Minimizing the Endowment Tax

Goldman Sachs offers strategies universities can use to reduce the effect of the new endowment tax.

Ever since Congress included a 1.4% excise tax on certain university endowments as part of the Tax Cuts and Jobs Act of 2017, colleges and universities that are potentially affected by the new tax have been lobbying for its removal.

In March, 49 college and university presidents wrote a letter to leaders of Congress, urging them to repeal the endowment tax, saying that it will impose an “unprecedented and damaging tax” on the charitable resources of American colleges and universities.

And the lobby efforts seem to be making some headway. Representatives John Delaney (D-MD) and Bradley Byrne (R-AL), introduced a bill in March to repeal the excise tax. And earlier this month, Rep. Tom Reed (R-NY) introduced a bill that would eliminate the tax for endowments that spend 25% of their annual investment earnings on reducing the cost of tuition for middle-income students.

But until those bills make their way to becoming law, colleges and universities with at least 500 students, and assets of more than $500,000 per student still have to deal with the 1.4% excise tax on net endowment income.  However,  “there are three things that we think an endowment can do to minimize the tax,” Kane Brenan, global head and co-CIO of Goldman Sachs Asset Management’s Global Portfolio Solutions (GPS) group, told CIO.

From a legislative standpoint, Kane said an endowment can continue to lobby Congress to change or minimize the tax, as any trade organization might do when certain legislation has a negative effect on its industry. Second, on the operational and administrative side, universities can run their school in such a way that it doesn’t fall within the excise tax’s parameters.  

“It’s still vague in terms of how they’re defining the number of students,” Carolyn Tavares, vice president, global portfolio solutions, told CIO. “There is still some ambiguity which the IRS has yet to clarify.”

This ambiguity could allow universities some wiggle room when it comes to determining whether their enrollment or assets per student exceeds the threshold that would cause the excise tax to kick in. For example, colleges with enrollments near the limit may reduce their enrollment to less than 500, or change the way they measure it to reduce the assets per student below $500,000.

And the third thing they can do, according to Goldman Sachs, is manage the endowment’s investments to minimize the impact of the tax. This includes basic tax planning strategies, which was not relevant to endowments before the new tax law, such as offsetting gains with losses, and “all the typical things a tax-aware person can do,” said Kane.

And although Kane and Tavares said they were adamant that endowments should not materially change their portfolio to minimize the tax, they had four suggestions for endowments to help minimize the tax on the investment side:

  1. Use incoming contributions to meet spending needs first. Build up a cash pool throughout the year funded by contributions to meet near-term spending to avoid realizing capital gains.
  2. Instruct managers not to reinvest dividends and interest.  Because they will be taxed regardless, leaving dividends and interest in cash allows it to be used to meet spending needs and any tax liability.
  3. Offset realized gains with losses. If assets need to be sold, endowments should sell those with tax losses first. One possible strategy is to use a passive manager in a separate account that offsets gains taken in the total portfolio with losses in individual securities from the index account.
  4. Invest more passively. Active managers tend to generate capital gains and trade more frequently than passive managers. And those with price targets that sell when those targets are reached are selling gain securities and holding loss securities, which is the opposite of standard tax management.

Tags: , ,