The Tax-Exempt Status of Colleges and Universities: A Comprehensive Analysis

Nearly every university in the United States is registered and files as a 501(c)(3) organization, a special status that provides preferential tax treatment potentially worth billions of dollars. This article delves into the multifaceted aspects of this tax-exempt status, its benefits, potential drawbacks, and the ongoing debate surrounding its justification.

Understanding 501(c)(3) Status and Its Advantages

Universities and their medical centers are registered with the Internal Revenue Service (IRS) as 501(c)(3) charitable nonprofit organizations. This designation stems from the recognition that higher education institutions provide the public good of education to surrounding communities. The federal tax code classifies tax-exempt colleges and universities, and their foundations, as public charities. Because higher education institutions provide the public good of education to surrounding communities, their property holdings are exempt from taxation in all 50 states.

Endowment Earnings and Tax Exemption

A financially advantageous attribute of a 501(c)(3) organization is that the money it earns from its endowment is not subject to taxation. For example, Harvard’s endowment currently sits at $53.2 billion. Assuming a 5% rate of return, this means that Harvard would generate over $2.5 billion per year in endowment earnings. Currently, Harvard gets to keep all of this money. In fact, endowments can be misleading because the university primarily only uses the earnings from the endowment.

Charitable Contributions and Tax Deductibility

Tax-exempt organizations provide significant tax benefits to their donors by allowing their donations to be tax deductible. For example, if a donor in the top tax bracket (37% tax rate in 2025 on income over $626,350 for single taxpayers or income over $751,600 for married taxpayers) were to donate $100,000 to Harvard, this donation would be able to be deducted as an itemized expense. If Harvard were to lose its tax-exempt status, donors would no longer be able to lower their taxable income by this charitable contribution. Donors may still wish to donate to Harvard without this beneficial tax treatment.

Exemption from State and Local Taxes

Organizations with a 501(c)(3) status are also typically exempt from paying state and local taxes. A particularly notable benefit for Harvard and other similar universities on large pieces of prime real estate is that they are not required to pay property taxes. Depending on the value of the property Harvard is situated on, this exemption can save millions per year as the town of Cambridge, Massachusetts, levies a tax of $11.52 per $1,000 of land value. Even if the land is only worth $200 million, Harvard losing their 501(c)(3) tax status would lead to a tax bill to Cambridge for over $2 million per year.

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Potential Consequences of Losing Tax-Exempt Status

A recent Bloomberg News article estimates that Harvard losing its status as a 501(c)(3) organization would cost the university over $465 million annually. Using this estimate, it would only take a little more than two years for Harvard to pay $1 billion in taxes (nearly $2 billion over the course of Trump’s second term) that it would otherwise not have to pay as a 501(c)(3) organization. These expenses ultimately come at a steep cost to its students and faculty as it leaves fewer funds available for scholarships, grants, and support. Importantly, being a nonprofit university can define the school’s reputation, and losing that status can lead to other consequences.

Impact on Reputation and Educational Quality

A recent article in The Economist discusses how universities that do not have a 501(c)(3) status have been riddled with controversies and questions over the quality of education.

Scrutiny over Race-Based Policies

The Treasury Department is considering changing rules to revoke tax-exempt status for colleges that consider race in student admissions, scholarships and other areas - potentially threatening the financial stability of hundreds of institutions. The proposals would bar private, nonprofit schools from remaining tax exempt if they favor any racial groups in matters such as financial assistance, loans, use of facilities or other programs, according to people with knowledge of the deliberations, who include a staffer in the Treasury’s Office of Tax Policy. The proposals are being drawn up as IRS revenue procedures - a form of guidance for interpreting and enforcing tax laws. They could take effect without congressional approval. If enacted, the changes would dramatically expand the administration’s effort to reshape higher education and combat what President Donald Trump has characterized as a left-leaning bias at many institutions. Existing regulations let schools keep their tax-exempt 501(c)(3) status while favoring racial minority groups - if the “purpose and effect” is to promote that school’s “racially nondiscriminatory policy.” The new proposals define race as including color and national or ethnic origin. The measures would effectively require schools to adopt race-blind policies or risk paying what would collectively amount to billions of dollars in taxes. Compliance would likely mean ending many programs that try to counter longstanding disparities in wealth and higher educational experience among certain minority groups, including Black and Hispanic students.

The Evolving Economic Model of Higher Education

With the meteoric ascendance of the knowledge economy, colleges and universities have become financial titans in urban centers. After a group of universities lobbied to pass the Bayh Dole Act in 1980, schools like Stanford, MIT and Yale immediately created technology transfer offices to privatize and profit from federally sponsored research. Today universities use their academic research to create commercial goods or patents in a range of fields, from the pharmaceutical industries and software products to military defense weaponry. After the fall of factories, knowledge has become the new face of capitalism with university bell towers lauded as the smokestacks of today’s cities.

Public-Private Partnerships and Innovation Districts

Today’s schools bring the once suburban research parks to the city as “innovation districts” where academic research and corporate partnerships meet real estate, retail and cheap labor. Real estate developers like Wexford: Science + Technology focus on what they call “knowledge communities” and work with cities and schools to build a monied portfolio of university-affiliated projects like Philadelphia’s uCity Square, Converge Miami and Cortex in St. Louis. Urban neighborhoods are being transformed to optimize “value capture”: the conversion of city blocks into research profits. Under the cover of educational purposes, research that has the potential to produce millions in patents and revenues remains largely tax exempt while conducted in tax-exempt buildings. These financial arrangements are quite lucrative for city leaders, university administrators and their corporate partners.

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The Paradox for City Residents

A critical paradox has emerged with dire consequences for our cities. We assume that higher education is an inherent public good, most clearly marked by its exemption from property taxes. But nonprofit status is precisely what allows for an easier transfer of public dollars into higher education’s private developments. The former mayor of New Haven, Conn., Toni Harp, said such arrangements create a property-tax gray area where profitable research produced for private companies is conducted in educational buildings that are not on the tax rolls. At approximately $13 million, Yale pays the largest PILOT in the country. But this is merely a fraction of the estimated $102 million in property taxes that, if Yale weren’t tax exempt, would come from the school or the additional $31 million that would come from Yale-New Haven Hospital. Most schools also reap the benefits of police and fire protection, snow and trash removal, the maintenance of roads and the electrical grid, and other municipal services while struggling host cities pay the price. Homeowners and small-business owners ultimately carry the weight of increased property taxes caused by campuses and their knowledge communities while the owners of rental properties make units smaller and inflate their prices to prioritize the needs and financial means of those affiliated with the university.

Examples of Tax-Exempt Status Controversies

In 2016, Princeton University paid more than $18 million to settle a lawsuit with residents of the historically Black neighborhood of Witherspoon-Jackson. Residents discovered a noticeable jump in their property-tax bill and wondered why. They realized that nearby university buildings remained tax-exempt while producing research that generated millions of dollars in commercial royalties. One plaintiff in the Princeton case described the university as a “hedge fund that conducts classes.” In 2018, with a six to one vote, the Tempe City Council approved an Omni Hotel and Conference Center project that would pay almost no sales tax for up to 30 years. It would also pay no property taxes because it is going to sit on university land owned by the Arizona Board of Regents. Meanwhile, as in many states, Arizona continued to pull back on its contributions to public higher education. ASU realized they could lease their tax-exempt land to private companies, and instead of shelling out property taxes, these companies could make a lower direct payment to the university. Elected officials have no say in how the money is spent while such university developments simultaneously raise property values and contribute little to public services. Sean McCarthy, a research analyst with the Arizona Tax Research Association, held little sympathy for ASU’s stated plight of balancing the budget. After reading about the Omni deal, he put together a scathing policy review detailing the long history of “tax free zones” at ASU. He points to the State Farm Insurance regional headquarters on campus as an example of how this works: The Arizona Board of Regents holds the deed to the land and State Farm leases the property, which allows the largest commercial development in Arizona to pay a fraction of its property-tax burden. ASU is able to use the revenue to spend without public oversight. Arizona Attorney General Mark Brnovich shared McCarthy’s outrage, and in January 2019 he sued the Arizona Board of Regents for essentially renting out its tax-exempt status to private businesses. Few were surprised when the State Supreme Court dismissed the case in developer-friendly Arizona. And ASU continues to expand its campus projects into downtown Phoenix where they have partnered with Wexford to build an “innovation center.” ASU expects that the designation of “education purposes” will also exempt this development from property taxes.

Calls for Reform and New Tax Arrangements

Such piecemeal victories have not deterred increased calls for a new tax arrangement between urban universities and their cities. Campaigns from the University of Chicago to UCLA are seizing the moment to argue that a key piece of social justice and anti-racism requires that schools develop a new business model that, at least, redistributes the wealth extracted from cities back into its neighborhoods. On March 30, 2020, toward the beginning of the global COVID-19 pandemic, New Haven citizens stormed the city’s Zoom budget meeting to vent their outrage at Yale University’s continued strain on city finances. Residents specifically pointed to Yale’s vast and tax-exempt property holdings compared to the deficit-ridden New Haven public schools hungry for property-tax dollars. Four months later, on July 29, a new coalition of Yale union workers and residents followed up with a 600-vehicle “Respect Caravan” that brought downtown traffic to a halt. With signs that read “Yale: Pay Your Fair Share,” organizers acknowledged that the university offers the city voluntary PILOTS (payments in lieu of taxes) but declared these funds were “pocket change” compared to the $30 billion endowment. For the protestors, COVID-19 merely exacerbated a growing disparity between urban colleges and universities and their host cities.

The Legal and Regulatory Framework

The vast majority of public and private universities and colleges are tax-exempt entities as defined by IRC Section 501(c)(3) because of their educational purposes-purposes that the federal government has long recognized as fundamental to fostering the productive and civic capacity of its citizens-and/or the fact that they are state governmental entities. Income from activities that are substantially related to the purpose of an institution’s tax exemption, charitable contributions received, and investment income are not subject to federal income tax. Many public universities qualify as governmental entities that are not subject to federal income tax based on the principles of inter-governmental immunity. As tax-exempt entities, universities and colleges are regulated by both the Federal government as well as State governments. The Internal Revenue Service (IRS) requires all private universities and public charitable foundations that support public universities to submit an IRS Form 990 each year. Institutions are required to report on their mission, revenues, expenditures, endowments, salaries and benefits of top officials, charitable gifts, lobbying activities, and more. The IRS also closely oversees charitable giving to tax-exempt universities and colleges. Tax-exempt private and public universities and colleges are also subject to unrelated business income tax (UBIT). The educational purposes of universities and colleges - teaching, research, and public service - have been recognized in federal law as critical to the well-being of our democratic society.

The Endowment Tax

The Tax Cuts and Jobs Act (TCJA) imposed a new, unprecedented 1.4 percent excise tax on net investment income for private colleges and universities with endowment and other assets (other than those used directly in carrying out the institution’s educational purposes) valued at the close of the preceding tax year of at least $500,000 per full-time student. President Donald Trump said he’d revoke Harvard’s tax-exempt status, but what does it mean that a university is tax-exempt, and what does it do for students?

Proposed Changes to Endowment Tax Rates

In late May, House Republicans passed H.R. 1, the One Big Beautiful Bill Act, using the budget reconciliation process. The Senate Finance Committee responded on June 16 by releasing its own version of the legislation. As Congress prepares for the expiration of major provisions in the 2017 Tax Cuts and Jobs Act (TCJA), H.R. 1 proposes significant changes to the federal tax code, including new rules for colleges, universities, foundations, and other tax-exempt organizations. While institutions with smaller endowments per student would continue to be taxed at the current 1.4% rate, the House and Senate bills would replace the flat 1.4% excise tax with graduated rates based on endowment assets per student, effective in 2026. Under the new system, each university would pay a single rate on all net investment income.

Modifications to Private Foundation Taxes

The House-passed bill would also change how private foundations are taxed. Some private foundations are exempt from federal income taxes because their income and assets are dedicated to activities that benefit the public, such as education, relief for low-income communities, or other recognized charitable goals. Since the Revenue Act of 1978, the tax rate on private foundations’ net investment income has hovered between 1-2%. Currently, there is a flat tax rate of 1.39%. Private foundations affiliated with corporations face restrictions on how much of a business they can own. If a foundation owns too much of a company, it may be subject to the excess business holdings tax, which is designed to prevent foundations from controlling businesses for extended periods.

The Debate Over Tax-Exempt Status

President Donald Trump posted on Truth Social saying Harvard University should lose its tax-exempt status after the nonprofit institution refused to submit to the Trump administration’s list of demanded changes. Many colleges and universities are tax-exempt because of the educational services they provide. Tax-exempt colleges and universities are more likely to use revenues to fund academic programs, student financial aid, medical research and development, and other public benefits. Experts doubt Harvard will lose its status, but if it does, it may dissuade some donors from donating. Donations to tax-exempt organizations can be tax deductible.

Arguments for Maintaining Tax-Exempt Status

Colleges and universities are tax-exempt because the government recognizes the education they provide fosters civic engagement and citizens’ success. Every year, tax-exempt entities demonstrate compliance with federal and state laws and regulations to maintain their status. Because educational services are considered valuable to democracy, tax-exempt colleges and universities can use their status to maximize the use of their revenues. Tax-exempt colleges and universities can theoretically spend more of their money on research and scholarships. They can use their revenues to fund academic programs, student financial aid, medical research and development, and other public benefits. Additionally, nonprofit organizations are less concerned about creating income and can focus on providing education to students. For-profit organizations, which are focused on making money, are known for aggressive student recruitment tactics, low completion rates, and poor earnings outcomes. Tax-exempt organizations can also garner more donations, as donors are inclined to donate to receive their own tax benefits. Donations to tax-exempt organizations can be eligible for a tax deduction.

Potential Impacts of Revoking Tax-Exempt Status

Almost two million organizations, from churches to universities to charitable foundations, have tax-exempt status. Revoking tax status involves an audit by the IRS and meetings between the representatives from the nonprofit and IRS officials. If Harvard’s tax-exempt status is revoked, federal law allows for organizations to appeal the decision in court. It’s unlikely Harvard will lose tax-exempt status, but if it does, it may suffer somewhat financially. Harvard likely saves tens of millions of dollars each year by being tax-exempt. Experts say it may also experience a decrease in donations from donors who want to leverage tax deductions. According to The Harvard Crimson, Harvard has received an influx of donations since the university refused the Trump administration’s demands. However, Harvard has a sizable endowment to rely on: roughly $52.3 billion. While much of an endowment is typically earmarked for certain purposes, it can provide a university with a bit of a safety net.

Concerns About Government Overreach

“The administration’s prescription goes beyond the power of the federal government,” Alan M. Garber, president of Harvard, wrote in his letter responding to the Trump administration’s demands. “It violates Harvard’s First Amendment rights and exceeds the statutory limits of the government’s authority under Title VI. And it threatens our values as a private institution devoted to the pursuit, production, and dissemination of knowledge.” “No government - regardless of which party is in power - should dictate what private universities can teach, whom they can admit and hire, and which areas of study and inquiry they can pursue,” Garber continued. There is some question about the legality of the president directing the IRS to revoke tax-exempt status. In 1998, Congress passed a law prohibiting the president from influencing taxpayer audits and investigations by the IRS. The White House said the IRS started considering revoking Harvard’s status before the President’s Truth Social post.

The Role of Endowments

Most private nonprofit colleges and universities are exempt from taxes because of their status as 501(c)(3) organizations and their educational mission. Many of these institutions attempt to accumulate endowments-financial assets that generate income to supplement budgets and provide long-term fiscal stability. Endowments support a wide range of activities. The tax treatment of private nonprofit college and university endowments differs from the treatment of private foundations. Private foundations are tax-exempt organizations established by an individual, family, or company for charitable purposes. Unlike college and university endowments, which accrue from multiple sources over time, foundations must pay an excise tax on their net investment income (generally 2 percent but reduced to 1 percent if their distributions are growing over time). Nonoperating foundations, which are funded by a single or small group of donors and distribute money to others rather than engage themselves in charitable activities, are required to pay out at least 5 percent of their funds each year. In contrast, operating foundations can receive donations from many donors and primarily operate charitable activities themselves rather than distribute grants. Public and private colleges and universities collectively hold over $500 billion in endowment wealth, but just 23 of these institutions hold approximately 50 percent of the assets. Endowments provide income that supplements tuition and fees, state appropriations, and other funding sources to support the education of undergraduate and graduate students, as well as research, public service, and other institutional activities. When measuring institutional strength, it is best to examine endowment per student rather than total endowment dollars. The endowments of the wealthiest private research universities enrolling 10 percent of students in the sector average about $1.5 million per student. The average combined endowment ($486,000 per student) for the wealthiest institutions enrolling half the students in this sector is more than 10 times the average endowment ($43,000 per student) of the institutions with the lowest endowments where the other half of this sector’s students are enrolled. Endowment wealth at private bachelor’s colleges is similarly skewed.

Endowment Taxes and Their Impact

While the tax generates little revenue for the federal government, it may have set a precedent for imposing further taxes on these nonprofit entities. Some members of Congress have questioned whether these wealthy institutions actually use their resources to further society’s educational goals in a meaningful way, largely because few low-income students enroll at institutions with large endowments, which have very selective admissions. However, the high-endowment schools do use some of their wealth to reduce the prices they charge low-income students. Low-income students who attend the best-endowed institutions benefit both from the opportunities offered and from considerably lower net tuition prices than they would pay elsewhere. Financial aid is already so generous at these institutions that the tax will not likely lower prices. The endowment tax is controversial. There are bipartisan efforts in Congress to repeal the tax, which is, unsurprisingly, unpopular among the higher education community. Some earlier proposals for taxing colleges and universities involved providing incentives for institutions to spend their endowments in certain ways or to modify their pricing structures.

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