Impact of the 2025 Reconciliation Act on Colleges and Universities

On July 4, 2025, President Donald Trump signed into law “[a]n Act to provide for reconciliation pursuant to title II of H. Con. Res. 14.” (formerly known as the One Big Beautiful Bill Act, referred to herein as the “Act”), an all-encompassing reconciliation bill including sweeping domestic policy changes championed by the president that are expected to impact virtually every industry, business, and household of America. This legislation includes amendments to the Endowment Excise Tax (defined below) and is expected to have a significant impact on private colleges and universities with large endowments. In addition, the Act modifies and expands the application and scope of the Covered Employee Excise Tax (defined below) imposed on certain tax-exempt organizations (including private colleges and universities and certain public colleges and universities) with certain highly compensated employees in a manner that may significantly increase the tax burden imposed on such institutions.

The changes to the Endowment Excise Tax and Covered Employee Excise Tax as a result of the Act discussed below can be summarized as follows:

Endowment Excise Tax (Section 4968)

Covered Employee Excise Tax (Section 4960)

A. Excise Tax on Endowments

Universities and their endowments have historically been exempt from federal income taxation under section 501(c)(3) of the Code, subject to certain exceptions (most notably in respect of income unrelated to their tax-exempt purpose (so called “unrelated business taxable income”)).¹ As discussed in our recent client alert, the 2017 Tax Cuts and Jobs Act (“TCJA”) established a 1.4% excise tax on the endowments of applicable private universities that had at least 500 tuition-paying students, more than 50% of such students located in the United States and an endowment with a fair market value of $500,000 or greater per student (the “Endowment Excise Tax”). The Endowment Excise Tax is imposed on the “net investment income” of the university endowment, generally consisting of interest, dividends, rents, royalties and gains from the sale of assets, net of certain deductions.

Increased Minimum Student Requirement

The minimum number of an institution’s tuition-paying students required for the Endowment Excise Tax to apply has been increased from 500 to 3,000. As a result, many smaller colleges and universities will no longer be subject to the Endowment Excise Tax, regardless of endowment size.

Tiered Excise Tax Rates

The most notable change under the Act is the replacement of the flat 1.4% Endowment Excise Tax under the TCJA with a multi-tiered rate structure based on the institution’s "student adjusted endowment," which is the fair market value of the institution’s investment assets per student. The determination of student adjustment endowment for each tax year is calculated as of the end of the preceding taxable year. The new rate structure is as follows:

This tiered approach is designed to impose a significantly higher tax burden on institutions with the largest endowments per student, reflecting a policy shift toward the taxation of university investment income as a revenue offset against tax cuts elsewhere in the Act.

Expanded Scope of Taxable Income

The Act broadens the definition of “net investment income” subject to the Endowment Excise Tax. In addition to investment income covered under the TCJA, such as interest, dividends, rents, royalties, and capital gains, the following are now explicitly included as well:

• Interest from Student Loans: Any interest income from student loans made by the institution or related organizations is now treated as gross investment income.
• Federally Subsidized Royalty Income: Royalty income derived from intellectual property (such as patents or copyrights) developed by students or faculty using federal funds is now taxable, even if such income would previously have been exempt under regulatory exceptions.

Calculation and Attribution Rules

The "student adjusted endowment" is calculated by dividing the aggregate fair market value of the institution’s investment assets by the number of students, determined on a full-time equivalent basis. The Act also requires that assets and net investment income of related organizations, such as supporting foundations or controlled entities, be attributed to the educational institution, with certain exceptions to prevent inclusion of assets not intended for the institution’s benefit.

Reporting and Compliance Obligations

Affected institutions are now subject to enhanced reporting requirements. Namely, they must disclose the number of tuition-paying students, and the number of full-time equivalent students used in the calculation of the student adjusted endowment on IRS Form 4720 on an annual basis.

Anti-Avoidance Measures and Regulatory Authority

The Secretary of the Treasury is granted broad authority to issue regulations and guidance to prevent avoidance of the Endowment Excise Tax. This includes measures to counteract attempts to restructure endowment funds or related arrangements in ways designed to reduce or eliminate the value of net investment income or assets subject to the Endowment Excise Tax.

Effective Dates

The amendments to the Endowment Excise Tax apply to taxable years beginning after December 31, 2025.

B. Excise Tax on Covered Employees

The Act also introduces significant changes to the section 4960 excise tax regime applicable to tax-exempt organizations with certain highly compensated employees, including private colleges and universities and certain public colleges and universities.²

Section 4960 was introduced as part of the TCJA and imposes a 21% excise tax (the “Covered Employee Excise Tax”) on an applicable tax-exempt organization with respect to two categories of remuneration paid to certain “covered employees”:

• Remuneration in Excess of $1 Million: Compensation paid by the organization to a covered employee that exceeds $1 million in a taxable year.
• Excess Parachute Payments: Certain “excess parachute payments,” which are typically large severance or termination payments that exceed a specified threshold.

Under the TCJA, the Covered Employee Excise Tax applied only to the five most highly compensated employees of an applicable tax-exempt organization or certain related entities for each year. The Act expands the definition of a “covered employee” to now include any employee or former employee of an applicable tax-exempt organization (or any predecessor) who received remuneration in excess of $1 million or payments qualifying as excess parachute payments beginning in taxable years after December 31, 2016 instead of limiting the tax to only the five most highly compensated employees. The determination of whether someone is a covered employee is based on the total payments they received throughout the year. If a former employee receives compensation or severance from the organization after they have left, and that payment meets the excise tax criteria, the organization must pay the 21% excise tax on the applicable amount even though the individual is no longer employed.

By broadening the pool of individuals whose compensation may be subject to the excise tax, the Act may significantly increase the number of highly compensated individuals within tax-exempt organizations are subject to this tax.

The amendment is effective for taxable years beginning after December 31, 2025.

Conclusion

The Act marks a significant escalation in the federal taxation of private university endowments and their highly paid employees. By introducing a tiered Endowment Excise Tax structure with increased rates for larger endowments, expanding the scope of income subject to the Endowment Excise Tax, and broadening the scope of persons subject to the Covered Employee Excise Tax, the Act targets the nation’s wealthiest and most prestigious private educational institutions in order to fund other spending priorities.

Changes to the Endowment Excise Tax under the Act are expected to have a substantial impact on the investment activity of private colleges and universities. Although the impact of these rules is not entirely clear, endowment managers may seek to limit exposure to the NII rules, ensure adequate cash returns from investments to pay taxes and take other actions in preparation for application of these rules; many such institutions are already seeking to sell a portion of their private fund investments in secondary transactions and are exercising liquidity options in open-ended funds. Changes to the definition of NII may also have a profound effect on research activities of private institutions. College and universities with highly compensated employees may also want to examine their compensation plans in light of the expanded application of the Covered Employee Excise Tax.

If you have any questions regarding the Act or how it may affect you, please contact the authors of this alert or your O’Melveny advisor.

¹ Unless otherwise indicated, all references to “section” herein refer to the Internal Revenue Code of 1986 (the “Code”).

² Whether a public college or university is subject to the Covered Employee Excise Tax varies based on the manner in which the institution is exempt-from tax. This analysis is beyond the scope of this discussion, but state colleges and universities are advised to consult their tax advisor regarding the application of Covered Employee Excise Tax under their particular circumstances.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Alexander Roberts, an O’Melveny partner licensed to practice law in New York; Matt Cowan, an O’Melveny partner licensed to practice law in California; Jennifer B. Sokoler, an O’Melveny partner licensed to practice law in New York; Dawn Lim, an O’Melveny counsel licensed to practice law in New York; Arsalan Memon, an O’Melveny associate licensed to practice law in California, New Jersey, and New York; and Lauren Lekey, an O’Melveny associate licensed to practice law in California, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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