Charles Filips, Kimberly Boberg, David Levine and David Powell, with Groom Law Group, and Michael A. Webb, senior financial adviser at CAPTRUST, answer:
Your recordkeeper may be correct, depending on the size of your institution. This excise tax of 1.4% of Net Investment Income of the college/university, which only applies to private colleges and universities, was part of the Tax Cuts and Jobs Act. Final regulations were issued effective in the 2021 tax year clarifying that 457(b) investment income would be treated as Net Investment Income subject to the excise tax under IRC section 4968, per the following excerpt:
“…In contrast, plans under section 457 are unfunded because funds are not set aside for the purpose of providing benefits to plan participants in a manner that would result in a ‘funded’ obligation to provide benefits under the plan. Under section 457(b)(6), assets held pursuant to an eligible deferred compensation plan, including amounts held in a grantor trust, must remain solely the property and rights of the employer and would be subject to the claims of the employer’s general creditors. See § 1.457-8(b)(2). Similarly, amounts set aside by an eligible employer intended to pay for benefits under an ineligible section 457(f) plan, including assets set aside in a grantor trust, are treated as assets of the employer and subject to the claims of the employer’s general creditors. Accordingly, assets set aside and held by an educational institution, including in a grantor trust, to be used to pay the employees’ benefits under an educational institution’s section 457(b) or section 457(f) plan are considered assets of the educational institution. As a result, these final regulations provide that a grantor trust or other financing vehicle used in connection with these unfunded plans is a ‘related organization’ for purposes of section 4968(d), and its assets will be treated as the assets of the educational institution. The Treasury Department and the IRS note that because assets in an unfunded plan are available to the employer just like any other assets, they are not considered ‘used directly in carrying out the institution’s exempt purpose’ for purposes of section 4968(b)(1)(D).” See 85 Fed. Reg. 65526, 65543.
Other sections of the regulations state that income on assets of related organizations that are not used directly in carrying out the institution’s exempt purpose is Net Investment Income for the purposes of calculating the 4968 excise tax.
However, only private colleges and universities who meet the following criteria are subject to the tax:
- At least 500 tuition-paying students in the preceding tax year;
- More than 50% of those students located in the United States; and
- An aggregate fair-market value of nonexempt purpose assets that was at least $500,000 per student at the end of the preceding tax year.
See 26 CFR section 53.4968-1(b)(1).
NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.
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