Tax Reform Impact on Nonprofit Organizations
As the New Year begins, tax-exempt organizations, for-profit entities, and individuals will need to adjust to sweeping tax legislation signed into law just before year-end: the Tax Cuts and Jobs Act. After two different versions of the initial bill passed in the Senate and House of Representatives in late 2017, and differences in the bills were reconciled in the Congressional conference committee, a final Conference Agreement version of the bill passed both chambers of Congress, before being signed into law by the President on December 22, 2017.
The Act is wide-ranging legislation to amend the Internal Revenue Code to ultimately reduce tax rates and adjust requirements, credits, and deductions for for-profit entities and individuals, and includes several provisions directly and indirectly impacting tax-exempt organizations. The legislation offers an opportunity to be proactive in adjusting operations to minimize any potential negative impact and capitalize on reduced tax rates. As experts in nonprofit tax compliance, our analysis and discussion of the Act should provide insight into planning opportunities for executive compensation, unrelated business income tax, and charitable contributions in 2018 and beyond. It is also important to note that not all proposals were ultimately included in the final version of the law.
The Tax Cuts and Jobs Act began the legislative process as two different bill versions containing a mix of provisions from older tax reform drafts. Most of these provisions did not survive to make it into the signed law.
- The House bill proposed a weakened version of the Johnson Amendment, which would have allowed certain charitable tax-exempt organizations to enter the political realm by endorsing political candidates and expressing political stances. The amendment was removed, keeping charitable tax-exempt organizations, private foundations, and houses of worship free from political pressures.
- Although there was much discussion about how to reform donor advised funds, possibly including adding aggressive payout requirements, these rules were not changed. Payout requirements for private foundations also were not changed.
- The current two-tiered excise tax rate system for private foundations will remain in effect instead of the proposed flat 1.4% rate. The 2% tax rate on net investment income will be enforced unless sufficient distributions are made, at which point, the excise tax rate is reduced to 1%.
- No change will be made to the royalty income exception, which threatened to remove a widely used rule that allowed for income earned from the use of intangible assets such as member lists and logos to be excluded from UBI. The Senate proposal most likely had universities and sports leagues in mind for the repeal and not small to mid-size charities earning passive royalties from commercial co-venture agreements or licensing arrangements. Additionally, due to the passive nature of royalty contracts creating only minor expenses, this repeal had the potential to significantly increase unrelated business income tax bills, while forcing many tax-exempt organizations to begin filing the Form 990-T for the first time.
- Related to intermediate sanctions, later versions of the bill removed language weakening or removing safe harbors for compensation determination, as well as an additional excise tax for tax-exempt organizations involved in excess benefit transactions.
- An initial version of the Senate tax bill included an extension of intermediate sanctions to 501(c)(5) and 501(c)(6) organizations, but this language was removed for the final legislation. Intermediate sanctions rules remain applicable for 501(c)(3) and 501(c)(4) organizations.
- Yet again, discussion on increasing the volunteer mileage rate dissipated, and therefore the rate will remain at 14 cents per mile for the foreseeable future.
- Art museums set up as private operating foundations dodged a proposal in an early version of the House bill that would have required such museums to be open to the public at least 1,000 hours per year.
- While discussed as a mitigating factor for possible negative impacts from other tax reform provisions in charitable giving (see Charitable Contribution section below), Congress did not include a proposal to provide above-the-line deductions for charitable giving in the final legislation.
Executive Compensation – How High Is Too High?
In an attempt to bring regulations for tax-exempt organizations in line with for-profit entities, a provision in the Act will levy a 21% excise tax on tax-exempt organizations for employees earning compensation in excess of $1 million per year, effective for tax years beginning after December 31, 2017. Most highly paid executives are covered by employment contracts and so applicable nonprofits will be faced with either paying the tax or reducing compensation thereby potentially risking the loss of their top talent. The excise tax also applies to large severance payments, also referred to as "parachute" payments. For the purpose of this provision, total compensation is considered paid at the point it is no longer subject to a substantial risk of forfeiture in accordance with section 457(f)(3)(B) of the Internal Revenue Code, thereby including vested deferred compensation amounts.
Unrelated Business Income Tax – Limited, but Significant Changes
Before being pulled from the final bill, the royalty exception change was poised to be the biggest change to unrelated business income tax rules. Perhaps the next most wide-ranging and impactful change for the UBI rules is the new taxation of qualified fringe benefits for tax-exempt organizations. Effective for 2018, tax-exempt organizations providing fringe benefits such as qualified transportation, qualified parking, or on-premises athletic facility access for employees will be subject to unrelated business income tax by the amount paid or incurred by the organization for such benefits. This change comes as a result of the disallowance for transportation, parking, and on-premise athletic facility expense deductions for all employers, and in an effort to keep tax-exempt and for-profit organizations on a level playing field, such expenses are now taxable for nonprofits. Fringe benefit plans have become commonplace, especially in our local DC metro area. Until the Treasury Department provides further clarity on the extent of the benefits and organizations to be impacted, it will be important to be proactive in discussions on whether to absorb the additional tax costs or simply reduce employee benefits.
The Act also includes a provision to mandate calculating net unrelated business taxable income separately for each unrelated trade or business activity. Losses derived from one unrelated business will not be allowed to offset income from another unrelated business activity. If possible, tax-exempt organizations should consider tax strategies to effectively combine unrelated business income streams. For example, a tax-exempt organization may consider moving similar lines of UBI into a wholly-owned for-profit subsidiary in order to allow losses to offset gains.
Based upon the corporate tax law changes, the unrelated business income tax calculation will be affected in the following ways:
- The Act repeals net operating loss carrybacks while extending the term for net operating loss carryforwards to an indefinite length. Net operating loss carryforwards arising in taxable years after December 31, 2017 will be limited to 80% of taxable income.
- The corporate tax rate will be a 21% flat rate effective for tax years beginning after December 31, 2017. Some organizations with a small amount of taxable UBI may be in for a surprise as their rates were likely well under the new 21% rate.
- The corporate alternative minimum tax will be removed for tax years beginning after December 31, 2017.
Charitable Contributions – Unintended Consequences?
Changes to tax calculations for individuals regarding deductions should raise concern for tax-exempt organizations in 2018 and beyond. While donors who itemize deductions may be able to deduct charitable contributions up to 60% (increased from 50%) of their adjusted gross income, the increase of the standard deduction to $12,000 (if single; $24,000 if married), along with the decrease of state and local tax, mortgage interest, and other deductions could significantly lower the number of donors who itemize deductions. According to the Council on Foundations, charitable giving could "decrease $16-$24 billion per year" (Spruill), however, the overall impact of the Act on charitable giving remains a topic of debate. To be safe, a familiar suggestion to charitable tax-exempt organizations would be to continue the creative and innovative search for sources of revenue, while being sure to consult your tax adviser along the way. The idea of having taxable income is often undesirable for organizations, however, utilizing the inviting 21% taxable income rate could help supplement existing activities.
In Conclusion – The Road Ahead
The Tax Cuts and Jobs Act provides for both opportunities and challenges as nonprofits wrestle with changes to tax rules that haven’t seen changes in decades. It is essential for tax-exempt organizations to be proactive in planning for the Act’s impact on their tax situation. The changes to executive compensation and qualified fringe benefits will impact a wide range of organizations across the tax-exempt spectrum. There is no shortage of predictions about how the new tax law will impact charitable giving once the law takes effect. Charitable organizations should try to stay ahead by continuing to develop fundraising efforts and diversifying revenue streams.