Many changes in federal tax polziy during the past f ive years have and will continue to have a sign$cant impact on institutions of higher education. Current tax policies as well as future developments and their implications for institutional planners are reviewed and assessed in this chapter.

Federal Tax Policy and Higher Education: Assessing Recent Developments

Dorothy K. Robinson

The past five years have seen developments in federal tax policy that have significant implications for institutions of higher education. The most obvious was the Economic Recovery Tax Act (ERTA) of 1981, with its across-the-board tax rate cuts for individuals, new accelerated cost-recovery system, new above-the-line charitable deduction for indi- viduals, incremental research tax credit for corporations, and other provisions mostly designed to stimulate the economy. In addition, the results or even the side effects of real or threatened changes in federal relationships with the not-for-profit sector, and with higher education in particular (including anticipated as well as actual cuts in federal funding for research and training programs and student loans), have heightened institutional sensitivity to other tax issues. The acknowl- edged necessity of bringing federal deficits under control makes it likely that the tax laws will remain a focus of congressional attention, with tax policy a primary mechanism of federal impact on higher education.

V A. Hodgkinson (Ed ). Impart and Cho1h.p ofa Cham&- FIdnal Role. New Directions for Institutional Research, no 45. San Francisco: Jorsey-Bas, March 1985 27

This chapter will review five areas of tax policy in which there have been recent developments: the charitable deduction and the tax climate for giving; tax incentives for corporate-sponsored scientific research and education; tax-exempt financing; unrelated-business in- come tax; and the taxation of fringe benefits. For each area, I will sug- gest some ways in which additional institutional research can aid in understanding the effects of those changes that have come or that can be anticipated and in devising strategies that take advantage of this information.

In selecting these five areas for review, I do not mean to diminish the importance of a number of other currently prominent tax issues- for example, sale-leasebacks and antidiscrimination regulation by the Internal Revenue Service. Because of space limitations, however, I have restricted my discussion to issues that have broad effects or whose recent or pending developments should stimulate appraisals by a wide range of institutions.

The Charitable Deduction and the Tax Climate for Giving

The tax law changes in ERTA initially created substantial uncertainty about the educational sector’s ability to maintain and increase the portion of its support that comes from private giving. ERTA brought about a number of changes, some favorable and some unfavorable to charitable giving by individuals and corporations. On balance, because of the incentive to giving that higher tax rates provide, changes have been expected to dampen charitable giving. ERTA included a 23 percent reduction in individual marginal tax bracket tax rates over three years, a lowering of the maximum tax rate on unearned income from 70 to 50 percent, reduction of the maximum capital-gains tax rate from 28 to 20 percent, and substantial liberalizations of gift and estate taxation.

The income tax changes (and, perhaps to a lesser extent, the gift and estate tax changes) theoretically encourage private giving by plac- ing more cash at the disposal of individual donors. Nevertheless, they also increase the after-tax cost of donating in every case, especially at higher taxable-income levels, where the rate reductions are the great- est. Thus, the previous thirty-cent after-tax cost of a one-dollar dona- tion from a taxpayer, who had been taxed at 70 percent on that dollar (formerly the highest tax rate on unearned income), is now raised to fifty cents as the tax rate is lowered to 50 percent. Individual giving has been variously estimated by economists to be significantly price-sensitive,

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with evidence that this sensitivity increases with income level (see, for example, Clotfelter and Steuerle, 1981, which includes a review of prior studies; Sunley, 1978). Moreover, the higher-income taxpayers - those affected the most by the tax rate reductions in ERTA-are dispropor- tionately heavy donors to higher education, as opposed to the remain- ing types of charitable, religious, and other nonprofit enterprises (see, for example, Levi and Steinbach, 1973; Dye and others, 1979, p. 208).

A study (Clotfelter and Salamon, 1981) prepared for the Urban Institute and released shortly after the August 1981 enactment of ERTA projected that these negative price effects of the ERTA income tax cuts on individual giving, at least in the short run, would be likely to outweigh the positive, income effects of the legislation and that, as a result, total giving to charities could be expected to fall short over 1983- 1984 by $18.3 billion cumulative (without adjustment for inflation) from what it would have been under prior law. In percentage terms, education was projected to fare the worst of all segments of nonprofit sector: Individual giving to education was projected to decline from 1980 levels by 3.3 percent (after adjustment for inflation) over the same period.

Charitable Deduction for Nonitemizers. ERTA established a new phased-in charitable deduction for nonitemizing taxpayers, equal to 25 percent of the first $100 of contributions in 1982 and 1983, 25 percent of the first $300 of contributions in 1984, and 50 percent and 100 percent of contributions without a cap in 1985 and 1986, respectively. This pro- vision, Code Section 170(i), %unsets” in 1986 unless Congress acts to extend it. (All references in this chapter to the Code are to the Internal Revenue Code of 1954, as amended.

At least in the short run, the value of the above-the-line deduc- tion to colleges and universities is not so much in the amount of con- tributions it is expected to attract, since the bulk of individual giving to higher education comes from donors who itemize. Rather, this deduc- tion is valuable primarily because it answers criticisms that the item- ized charitable deduction is undemocratic, benefits only the fewer than 30 percent of taxpayers who itemize, and is inequitable because that minority has overwhelmingly higher incomes. Making the deduction universally available also encourages understanding of the charitable deduction as appropriate for deriving a true definition of taxable in- come. This argument - that the deduction is income-defining because charitable contributions represent diversions of private income to public purposes and therefore ought not to be taxed - applies equally in defense of the itemized deduction.

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The evidence will not be available until after 1986, when the deduction is fully phased in, but the above-the-line deduction may bring about tangible benefits for higher education by increasing donor participation rates and establishing giving habits among younger alumni. This effect could be increasingly significant if alumni contribu- tions, which represented roughly one quarter of higher education’s total voluntary support in 1981-1982 (Council for Financial Aid to Educa- tion, 1983), continue to creep upward as a share of total support. Such an effect, of course, would depend on making the deduction permanent.

Tmation of Gifts and Bequests. ERTA substantially liberalized gift and estate taxation. The most significant changes were removal of the limit on the marital deduction for gift and estate taxes, so that there can now exist unlimited tax-free interspousal transfers; a four-year phased reduction in maximum rates, from 70 percent to 50 percent, on estates over $2.5 million; and stepped increases in the unified gift and estate tax credit, from $47,000 to $192,800, over a six-year period, which will mean an exemption of taxable estates valued at $600,000 or less from all taxes commencing in 1987. As with the income tax changes, and for many of the same reasons, these and other, more tech- nical revisions significantly reduce the impact of estate and gift taxes and expand the opportunities for tax-free transfers of assets. These revisions are also expected to diminish the tax incentive of the estate and gift tax charitable deductions for inducing gifts and bequests to charities (Hopkins, 1982, pp. 64-73).

Corporate Contributions. Corporate donations, which have long been a relatively minor source of financial support for higher educa- tion, are probably discouraged overall by ERTA. While the limit on corporate charitable contributions (Code Section 170(b)(2)) was raised from 5 percent to 10 percent of taxable income, ERTA’s liberalization of depreciation allowances, and other provisions that reduce corporate taxable income, have effectively reduced that limit. Thus, the change may have little net effect and, in any event, would affect only the rela- tively few corporations whose contributions exceed the former limit. More significant is the new increased deduction, which ERTA also added for corporate contributions of new scientific equipment (see the discus- sion of tax incentives for corporate-sponsored scientific research and education, below).

Overview. The charitable deduction has been the primary area of tax policy that has concerned colleges and universities for roughly a decade, since the arrival on the federal scene of the “tax expenditure” concept and its incorporation into the congressional budgeting process. During this period, and especially in connection with the work of the

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Commission on Private Giving and Public Needs (the Filer Commis- sion), economists and others have studied the relationship between philanthropy and the charitable deduction extensively. Many of their studies have used various data and econometric methods to estimate the price-sensitivity of giving. Feldstein and Taylor (1977), for exam- ple, have pointed out the relative “efficiency” of the deduction, com- pared with direct government expenditure, where price elasticities are estimated to be below - 1. Below that level, tax increases that affect the price of giving cost charities more in lost contributions, dollar for dollar, than they raise in government revenue. Thus, the implications should give pause to reformers who would scrap the deduction in favor of direct government subsidies.

In response to the Reagan administration’s 1981 budget propo- sals, and even more recently, there has been well-publicized concern for protecting the financial base of the voluntary sector during a time of federal budgetary cutbacks. A study for the Urban Institute (Salamon and Abramson, 1982) built on the earlier analysis of Clotfelter and Salamon (1981) to project revenue losses that the nonprofit sector would face overall in government funding under the original 1981 Reagan budget proposals. The study concluded that private giving would have to increase at a rate “three to four times higher than the highest rate it has achieved in recent decades” (p. 63) to keep up with inflation as well as make up for these lost revenues. While such con- cern ultimately may have been responsible for the continuing strength of charitable giving during the Reagan administration (despite the recession), it has not insulated the charitable deduction from challenge.

Of course, proposals to modify or reform the deduction would have significant institutional effects on higher education. Proposals to replace part of the deduction with a credit, to reintroduce the deduc- tion as a tax-preference item for the minimum tax, and to tax gifts of appreciated property partially or wholly could all be expected to affect aggregate giving to higher education negatively if they diminished tax incentives for upper-bracket taxpayers and donors of large gifts or appreciated property and replaced these incentives with others to bene- fit lower-income taxpayers. Other proposals to remedy particular defi- ciencies in the deduction- such as limiting authors’ and creators’ deduc- tions for contributing manuscripts and artworks to an amount not to exceed their costs- would have obvious benefits for institutions. Pro- posals for a flat-rate tax continue to be discussed with increasing serious- ness and could constitute a major reversal for those who emphasize the tax incentives provided by the combination of the charitable deduction with substantial tax rates (see Lindsey, 1983).

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Additional study of the relationship between tax incentives and voluntary support for higher education should focus on donor attributes (for example, income levels and method of tax reporting) and types of gift (property versus cash) to have particular significance for colleges and universities and inform the best institutional responses to the mul- tiplicity of legislative tax proposals. Nevertheless, estimates of impact will not be meaningful to any individual institution unless that institu- tion has an understanding of its own data on giving: Who are the insti- tution’s donors, alumni, and nonalumni by income and age? Just how important are major gifts? How important are gifts of appreciated property? Bequests? What is the composition of gifts by purpose (current versus endowment, restricted versus unrestricted)? Is the composition shifting? Within higher education there may be important differences in the projected impact of various changes by type of institution (pri- vate versus public, four-year versus two-year, coeducational versus single-sex), since the levels of giving, preferred forms of gift, and pur- poses of gifts vary so considerably among them (see Council for Finan- cial Aid to Education, 1983; Jenny and Allan, 1977).

Institutional researchers and other administrators should use what is already understood about relationships among taxes and bear in mind the profile presented by the institution’s own data. Applica- tions of the knowledge include such tasks as targeting fund-raising goals and evaluating results, evaluating the adequacy of development vehicles for accommodating anticipated tax-related donor concerns, and devising particular development strategies that take advantage of tax-related opportunities. Better knowledge of tax relationships may also be useful for informing other institutional planning activities, for example, planning capital expenditures, that depend on projections of fund raising.

Tax Incentives for Corporate-Sponsored Scientific Research and Education

ERTA enacted two separate provisions intended to benefit corporate-sponsored scientific research and training at colleges and universities: a new 25 percent tax credit on qualifying incremental research expenditures of businesses and a liberalized charitable deduc- tion measure for corporate donations of new inventory equipment for scientific research. These provisions were contemporaneous with a surge of interest, on the part of universities as well as industry, in estab- lishing increased collaborative relationships. The provisions were also accompanied by other tax developments that have stimulated interest

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in private research investment vehicles, including R&D limited part- nerships; these have sought out university participation in a variety of forms. Although the actual impact of these two ERTA provisions on colleges and universities has not yet been studied in more than a pre- liminary way, they have aroused considerable interest among colleges and universities as a first step toward building more substantial corpor- ate support.

The Research Tax Credit. The tax credit, provided under new Code Section 44F, is available to ongoing businesses for in-house research expenses for 65 percent of qualifying expenses apid to any contractor for research and experimentation (including “applied” research) conducted within the United States (not including research in the social sciences or humanities). Proposed regulations would exclude all research in fields other than laboratory sciences, engineering, and technology, but would permit the credit for those software development costs that qualify as deductible research expenses. A credit is also allowed to corporations for 65 percent of amounts paid to universities or col- leges for basic research (defined as “any original investigation for the advancement of scientific knowledge not having a specific commercial objective”). Basic research, too, is subject to the same restrictions regarding nonscience fields and foreign locations. In both cases, the 65 percent factor represents an assumed percentage of direct costs in relation to total contract costs, since indirect expenses and overhead, typically reimbursed in research contracts, cannot be included for pur- poses of obtaining the credit on in-house research. The 25 percent credit is allowed on the increment of the allowed research expenses over research expenses averaged for a base period of three years. That base, however, may never be less than 50 percent of the current year’s expenses, so that there is effectively a ceiling on the credit at 12.5 percent of quali- fying expenses. The tax credit in nonrefundable, and therefore furnishes no benefit to businesses whose tax has otherwise been reduced. Finally, the credit is scheduled to go out of effect at the end of 1985. Legislation is currently pending in Congress to make the research tax credit per- manent and restructure it to make it nonincremental with respect to amounts paid universities for basic research.

Corporate Contributions of Scientz9c Equipment. The equipment contribution provision Code Section 170(e)(4), increased the tax deduc- tion allowed for corporate contributions of new inventory equipment to colleges and universities for research and research training- but not generally for education- in the physical or biological sciences. The new deductible amount is the corporation’s basis in the property (manu- facturing cost) plus one half of unrealized appreciation (the difference

between cost and marketing price), up to a maximum of twice the basis. This is an exception to the normal rule that limits the deductible amount for donations of inventory property to the property’s basis or cost.

The ERTA equipment contribution rule applies only to contrib- utions of new equipment that has been manufactured by the donor less than two years previously. The donee institution must agree in writing that the equipment will be used at least 80 percent for research, experi- mentation, or research training in the physical or biological sciences and that it will not be transferred to another party in exchange for money, other property, or services. Legislation currently pending in Congress would expand the provision to permit all educational uses, not just research. The latter change would greatly increase the equip- ment’s usefulness to those colleges where scientific research is not a major activity.

Overview. A recent study (Collins, 1983) evaluated the tax incentives offered to business by these provisions and attempted to ascertain their likely effect on industry research and development expenditures. The study found that the research tax credit provides improved tax treatment for firms that have growing R&D expenditures, but available evidence about the short-run effects was not conclusive about whether the tax credit actually induces incremental R&D expen- ditures. The report concluded that the tax credit “may be one of a number of factors helping to maintain R&D budgets in the current tight financial situation” (p. 7).

Drawing largely on various industry survey and interview results, the study found that the equipment-donation provision clearly benefits firms whose products have high gross profit margins (that is, a high ratio of market price to production cost) and that an increase in such dona- tions is likely over the short run. Such an increase will be partly attribut- able to the tax provision and partly to other factors (Collins, p. 17). It may be surmised that the rapid computerization of campuses is one beneficiary of this provision. Nevertheless, it is not certain that manufac- turers have penetrated campuses because of the deduction; their methods may have more to do with marketing strategy. The effects of the deduc- tion are simply not yet well enough known to answer this question.

Although the actual effects of these two tax incentives have not yet been evaluated completely, the Collins (1983) study offers some insights that may be helpful to administrators seeking to build corporate support for their institutions. For example, on the basis of survey results, Collins cites several factors important in influencing a company’s deci- sion to donate equipment. These include the suitability of the equipment,

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public relations, market development, improved tax treatment, and other considerations having to do with universities’ requests and cor- porations’ desire to respond in ways that will produce and maintain a competitive scientific and technical skills base in the nation (pp. 17-18). These factors should be taken into account in designing solicitation programs and strategies aimed at particular manufacturers.

An important first step for institutions seeking to use these corporate tax incentives to maximum advantage is developing an institutional data base on corporate-sponsored research support and equipment donations. Such a data base would be an important tool for coordinating efforts toward gaining research support and equipment donations. Thus, these efforts could be coordinated not only with each other but also with the institution’s overall corporate development pro- gram. At colleges and universities, administrative responsibility for sponsored research tends to be separate from responsibility for solicit- ing corporate donations. Equipment donations-especially when equip- ment would qualify for the deduction but is not related to a specific funded research project - may fall through the cracks, since they may require broader solicitation techniques than research administrators use but also may not be seen as within the province of development personnel, who solicit cash or general property gifts. Methods must be devised for internally ascertaining the research-related scientific equip- ment needs of academic departments and feeding these into a coherent solicitation program.

Tax-Exempt Financing

Tax-exempt financing may be undertaken for many private and public purposes through the issuance of state or local revenue bonds, whose interest is tax-exempt to bondholders under Code Sections 103(a) and (b). This type of financing has grown rapidly in recent years. In reaction, there have been repeated legislative efforts to impose restric- tions that would cut back the tax revenue loss and relieve upward pres- sure on interest rates. Colleges and universities have widely made use of tax-exempt bonds to finance the construction of dormitories and other educational facilities and to finance student loans. As tuitions rise and federal student loan and loan guarantee programs either are cut or fail to keep pace with educational costs, institutions have viewed tax- exempt financing as a mechanism capable of playing an increasingly important role in supplementing financial aid budgets for the future.

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) imposed a number of restrictions on most private-purpose tax-exempt

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bonds. For example, it imposed certain public approval requirements on industrial-development bonds and restricted cost-recovery deduc- tions on the facilities financed with them. (TEFRA did not impose these restrictions on student loan bonds or on bonds used by the tax- exempt organizations described in Section 501(c)(3) of the Code.) New information-reporting requirements were also imposed on all types of private-purpose tax-exempt bonds, including student loan bonds and exempt organization construction and facilities bonds.

The Tax Reform Act of 1984 has not imposed further restric- tions on private-purpose tax-exempt bonds. Again, exempt organiza- tion construction and facilities bonds have been excluded from those restrictions, but the act imposes a new state-by-state annual volume limit of $150 per capita (or, alternatively, $200 million aggregate) on the issuance of private-purpose bonds. This limit applies to student loan bonds pooled together with exempt industrial development bonds. In addition, the Treasury Department is authorized to issue new regu- lations on arbitrage, restricting the spread of the interest rate on loans funded by exempt student loan bonds over the rate paid to bondholders (plus allowed expenses). In the case of bonds funding nonguaranteed student loans and PLUS program loans, the new arbitrage rules will restrict the permitted spread to 1.125 percentage points and require rebate of arbitrage profits for issues after December 31, 1985. In the case of bonds funding Guaranteed Student Loans and PLUS loans, the Treasury Department in its regulations may similarly restrict arbitrage on GSL and PLUS program issues.

The recent move to limit the use of tax-exempt financing for student loans had not focused solely on the tax laws. Federal statutes provide for a special allowance, or subsidy, to lenders of insured student loans. If the loans are financed by tax-exempt bonds, then to qualify for the allowance the issuing authority must submit to the Department of Education for its approval a plan that meets certain requirements (20 U.S.C. §1087-l(d)). (All references in this chapter to the U.S.C. are the to United States Code.) If the plan is not approved, no special allowance is paid. The Student Loan Consolidation and Technical Amendments Act of 1983 imposed a new requirement for the plan to ensure that the issuance of tax-exempt obligations would not exceed “the reasonable needs for student loan credit within the area served. . . after taking into account existing sources of student loan credit” (20 U.S.C. 0 1087-l(d)( l)(G)). Reiterating the words of Congressman William Ford (D-Ill.) that the revision was intended to “police the amount of capital raised through tax-exempt bonds to ensure that excessive amounts beyond the reasonable needs of student loan credit

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are not being sold,” the Department of Education has applied the new provision strictly, taking an active role in restricting access to tax- exempt financing for student loans by requiring documentation of a “need” (see “Notice of Proposed Rulemaking,” 1984, p. 5330). In December 1983, by failing to approve a number of plans, the Depart- ment of Education limited the special allowance to a series of pending tax-exempt bond issues for student loans, forcing the cancellation of bond issues totalling more than $500 million (Pierce, 1984, p. 3). The Tax Reform Act of 1984 now requires an appeal mechanism allowing the Treasury Department to review decisions by the Department of Education that adversely affect student loan bond issues.

Administrators should follow developments on this issue care- fully. When evaluating alternative financing methods for financial aid, institutions should carefully consider whether the costs of tax- exempt financing- including possible loss of the special allowance and limitations on the interest rate that can be charged to student loan borrowers - will exceed those of taxable financing.

The Tax on Unrelated Business Income

In response to financial pressure, colleges and universities in recent years have looked increasingly for revenue from innovative pro- gram activities and forms of investments. This initiative has increased potential taxes on unrelated business income and has required admin- istrators to consider the possible tax consequences of a wide variety of transactions. The relevant tax code provisions have not been signifi- cantly changed in the past few years, but their application reflects (1) stepped reductions in corporate tax rates from 17 percent to 15 per- cent and from 20 percent to 18 percent on income below $25,000 and $50,000, respectively and (2) ERTA’s liberalized cost-recovery deduc- tions, as modified by TEFRA.

Review of the Tar. The unrelated-business income tax was imposed in the Revenue Act of 1950 in response to a well-publicized perception that exempt organizations - and especially colleges and universities - were engaged in profitmaking activities, to the disadvan- tage of taxpaying businesses. That act also established that, so long as unrelated business did not displace an organization’s primary activity, the organization would not lose its exemption. The tax is imposed at normal corporate (or trust) rates on exempt organizations’ taxable income from regularly carried-on trade or business activity deemed unrelated to the tax-exempt purpose (Code Sections 511-513). The cri- terion of relatedness generally requires a substantial causal relationship

with or important contribution by the activity to the organization’s exempt purpose. The tax is also imposed on unrelated debt-financed income, or income from property put to an unrelated use, if its pur- chase was financed by borrowing or if it otherwise was subject to indebt- edness when acquired (Code Section 514).

There are a number of statutory exceptions. For example, activ- ities of colleges and universities undertaken primarily for the conven- ience of their students or employees (such as campus bookstores) are not taxed, nor are volunteer activities or sales of donated merchandise, and an organization may sell or otherwise dispose of a byproduct of its exempt function without incurring a tax. Most important, passive forms of investment income (interest, dividends, rents from real estate, royalties, and capital gains from non-debt-financed property) are gen- erally not taxed, nor is the research income of colleges and universities taxed, regardless of the source and whether it is applied or basic.

While these concepts are fairly simple, imposition of the tax depends on determinations of the facts and circumstances and on numerous technical rules (for example, while real estate rents are non- taxable, if services are also furnished to the tenant, the rental income may be taxable). Also, the Internal Revenue Service may fragment an activity into subcategories, disallowing certain activities from the aggre- gate related to an organization’s exempt purposes. Thus, the operation of a museum shop may be related in the aggregate to the organization’s exempt purpose, but the sale of some types of merchandise may be viewed as an unrelated business, and the activity may be deemed tax- able, even on an item-by-item basis (Yanowitz and Purcell, 1983).

The federal income tax regulations do not provide specific guid- ance for applying the rules on unrelated-business income tax to many of the activities in which colleges and universities engage. Published rulings fill in some of these gaps, but the most detailed sources of insight into the IRS position (although nonbinding for other taxpayers) are the numerous private-letter rulings and technical-advice memo- randa issued by the IRS in specific cases. The sheer number of such rul- ings in recent years shows the difficulties institutions face in applying the rules to their different fact situations. Nevertheless, evident incon- sistencies among the rulings, and the trend toward increased fragment- ing of activities that the rulings demonstrate, can only increase the uncertainty of assessing the taxability of certain activities.

Use of Facilities. One area where application of the tax has concerned colleges and universities, and in which there remains sub- stantial uncertainty is the use of facilities by off-campus individuals or organizations. For example, although the courts have not yet ruled on

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this issue, the IRS (IRS Priv. Letter Rul. 790219) has viewed receipts from time-sharing use of a university’s academic computer by other nonprofit organizations as unrelated business income. Rental of other types of facilities (such as athletic facilities) to outside organizations, if structured as pure real-estate rentals (without ancillary services), will be nontaxable, but if the outside use is taxable (that is, does not qualify for the rent exclusion), it will be important to allocate the deductible expenses properly. Allocation of facility expenses on the basis of actual use for each purpose may yield an expense deduction vastly different from that obtained by some other method. In a recent case involving the dual employment of an ice-skating rink for special outside events as well as for exempt use, the Tax Court upheld an actual use allocation, rather than allocating expenses to the outside use (Rensselaer Polytechnic Institute v. Commissioner of Internal Revenue, 1982). This decision was upheld by the U.S. Court of Appeals for the Second Circuit (Zd., 1984). The allocation method that the government advocated in this case effectively allocated idle time to the exempt use only. This method could create a substantial tax liability if applied to the use of such facili- ties as computers.

CommercMZly Sponsored Research. Other activities that may receive increased attention in the future, if only because of their grow- ing visibility, are commercially sponsored research, university-industry joint ventures or similar research collaborations, and the related licens- ing activities of colleges and universities. Assuming no change in the unrelated-business income tax rules concerning these areas, continued attention to the structure and characterization of relationships will be particularly important for preserving nontaxable treatment. Research income of the university of college will not necessarily qualify for the research exclusion, even though a commercial sponsor may qualify for a research tax credit or deduction. The two will commonly coincide, but they may diverge when it comes to research that consists of the develop- ment of product prototypes of improvements, for example. As the vol- ume of corporate-sponsored university research increases, research administrators should bear in mind potential “gray areas” in the tax treatment of research that relates to the development of particular prod- ucts by the commercial sponsor.

Investments. Traditional endowment investments in stocks and bonds yield dividend and interest income, which is generally nontax- able unless the investments are financed by borrowing. For a variety of reasons, colleges and universities recently have shown increasing inter- est in other forms of investment besides traditional ones, including real estate (often as joint ventures), oil and gas partnerships, and venture

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capital partnerships. These latter vehicles have required tax analysis as part of the evaluation process in the computation of rate of return and structuring of the ventures. Typically, the issues involve structuring transactions so that income falls within applicable exceptions to unre- lated business income - rent, royalties, dividends, interest or capital gains - and ensuring that income is not otherwise taxable as unrelated debt-financed income (should transactions entail borrowing or acquir- ing property encumbered by mortgages, liens, or the like). If income is taxable, the after-tax rate of return must be adequate, as compared with alternative investments. The more fundamental question of jeop- ardizing the institution’s exempt status may also arise if the institution contemplates participating in an investment partnership as a general partner.

An important exception to the unrelated debt-financed income provisions was enacted in 1980 for real-estate investments of pen- sion funds. The Tax Reform Act of 1984 extended this exception to colleges and universities - removing the major drawback to this form of investment-but also restricted it. To qualify for the exception, seller financing is not permitted, and partnership investments are subject to special restrictions.

Current Outlook. The U.S. Small Business Administration argued in a recent report that, as currently structured, the unrelated- business income tax is not curbing unfair competition by exempt orga- nizations (U .S. Small Business Administration, 1983, pp. 30-46). The report recommended that the tax be restructured to curtail such activity, whether by imposing higher-than-ordinary corporate tax rates or pro- hibiting the activity altogether. The report cited examples of exempt organizations competing with small businesses by providing audiovisual services, analytical testing, consulting, research services, computer services, and travel programs. The actual amount of commercially competitive activity by colleges and universities (and the meaning of the term unfair when applied to such competition) is subject to factual and theoretical arguments beyond the scope of this chapter. The legal relevance of competition, under presnt law, is only marginal: Its pres- ence may tend to show that an activity is a trade or a business that is regularly carried on, but lack of competition, as a legal matter, may not insulate an activity from taxation (see Louisiana Credit Union League v. United States, 1982, 693 F.2d. 525, pp. 541-542). It is clear, however, that active competition with businesses feeds this type of criticism and anxiety on the part of the business community. It should also be noted as a matter of practice that property tax considerations often constrain competition from institutions more than the threat of unrelated-business income tax does. The latter, after all, is a tax on net taxable income.

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Given the increasing frequency and importance of unrelated- business income tax considerations, an orderly institutional approach to tax planning and analysis is essential. Since the structure of an activ- ity so often makes the difference between tax-exempt and taxable income, tax planning should be routinely included in the development of most, if not all, revenue-producing activities (other than educational programs). In addition, there should be continuous monitoring of tax- reported as well as nontaxable activities when changes in circumstances or methods of operation may alter the tax analysis.

Taxation of Fringe Benefits

Overall, taxation of fringe benefits is no more relevant to colleges and universities than to other types of employers. Within the array of benefits typically offered by institutions of higher education, however, some are uniquely important. These include, for example, tuition remission plans and below-market rental housing for faculty. In addi- tion, because of higher education’s generally depressed salaries, rela- tive to other economic sectors, the tax treatment of fringe benefits has been a matter of common concern to faculty and administrators alike.

The federal income tax code provides broadly that gross income includes all income “from whatever source derived” (Code OSl), a phrase broad enough to include “any economic or financial benefit con- ferred on the employee as compensation” (Commissioner v. Smith, 1945, 324 U.S. 177, p. 181). The tax code expressly provides a number of exceptions to this general rule. In addition, for many years, many types of incidental fringe benefits commonly offered by employers were treated by the Internal Revenue Service as nontaxable, not by virtue of Code provisions but as a matter of administrative practice. In large part, this practice derived from the difficulty of valuing in-kind bene- fits, whose cost to the employer was in many cases nil. As practices widened to take advantage of methods of giving tax-free compensation to employees, the Treasury Department in 1975 issued a “discussion draft” of regulations that would have taxed a wide variety of fringe benefits. After a storm of controversy, the draft was withdrawn in 1976. Congress subsequently stepped in, declaring a moratorium on the issu- ance of such regulations. The moratorium was extended twice, includ- ing under ERTA through December 31, 1983. In the Tax Reform Act of 1984, Congress took the major step of codifying fringe benefit exclu- sions to replace the web of administrative practice in the areas of no- additional-cost services, employee discounts, working-condition fringes, and de minimis fringes.

In connection with its codifying of fringe benefits, Congress also

took action with respect to tuition remission programs of colleges and universities. These plans, common throughout higher education, offer at least partial tuition remission for spouses and children of faculty and, in some cases, of staff members. Tuition remission may be pro- vided only at the home institution, or on a reciprocal basis with par- ticipating institutions, or in the form of portable tuition grants usable at any institution. The plans also may include arrangements under which graduate assistants receive tuition reductions in exchange for teaching.

Until the 1984 act, tuition remission programs of educational institutions had been protected by tax regulations that defined them as scholarships excludable from income under Code Section 11 7 (Treas. Reg. 1.1 17-3(a)). These regulations remained intact after an IRS attempt to alter them in 1976 met with great resistance from higher education. In addition, the programs were protected under the sweep of the Congressional moratorium on fringe benefit regulations (now expired).

The 1984 act permanently clarified the status of these programs, establishing that such qualified tuition reductions (or portable grants) for elementary, secondary and undergraduate tuition are nontaxable to either parent or student. Nevertheless, it imposes the new requirement (effective July 1, 1985) that the tuition reduction be “available on sub- stantially the same terms to each member of a group of employees, which is defined under a reasonable classification” that does not dis- criminate in favor of “officers, owners, or highly compensated employ- ees.” The major question of how these plans can help recruit faculty without running afoul of requirements for nontaxability remains to be answered, either through the regulatory process or by means of tax rulings.

Congress also declined to establish the permanent nontaxability of rental housing provided by colleges and universities to faculty mem- bers on or near campus at below market rates, but it did enact a mora- torium on taxation of this benefit for housing furnished during the years 1984 and 1985. In private letter rulings, the Internal Revenue Service had taken the position that the difference between the rent charged and the fair market value of the housing is taxable income to the individual (IRS Priv. Letter Rul. 3213005).

Other fringe benefits of particular interest to colleges and uni- versities include employer-provided education assistance under Code Section 127 (the tax-free treatment ofwhich came into effect under ERTA and “sunset” on December 31, 1983) and cafeteria plans, which permit employees to select among nontaxable and taxable benefits. The failure

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of Congress to extend the former provision could pose substantial diffi- culties for those graduate programs whose students depend on employer assistance. In early 1984, cafeteria plans came under broad attack by the Internal Revenue Service when they offered expense reimburse- ment programs in combination with salary reduction arrangements. In the 1984 act, congress reaffirmed the viability of cafeteria plans. The plans will be subject, prospectively, to regulations of the Treasury Department. If not changed substantially from their proposed form, those regulations will allow for funding by salary reduction, but will stipulate a number of new restrictions on the plans.

Summary

Recent tax developments have presented a mixed picture for higher education. With the exception of tax-exempt financing for stu- dent loans, legislative developments directed toward higher education have been generally positive, although concern remains over proposals for reform of the charitable deduction. Overall, the expected indirect effects of tax legislation in recent years have been adverse in the short run, but it is not clear whether fears have been borne out. The effects have not been equal across institutions, and so it remains for each insti- tution to assess its own position in terms of its own characteristics in those areas that have been affected. Since taxation issues seem to be creeping into virtually all areas of institutional activity, awareness of them should be absorbed appropriately and creatively into the planning and administrative functions.

References

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Clotfelter, C., and Steuerle, E. “Charitable Contributions.” In H. Aaron and J. Peck- man (Eds.), How Taxes Aflect Economic Behauior. Washington, D.C.: The Brookings Institution, 1981.

Collins, F. L. An Early Assessment of Three RBD Tar Incentives Provided by the Economic Recovery Tax Act of 1981. Washington, D.C.: National Science Foundation, 1983.

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Activip, Michigan: Survey Research Center, Institute for Social Research, The Uni- versity of Michigan, 1979.

Feldstein, M., and Taylor, A. “The Income Tax and Charitable Contributions: Esti- mates and Simulations with the Treasury Tax Files.” In Research Papers Sponsored by the

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Commission on Private Philanthropy and Public Nee&. Vol. 3. Washington, D.C.: U.S. Department of the Treasury, 1977.

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Levi, J . , and Steinbach, S . Patterns of Giving to Higher Education 11: A n Analysis of Voluntary Support of American Colleges and Universities 1970- 71. Washington, D.C. : American Council on Education, 1973.

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Dorothy K. Robinson is associate general counsel, Yale University.