And Then They Came for the Endowments, Revisited: The Section 4940 Excise Tax Revisions
Christopher Ryan did a great job last week musing on the various provisions of the House Budget Reconciliation Bill for the OBBB Act, including his thoughts on the restructuring of the excise tax on university endowments. Now that we are all back from Law and Society and/or the Memorial Day long weekend, I want to highlight one more provision of the OBBB that goes after large endowments: changes to the Section 4940 excise tax.
By way of background, Section 4940 was passed in 1969 as part of the Chapter 42 private foundation excise taxes. Unlike the other excise taxes passed as part of that package (such as the minimum distribution requirements of Section 4942 or the self-dealing rules of Section 4941), Section 4940 was not primarily regulatory in purpose. Rather, Section 4940 was a straight excise tax on net investment income, designed to raise money to fund the enforcement of this new slate of excise taxes. When passed in 1969, the excise tax rate was 4%, and was lowered to 2% in 1978. In 1985, the primary excise tax rate was set at 2% but if a foundation met certain heighted distribution requirements, it could (in some cases, subject to weird timing issues, and only after a complicated calculation…) qualify for a 1% excise tax rate.
Over time, two things became clear. First, the 1% excise tax rate reduction wasn’t particularly effective in incentivizing more distributions, in part because it was very clunky in drafting and application. Additionally, the funds brought in by the Section 4940 were more than necessary to fund enforcement of the Chapter 42 excise taxes. And so, after many years of being included and then excluded from many a tax bill, amendments to Section 4940 were successfully enacted in 2020 to set a single, flat rate of 1.39%. Get rid of the complicated multiple rates, lower the rate across the board, but still fulfill the basic purpose of Section 4940 – all good.
Fast forward to today: Section 112022 (at page 101) of the OBBB (discussion at page 38 of this document) introduces a sliding scale for the excise tax rate. While private foundations with gross assets valued at under $50.0 million (the legislation specifically says valued at the close of the tax year without reduction for liabilities) will continue to pay the 1.39% rate, larger foundations will pay more on a sliding scale, with private foundations with assets valued in excess of $5.0 billion paying a flat 10%. (Google’s AI Overview tells me that there are approximately 24 private foundations that would meet these criteria – I give no warranties about the accuracy of that information, especially given the caveat for liabilities.)
Two things struck me about this change. First, I’ve seen no discussion linking the increase in the rate to the costs of enforcement, which was the rationale behind the rule from inception and from which the 1.39% rate at least nominally was about (as well as keeping the change revenue neutral). Unlinking this as a general matter signals a willingness to tax this income (and charities generally) for whatever reason is deemed appropriate. I don’t doubt that this is, at least in part, a pure revenue raiser for the rest of this one, big, expensive bill. Additionally, it feels extraordinarily punitive, demonstrating even more hostility to endowments, specifically and charity, generally. While Big Philanthropy (including large endowments of all kinds) certainly has its issues, neither this excise tax increase nor the tax on university endowments is designed in any meaningful way to address these issues. As with the university excise tax, it is really just a revenue raiser on the back of currently politically unpopular group, without much in the way of a meaningful tax policy justification.
With concern, eww