By Laura Kalick, JD, LLM in Taxation
The Tax Cut and Jobs Act of 2017 (the “Act”) will have a profound impact on tax-exempt organizations. Even those that don’t report unrelated trade or business income or pay their executives over $1 million may still be affected.
Here are the top six tax reform-related issues nonprofits will need to address:
1. Internal Revenue Code (IRC) Section 512(a)(7): Certain qualified transportation fringe benefits, including those relating to parking garages, must be reported as unrelated business income (UBI).
All tax-exempt organizations will have to include as unrelated business taxable income (UBTI) any amount paid or incurred for any qualified transportation fringe benefit or any parking facility used in connection with qualified parking.
If an organization has a parking garage that offers free parking to its employees, the new law says that the costs paid or incurred by the organization for providing the parking must be included in its UBTI. However, if its garage is used for parking that is already counted as UBI, such as parking for the general public, then the percentage of those costs attributable to the amount already included in its UBI does not have to be included in the amount treated as UBI under the new provision. The organization may be providing parking in the structure to students, patients, and visitors, and those costs would not count as UBI; as a result, the organization would then have to allocate all the costs of providing the parking to come up with the amount that is included in UBI. The only way an organization can avoid counting the employee parking as UBI is to have employees pay for the parking with their after-tax dollars.
The new provision also taxes certain other transportation fringe benefits, including commuter transportation and transit passes.
This provision was an attempt to put exempt organizations on the same footing as taxable organizations that will no longer be able to deduct these costs. It is effective for amounts paid or incurred after Dec. 31, 2017.
2. IRC Section 4960: Tax on excess tax-exempt organization executive compensation.
Tax-exempt organizations that pay an executive considered a “covered employee” more than $1 million will be subject to a 21 percent tax on the excess amount over $1 million. A covered employee is any current or former employee of a tax-exempt organization who is either (a) one of the five highest compensated employees in the organization for the tax year, or (b) was a covered employee in the organization, or any predecessor of the organization, for any tax year after Dec. 31, 2016. So, once an individual is a covered employee, he or she is always considered a covered employee.
In addition, the new provision imposes the same tax on certain parachute payments (which may be less than $1 million). This provision applies not only to typical 501(c) tax-exempt organizations, but to all organizations that derive their income tax exemption from Internal Revenue Code section 501(a), including pension trusts. It also applies to non-501(c) exempt organizations, such as state and local government entities, which includes state colleges, so that highly-compensated athletic coaches would be on equal footing as coaches from private universities (although some believe that a technical correction is needed to impose the tax on state institutions). There is also a special carve-out for licensed medical professionals, including veterinarians, for the performance of medical or veterinary services, to the extent that the compensation received is for the provision of medical services and not for other services, such as administration or business development.
Most significantly, it is not only the compensation from the tax-exempt organization that counts towards the $1 million, but also the compensation paid from both tax-exempt and taxable related organizations. A related organization is an organization that controls, or is controlled by, the organization (parent/subsidiary); is controlled by one or more persons that control the organization (brother/sister); and/or is a supported or supporting organization. If compensation from more than one employer is used to calculate the excise tax, then each employer is liable for its proportionate share of the tax.
Because of its complexity, the Treasury Department has added this provision to its list of Priority Guidance items. It’s important to note that there is no relationship between this new provision and the intermediate sanctions provisions; for example, just because a person makes over $1 million does not mean the compensation is unreasonable. However, we expect that those who are subject to the provision will undergo greater scrutiny. Thus, it’s important that organizations establish the rebuttable presumption of reasonableness when it comes to executive compensation. An independent authorized body can help by reviewing the proposed compensation based on comparable data and documenting both the independence and the basis for the decision.
The effective date of this provision is for all tax years beginning after Dec. 31, 2017.
3. IRC Section 512(a)(6): The losses from one unrelated trade or business activity cannot be used to offset the income from another unrelated trade or business.
Section 512(a)(6) is consistent with the position that the IRS takes on audits, which is to deny the losses of an activity if the loss occurs year after year. The IRS believes that if there were perpetual losses, there was no profit motive, which is a requirement for the existence of a trade or business. Without a trade or business, there could not be an unrelated trade or business. This was a similar approach the IRS had to “hobby losses.”
This provision is effective for tax years beginning after Dec. 31, 2017. Net operating losses arising in tax years beginning before Jan. 1, 2018 are not subject to the rule and may be used to offset income from any trade or business to the extent of 80 percent of the income from the trade or business. Any amount so limited may be carried forward to future years.
Nevertheless, many questions remain regarding this provision:
- Will each investment in a partnership (a so-called “alternative investment”) be considered a separate trade or business, or can the alternative investments be aggregated, with each one’s income and losses offsetting the income and losses of another?
- Will all rental activity be aggregated as one trade or business?
- Will management of other associations be treated as one management activity or multiple businesses?
To address these questions, the IRS plans to include additional guidance on this provision in its Priority Guidance items.
4. IRC Section 4968: Endowment tax.
Even though IRC Section 4968 is called “Excise tax based on investment income of private colleges and universities,” large exempt organizations with post-secondary schools should also review the basic rules. The new law imposes a 1.4 percent tax on the net investment income of certain private educational institutions. These institutions must have more than 500 full-time students attending the institution, at least half of whom are in the U.S.; in addition, their non-exempt purpose assets must be at least $500,000 per student. Meanwhile, part-time students should be taken into account by proportionally adding them to the full‑time equivalency.
The rationale behind this provision is to tax college and university endowments in the same manner as private foundations. In fact, net investment income is defined by the private foundation provisions of IRC 4940 and generally includes interest, dividends, rents, royalties, and capital gain net income, and is reduced by expenses incurred to earn this income. In reaching the asset threshold, the assets of related organizations are considered.
Many initially thought the provision would only impact between 30 and 60 colleges and universities. However, large healthcare systems and other exempt groups may have nursing schools or other schools that could be impacted when the assets of the related entities are considered. The rules are effective for tax years beginning after Dec. 31, 2017, so there may be opportunities to make the educational institution independent of the other entities so that the asset test is not met.
5. IRC Section 162: New lobbying rule.
Tax-exempt organizations, such as 501(c)(6) organizations that lobby, must either notify their members as to how much of their dues are nondeductible because they’re spent on lobbying or pay a proxy tax at the highest corporate rate. Under the previous tax law, an exception to the definition of lobbying existed when the lobbying amounts were paid or incurred to local councils or similar governing bodies, including Indian tribal governments. However, the new law repeals the exception for such amounts paid or incurred after the law’s enactment date.
Nevertheless, this change does not impact section 501(c)(3) organizations. This is because the definition of lobbying—for purposes of whether a substantial part of an organization’s activities includes influencing legislation—already included attempts to influence the actions of any local council or similar governing body.
6. Various new tax provisions will change charitable giving.
With the increase in the standard deduction and the limitation on deducting state and local taxes, fewer people will likely itemize their deductions on their 2018 returns, thus decreasing the tax incentive to make charitable gifts. In addition, the estate and gift tax exclusions were also doubled, which may lessen the incentive to make bequests to charities. These changes may lead to an estimated $12 to $20 billion decline in overall charitable giving (http://www.taxpolicycenter.org/taxvox/21-million-taxpayers-will-stop-taking-charitable-deduction-under-tcja).
Nevertheless, the tax incentives for high net worth persons were increased by raising the annual limit of cash donations to public charities from 50 percent of a person’s adjusted gross income (AGI) to 60 percent. The Act also repeals the “Pease” limitation, which was originally created to raise tax revenue by reducing the amount of the allowable itemized deductions (including charitable contributions) once a taxpayer’s AGI reached a certain amount. This provision came into effect on Jan. 1, 2018 and sunsets in 2025. Therefore, charities should focus on developing high net worth donors now.
Finally, the law eliminates the 80 percent charitable deduction for contributions to organizations where the donor receives the right to purchase tickets to college and university athletic events. The prior law ran contrary to established tax law, which stated that there would be no charitable deduction when something of value was received in return. Thus, individuals should take extreme caution if they encounter a scheme that allows for a tax deduction in exchange for a chance to buy priority seating. Just as a raffle ticket sold by a charity is not deductible, neither is purchasing a chance to buy tickets. The IRS will be on the lookout for new arrangements that attempt to avoid the new law and could even go after them as tax shelters.
The tax law is constantly changing. For example, the Philanthropic Enterprise Act of 2017, which was part of the Budget Reconciliation Act, was signed into law on Feb. 9, 2018. The law amends the “excess business holding” rules imposed on private foundations and allows them to own all (100 percent) of a business under certain conditions (without the law, the foundation would have had to divest itself of 80 percent of the stock). The bill was led by Newman’s Own Foundation, which owns a hundred percent of the entity that sells salad dressing and spaghetti sauce. The new law allows a foundation to have a hundred percent ownership of a company if the company is independently run, and all its profits go to charity. This new law may provide new charitable giving opportunities.
Thus, it’s important that organizations stay tuned for guidance on the new and upcoming rules.
This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Spring 2018). Copyright © 2018 BDO USA, LLP. All rights reserved. www.bdo.com