Congress Fumbles the Ball on Section 4960 (Guest Post by Ellen Aprill)

[Note: This guest post is written by Ellen P. Aprill, who holds the John E. Anderson chair in tax law at Loyola Law School, Los Angeles. Read more of her work here. Follow her on Twitter at @ellenaprill. ]

The tax legislation signed into law by President Trump on December 22 takes aim at tax-exempt organizations that pay presidents, college football coaches, and other employees more than $1 million a year. But as with so many other aspects of the hastily drafted bill, Republican lawmakers fumbled on this provision too. While the drafters evidently intended to impose a 21% excise tax on both public and tax-exempt private institution that have employees with compensation over $1 million, they appear to have inadvertently left public universities off the hook. 
 
 As a result, the new excise tax quite likely won’t apply to public universities with highly paid employees, such as Nick Saban (who makes more than $11.1 million a year), Clemson coach Dabo Swinney ($8.5 million), or Michigan coach Jim Harbaugh ($7.0 million). It will, however, apply to private universities with their own highly compensated employees, such as Stanford coach David Shaw ($5.7 million), Texas Christian’s Gary Patterson ($5.1 million), and Northwestern’s Pat Fitzgerald ($3.3 million). That’s good news for state-school sports fans, whose teams will now have an advantage in the scramble for top coaching talent. But it may come as a surprise to Republican lawmakers who — according to the explanation accompanying the House-Senate conference report — thought that the new excise tax would apply to state and local government employers whose income is excluded from federal income tax.

In the eyes of the public, the excise tax does apply to public institutions. One newspaper report states that the section 4960 excise tax will hit “every major college with a coach or athletic director who earns seven figures” — that is, both those at private and those at public institutions. Another media commentator welcomed the provision for its “smack down on high salaries,” listing presidents and coaches of public as well as private institutions.

Exempt organization practitioners have, of course, been studying the language and implications of new section 4960. In a recent issue of the online publication EO Tax Journal, its editor, Paul Streckfus, reported such a discussion with Marcus Owens, a well-known exempt organization practitioner and former director of the IRS exempt organizations division. They took particular note of the fact, that, although University of Alabama pays its football coach many millions of dollars a year, it does not seem to be caught by the provision because it is a state institution. They wondered, however, whether the language in new section 4960 stating that an applicable tax exempt organization for purposes of the provision includes any organization with income “excluded from tax under section 115(1)” could subject public universities to the excise tax.

If subjecting public institutions to this excise tax was the drafters’ intent, they did not succeed. Section 115(1) states that gross income “does not include income derived from any public utility or the exercise of any essential governmental function and accruing to a State or any political subdivision thereof.” The drafters of section 4960 seem to believe that public colleges and universities rely on section 115(1) in order to avoid income taxation. That is a common and understandable reading of the language of section 115(1). It is, however, a misreading. This mistake is a serious one with far-ranging consequences. Public universities employ a large percentage of the most highly compensated coaches of power conference teams.

The IRS has long taken the view that states and political subdivisions avoid income tax not under section 115(1), but under a doctrine of implied statutory immunity. Unless otherwise specified in the Internal Revenue Code, states and their political subdivisions are not taxpayers under the Code, and their income is not gross income within the meaning of section 61. That is, under current law, it is constitutional for Congress to tax the states and their political subdivisions. The doctrine of intergovernmental immunity does not bar the federal government from taxing the income of states and political subdivisions. Respect for our federalist system, however, requires Congress to be explicit in overriding the implied immunity. As Revenue Ruling 87–2 explained, “Income earned by a state, a political subdivision of a state, or an integral part of a state or political subdivision of a state is generally not taxable in the absence of specific statutory authorization for taxing such income.” See generally Ellen P. Aprill, The Integral, the Essential, and the Instrumental: Federal Income Tax Treatment of Government Affiliates.

Section 511(a)(2)(B) is an example of a specific statutory authorization. It includes among the entities subject to unrelated business income tax not only organizations exempt from tax under section 501(c) and pension plans exempt under section 401(a), but also any public college or university that is “an agency or instrumentality of any government or any political subdivision thereof, or which is owned or operated by a government or any political subdivision thereof, or by any agency or instrumentality of one or more governments or political subdivisions.” According to legislative history, Congress included this language in order to place public institutions on a parity with private colleges and universities exempt under section 501(c)(3). New section 4960 does not include similar statutory language, but only the reference to section 115(1).

Public universities and colleges, however, rarely base their tax-free status on section 115(1). As dozens of private letter rulings attest, they escape federal income taxation because they are either an integral part of a state or political subdivision or possess themselves sufficient powers, such as police power, to qualify as a political subdivision. Private Letter Ruling 7904006, for example, determined that a state university system was a political subdivision of a state because of the public purposes of the state university system, the control and financing of the system by the state and the existence of the regulatory powers and power of eminent domain accorded to the system by the state. It explained that a particular university in the system was an integral part of the state university system and thus an integral part of a political subdivision of the state. The ruling specifically stated in its conclusions that section 115 did not apply to the university. Similarly, Private Letter Ruling 9143048 stated that section 115 does not apply to a public community college because it was an integral part of a state’s political subdivision.

Under the long-standing view of the IRS, section 115(1) organizations are not and cannot be political subdivisions or integral parts of political subdivisions. To qualify under section 115(1), an entity must be separately organized from a state or political subdivisions, save or makes money for the state or political subdivisions, ensure that its assets revert to the state or political subdivisions upon dissolution, and avoid conferring substantial private benefit. See Rev. Rul. 90–74. I have called these entities “governmental affiliates;” a recent article dubbed them quasi-governmental entities.

Many section 115(1) entities are hospitals. These section 115(1) entities will escape the new excise tax for any too highly compensated physicians because of the exception for medical services in section 4960. However, the activities of entities with income excluded under section 115(1) are many and varied. They include investment funds, pooled liability funds, health plans, land banks, and economic development corporations, all of which are now subject to the section 4960 excise tax.

Perhaps in subjecting section 115(1) organizations to the section 4960 excise tax, Congress concluded that some of these entities are paying compensation over $1 million dollars. If, however, Congress thought that, by including section 115(1) entities among the organizations subject to section 4960, the provision will require public universities to pay the excise tax on excessive compensation of football and basketball coaches or university presidents, the lawmakers failed to achieve their goal. To achieve this goal, section 4960 needs technical correction that revises it to include a provision similar to the one subjecting public colleges and universities to the unrelated business tax. This possible error is but another of the problems inherent in drafting tax legislation too quickly.