PRESENT LAW AND BACKGROUND 

RELATING TO TAX EXEMPTIONS AND INCENTIVES 

FOR HIGHER EDUCATION 

Scheduled for a Hearing 

Before the 

SENATE COMMITTEE ON FINANCE 

on December 5, 2006 

Prepared by the Staff 

of the 

JOINT COMMITTEE ON TAXATION 

December 4, 2006 

JCX-49-06 
i 

CONTENTS 

Page

INTRODUCTION .......................................................................................................................... 1 

I. EXECUTIVE SUMMARY ...................................................................................................... 2 

II. PRESENT LAW ....................................................................................................................... 4 

A. Tax Exemption for Educational Organizations................................................................... 4 

B. Tax Incentives for Contributions to Educational Organizations....................................... 13 

C. Tax-Exempt Financing for Facilities and Activities of Providers of Higher Education... 15 

D. Tax Benefits for Education Expenses............................................................................... 20 

III. SELECTED ISSUES AND ANALYSIS................................................................................ 25 

A. Background Data on College Enrollment and Costs ........................................................ 25 

B. The Economics of Subsidizing Education ........................................................................ 29 

C. Issues Relating to the Tax Benefits Provided to Higher Education Organizations........... 31 

D. Issues With Respect to Tax Benefits for Individuals Relating to Higher Education 

Expenses ........................................................................................................................... 40 
1 

INTRODUCTION 

The Senate Committee on Finance has scheduled a public hearing on December 5, 2006, 

titled “Report Card on Tax Exemptions and Incentives for Higher Education: Pass, Fail, or Need 

Improvement?” This document,1

 prepared by the staff of the Joint Committee on Taxation, 

provides a description of present law and a discussion of selected issues arising with respect to 

Federal tax benefits provided to tax exempt colleges and universities and various educationrelated tax incentives. 

 1

 This document may be cited as follows: Joint Committee on Taxation, Present Law and 

Background Relating to Tax Exemptions and Incentives for Higher Education (JCX-49-06), December 4, 

2006. 
2 

I. EXECUTIVE SUMMARY 

Present law

Public and private colleges and universities generally are exempt from Federal income 

tax on contributions received, income from activities that are substantially related to the purpose 

of the organization’s tax exemption, and investment income, but generally must pay tax on 

income from a trade or business that is not substantially related to exempt purposes. Tax-exempt 

colleges and universities described in section 501(c)(3)2 are classified as public charities and not 

as private foundations for tax purposes, and therefore are not subject to tax on investment 

income, payout requirements, or the other rules applicable to private foundations, and donors to 

colleges and universities and other public charities thus receive more favorable tax treatment on 

charitable contributions than do donors to private foundations. 

The construction, renovation, and operation of public schools (including State colleges 

and universities) are activities eligible for financing with the proceeds of tax-exempt, 

governmental bonds. In addition, State and local governments may issue tax-exempt bonds to 

provide financing to nongovernmental persons such as section 501(c)(3) organizations. Both 

capital expenditures and limited working capital expenditures of charitable and educational 

organizations described in section 501(c)(3) of the Code – including post-secondary schools – 

generally may be financed with tax-exempt bonds. Unlike tax-exempt bonds issued on behalf of 

other private parties, there is no annual State limit on the amount of bonds that may be issued for 

section 501(c)(3) organizations. 

Present law includes a variety of provisions that provide tax benefits to individual 

taxpayers for higher education expenses. These provisions include tax benefits for current 

expenses, such as the Hope and Lifetime Learning credits, the above-the-line deduction for 

certain higher education expenses,3 and the exclusions for employer-provided education 

assistance,4 qualified tuition reduction, and qualified scholarships. Present law also includes tax 

benefits for saving for future education expenses, including qualified tuition programs, Coverdell 

education savings accounts, and the exclusion of earnings on educational savings bonds. In 

addition, individuals may save for education expenses on a tax-favored basis through the use of 

other savings vehicles, such as Roth IRAs and deferred annuities, even though these vehicles are 

not designed specifically for education expenses. Tax benefits also are provided for past 

expenses, i.e., a deduction for the payment of certain student loan interest and an exclusion for 

the forgiveness of certain student loan indebtedness. These tax provisions result in significant 

tax expenditures. 

 2

 All section references are to the Internal Revenue Code of 1986, as amended, unless otherwise 

indicated. 

3

 The above-the-line deduction was available for taxable years beginning in 2004 and 2005. 

4

 Certain provisions relating to the tax benefits provided to individuals for higher education 

expenses expire after 2010 under the sunset provisions of the Economic Growth and Tax Relief 

Reconciliation Act of 2001 (“EGTRRA”). 
3 

Selected issues and analysis

One issue in the educational context relates to the comparative treatment of endowments 

held by a college or university that is a public charity (no pay out required) versus the treatment 

of endowments held by a private foundation (pay out required). Arguably, such accumulations 

of income raise some of the same concerns whether the accumulation occurs in a private 

foundation or a public charity, such as a college or university. 

Distinguishing between the activities of an educational institution that are truly 

educational in nature, and hence qualify for tax-exempt treatment, and those that lack a 

significant public purpose, is an important issue. The costs of acquiring a college education have 

generally risen at a much faster pace than inflation over the past several decades. Most 

economists generally have argued that there are important public benefits from education, and 

thus that public subsidization of education is likely economically efficient. Many also argue that, 

apart from any efficiency gains, subsidizing education for the less well off is desirable for 

reasons of equity, as education levels are highly correlated with future income. While the tax 

benefits provided for education expenses under present law may serve to make education more 

affordable for some taxpayers, these benefits have also been cited as a significant source of 

complexity, particularly given the number of different benefits and the varying qualifications for 

each benefit. The expiring nature of some of the provisions also adds to complexity and makes 

planning for education expenses more difficult. A number of proposals have been advanced that 

would simplify and rationalize the various provisions, such as combining the separate Hope and 

Lifetime Learning credits into a single credit. 

Other issues relate to whether an activity is educational in nature, or the extent to which a 

noneducational activity nonetheless is exempt from the unrelated business income tax because 

income from the activity fits within a statutory exemption. This is the case with respect to 

commercial activities, such as operation of a university press, bookstore, or restaurant, and in the 

context of scientific research and technology transfers by colleges and universities. It is also the 

case for activities such as corporate sponsorship arrangements, which are treated as not subject to 

the unrelated business income tax so long as certain requirements are met. Issues often arise 

regarding whether certain types of receipts constitute royalties, which generally are excluded in 

determining an organization’s unrelated business taxable income. In addition, some colleges and 

universities offer travel tours that are promoted as educational. 

With respect to tax-exempt financing, one issue relates to the ability of educational 

organizations described in section 501(c)(3) to invest accumulated assets at yields higher than 

the yields on their tax-exempt borrowings. While the ability of issuers to earn and retain 

arbitrage profits through the investment of tax-exempt bond proceeds generally is restricted, the 

Code does not define arbitrage in a manner that eliminates every opportunity to earn such profits, 

i.e., the Code generally only restricts the investment of bond proceeds and amounts that replace 

such proceeds. The ability of tax-exempt entities to earn an untaxed return on their other 

investment assets in addition to the ability to borrow on a tax-exempt basis increases the 

incentive for such entities to issue tax-exempt bonds. 
4 

II. PRESENT LAW 

A. Tax Exemption for Educational Organizations 

Section 501(c)(3) organizations

In general

Charitable and educational organizations described in Code section 501(c)(3) generally 

are exempt from Federal income tax on contributions received, income from activities that are 

substantially related to the purpose of the organization’s tax exemption, and investment income.5

 

A charitable or educational organization must operate primarily in pursuance of one or more taxexempt purposes constituting the basis of its tax exemption.6

 The term “charitable” includes, for 

purposes of section 501(c)(3), the advancement of education or science.7

 The term 

“educational,” as used in section 501(c)(3), relates to the instruction or training of individuals for 

the purpose of improving or developing their capabilities, or the instruction of the public on 

subjects useful to individuals and beneficial to the community.8

 

The following types of organizations may qualify as educational within section 501(c)(3): 

(1) an organization, such as a primary or secondary school, a college, or a professional or trade 

school, that has a regularly scheduled curriculum, a regular faculty, and a regularly enrolled 

student body in attendance at a place where the educational activities are regularly carried on; (2) 

an organization whose activities consist of conducting public discussion groups, forums, panels, 

lectures, or other similar programs; (3) an organization that presents a course of instruction by 

correspondence or through the use of television or radio; (4) a museum, zoo, planetarium, 

symphony orchestra, or other similar organization; and (5) a nonprofit children’s day care center. 

In addition, college athletic organizations that promote certain aspects of athletic competition 

have generally been held to be educational and, thus, exempt under section 501(c)(3). The 

exemption is based on the principle that an athletic program conducted for the physical 

development and betterment of the students is an integral part of a university’s overall 

educational activities. In general, the revenue that a college or university derives from admission 

to athletic events is considered to be income from a business related to educational purposes and 

not subject to the tax on unrelated business income.9

 5

 Private foundations, a subset of section 501(c)(3) organizations, are subject to an excise tax on 

investment income of two percent (reduced to one percent if certain requirements are met). Sec. 4940. 

6

 Treas. Reg. sec. 1.501(c)(3)-1(c)(1). 

7

 Treas. Reg. sec. 1.501(c)(3)-1(d)(2). 

8

 Treas. Reg. sec. 1.501(c)(3)-1(d)(3). 

9

 In the legislative history of the Revenue Act of 1950, Congress stated that “[a]thletic activities 

of schools are substantially related to their educational functions.” Therefore, “a university would not be 

taxable on income derived from a basketball tournament sponsored by it, even where the teams were 
5 

A primary issue in determining whether something is educational is not the content of the 

information but the method the organization uses to convey information. In general, the 

analytical exercise is to determine whether an organization’s presentation of information is 

objective and balanced, or whether the organization instead is an advocate for propaganda. This 

is a fine and difficult line to draw, and one with constitutional implications. Because the term 

“educational” is not defined in the statute and is “inherently general,”10 the IRS must be careful 

in administering the term not to deny tax exemption as an educational organization because of 

the content of the organization’s speech. Indeed, part of the Treasury regulations defining 

educational were held unconstitutionally vague on the ground that the regulation left too much 

discretion over the content of speech to IRS determinations.11 As an alternative, the IRS 

developed a four-part test, the “methodology test,” which it now uses to determine whether the 

activities of an organization that advocates a particular viewpoint or position are educational. 

Regarding the methodology test, the IRS states that it is the long-standing position of the IRS 

“that the method used by an organization in advocating its position, rather than the position 

itself, is the standard for determining whether an organization has educational purposes.”12

In addition to meeting the exempt purpose requirement, a section 501(c)(3) organization 

must satisfy the following operational requirements: (1) the net earnings of the organization may 

not inure to the benefit of any person in a position to influence the activities of the organization; 

(2) the organization must operate to provide a public benefit, not a private benefit;13 (3) the 

organization may not be operated primarily to conduct an unrelated trade or business;14 (4) the 

organization may not engage in substantial legislative lobbying; and (5) the organization may not 

participate or intervene in any political campaign. 

A private school that otherwise satisfies the requirements of section 501(c)(3) as an 

educational institution will not qualify for exemption unless it has a racially nondiscriminatory 

policy as to students. For example, a private school must include a statement in its charter, 

bylaws, other governing instrument, or in a resolution of its governing body, that it has a racially 

 

composed of students of other schools.” H. R. Rep. No. 2319, 81st Cong., 2d Sess., at 37 (1950); S. Rep. 

No. 2375, 81st Cong., 2d Sess. (1950). 

10 National Alliance v. United States, 710 F.2d 868, 873 (D.C. Cir. 1983). 

11 The regulations in question provide that “[a]n organization may be educational even though it 

advocates a particular position or viewpoint so long as it presents a sufficiently full and fair exposition of 

the pertinent facts as to permit an individual or the public to form an independent opinion or conclusion. 

On the other hand, an organization is not educational if its principal function is the mere presentation of 

unsupported opinion.” Treas. Reg. sec. 1.501(c)(3)-1(d)(3)(i). The “full and fair exposition” test was 

held unconstitutional in Big Mama Rag, Inc. v. United States, 631 F.2d 1030 (D.C. Cir. 1980). 

12 Rev. Proc. 86-43, 1986-2 C.B. 729. 

13 Treas. Reg. sec. 1.501(c)(3)-1(d)(1)(ii). 

14 Treas. Reg. sec. 1.501(c)(3)-1(e)(1). Conducting a certain level of unrelated trade or business 

activity will not jeopardize tax-exempt status. 
6 

nondiscriminatory policy as to students and that it does not discriminate against applicants and 

students on the basis of race, color, or national or ethnic origin.15

Private inurement and private benefit prohibitions

The doctrine of private inurement generally prohibits a section 501(c)(3) organization, 

including educational organizations, from using its assets for the benefit of a person or entity 

with a close relationship to the organization, persons sometimes deemed “insiders” of the 

organization, such as directors, officers, and key employees. The issue of private inurement 

often arises where an organization pays unreasonable compensation (i.e., more than the value of 

the services) to such an insider. However, the inurement prohibition is designed to reach any 

transaction through which an insider is unduly benefited by an organization, either directly or 

indirectly. 

There is no “de minimis” exception under the inurement prohibition, and an organization 

that engages in an inurement transaction may face revocation of its exempt status. Until 1996, 

there was no sanction short of revocation of exempt status in the event of an inurement 

transaction. In 1996, however, Congress imposed excise taxes, frequently referred to as 

“intermediate sanctions,” on “excess benefit transactions” between certain exempt organizations 

and “disqualified persons.”16 The intermediate sanctions rules, which apply only to transactions 

involving organizations exempt under sections 501(c)(3) and 501(c)(4), impose excise taxes on 

an insider (a “disqualified person”) who receives an excess benefit and, under certain 

circumstances, on organization managers who approved the transaction. 

Section 501(c)(3) organizations (but not other organizations) also are subject to a 

prohibition against conferring more than incidental “private benefit.” The private benefit 

prohibition applies to non-fair market value transactions with individuals or entities, not merely 

with insiders, and thus is in some respects broader than the private inurement prohibition. As a 

general matter, colleges and universities confer some amount of private benefit on students in the 

form of an education, particularly in situations where students receive scholarships and thus do 

not pay the entire cost of the education. Nonetheless, the private benefit conferred on recipients 

of scholarships from a college or university generally is viewed as incidental to serving the 

broader public interest in education, provided that scholarship recipients are selected on the basis 

of appropriate criteria (not including, for example, on the basis of a relationship with a school 

insider).17

 15 Rev. Proc. 75-50, 1975-2 C.B. 587 (establishing guidelines and recordkeeping requirements 

for determining whether private schools that are applying for recognition of exemption have racially 

nondiscriminatory policies as to students). 

16 The term disqualified person is defined in section 4958(f)(1) and generally includes those in a 

position to exercise substantial influence over the affairs of the organization. 

17 See Frances R. Hill & Douglas M. Mancino, Taxation of Exempt Organizations, sec. 

4.02[1][b] (2006). 
7 

Governmental entities

In 1913, Congress specifically provided for the exclusion of the income of entities that 

perform an essential governmental function.18 The exclusion applies to (1) income derived from 

any public utility or the exercise of any essential governmental function and accruing to a State 

or any political subdivision thereof, or the District of Columbia; or (2) income accruing to the 

government of any possession of the United States, or any political subdivision thereof. 

Whether activities involve the exercise of an “essential governmental function” is 

generally decided on a case-by-case basis. Relevant factors include whether the activity is one 

traditionally considered “governmental,” whether it involves the exercise of a governmental 

activity, and the extent of governmental financial interest in the activity. The income must be 

derived from a qualifying activity; it is not sufficient that the income be paid over to or benefit a 

qualifying activity. The second requirement, that the income “accrue to” a State or political 

subdivision, occurs when the State or subdivision has an unrestricted right to a proportionate 

share of the income. 

The income of State colleges and universities generally is tax exempt. However, as 

described below, State colleges and universities are subject to the unrelated business income tax. 

Public charity versus private foundation

In general

Once an organization qualifies for tax exempt status under section 501(c)(3), the 

organization must be classified as either a public charity or a private foundation.19 An 

organization may qualify as a public charity20 in several ways. Certain specified types of 

organizations automatically are classified as public charities, including colleges and universities. 

Others include churches, hospitals and certain other medical organizations, certain organizations 

providing assistance to colleges and universities, or a governmental unit.21 An organization that 

is not automatically classified as a public charity may qualify as a public charity in a variety of 

ways. 

 18 Sec. 115. 

19 Sec. 509(a). Private foundations are either private operating foundations or private nonoperating foundations. In general, private operating foundations operate their own charitable programs in 

contrast to private non-operating foundations, which generally are grant-making organizations. Most 

private foundations are non-operating foundations. Operating foundations are not subject to the payout 

requirements of private foundations and are not considered a private foundation for purposes of the 

charitable contribution deduction rules. 

20 The Code does not expressly define the term “public charity,” but rather provides exceptions to 

those entities that are treated as private foundations. 

21 Sec. 509(a)(1) (referring to sections 170(b)(1)(A)(i) through (iv) for a description of these 

organizations). 
8 

• It may qualify as a publicly supported public charity if at least one-third of its total 

support is from governmental units or the general public,22 or, failing this mechanical 

test, if it passes a “facts and circumstances” test.23 In general, this includes publicly 

or governmentally supported museums of history, art, or science, libraries, 

community centers to promote the arts, organizations providing facilities for the 

support of an opera, symphony orchestra, ballet, or to the general public, and 

organizations such as the American Red Cross.24

• It may qualify as a publicly supported public charity based on support received 

through the operation of trades or businesses that are related to such organization’s 

exempt purposes, i.e., if it normally receives more than one-third of its support from a 

combination of (1) gifts, grants, contributions, or membership fees and (2) certain 

gross receipts from admissions, sales of merchandise, performance of services, and 

furnishing of facilities in connection with activities that are related to the 

organization’s exempt purposes.25

• It may qualify as a “supporting organization” by providing support to another section 

501(c)(3) entity that is not a private foundation.26 

• It may qualify by being organized and operated exclusively for testing for public 

safety.27 

An organization that does not fit within any of the above categories is a private foundation. In 

general, private foundations are funded from a limited number of sources (e.g., an individual, a 

family, or a corporation). 

Substantive rules

Unlike public charities, private foundations are subject to tax on their net investment 

income at a rate of two percent (one percent in some cases).28 Private foundations also are 

subject to more restrictions on their activities than are public charities. For example, private 

foundations are required to make a minimum amount of charitable distributions each year (a pay 

 22 Treas. Reg. sec. 1.170A-9(e)(2). 

23 Treas. Reg. sec. 1.170A-9(e)(3). 

24 Treas. Reg. sec. 1.170A-9(e)(1)(ii). 

25 Sec. 509(a)(2)(A). In addition, the organization must not normally receive more than one-third 

of its public support in each taxable year from the sum of (1) gross investment income and (2) the excess 

of unrelated business taxable income as determined under section 512 over the amount of unrelated 

business income tax imposed by section 511. Sec. 509(a)(2)(B). 

26 Sec. 509(a)(3). 

27 Sec. 509(a)(4). 

28 Sec. 4940. 
9 

out requirement),29 are limited in the extent to which they may control a business,30 may not 

make speculative investments,31 and may not make certain expenditures (including expenditures 

for noncharitable purposes, lobbying, political activities, grants to individuals without prior IRS 

approval, and grants to organizations other than public charities and certain foundations unless 

special procedures are followed).32 Violations result in excise taxes on the foundation and, in the 

case of speculative investments and taxable expenditures, on the management of the foundation. 

Although there are rules that regulate transactions between a public charity or a private 

foundation and a respective insider of the organization, the private foundation “self-dealing” 

regime33 is much more restrictive than the public charity “intermediate sanctions” regime.34 The 

self-dealing regime generally prohibits transactions between a foundation and an insider of the 

foundation, whereas the intermediate sanctions regime permits public charities to enter into 

insider transactions so long as no excess benefit is provided to the insider.35 If the self-dealing or 

intermediate sanctions rules are violated, the resulting excise taxes on the insider generally are 

significantly more punitive with respect to transactions with private foundations than with public 

charities.36

Contributions to private foundations generally do not receive as favorable tax treatment 

as do contributions to public charities for purposes of the charitable contribution deduction. 

Unrelated business income tax

In general

In general, an exempt organization may have revenue from four sources: (1) 

contributions, gifts, and grants; (2) trade or business income that is related to exempt activities 

(e.g., program service revenue such as tuition); (3) investment income; and (4) trade or business 

income that is not related to exempt activities. The Federal income tax exemption generally 

 29 Sec. 4942. 

30 Sec. 4943. 

31 Sec. 4944. 

32 Sec. 4945. 

33 Sec. 4941. 

34 Sec. 4958. 

35 The two regimes take a similar approach with respect to the payment of compensation to an 

organization insider, i.e., the payment of compensation is permitted so long as the amount paid is 

reasonable and not excessive. 

36 The self-dealing tax is imposed on the entire amount involved in the transaction (except for the 

payment of compensation, with respect to which the tax is imposed on the excess compensation), whereas 

the intermediate sanctions tax is imposed on the excess benefit provided. 
10 

extends to the first three categories, and does not extend to an organization’s unrelated trade or 

business income. 

The unrelated business income tax was introduced in 1950 to address the problem of 

unfair competition between for profit companies and nonprofit organizations conducting an 

unrelated for profit activity. The unrelated business income tax generally applies to income 

derived from a trade or business regularly carried on by the organization that is not substantially 

related to the performance of the organization’s tax-exempt functions.37 Most exempt 

organizations are subject to the tax.38 Although most State and local governments generally are 

not subject to taxation on unrelated business taxable income,39 State colleges and universities 

that are agencies or instrumentalities of any government or any political subdivision of a 

government, or that are owned or operated by a government or political subdivision of a 

government generally are subject to unrelated business income taxation.40 

An organization that is subject to the unrelated business income tax and that has $1,000 

or more of gross unrelated business taxable income must report that income on Form 990-T 

(Exempt Organization Business Income Tax Return). 

Most exempt organizations generally may operate an unrelated trade or business so long 

as it is not a primary purpose of the organization. Therefore, engaging in a substantial amount of 

unrelated business activity is permitted and will not jeopardize exempt status.41 By contrast, a 

charitable organization may not operate an unrelated trade or business as a substantial part of its 

activities.42 

Certain types of income are specifically exempt from the unrelated business income tax, 

such as dividends, interest, royalties, and certain rents, unless derived from debt-financed 

property or, in some cases, from 50-percent controlled subsidiaries. Other exemptions from the 

unrelated business income tax are provided for activities in which substantially all the work is 

 37 Secs. 511-514. 

38 Organizations subject to the unrelated business income tax include all organizations described 

in section 501(c) (except for U.S. instrumentalities and certain charitable trusts), qualified pension, profitsharing, and stock bonus plans described in section 401(a), and certain State colleges and universities. 

Sec. 511(a)(2). 

39 Sec. 511(a)(2)(A). 

40 Sec. 511(a)(2)(B). For this purpose, government includes any foreign government (to the 

extent not contrary to a treaty), the United States and any of its possessions, any State, and the District of 

Columbia. The tax also applies in the case of a corporation wholly owned by one or more such colleges 

or universities. 

41 Because the exempt purposes of organizations differ, there may be differences in application 

of the unrelated business income tax rules, in particular, the determination of whether an activity is 

substantially related to an organization’s exempt purposes. 

42 Treas. Reg. sec. 1.501(c)(3)-1(e). 
11 

performed by volunteers, for income from the sale of donated goods, and for certain activities 

carried on for the convenience of members, students, patients, officers, or employees of a 

charitable organization. In addition, special unrelated business income tax provisions exempt 

from tax certain activities of trade shows and State fairs, income from bingo games, and income 

from the distribution of certain low-cost items incidental to the solicitation of charitable 

contributions. Organizations liable for tax on unrelated business taxable income may be liable 

for alternative minimum tax determined after taking into account adjustments and tax preference 

items. 

Debt-financed property

In general, income of a tax-exempt organization that is produced by debt-financed 

property is treated as unrelated business income in proportion to the acquisition indebtedness on 

the income-producing property. For purposes of determining unrelated business income, debtfinanced property generally means any property that is held to produce income and with respect 

to which there is acquisition indebtedness at any time during the taxable year. Acquisition 

indebtedness generally means the amount of unpaid indebtedness incurred by an organization to 

acquire or improve the property and indebtedness that would not have been incurred but for the 

acquisition or improvement of the property. Acquisition indebtedness does not include, 

however, (1) certain indebtedness incurred in the performance or exercise of a purpose or 

function constituting the basis of the organization’s exemption, (2) obligations to pay certain 

types of annuities, (3) an obligation, to the extent it is insured by the Federal Housing 

Administration, to finance the purchase, rehabilitation, or construction of housing for low and 

moderate income persons, or (4) indebtedness incurred by qualified organizations (certain 

educational organizations and pension plans) to acquire or improve real property. Special rules 

apply in the case of an exempt organization that owns a partnership interest in a partnership that 

holds debt-financed income-producing property. An exempt organization’s share of partnership 

income that is derived from such debt-financed property generally is taxed as debt-financed 

income unless an exception provides otherwise. 

Treatment of income from controlled entities

Section 512(b)(13) provides special rules regarding income derived by an exempt 

organization from a controlled subsidiary. The general rule treats otherwise excluded rent, 

royalty, annuity, and interest income as unrelated business income if such income is received 

from a taxable or tax-exempt subsidiary that is 50 percent controlled by the parent tax-exempt 

organization (to the extent the payment reduces the net unrelated income (or increases any net 

unrelated loss) of the controlled entity (determined as if the entity were tax exempt)). With 

respect to payments from a controlled subsidiary made pursuant to a binding written contract in 

effect on August 17, 2006 (or renewal of such a contract on substantially similar terms), the 

general rule applies only to the portion of payments received or accrued in a taxable year that 

exceeds the amount of the specified payment that would have been paid or accrued if such 

payment had been determined under the principles of section 482 (generally, the excess amount 

above fair market value). A 20-percent penalty is imposed on the larger of such excess 

determined without regard to any amendment or supplement to a return of tax, or such excess 

determined with regard to all such amendments and supplements. 
12 

In the case of a stock subsidiary, “control” means ownership by vote or value of more 

than 50 percent of the stock. In the case of a partnership or other entity, control means 

ownership of more than 50 percent of the profits, capital, or beneficial interests. In addition, the 

constructive ownership rules of section 318 apply for purposes of section 512(b)(13). Thus, a 

parent exempt organization is deemed to control any subsidiary in which it holds more than 50 

percent of the voting power or value, directly (as in the case of a first-tier subsidiary) or 

indirectly (as in the case of a second-tier subsidiary). 
13 

B. Tax Incentives for Contributions to Educational Organizations 

Charitable contribution deduction

In computing taxable income, a taxpayer who itemizes deductions generally is allowed to 

deduct the amount of cash and the fair market value of property contributed to an organization 

described in section 501(c)(3) or to a Federal, State, or local governmental entity, including to 

most colleges and universities. 

The amount of the deduction allowable for a taxable year with respect to a charitable 

contribution of property may be reduced or limited depending on the type of property 

contributed, the type of charitable organization to which the property is contributed, and the 

income of the taxpayer.43 In general, as noted above, more generous charitable contribution 

deduction rules apply to gifts made to public charities, such as colleges and universities, than to 

gifts made to private foundations. Contributions to a public charity generally are deductible up 

to 50 percent of the donor’s adjusted gross income (30 percent for capital gain property), 

whereas contributions to most private foundations generally are deductible up to 30 percent of 

the donor’s adjusted gross income (20 percent for capital gain property).44 In addition, gifts of 

capital gain property to a public charity generally are deductible at the property’s fair market 

value,45 whereas gifts of capital gain property (other than publicly traded stock) to most private 

foundations are deductible at the taxpayer’s basis (cost) in the property.46

Within certain limitations, donors also are entitled to deduct their contributions to a 

section 501(c)(3) organization or to a Federal, State, or local governmental entity, including to 

educational organizations such as colleges and universities, for Federal estate and gift tax 

purposes. By contrast, contributions to nongovernmental, non-charitable tax-exempt 

organizations generally are not deductible by the donor, though such organizations are eligible 

for the exemption from Federal income tax with respect to such donations. Recipients of 

charitable assistance generally may exclude the assistance from income as a gift.47 

In general, if a donor receives a benefit or quid pro quo in return for a contribution, any 

charitable contribution deduction is reduced by the amount of the benefit received. For example, 

amounts paid for tuition are not deductible as a charitable contribution. 

 43 Secs. 170(b) and (e). 

44 Sec. 170(b)(1). 

45 Sec. 170(e)(1). However, contributions of tangible personal property not for an exempt 

purpose of the donee organization are deductible at the taxpayer’s basis in the property. Sec. 

170(e)(1)(B)(i). A special rule determines the aggregate deduction for contributions of certain intellectual 

property. Secs. 170(e)(1)(B)(iii) and 170(m). 

46 Sec. 170(e)(1)(B)(ii) and 170(e)(5). 

47 Sec. 102(a). 
14 

A donor who claims a deduction for a charitable contribution must maintain reliable 

written records regarding the contribution, regardless of the value or amount of the contribution. 

In the case of a charitable contribution of money (regardless of the amount), applicable 

recordkeeping requirements are satisfied only if the donor maintains as a record of the 

contribution a bank record or a written communication from the donee showing the name of the 

donee organization, the date of the contribution, and the amount of the contribution.48 In 

addition, no charitable deduction is allowed for a contribution of $250 or more unless the 

taxpayer substantiates the contribution by a contemporaneous written acknowledgement of the 

contribution by the donee organization. Such acknowledgement must include the amount of cash 

and a description (but not value) of any property other than cash contributed, whether the donee 

provided any goods or services in consideration for the contribution, and a good faith estimate of 

the value of any such goods or services.49 Additional substantiation rules apply to contributions 

for which deductions of more than $500 and more than $5,000 are claimed. 

Distributions from individual retirement arrangements

In general, present law provides an exclusion from gross income for otherwise taxable 

distributions from a traditional or a Roth individual retirement arrangement (“IRA”) in the case 

of qualified charitable distributions.50 The exclusion may not exceed $100,000 per taxpayer per 

taxable year. A qualified charitable distribution is any distribution from an IRA directly by the 

IRA trustee to an organization described in section 170(b)(1)(A) (other than an organization 

described in section 509(a)(3) or a donor advised fund (as defined in section 4966(d)(2)). 

Colleges and universities generally are organizations described in section 170(b)(1)(A). 

Distributions are eligible for the exclusion only if made on or after the date the IRA owner 

attains age 70-1⁄2. Distributions made in taxable years beginning after December 31, 2007, do not 

qualify for the exclusion. 

The exclusion applies only if a charitable contribution deduction for the entire 

distribution otherwise would be allowable, determined without regard to the generally applicable 

percentage limitations. Thus, for example, if the deductible amount is reduced because of a 

benefit received in exchange, or if a deduction is not allowable because the donor did not obtain 

sufficient substantiation, the exclusion is not available with respect to any part of the IRA 

distribution. Distributions that are excluded from gross income by reason of the provision are 

not taken into account in determining the deduction for charitable contributions under section 

170. 

 48 Sec. 170(f)(17). 

49 Sec. 170(f)(8). 

50 This does not include distributions from employer-sponsored retirements plans, including 

SIMPLE IRAs and simplified employee pensions (“SEPs”). 
15 

C. Tax-Exempt Financing for Facilities and Activities 

of Providers of Higher Education 

Overview

Interest on bonds issued by State and local governments generally is excluded from gross 

income for Federal income tax purposes.51 Because the interest income is excluded from gross 

income, investors generally are willing to accept a lower rate on tax-exempt bonds than they 

might otherwise accept on a taxable investment. This, in turn, lowers the borrowing cost for the 

beneficiaries of such financing. 

Bonds issued by State and local governments may be classified as either governmental 

bonds or private activity bonds. Governmental bonds are bonds the proceeds of which are 

primarily used to finance governmental functions or which are repaid with governmental funds. 

Like other activities carried out and paid for by State and local governments, the construction, 

renovation, and operation of public schools (including State universities) are activities eligible 

for financing with the proceeds of tax-exempt, governmental bonds. 

Private activity bonds are bonds in which the State or local government serves as a 

conduit providing financing to nongovernmental persons. For these purposes, the term 

“nongovernmental person” generally includes the Federal Government and all other individuals 

and entities, including section 501(c)(3) organizations, other than States or local governments. 

Present law provides two tests for determining whether a State or local bond is in substance a 

private activity bond, the private business test and the private loan test.52 The exclusion from 

income for interest on State and local bonds does not apply to private activity bonds, unless the 

bonds are issued for certain permitted purposes (“qualified private activity bonds”) and other 

Code requirements are met. 

One type of qualified private activity bond is a qualified 501(c)(3) bond, which is a bond 

issued by a State or local government to finance the activities of an organization described in 

section 501(c)(3). 53 Both capital expenditures and limited working capital expenditures of 

charitable organizations described in section 501(c)(3) of the Code – including elementary, 

secondary, and post-secondary schools − generally may be financed with tax-exempt, qualified 

private activity bonds. Unlike most qualified private activity bonds, qualified 501(c)(3) bonds 

are not subject to the State limits on the amount of qualified private activity bonds that may be 

issued. In addition, unlike most qualified private activity bonds, qualified 501(c)(3) bonds may 

be advance refunded. 

 51 Sec. 103(a). 

52 Secs. 141(b) and (c). 

53 Sec. 141(e). Qualified activity bonds also include exempt facility bonds; qualified mortgage or 

veterans’ mortgage bonds; small issue and redevelopment bonds, and student loan bonds. Present law 

also provides special rules for qualified private activity bonds issued within certain geographic areas (e.g., 

enterprise or empowerment zones, the New York Liberty Zone, and the Gulf Opportunity Zone) to 

provide incentives for businesses to locate in those areas. 
16 

Private activity bond tests

As noted above, the Code provides two primary standards for determining whether a 

State or local bond is a private activity bond. The first standard is the two-part private business 

test. If the private business test is not satisfied, a bond can still be a private activity bond if the 

private loan test is met. 

Private business tests

Private business use and private payments result in State and local bonds being private 

activity bonds if both parts of the two-part private business test are satisfied−

1. More than 10 percent of the bond proceeds is to be used (directly or indirectly) by a 

private business (the “private business use test”); and 

2. More than 10 percent of the debt service on the bonds is secured by an interest in 

property to be used in a private business use or to be derived from payments in respect 

of such property (the “private payment test”).54 

Private loan test

The second standard for determining whether a State or local bond is a private activity 

bond is whether an amount exceeding the lesser of (1) five percent of the bond proceeds or (2) $5 

million is used (directly or indirectly) to finance loans to private persons. Private loans include 

both business and other (e.g., personal) uses and payments by private persons; however, in the 

case of business uses and payments, all private loans also constitute private business uses and 

payments subject to the private business test. Present law provides that the substance of a 

transaction governs in determining whether the transaction gives rise to a private loan. In 

general, any transaction which transfers tax ownership of property to a private person is treated 

as a loan. 

Qualified 501(c)(3) bonds

In general

A bond issue is not treated as a qualified 501(c)(3) bond (i.e., is not tax exempt) if such 

bond issue meets a modified version of the private business test. Under the modified version of 

the private business test, the maximum amount of private business use and private payments is 

five percent of the net proceeds55 of the issue.56 Facilities financed with qualified 501(c)(3) 

 54 The 10-percent private business use and payment threshold is reduced to five percent for 

private business uses that are unrelated to a governmental purpose also being financed with proceeds of 

the bond issue. 

55 The term “net proceeds” means the proceeds of a bond issue reduced by amounts in a 

reasonably required reserve or replacement fund (which is generally limited to 10 percent of the 

proceeds). Sec. 150(a)(3). 
17 

bonds also are required to be owned by a section 501(c)(3) organization or by a governmental 

unit. Moreover, the use of bond proceeds or bond-financed property in unrelated trades or 

businesses (determined by applying section 513(a)) is treated as private business use. Thus, the 

use of bond proceeds by a section 501(c)(3) organization in an unrelated trade or business is 

limited to five-percent of the net proceeds of the bond issue. 

Exemption from volume cap and certain other restrictions

Qualified 501(c)(3) bonds are not subject to a number of restrictions that apply to other 

qualified private activity bonds. For example, the aggregate volume of most qualified private 

activity bonds is restricted by the annual volume cap imposed on issuers within each State (the 

"State volume cap").57 The State volume cap rules reflect Congress’ intent to control the total 

volume of tax-exempt bonds issued for private activities. For calendar year 2006, these annual 

volume limits, which are indexed for inflation, equal $80 per resident of the State, or $246.61 

million, if greater. Qualified 501(c)(3) bonds, which includes bonds issued to finance the 

activities of charitable educational organizations described in section 501(c)(3), are not subject to 

the State volume cap.58 In addition, unlike most qualified private activity bonds issued after 

August 7, 1986,59 the interest income from qualified 501(c)(3) bonds is not a preference item for 

purposes of calculating the alternative minimum tax. 

Advance refunding of qualified 501(c)(3) bonds

The Code also provides more favorable refunding rules for qualified 501(c)(3) bonds than 

for other types of qualified private activity bonds. Private activity bonds, other than qualified 

501(c)(3) bonds, may not be advance refunded.60

 56 Sec. 145(a)(2). 

57 Sec. 146. 

58 Although qualified 501(c)(3) bonds are not subject to the State volume cap, prior to the 

Taxpayer Relief Act of 1997 (the “1997 Act”), the Code limited the amount of qualified 501(c)(3) 

outstanding bonds from which a section 501(c)(3) organization could benefit to $150 million. In applying 

this “$150 million limit,” all section 501(c)(3) organizations under common management or control were 

treated as a single organization. The limit did not apply to bonds for hospital facilities, defined to include 

acute care, primarily inpatient, organizations. The 1997 Act repealed the $150 million limit for bonds 

issued after the date of enactment (August 5, 1997), to finance capital expenditures incurred after such 

date. The $150 million limit continues to govern the issuance of other non-hospital qualified 501(c)(3) 

bonds (e.g., advance refunding bonds with respect to capital expenditures incurred on or before such date, 

new-money bonds for capital expenditures incurred on or before such date, or new-money bonds for 

working capital expenditures). 

59 Sec. 57(a)(5). Special rules apply to exclude refundings of bonds issued before August 8, 

1986, and certain bonds issued before September 1, 1986. 

60 As part of the Gulf Opportunity Zone Act of 2005, Pub. L. No. 109-135, a limited number of 

exempt facility bonds issued for airports, docks, and wharves also may be advance refunded. 
18 

A refunding bond is defined as any bond used to pay principal, interest, or redemption 

price on a prior bond issue (the refunded bond). The Code contains different rules for “current” 

as opposed to “advance” refunding bonds. A current refunding occurs when the refunded bond 

is redeemed within 90 days of issuance of the refunding bonds. Conversely, a bond is classified 

as an advance refunding bond if it is issued more than 90 days before the redemption of the 

refunded bond.61 Proceeds of advance refunding bonds are generally invested in an escrow 

account and held until a future date when the refunded bond may be redeemed. Thus, after 

issuance of an advance refunding bond, there is a period of time when both the refunding bonds 

and the refunded bonds remain outstanding. 

There is no statutory limitation on the number of times that tax-exempt bonds may be 

currently refunded. However, the Code limits the number of advance refundings with taxexempt bonds. Generally, qualified 501(c)(3) bonds and governmental bonds may be advance 

refunded one time.62 

Arbitrage restrictions on tax-exempt bonds

To prevent tax-exempt entities from issuing more Federally subsidized tax-exempt bonds 

than is necessary for the activity being financed or from issuing such bonds earlier than 

necessary, the income exclusion for interest paid on States and local bonds does not apply to any 

arbitrage bond.63 An arbitrage bond is defined as any bond that is part of an issue if any 

proceeds of the issue are reasonably expected to be used (or intentionally are used) to acquire 

higher yielding investments or any replacement proceeds that are used to acquire higher yielding 

investments.64 Treasury regulations define replacement proceeds as any amounts that have a 

sufficiently direct nexus to the bond issue or to the governmental purpose of the bond issue to 

conclude that such amounts would have been used for that governmental purpose if the proceeds 

of the bonds were not used for such purpose.65 Examples of replacement proceeds include 

sinking funds and pledge funds that are used to pay principal or interest on the bond issue. 

In general, arbitrage profits may be earned only during specified periods (e.g., defined 

“temporary periods” before funds are needed for the purpose of the borrowing) or on specified 

types of investments (e.g., “reasonably required reserve or replacement funds”). Subject to 

limited exceptions, profits that are earned during these periods or on such investments must be 

rebated to the Federal Government. 

 61 Sec. 149(d)(5). 

62 Sec. 149(d)(3). Bonds issued before 1986 and pursuant to certain transition rules contained in 

the Tax Reform Act of 1986 may be advance refunded more than one time in certain cases. 

63 Secs. 103(a) and (b)(2). 

64 Sec. 148. 

65 Treas. Reg. sec. 1.148-1(c)(1). 
19 

Present law includes three exceptions to the arbitrage rebate rules applicable to 

education-related bonds. First, issuers of all types of tax-exempt bonds are not required to rebate 

arbitrage profits if all of the proceeds of the bonds are spent for the purpose of the borrowing 

within six months after issuance.66 Second, in the case of bonds to finance certain construction 

activities, including school construction and renovation, the six-month period is extended to 24 

months. Arbitrage profits earned on construction proceeds are not required to be rebated if all 

such proceeds (other than certain retainage amounts) are spent by the end of the 24-month period 

and prescribed intermediate spending percentages are satisfied.67 Third, governmental bonds 

issued by “small” governments are not subject to the rebate requirement. Small governments are 

defined as general purpose governmental units that issue no more than $5 million of tax-exempt 

governmental bonds in a calendar year. The $5 million limit is increased to $15 million if at 

least $10 million of the bonds are used to finance public schools.68

 66 In the case of certain governmental bonds (including bonds to finance public schools), the sixmonth expenditure exception is treated as satisfied if at least 95 percent of the proceeds is spent within six 

months and the remaining five percent is spent within 12 months after the bonds are issued. 

67 Retainage amounts are limited to no more than five percent of the bond proceeds, and these 

amounts must be spent for the purpose of the borrowing no later than 36 months after the bonds are 

issued. Issuers qualifying for this “construction bond” exception may elect to be subject to a fixed 

penalty payment regime in lieu of rebate if they fail to satisfy the spending requirements. 

68 The Economic Growth and Tax Reconciliation Act of 2001 (“EGTRA”) amended section 

148(f)(4)(D)(vii) to increase the additional amount of governmental bonds that small governmental units 

may issue for public schools without being subject to the arbitrage rebate requirements from $5 million to 

$10 million. However, the amendment is subject to the general sunset provisions of EGTRA and will not 

be available after December 31, 2010. 
20 

D. Tax Benefits for Education Expenses 

In general

Present law provides a variety of tax benefits for individuals who incur higher education 

expenses. Individuals may take advantage of a myriad of provisions, including provisions 

providing tax benefits for current higher education expenses, saving for future expenses, and 

expenses that have already been incurred (i.e., expenses relating to student loans).69 These tax 

provisions result in significant tax expenditures. Tax benefits for individuals with respect to 

education expenses are estimated to result in a tax expenditure for fiscal years 2006-2010 of 

almost $49 billion.70

To the extent that one of these benefits does not apply, e.g., because there is a limit on the 

expenses eligible for a benefit, then higher education expenses generally are not deductible by 

the individual. However, a deduction for education expenses generally is allowed under section 

162 if the education or training (1) maintains or improves a skill required in a trade or business 

currently engaged in by the taxpayer, or (2) meets the express requirements of the taxpayer's 

employer, or requirements of applicable law or regulations, imposed as a condition of continued 

employment.71 Education expenses are not deductible if they relate to certain minimum 

educational requirements or to education or training that enables a taxpayer to begin working in a 

new trade or business. In the case of an employee, education expenses are subject to the twopercent floor on itemized deductions, and also to the overall limit on itemized deductions. 

Tax benefits for current expenses

Hope tax credit

The Hope tax credit is a nonrefundable tax credit of up to $1,650 per year (2006 and 2007 

amount indexed for inflation for future years) per eligible student for qualified tuition and fees 

for the first two years of post-secondary education.72 In order to qualify for the credit, the 

 69 A brief description of these tax provisions is provided below. See Joint Committee on 

Taxation, Present Law and Analysis Relating to Tax Benefits for Higher Education (JCX-52-04), July 21, 

2004, at 8-27, for further detail. 

70 See Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 

2006-2010 (JCS-2-06), April 25, 2006, at 37. The tax expenditure items included in this total are the 

Hope and Lifetime Learning credits, the deduction for interest on student loans, the exclusion of earnings 

on amounts in qualified tuition programs and Coverdell education savings accounts, the exclusion of 

interest on educational savings bonds, the exclusion for discharge of certain student loan debt, and the 

exclusions for qualified scholarships and employer-provided educational assistance and tuition reduction. 

Tax expenditures are an estimate of the economic benefits that are provided though the tax laws by 

reference to a normal income tax law. For a variety of reasons, tax expenditures are not the same as 

revenue estimates and do not represent the revenue effect of a repeal of the provision. Id. at 2, 27. 

71 Treas. Reg. sec. 1.162-5. 

72 Sec. 25A. 
21 

student must be enrolled on at least a half-time basis in a degree program. The Hope credit is 

phased out ratably for taxpayers with modified adjusted gross income between $45,000 and 

$55,000 ($90,000 and $110,000 for married taxpayers filing a joint return) for 2006 and between 

$47,000 and $57,000 ($94,000 and $114,000 for married taxpayers filing a joint return) for 2007. 

The adjusted gross income phase-out ranges are indexed for inflation. A taxpayer may not claim 

the Hope credit and the Lifetime Learning credit or the above-the-line deduction with respect to 

the same student in the same year. In 2004, 7.2 million tax returns claimed education tax credits 

(i.e., either the Hope or Lifetime Learning credit) of $6.0 billion. 

Lifetime Learning credit

The Lifetime Learning credit is a nonrefundable tax credit of up to 20 percent of qualified 

tuition and fees.73 Up to $10,000 of such expenses per taxpayer return are eligible for the credit. 

In contrast to the Hope credit, the maximum credit is not indexed for inflation, the credit applies 

on a per-return rather than per-student basis, and the credit is not limited to the first two years of 

post-secondary education. The Lifetime Learning credit is available whether or not the student is 

enrolled on at least a half-time basis. The same income phaseout applies to the Lifetime Learning 

credit as applies to the Hope credit. A taxpayer may not claim the Lifetime Learning credit and 

the Hope credit or the above-the-line deduction with respect to the same student in the same 

year. 

Above-the-line deduction

For 2004 and 2005, an above-the-line deduction of $4,000 of higher education expenses 

is available to taxpayers whose adjusted gross income does not exceed $65,000 ($130,000 in the 

case of married taxpayers filing a joint return) and $2,000 for individuals with adjusted gross 

income not in excess of $80,000 ($160,000 for married taxpayers filing a joint return).74 The 

deduction applies to tuition and fees. A taxpayer may not claim the above-the-line deduction 

with respect to a student for whom a Hope or Lifetime Learning credit is claimed in the same 

year. The above-the-line deduction is not available after 2005. 

Exclusion for employer-provided educational assistance

If certain requirements are satisfied, up to $5,250 annually of employer-provided 

educational assistance is excludable from gross income and wages for employment tax 

purposes.75 The exclusion expires after 2010 under the sunset provisions of the Economic 

Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”). 

 73 Id. 

74 Secs. 62(a)(18) and 222. 

75 Sec. 127. 
22 

Qualified scholarships and tuition reduction

Qualified scholarships for qualified tuition, fees, books, supplies, and equipment received 

by an individual who is a degree candidate are excludable from gross income.76 Qualified tuition 

reduction for certain education provided to employees of an educational organization (and their 

spouses and dependents) is excludable from gross income and wages. These exclusions do not 

apply to any amount received that is compensation for services by the student as a condition of 

receiving the scholarship or tuition reduction. 

Tax benefits for saving for higher education expenses

Section 529 qualified tuition programs

A qualified tuition program is a program established by a State (or instrumentality of the 

State) or a qualified educational institution.77 In the case of a State program, the qualified tuition 

program may be either a prepaid tuition program or a savings account program. In the case of a 

program of a qualified educational institution, the program may only be a prepaid tuition 

program. Contributions to a qualified tuition program are not tax deductible for Federal income 

tax purposes. However, amounts in the account accumulate on a tax-free basis (i.e., income on 

accounts in the plan is not subject to current income tax) and distributions are tax free if used for 

qualified educational expenses. Qualified expenses include tuition, fees, books, supplies and 

equipment and, in the case of a student enrolled on at least a half-time basis, room and board. 

Distributions that are not for qualified expenses are includible in gross income and subject to an 

additional 10-percent tax. 

There is no dollar limit on the amount that can be contributed to a qualified tuition 

program; however, the program is required to provide adequate safeguards that the contributions 

will not exceed the amount necessary to provide for the qualified expenses of the account 

beneficiary. 

Special estate and gift tax rules apply to qualified tuition programs. For example, an 

individual may contribute up to five times the annual gift tax exclusion amount in a single year 

(currently, the annual limit is $12,000) on behalf of a beneficiary without adverse gift and 

generation skipping transfer tax consequences by electing to treat the contribution as having been 

made ratably over the 5-year period beginning with the calendar year in which the contribution is 

made. 

Certain provisions relating to section 529 programs were subject to the EGTRRA sunset. 

The application of the sunset to these programs was repealed, however, by the Pension 

Protection Act of 2006. Thus, those provisions are now permanent. The Pension Protection Act 

also specifically authorized the Secretary to prescribe regulations as may be necessary or 

appropriate to carry out the purposes of the provisions relating to section 529 programs and to 

 76 Sec. 117. 

77 Sec. 529. 
23 

prevent abuse of such purposes, including regulations relating to the gift, estate, and generation 

skipping transfer taxes. 

Coverdell education savings accounts

A Coverdell education savings account is a trust or custodial account established on 

behalf of an eligible beneficiary.78 Contributions to a Coverdell education savings account are 

not deductible for Federal income tax purposes; however, income on amounts in the account 

accumulates on a tax-free basis. Distributions from a Coverdell education savings account are 

tax-free if used for qualified expenses; other distributions are includable in gross income and 

subject to an additional 10-percent tax. Qualified expenses include higher education expenses as 

defined for purposes of qualified tuition programs (i.e., tuition, fees, books, supplies, equipment 

and, in some cases room and board expenses). In addition, qualified expenses include certain 

elementary and secondary expenses. The maximum amount that may be contributed to a 

Coverdell education savings account in any year by an individual contributor for a beneficiary is 

$2,000. The contribution limit for individual contributors is phased out ratably for taxpayers 

with modified adjusted gross income between $95,000 and $110,000 ($190,000 and $220,000 for 

married taxpayers filing a joint return); the adjusted gross income of the contributor, and not that 

of the beneficiary, controls whether a contribution is permitted by the taxpayer. 

A number of provisions relating to Coverdell education savings accounts are subject to 

the EGTRRA sunset, including the increase in the contribution limit from $500 to $2,000. 

Exclusion of earnings on education savings bonds

Interest earned on a qualified U.S. Series EE savings bond issued after 1989 is excludable 

from gross income if the proceeds of the bond upon redemption do not exceed the qualified 

higher education expenses paid by the taxpayer during the year.79 Qualified higher education 

expenses are defined as under the Hope and Lifetime Learning credits, and include qualified 

tuition and fees. For 2006, the exclusion is phased out ratably for taxpayers with modified 

adjusted gross income between $63,100 and $78,100 ($94,700 and $124,700 for married 

taxpayers filing a joint return). For 2007, the exclusion phases out for taxpayers with modified 

adjusted gross income between $65,600 and $80,600 ($98,400 and $128,400 for married 

taxpayers filing a joint return). The phase-out amounts are indexed for inflation. 

Other tax-favored savings arrangements

Present law provides favorable tax treatment for a number of savings vehicles. While not 

designed specifically for saving for educational expenses, they may be used by taxpayers for 

such purpose. These savings vehicles include Roth IRAs, traditional IRAs, deferred annuities, 

and qualified retirement plans. The special rules relating to each type of arrangement vary. 

 78 Sec. 530. 

79 Sec. 135. 
24 

Tax benefits relating to past expenses (provisions relating to student loans)

Deduction for student loan interest

Up to $2,500 per year of student loan interest is deductible as an above-the-line 

deduction.80 The deduction is phased out ratably for taxpayers with modified adjusted gross 

income between $50,000 and $65,000 ($105,000 and $135,000 for married taxpayers filing a 

joint return) for 2006 and between $55,000 and $70,000 ($110,000 and $140,000 for married 

taxpayers filing a joint return) for 2007. The adjusted gross income phase-out ranges are indexed 

for inflation. Certain provisions relating to the student loan interest deduction are subject to the 

EGTRRA sunset, including an increase in the income levels at which the deduction is phased 

out. 

Exclusion of income for student loan forgiveness

Gross income does not include any amount from the forgiveness (in whole or in part) of 

certain student loans, provided the forgiveness is contingent upon the student working for a 

certain period of time in certain professions for any of a broad class of employers.81

In addition, an individual’s gross income does not include amounts from the forgiveness 

of loans made by educational organizations (and certain tax-exempt organizations in the case of 

refinancing loans) out of private, nongovernmental funds if the proceeds of such loans are used 

to pay costs of attendance at an educational institution or to refinance any outstanding student 

loans (not just loans made by educational organizations) and the student is not employed by the 

lender organization. In the case of such loans made or refinanced by educational organizations 

(or refinancing loans made by certain tax-exempt organizations), cancellation of the student loan 

must be contingent upon the student working in an occupation or area with unmet needs and such 

work must be performed for or under the direction of a tax-exempt charitable organization or a 

governmental entity. 

Finally, an individual’s gross income does not include any loan repayment amount 

received under the National Health Service Corps loan repayment program or certain state loan 

repayment programs. 

 80 Sec. 221. 

81 Sec. 108(f). 
25 

III. SELECTED ISSUES AND ANALYSIS 

A. Background Data on College Enrollment and Costs 

Since 1991 more than 14 million students have enrolled annually in post-secondary 

education or training programs, with approximately 75 percent enrolled in public institutions and 

25 percent in private institutions in 2004. The full-time equivalent enrollment has exceeded 10 

million in every year since 1991. Of all those enrolled in 2004, 62 percent were enrolled in fouryear institutions. 

In the late 1970s, college costs lagged behind inflation, but they have generally risen 

faster than inflation since 1981. An exception to this has been for the cost for undergraduate 

tuition and fees at public two-year colleges, which began to moderate in the mid 1990s and rose 

by less than the rate of inflation in several years (see Table 1). However, more recently there 

have been sharp increases in costs at these institutions as well. 

Since 1976, college tuition and fees generally have risen at a rate close to twice that of 

the economy's overall price level. For the 1976-77 academic year, the total cost82 of attending a 

four-year private college averaged $3,977 (tuition and fees of $2,534) and the total cost of 

attending a four-year public college averaged $1,935 (tuition and fees of $617). For the 1986-87 

academic year, the comparable total cost figure had risen to $10,039 (tuition and fees of $6,658) 

for a four-year private college and to $4,138 (tuition and fees of $1,414) for a four-year public 

college. By the 2004-2005 academic year, the comparable total cost figure had risen to $26,489 

(tuition and fees of $18,838) for a four-year private college and to $11,441 (tuition and fees of 

$5,038) for a four-year public college. For the 2004-2005 academic year, the average cost of 

tuition and fees at a two-year public college was $1,847 and $12,182 at a two-year private 

college.83 Table 1 below details average tuition and fees by type of college in both current and 

constant (inflation adjusted) dollars since 1986. 

Over the past decade, governmental funding of public higher education has declined as a 

share of total funding. Table 2 reports the revenues of public degree-granting institutions of 

higher education by source. As a percentage of all revenues, Federal funds have remained 

relatively constant, State and local funding has declined, tuition and fees have increased, and 

other funding has increased. 

Private institutions of higher education rely less heavily on public sources of funding, 

though they are a significant source of funds. Private institutions rely more heavily on tuition 

and fees for revenue, and, in contrast to public institutions, receive a significant fraction of 

revenue from gifts and investment returns on endowments. Endowment returns are a highly 

variable source of revenues, however. Table 3 shows revenues of private not-for-profit 

postsecondary degree granting institutions for selected years.

 82 “Total cost” includes tuition and fees, and on-campus room and board costs. 

83 Department of Education. National Center for Education Statistics, Digest of Education 

Statistics 2005. 
26 

Table 1.–Average Undergraduate Tuition and Fees, 1986-87 Through 2004-2005 

Current Dollars Constant 2005 Do

Year 

Private 

four-year 

Private 

two-year 

Public 

four-year 

Public 

two-year 

Private 

four-year 

Private 

two-year 

Pu

four

1986-87 6,658 3,684 1,414 660 11,652 6,446 2,1987-88 7,116 4,161 1,537 706 11,986 7,008 2,1988-89 7,722 4,817 1,646 730 12,448 7,766 2,1989-90 8,396 5,196 1,780 756 12,876 7,969 2,1990-91 9,083 5,570 1,888 824 13,292 8,152 2,1991-92 9,759 5,754 2,117 936 13,786 8,128 2,1992-93 10,294 6,059 2,349 1,025 14,117 8,310 3,1993-94 10,952 6,370 2,537 1,125 14,615 8,501 3,1994-95 11,481 6,914 2,681 1,192 14,918 8,984 3,1995-96 12,243 7,094 2,848 1,239 15,461 8,959 3,1996-97 12,881 7,236 2,987 1,276 15,852 8,905 3,1997-98 13,344 7,464 3,110 1,314 16,112 9,012 3,1998-99 13,973 7,854 3,229 1,327 16,559 9,308 3,1999-00 14,588 8,235 3,349 1,338 16,818 9,494 3,2000-01 15,470 9,067 3,501 1,333 17,299 10,139 3,2001-02 16,211 10,076 3,735 1,380 17,737 11,024 4,2002-03 16,826 10,651 4,046 1,483 18,061 11,432 4,2003-04 17,777 11,546 4,587 1,702 18,621 12,094 4,2004-05 18,838 12,182 5,038 1,847 19,152 12,385 5,

Note: Current dollar figures are adjusted to constant dollars by reference to the average CPI of the calendar years spanned by the acade

tuition is reported. 

Source: U.S. Department of Education, National Center for Education Statistics, Digest of Education Statistics 2005. 
27 

Table 2.–Current Funds and Revenues of Public Postsecondary Degree-Granting Institut

By Source, Selected Years, 1985-1986 Through 2000-2001 

[Amount in Millions] 

Tuition and Fees 

State and Local 

Sources Federal Sources Other Sources*

Year Dollar Percent Dollar Percent Dollar Percent Dollar Perce

1985-86 9,439 14.5 31,547 48.5 6,852 10.5 17,167 26.4 1995-96 23,257 18.8 49,322 39.9 13,672 11.1 37,250 30.2 2000-01 31,920 18.1 69,948 39.6 19,745 11.2 55,302 31.2 

** Other sources includes income from educational activities, auxiliary enterprises, and hospitals. Source: U.S. Department of Education, National Center for Education Statistics, Digest of Education Statistics 2005. 
28 

Table 3.–Revenues of Private Not-for-Profit Postsecondary Degree-Granting Institutio

By Source, Selected Years, 1997-1998 Through 2002-2003 

[Amount in Millions]

Tuition and Fees 

 Federal State and 

Local Sources 

Private Gifts, 

Grants and 

Contracts 

 Investment 

Returns Oth

Year Dollar Percent Dollar Percent Dollar Percent Dollar Percent Dol

1997-98 26,499 27.8 12,631 13.3 13,246 13.9 22,312 23.4 20,52002-03 36,024 34.1 18,629 17.6 14,375 13.6 9,340 8.8 27,3

** Other sources includes income from educational activities, auxiliary enterprises, and hospitals. Source: U.S. Department of Education, National Center for Education Statistics, Digest of Education Statistics 2005.
29 

B. The Economics of Subsidizing Education 

Overview of the goals of subsidies

All levels of government make substantial direct expenditures to subsidize postsecondary education, including both expenditures on educational institutions and grants to 

individuals for financial assistance. In addition, private educational organizations channel gifts 

from private persons into subsidies for the education of other persons. By exempting such 

organizations from income tax and permitting the gifts to such organizations to be deductible, 

additional implicit subsidies under the Code are created for education. Other subsidies for 

education provided by the Code permit students to receive tax-free qualified scholarships, taxfree employer-provided educational assistance, tax-free cancellation of certain governmental 

student loans, and a deduction for student loan interest. Students and parents also are provided 

the benefits of the Hope and Lifetime Learning credits, the deduction for qualified tuition and 

related expenses, the exclusion from income of earnings on education savings accounts and 

qualified tuition programs, and the exclusion from income of the interest on U.S. savings bonds 

used to pay for post-secondary education. Analysts attempt to evaluate subsidies in terms of 

their efficiency, equity, and administrability. In this regard, it has been argued that subsidies to 

post-secondary education improve both economic efficiency and promote economic equity. 

Efficiency as a goal of subsidies to education

Economists generally have a predilection for favoring the outcomes of the free market 

and have reasoned that taxes or subsidies in the market generally lead to inefficient outcomes. 

That is, taxes or subsidies distort choices and divert resources from their highest and best use. 

However, economists also recognize that sometimes markets do not work efficiently. Economists 

observe that the consumption or acquisition of certain goods may create spillover, or external, 

effects that benefit society at large as well as the individual consumer who purchases the good. 

An example of such a good is a vaccination. The individual who is vaccinated benefits by not 

contracting an infectious disease, but the rest of society benefits as well, because by not 

contracting the disease the vaccinated individual also slows the spread of the disease to those 

who are not vaccinated. Economists call such a spillover effect a “positive externality.” On his 

or her own, the individual would weigh only his or her own reduced probability of contracting 

the disease against the cost of the vaccination. The individual would not account for the 

additional benefit the vaccination produces for society. As a result, the individual might choose 

not to be vaccinated, even though from society’s perspective, total reduction in the rate of 

infection throughout the population would be more than worth the cost of the vaccination. In this 

sense, the private market might produce too few of the vaccinations. The private market 

outcome is inefficiently small. Economists have suggested that the existence of positive 

externalities provides a rationale for the government to subsidize the acquisition of the good that 

produces the positive externalities. The subsidy will increase the acquisition of the good to its 

more efficient level. 

While much evidence suggests that job skill acquisition and education benefit the private 

individual in terms of higher market wages reflecting the individual’s higher level of 

productivity, many people have long believed that education also produces positive externalities. 

Commentators argue that society functions better with an educated populace and that markets 
30 

function better with educated consumers. They observe that education promotes innovation and 

that, because ideas and innovations are easily copied in the market place, the market return 

(wage or profit) from ideas and innovations may not reflect the full value to society from the idea 

or innovation. Just as a single individual does not appreciate the full benefit of a vaccination, a 

single individual may not be able to reap the full benefit of an idea or innovation. Thus, it is 

argued, subsidies for education are needed to improve the efficiency of society. 

On the other hand, recognizing that a subsidy might be justified does not identify the 

magnitude of the subsidy necessary to promote efficiency nor the best method for delivery of the 

subsidy. It is possible to create inefficient outcomes by over-subsidizing a good that produces 

positive externalities. Given that the United States already provides substantial subsidies to postsecondary education, it is not possible to say whether new subsidies would increase or decrease 

economic efficiency without some empirical analysis of the social benefits that would arise from 

creating new subsidies. 

Some observers note that, aside from potential spillover effects that education might 

create, the market for financing education may be inefficient. They observe that, while investors 

in housing or other tangible assets have property that can be pledged to secure financing to 

procure the asset, an individual cannot generally pledge his or her future earnings as security for 

a loan to obtain education or training designed to increase the individual's future earning 

potential. This inability to provide security for education loans constrains borrowing as an 

alternative to finance education for some taxpayers. Taxpayers who cannot borrow to finance 

education or training may forgo the education or training even though it would produce a high 

return for the investor. This inefficiency in the market for education finance may offer a 

justification for public subsidies. The inefficiency in the market for financing is likely most acute 

among lower-income taxpayers who generally do not have other assets that could be pledged as 

security for an education loan. This suggests that this potential source of market inefficiency also 

relates to the considerations of equity as a rationale for subsidies of education (discussed below). 

Equity as a goal of subsidies to education

As noted above, there is evidence indicating that education and training are rewarded in 

the market place. Recognizing this market outcome, some argue that it is appropriate to subsidize 

education to ensure that educational opportunities are widely available, including to those less 

well off in society. Commentators argue that education can play an important role in reducing 

poverty and income inequality. They observe that even if there were no positive externalities 

from education, promoting economic equity within a market economy provides a basis for 

subsidizing education. If equity is the goal of expanded subsidies to education, the cost of the 

subsidies should be weighed in terms of the private benefits received by the target groups, rather 

than the social benefits that might be generated by any possible spillovers. 
31 

C. Issues Relating to the Tax Benefits Provided 

to Higher Education Organizations 

Public charity - private foundation distinction

As indicated above, different rules apply to a section 501(c)(3) organization depending 

on whether the organization is classified as a public charity or a private foundation. Private 

foundations historically have accumulated income, and since 1950, Congress has provided for 

rules regarding unreasonable accumulations. Under the Revenue Act of 1950, certain charitable 

organizations (generally corresponding to private foundations) would lose their tax-exempt status 

if the organization’s aggregate accumulated income was “unreasonable in amount or duration” in 

order for the organization to carry out its charitable functions. In the Tax Reform Act of 1969, 

Congress replaced this rule with a provision that required a payout based on a specified 

percentage of a private foundation’s noncharitable-use assets.84 Congress determined that the 

1950 provision was defective in two respects.85 First, the prohibition on unreasonable income 

accumulations failed to preclude private foundations from holding or investing in assets which 

produced no current income, such as undeveloped land. As a result, although a donor to a 

foundation would receive an immediate charitable deduction on making a gift of nonproductive 

assets (or of property converted into such assets by the foundation), there could be an indefinite 

delay between the loss of tax revenues due to the deduction and the benefit intended to accrue to 

the public from the gift. Second, the prohibition on unreasonable income accumulations was 

difficult to enforce both because of its vagueness and the subjective nature of the test, and 

because the penalty of loss of exempt status was either unduly harsh for minor violations or 

largely ineffective for more substantial violations. Court cases had sanctioned as reasonable 

accumulations of income for up to 10 years for the sole purpose of increasing the size of the 

foundation’s corpus.86 

Arguably, the historical misgivings regarding accumulations of income, in the form of an 

endowment or otherwise, is relevant whether the accumulation occurs in a private foundation or 

a public charity, such as a college or university. Charitable contributions to an endowment result 

in an immediate tax benefit to the donor but, absent a payout requirement, may not result in an 

immediate benefit to the public. At some point, accumulations of income by a public charity 

may become unreasonable and antithetical to the requirement that a public charity be operated 

exclusively for exempt purposes. 

 84 Sec. 4942. As enacted in 1969, the payout was the greater of a foundation’s income or six 

percent of the foundation’s investment assets. The Secretary of the Treasury had the authority to adjust 

the percentage periodically. The present law payout is five percent of a foundation’s investment assets. 

85 See H.R. Rep. No. 91-413 (Pt. 1), 91st Cong., 1st Sess. 25-27 (1969); S. Rep. No. 91-552, 91st

Cong., 1st Sess. 34-38 (1969); Joint Committee on Taxation, General Explanation of the Tax Reform Act 

of 1969 (JCS-16-70), December 3, 1970, at 36-40 (1970); Treasury Department Report on Private 

Foundations, House Committee on Ways and Means, 89th Cong., 1st Sess. 23-30, 58-60, 92-96 (Comm. 

Print 1965). 

86 Treasury Department Report on Private Foundations, Committee on Finance United States 

Senate, 89th Cong., 1st Sess. (February 2, 1965) at 26. 
32 

In the years leading up to the Tax Reform Act of 1969, private foundations were widely 

seen as abusive because substantial contributors of foundations generally retained control of the 

foundation, calling into question the foundation’s commitment to charitable purposes. Today, it 

may not be as clear, given the growth and diversity of public charities, why some of the private 

foundation rules are not relevant for certain public charities, or whether some of the private 

foundation rules are performing their intended purpose or should be reconsidered.87 The 

retention of substantial holdings in a commercial business, the making of investments or 

expenditures that jeopardize or are inconsistent with exempt purposes, or, as noted above, the 

maintenance of large endowment funds may raise some of the same concerns whether conducted 

by a public charity or a private foundation. The relevance of a tax on the net investment income 

of private foundations also could be questioned, either as an anachronism or as a burden that 

should be shared equally among exempt or charitable organizations. 

Scope of activities that are related to educational purposes

In general

For any exempt organization that is subject to the unrelated business income tax, there is 

always a question whether a particular activity is substantially related to the furtherance of an 

organization’s exempt purposes. If an activity is not so related, then it may be subject to tax. A 

number of disparate issues arise in the educational context as to whether an activity is 

educational in nature, or the extent to which a noneducational activity nonetheless is exempt 

from the unrelated business income tax because income from the activity fits within a statutory 

exemption. As described below, many of the issues in this context are not new, but are 

illustrative of the ongoing tension as to whether an activity is educational or, even if not 

educational in nature, subject to tax. 

Commercial activities

The operation of a restaurant, bookshop, publication, or retail shop are all commercial 

activities regularly conducted by for profit entities, and also frequently undertaken by tax-exempt 

educational organizations. The IRS has ruled that each such activity may be consistent with 

exempt status.88 Two intertwined issues are the extent to which such commercial activity is 

substantially related to exempt purposes, and thus not subject to the unrelated business income 

tax, and whether such commercial activity is of a magnitude so as to jeopardize exempt status. 

In the university context, in enacting the unrelated business income tax provisions in 

1950, Congress explicitly recognized that certain publishing activities may be related to a 

university’s exempt purposes in appropriate cases, stating: “[i]ncome from a university press 

would be exempt in the ordinary case since it would be derived from an activity that is 

 87 See generally, Marion R. Fremont-Smith, Is It Time to Treat Private Foundations and Public 

Charities Alike? 52 The Exempt Organization Tax Review 257 (2006) 

88 See, e.g., Rev. Rul. 67-217, 1967-2 C.B. 181 (restaurant); Rev. Rul. 68-538, 1968-2 C.B. 116 

(university store); Rev. Rul. 62-234, 1963-2 C.B. 210 (journal).
33 

‘substantially related’ to the purposes of the university.”89 Along these lines, the Treasury 

Regulations provide that “a university radio station or press is considered a related trade or 

business if operated primarily as an integral part of the educational program of the university.”90 

However, the regulations also provide that such an activity is not a related activity “if operated in 

substantially the same manner as a commercial radio station or publishing house.”91 Thus, in the 

first instance, the commercial nature of the activity affects the determination of whether income 

from the activity is subject to the unrelated business income tax. If so, then the question 

becomes whether the activity reaches a level substantial enough to jeopardize exempt status. In 

general, organizations that engage in substantial publishing activity will not qualify for 

exemption as an educational organization if the publishing activity takes on too much of a 

“commercial hue.”92 This determination is especially difficult because publishing clearly is a 

commercial activity yet also involves the dissemination of information to the public.93 The IRS 

has successfully denied exemption to a number of publishing organizations (many of them 

religious organizations with a primary activity of publishing) on commerciality grounds. 

However, if an activity like publishing or operation of a bookshop does not jeopardize exemption 

under the commerciality doctrine, it in many cases will not result in unrelated business income 

tax, either because the activity is considered related to exempt educational purposes or because it 

is for the convenience of the organization’s members or students.94

The issue of commerciality also arises in the context of scientific research and technology 

transfers by colleges and universities. University technology transfer – in general, the 

commercialization of technology developed through university research – was encouraged by the 

passage of the Bayh-Dole Patent and Trademark Act of 1980,95 which allows universities and 

other nonprofit organizations to retain rights to inventions developed using Federal grant 

 89 H.R. Rep. No. 2319, 81st Cong., 2d Sess. 37 (1950); S. Rep. No. 2375, 81st Cong. 2d Sess. 29 

(1950). 

90 Treas. Reg. sec. 1.513-2(a)(4). 

91 Id. 

92 Better Business Bureau of Washington, D.C. v. United States, 326 U.S. 279, 283-4 (1945). 

93 The IRS has ruled that a publication distributed below cost may be educational in nature if (1) 

the content of the publication is educational, (2) the preparation of material follows methods generally 

accepted as “educational” in character, (3) the distribution of the materials is necessary or valuable in 

achieving the organization’s educational and scientific purposes, and (4) the manner in which the 

distribution is accomplished is distinguishable from ordinary commercial publishing practices. Rev. Rul. 

67-4, 1967-1 C.B. 121. 

94 See also Gen. Couns. Mem. 38,691 (Apr. 14, 1981) (concluding that a university’s publication 

and distribution of a scholarly journal, where the journal’s content was selected and authored by an 

unrelated section 501(c)(3) organization, did not constitute an unrelated trade or business). 

95 Pub. L. No. 96-517, 94 Stat. 3015 (1980) (codified as amended at 35 U.S.C. secs. 200-212). 
34 

money.96 Universities now frequently seek to profit financially through the licensing of 

university-developed research to third parties, often employing complex legal structures to 

facilitate such technology transfers. For example, although some universities license inventions 

directly to third parties in exchange for royalties, other institutions establish section 509(a)(3) 

supporting organizations and/or for-profit subsidiaries to engage in licensing and other 

commercialization activities on the universities’ behalf. Universities sometimes engage not only 

in university- and government-sponsored research, but also in research sponsored by commercial 

enterprises. 

The complexity of the structuring and financing of university technology transfer 

organizations gives rise to a number of tax issues. For example, in some situations questions 

may arise whether commercialization activities are consistent with a university’s tax-exempt 

educational or scientific purposes and whether such activities give rise to unrelated business 

taxable income. In general, such an activity will escape unrelated business income taxation if the 

activity is scientific research carried on in the public interest97 or is excepted from treatment as 

unrelated business taxable income under a specific provision of the Code.98 An issue may arise 

whether commercially sponsored scientific research is carried on in the public interest, consistent 

with the requirements of section 501(c)(3), where the commercial sponsor has a right to 

ownership or control of intellectual property resulting from the research.99

In other cases, a question may arise whether the terms of license arrangements with a forprofit subsidiary or third party result in the provision of impermissible private benefit to the 

subsidiary or third party, in violation of section 501(c)(3).100 Private benefit and/or private 

 96 See Mark L. Gordon, University Controlled or Owned Technology: The State of 

Commercialization and Recommendations, 30 J. Coll. & Univ. L. 641, 641-42 (2004); Milton Cerny, 

Technology Transfer and the New Economy, 47 Exempt Organization Tax Review 39, 39 (Jan. 2005). 

97 Scientific research generally is regarded as carried on in the public interest: (1) if the results 

are made available to the public on a nondiscriminatory basis; (2) if the research is performed for the 

United States or for a State or a political subdivision of a State; or (3) if the research is directed toward 

benefiting the public, e.g., if the research is carried on for the purpose of (1) aiding in the scientific 

education of college or university students, (2) obtaining scientific information that is published in a 

treatise, trade publication, etc., (3) discovering the cure for a disease, or (4) aiding a community or 

geographic area by attracting new industry to the community or area or by encouraging the development 

of, or retention of, an industry in the community or area. Treas. Reg. sec. 1.501(c)(3)-1(d)(5)(iii). 

98 See secs. 512(b)(2) (excluding royalties from unrelated business taxable income), 512(b)(7) 

excluding income from research for governmental units from unrelated business taxable income), 

512(b)(8) (excluding income from research performed by a university or hospital from unrelated business 

taxable income), and 512(b)(9) (excluding income from fundamental research, the results of which are 

freely available to the general public, from unrelated business taxable income). 

99 See Rev. Rul. 76-296, 1976-2 C.B. 141 (finding that commercially sponsored research may, in 

certain circumstances, be regarded as carried on in the public research where the results are timely 

published in a form available to the interested public). 

100 See Priv. Ltr. Rul. 200326035 (Apr. 4, 2003) (finding that an exclusive license between a 

section 501(c)(3) organization and a for-profit subsidiary owned by a supporting organization of the 
35 

inurement concerns may also arise in connection with incentive compensation arrangements with 

researchers, e.g., where a professor is provided a percentage of royalties arising from the 

commercialization of the professor’s research. 

Corporate sponsorship payments

The unfair competition rationale underlying the unrelated business income tax is 

implicated when exempt organizations receive income from activities that are not subject to the 

tax but that may provide an exempt organization with a competitive advantage in conducting an 

activity over a for-profit organization. Congress addressed such a case in 1997 by enacting rules 

about the tax treatment of corporate sponsorship payments, which some have argued is a form of 

advertising. Corporate sponsorship payments generally are exempt from unrelated business 

income tax under a special rule, so long as certain requirements are met.101 Prior to enactment of 

the special rule, the IRS had often questioned whether such arrangements allow charitable 

entities the ability to offer advertising to corporations at a lower rate. 

In general, a corporate sponsorship payment is a payment from a corporation to a taxexempt organization in exchange for becoming an “official sponsor” of a particular event of the 

tax-exempt organization. For example, a corporate sponsorship payment may occur when a 

corporation pays a university to become an official sponsor of the university’s football program, 

and the university in turn displays the corporation’s name and logo on the university’s football 

stadium where it can be seen by attendees and television viewers. 102 Another example is 

payment to an educational organization that regularly broadcasts a program in exchange for 

being featured on the program as a sponsor. 

For a number of years, the IRS was of the view that many corporate sponsorship 

payments were subject to the unrelated business income tax. One notable example concerned the 

1991 Mobil Cotton Bowl, whereby the Cotton Bowl Athletic Association (a tax-exempt 

organization) received a $1.5 million corporate sponsorship payment from Mobil Oil. The IRS 

challenged Mobil Oil’s sponsorship payment and determined that the payment was for 

advertising.103

 

section 501(c)(3) organization for the purpose of commercializing scientific research did not result in 

more than incidental private benefit, where the for-profit subsidiary did not have the right to control the 

research of the section 501(c)(3) organization). 

101 Sec. 513(i). 

102 In 1991 total corporate sponsorship payments to tax-exempt organizations was $1.1 billion, of 

which about $64 million was paid to the college football bowl organizations. Of this $64 million, an 

estimated $19.6 million was received for corporate title sponsorships rather than as corporate royalty 

payments. See Dennis Zimmerman, Corporate Title Sponsorship Payments to Nonprofit College 

Football Bowl Games: Should They Be Taxed?, Congressional Research Service 92-157E, Doc. 92-1744 

(Feb. 11, 1992). 

103 See Frank James Vari, The Unrelated Business Income Tax and its Effects Upon Collegiate 

Athletics, 9 Akron Tax J. 111 (1992). Several key court decisions were used in support of the IRS’s 
36 

In 1993, the IRS published proposed regulations to clarify the tax treatment of 

sponsorship payments and provide a safe harbor whereby sponsorship payments that met certain 

criteria would not be treated as unrelated business income. However, the proposed regulations 

generated controversy and left unanswered questions. Thus, in 1997, Congress added section 

513(i) to the Code in order to reduce the uncertainty with regard to the tax treatment of corporate 

sponsorship payments to exempt organizations. Congress determined that it was appropriate to 

distinguish sponsorship payments for which the donor receives no substantial return benefit other 

than the use or acknowledgment of the donor’s name or logo as part of a sponsored event from 

payments made in exchange for advertising provided by the recipient organization. The latter, 

but not the former, are subject to the unrelated business income tax.104

Affinity credit card arrangements and mailing list rentals

Issues often arise regarding whether certain types of receipts constitute royalties, which 

generally are excluded in determining an organization’s unrelated business taxable income.105 

Whether a particular income item is a royalty received in exchange for the passive license of an 

organization’s intellectual property will be determined based on the facts and circumstances of 

the case.106 Two issues that have been the source of considerable debate in this area are: (1) 

whether income from an affinity credit card program constitutes a royalty and (2) whether 

income from a mailing list rental constitutes a royalty. 

 

position. Included among these cases is United States v. American Bar Endowment, 477 U.S. 105 (1986), 

in which the Supreme Court stated that the standard test for the existence of a “trade or business” is 

whether the provision of goods or services is entered into with the dominant hope and intent of realizing a 

profit. Using that rationale, the IRS concluded that by providing valuable services, including advertising 

services, in return for large payments, the organization was engaged in an activity for the production of 

income from the provision of services. Hence, the organization was engaged in a trade or business 

activity. 

104 Sec. 513(i). An exempt “qualified sponsorship payment” is defined as any payment made by 

a person engaged in a trade or business with respect to which the person will receive no substantial return 

benefit other than the use or acknowledgment of the name or logo (or product lines) of the person’s trade 

or business in connection with the organization’s activities. However, if the business receives advertising 

(or other benefits) in exchange for making a payment, then the payment may be considered payment for 

the advertising or other benefits. In that case, only the amount of the payment (if any) that exceeds the 

fair market value of the advertising or other benefits is a qualified sponsorship payment. On April 24, 

2002, the IRS issued final regulations providing a safe harbor from taxation for qualified sponsorship 

payments. The final regulations clarified that payments other than qualified sponsorship payments are not 

automatically subject to unrelated business income tax. Instead, the tax treatment of nonqualified 

payments is determined under otherwise applicable unrelated business income tax rules. Treas. Reg. sec. 

1.513-4. 

105 Sec. 512(b)(1). 

106 Treas. Reg. sec. 1.512(b)-1. 
37 

Affinity credit card arrangements generally involve an agreement between an 

organization (such as a college or university) and a credit card issuer under which the 

organization’s name and logo will appear on the issuer’s credit cards. The cards are then 

marketed to an “affinity group,” i.e., a group of individuals associated with the organization. 

The organization, in turn, receives a payment that is usually based on a percentage of charges on 

the affinity cards. The issue that generally arises is whether the payment to the exempt 

organization is in exchange for the passive license of valuable intellectual property or is instead a 

payment for services, and thus not a royalty. For example, in Sierra Club v. Commissioner,

107

the Tax Court considered whether the retention by Sierra Club of the right to review promotional 

and marketing materials constituted the provision of marketing services by Sierra Club such as 

would convert the payment from a payment for a passive license to a payment for Sierra Club’s 

active participation in the marketing program. The court also considered whether an agreement 

by Sierra Club “to cooperate” in the solicitation and encouragement of Sierra Club’s members to 

participate in the program. The court sided with the taxpayer on both issues, finding that neither 

the retained right to approve marketing materials nor the obligation to cooperate constituted the 

provision of services such as would defeat the characterization of the payment as a royalty. The 

right to approve marketing materials simply helped Sierra Club protect its valuable intellectual 

property. The obligation to cooperate did not constitute an impermissible endorsement of the 

card issuer beyond that which necessarily results from licensing a name, logo, etc. Therefore, 

the court held that the income Sierra Club received in connection with the affinity arrangement 

was excludable from Sierra Club’s unrelated business taxable income. 

Courts have taken a similar approach to income from the rental of an exempt 

organization’s mailing list. For example, in Oregon State University Alumni Association, Inc. v. 

Commissioner,

108 the United States Court of Appeals for the Ninth Circuit held that income from 

mailing list rentals constituted a royalty even where the exempt organization that owned and 

licensed the list provided some clerical services and engaged in some promotional activity with 

regard to the arrangement. 

Notwithstanding the holdings in the above-described affinity credit card and mailing list 

rental cases, a taxpayer that provides more than a small amount of clerical services may risk 

having payments received in exchange for a license classified as payments for services rather 

than as excludable royalties. 

Travel tours

A number of exempt organizations, including colleges and universities, offer travel tours 

that are promoted as educational. The IRS takes the position that travel tours of a more social or 

recreational nature are not substantially related to an organization’s exempt educational purpose, 

and the income from such tours is unrelated business taxable income. Where a travel tour is 

 107 65 T.C.M. (CCH) 2582 (1993). 

108 193 F.3d 1098 (9th Cir. 1999). 
38 

truly educational, however, it may be related to an organization’s exempt purposes.109 The 

determination whether a particular travel tour is sufficiently educational to be considered 

substantially related to an organization exempt purposes is not always easy and thus has been the 

source of considerable controversy. In February 2000, the IRS issued final regulations that 

provide several examples in an effort to demonstrate when travel tours are educational, and thus 

related, and when they are not.110

Economic incentives to issue tax-exempt bonds

As discussed above, tax-exempt bonds lower the borrowing cost of State and local 

governments (or private parties in the case of qualified private activity bonds) because the bond 

investor is willing to accept a lower rate on the bonds than the investor might otherwise accept 

on a taxable investment. The lower borrowing cost also provides the parties to such financings 

with the opportunity to earn arbitrage profits. In the context of State and local bonds, arbitrage is 

the difference between the interest paid on tax-exempt bonds and the interest earned on higher 

yielding investments. Pure arbitrage transactions have no economic substance, but are made 

profitable solely through the ability to borrow at tax-exempt rates. If permitted to earn and retain 

arbitrage profits, issuers of tax-exempt bonds would have an economic incentive to issue more 

bonds, to issue them earlier, and to leave them outstanding longer than necessary to achieve the 

purpose of the financing. Arbitrage is an inefficient alternative to additional borrowing, because 

it is more costly to the Federal Government in terms of forgone tax revenue than the additional 

borrowing that would be necessary to produce the same amount of arbitrage profits. 

While the ability of issuers to earn and retain arbitrage profits through the investment of 

tax-exempt bond proceeds generally is restricted under present law, the Code does not define 

arbitrage in a manner that eliminates every opportunity to earn such profits. For example, 

present law does not restrict the investment of assets that are not financed with tax-exempt bond 

proceeds and are not otherwise used to replace bond proceeds (e.g., by pledging the assets to pay 

debt service on tax-exempt bonds). As a practical matter, this means that organizations eligible 

to receive tax-exempt financing, such as educational organizations described in section 

501(c)(3), generally may invest accumulated assets in investments earning yields higher than the 

yields on their tax-exempt borrowings. In addition, because these entities are tax exempt, the 

earnings on these investments are untaxed. The ability to earn an untaxed return on investment 

assets in addition to the ability to borrow on a tax-exempt basis increases the incentive for 

exempt entities to issue tax-exempt bonds beyond that which would exist if the only benefit 

received were the difference between tax-exempt and taxable borrowing rates. Contrast this with 

present law as it generally applies to individual and corporate taxpayers. Tax-exempt bonds also 

would provide individual and corporate taxpayers with an opportunity to earn tax arbitrage if 

such taxpayers were permitted to deduct interest on indebtedness incurred to purchase or carry 

obligations the interest on which is exempt from tax. Present law, however, generally restricts 

 109 Rev. Rul. 70-534, 1970-2 C.B. 113. 

110 Treas. Reg. sec. 1.513-7. 
39 

such transactions by disallowing a deduction for interest on indebtedness incurred to purchase or 

carry tax-exempt bonds.111

Moreover, unlike most other types of qualified private activity bonds, qualified 501(c)(3) 

bonds are not subject to the State volume cap limitations. Thus, although there is an economic 

incentive for section 501(c)(3) organizations to finance projects through the use of tax-exempt 

bonds rather than accumulated assets, present law does not impose any limitation on the 

aggregate amount of qualified 501(c)(3) bonds that may be issued.112 As a general matter, as the 

total volume of tax-exempt bonds increases it has the effect of increasing the borrowing costs for 

all issuers of tax-exempt bonds because of competition for investment in such obligations. 

Market forces generally will limit the ability of tax-exempt entities to leverage their accumulated 

assets by issuing tax-exempt bonds, but these same forces also may have the effect of increasing 

the cost of financing other services. 

 111 Sec. 265. 

112 As discussed above, in limited instances, there is a $150 million limitation on the outstanding 

amount of qualified 501(c)(3) bonds from which a section 501(c)(3) organization may benefit. In general, 

however, this rule only applies to working capital expenditures or bonds issued with respect to capital 

expenditures incurred after August 5, 1997. 
40 

D. Issues With Respect to Tax Benefits 

for Individuals Relating to Higher Education Expenses 

As described above, there are numerous provisions in the Code that allow taxpayers to 

reduce the cost of post-secondary education. Although the existence of a variety of tax 

incentives for education may mean that more taxpayers are able to take advantage of one or more 

education incentives, understanding the tax benefits provided by the different provisions, the 

various eligibility requirements, the interactions between different incentives and provisions 

within each incentive, and the recordkeeping and reporting requirements, may be time 

consuming and confusing for taxpayers who are interested in reducing their current education 

expenses or saving for future expenses. Specific sources of complexity include the absence of a 

uniform definition of qualifying education expenses, different income limitations for the 

different incentives, and provisions designed to prevent duplicative tax benefits with respect to 

the same expenses. The complexities of the varying definitions of qualifying expenses are 

illustrated in Table 4. Taxpayers also must address uncertainties associated with the fact that 

some of the education tax provisions are not permanent, and that certain rules applicable to 

permanent tax incentives are set to expire in 2010 absent further Congressional action. This is in 

addition to complexity that may exist independent of tax rules, such as that arising from the 

differences in fee structures, investment performance, and plan features. 

Complexity concerns in this area have prompted a number of simplification proposals in 

recent years. The staff of the Joint Committee on Taxation made several simplification 

proposals relating to education tax incentives in April 2001. These included: (1) establishing a 

uniform definition of qualified higher education expenses; (2) combining the Hope and Lifetime 

Learning credits; and (3) modifying the rules regarding the interaction of the various education 

tax incentives to provide a limitation that the same expenses could not qualify under more than 

one provision.113 In that report, the staff stated that “taxpayers are confronted with a confusing 

array of choices with respect to Federal tax incentives for financing education,” but noted that 

structural reform in this area would have to consider, among other things, the advantages and 

disadvantages of exclusion or deferral from income, income limits, and transition issues.114 The 

American Bar Association Section of Taxation, the Tax Division of the American Institute of 

Certified Public Accountants, and Tax Executives Institute have supported harmonization and 

simplification of education tax incentives, and identified as possible measures: (1) combining the 

Hope and Lifetime Learning credits; (2) simplifying the definition of student; (3) establishing a 

single amount of expenses eligible for the credit; (4) eliminating or standardizing the income 

ranges required for eligibility; (5) granting (in lieu of credits) exemption amounts to taxpayers 

who qualify for the credit under present law; (6) easing the requirements for the interest 

deduction and coordinating the phase-out amounts with other education incentives; and (7) 

 113 Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and 

Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 

1986, Volume II, 122-143 (JCS-3-01), April 2001. Some changes made by EGTRRA address the third 

category, interaction of the various provisions to limit the same expenses to only one type of benefit. 

114 Id. at 135. 
41 

replacing current tax benefits with a new universal education deduction or credit, i.e., developing 

one or two education-related deductions or credits to replace the current provisions.115 The 

President’s Advisory Panel on Federal Tax Reform has recommended replacing the present-law 

education savings vehicles (and present-law medical accounts, such as health savings accounts) 

with “Save for Family” accounts. Up to $10,000 could be contributed to such accounts annually. 

Contributions would be after-tax and distributions would not be includible in gross income if 

made for education expenses, health expenses, expenses for the purchase of a primary residence, 

and education.116

One issue that arises in the context of simplifying education tax incentives is whether the 

present-law rules appropriately target the tax benefits. For example, some argue that credits for 

education expenses should be refundable in order to subsidize education for individuals who 

need the subsidy the most. Others argue that refundable tax credits are administratively complex 

and that there are Federal spending programs, such as the Pell Grant program, that provide direct 

grants for education to a demographic group of individuals that is generally similar to the group 

that would be eligible for a refundable credit. Some argue that the per student approach of the 

Hope credit (rather than the per tax return approach of the Lifetime Learning credit) is a more 

equitable approach and would provide a more appropriate level of subsidy. Some have also 

pointed out that certain of the tax benefits are available only to a limited class. For example, the 

exclusion for qualified tuition reduction is available only to employees of qualified 

institutions.117 While available to a broader group of potential beneficiaries than the tuition 

reduction, the exclusion for employer-provided educational assistance has also been criticized for 

being available only to individuals whose employer has such a program.118 The tuition 

reduction exclusion applies with respect to dependents of the employee, whereas the general 

exclusion applies only to education of the employee. 

 115 American Bar Association, American Institute of Certified Public Accountants Tax Division 

and the Tax Executives Institute; American Bar Association Section of Taxation, Government 

Submissions, available at http://www.abanet.org/tax/pubpolicy/2001/01simple/7.html (noting that “[f]or 

many taxpayers, analysis and application of the intended incentives are too cumbersome to deal with 

compared with the benefits received,” and that “there are so many individual tests that must be satisfied 

for each benefit, taxpayers may inadvertently lose the benefits of a particular incentive because they either 

do not understand the provision or because they pay tuition or other qualifying expenses during the wrong 

tax year”), 6-7. 

116 The President’s Advisory Panel on Federal Tax Reform, Simple, Fair, & Pro-Growth: 

Proposals to Fix America’s Tax System (November 2005), at 120. 

117 The staff of the Joint Committee on Taxation has recommended repeal of the exclusion for 

tuition reduction for this reason. Joint Committee on Taxation, Options to Improve Tax Compliance and 

Reform Tax Expenditures (JCS-02-05), January 27, 2005 at 44-46. 

118 In addition to the objection of subsidizing education, the exclusion for employer-provided 

education assistance has also been justified on administrative and simplification grounds. In the absence 

of the exclusion certain employer-provided education that is job related would be excludable from 

income. The specific exclusion under section 127 avoids the need to make the factual determination as to 

whether the education is job related. 
42 

Table 4.–Treatment of Expenses Under Education Tax Benefits 

Provision Tuition 

Required 

Fees 

Books, Supplies, 

Equipment 

Room and 

Board 

1. Hope Credit  (sec. 25A) 

Included, except that tuition is a qualified expense with respect to any course or other education involving sports, games, or hobbies, only if such course or other education is part of the individual’s degree program. 

Included, except that (1) required fees with respect to any course or other education involving sports, games, or hobbies is included only if such course or other education is part of the individual’s degree program; and (2) nonacademic fees are not included. 

Not included. Not included. 

2. Lifetime Learning  Credit (sec. 25A) Same as Hope credit. Same as Hope credit. Not included. Not included. 3. Exclusion for  distributions from  qualified tuition  programs (sec. 529) 

Included. Included. Included, if required 

for enrollment or attendance. 

Included in the of students enroon at least a haltime basis. Amof room and boexpenses taken account may noexceed the greaof: (1) the room board amount included in the institution’s cosattendance for Federal student 
43 

Provision Tuition 

Required 

Fees 

Books, Supplies, 

Equipment 

Room and 

Board 

purposes, or (2) actual invoiced amount for studresiding in houowned or operaby the institutio

4. Exclusion for  distributions from  Coverdell education  savings accounts  (sec. 530) 

Included. Included. Same as qualified 

tuition programs. 

Same as qualifituition program

5. Savings bond  interest exclusion  (sec. 135) 

Same as Hope credit. Same as Hope credit, 

except that that nonacademic fees are not excluded from the definition of fees. 

Not included. Not included. 

6. Above-the-line  deduction for  interest on loans  for qualified  education expenses  (sec. 221) 

Included to the extent included in costs of attendance for Federal student aid purposes. 

Included to the extent included in costs of attendance for Federal student aid purposes. 

Included to the extent included in costs of attendance for Federal student aid purposes. 

Included to the extent included costs of attendafor Federal studaid purposes. 

7. Temporary  above-the-line  deduction for  higher education  expenses (sec. 222) 

Same as Hope credit. Same as Hope credit. Not included. Not included. 

8. Exclusion for  scholarships  (sec. 117(a)) 

Included. Included. Included. Not included. 
44 

Provision Tuition 

Required 

Fees 

Books, Supplies, 

Equipment 

Room and 

Board 

9. Exclusion for  qualified tuition  reduction  (sec. 117(d)) 

Included. Not included. Not included. Not included. 

10. Gift tax exclusion  (sec. 2503(e)) Included. Not included. Not included. Not included. 

1 The term “special needs services” and “special needs beneficiary” are not defined in present law. Legislative history indicates 

Secretary is to define a “special needs beneficiary” to include an individual who because of a physical, mental, or emotional cond

learning disability) requires additional time to complete his or her education. Treasury has not yet issued regulations regarding th