[50] Some argue that without government intervention, intergenerational income mobility will be in jeopardy. Others speculate that many people with great talent and potential—but no means to provide for a college education—will be unable to reach the level of success that they are capable of achieving. Therefore, intergenerational income mobility will suffer, “to the detriment of [those people] themselves, America’s egalitarian tradition, and the nation as a whole.”[51]