TCJA: What Changed for Tax-Exempt Organizations
Almost two years after the Tax Cuts and Job Act (TCJA) was signed into law in December 2017, important and much-needed guidance from the Internal Revenue Service is slowly trickling in. This article summarizes which laws changed for tax-exempt organizations and the updates available as of this writing.
UNRELATED BUSINESS INCOME TAX
Tax-exempt organizations previously determined their unrelated business taxable income (UBTI) by calculating gross unrelated business income and subtracting any deductions directly from the unrelated trade or business. In calculating UBTI, organizations with multiple separate unrelated trades or businesses were permitted to offset income from one unrelated trade or business with the deductions from another, to reduce their overall UBTI.
The UBTI silo rule requires a tax-exempt organization to compute UBTI separately with respect to each unrelated trade or business of the organization, effective for tax years beginning after December 31, 2017. Now, UBTI is calculated by disallowing the application of losses from one unrelated trade or business to offset income from a separate unrelated trade or business. The new rule prevents tax- exempt organizations from offsetting UBTI generated by a profitable unrelated trade or business with a loss from an unprofitable one. The IRS has provided little or no guidance other than stating that taxpayers should rely on a “reasonable good faith interpretation.” Therefore, until further guidance is provided, IRS states it would be acceptable to rely on the North American Industry Classification System (NAICS) 6-digit codes. So, in effect, if multiple unrelated trades or businesses are described by the same NAICS code, they could be treated as one trade or business for purposes of determining the nonprofit’s UBTI.
In addition, the IRS provided interim and transition rules for aggregating partnership interests and activities for purposes of the UBTI grouping rule.
- Tax-exempt organizations may aggregate UBTI from an interest in a single partnership that reports multiple trades or businesses, including trades or businesses conducted by lower-tier partnerships, as long as the directly held interest in the partnership meets the requirements of either of the following:;
- De Minimis Test. The tax-exempt organization directly holds an interest of no more than 2 percent of the profits and no more than 2 percent of the capital interest in a partnership.
- Control Test. The tax-exempt organization (1) directly holds no more than 20 percent of the capital interest in a partnership and (2) does not have “control or influence” over the partnership. Whether a tax-exempt organization has “control or influence” over the partnership is determined by facts and circumstances.
For both tests, the interest of a disqualified person, a supporting organization, or a controlled entity (within the meaning of Section 512(b)(13)) in the same partnership will be taken into account in determining the tax-exempt organization’s percentage interest.
- Tax-exempt organizations may treat a partnership interest acquired before August 21, 2018, as constituting a single trade or business, whether or not the partnership (or any lower-tier partnership) directly or indirectly conducts more than one trade or business.
Tax-exempt corporations with fiscal tax years beginning in 2017 and ending in 2018 calculate their tax by blending the rates in effect before 2018 with the 2018 rate. The nonprofit would pro-rate those amounts, based on the number of days in each period relative to the total days in the tax year. The sum of those results yields a blended rate. Note, the blended rate may be greater or less than the new flat tax rate of 21 percent.
UBTI AND NET OPERATING LOSSES (NOL)
An NOL could be carried back up to two tax years and forward up to 20 years to offset 100% of taxable income.
Net operating losses generated in taxable years beginning before January 1, 2018, may be used in subsequent years with no siloing limitation, in effect grandfathering them. As a result, since UBTI must now be calculated separately for each trade or business before calculating the total UBTI for years after January 1, 2018, NOLs should be calculated post-2017 and taken before pre-2018 NOL carryovers are taken. Any losses from a specific activity in a tax year beginning after 2017 can be carried forward and used to offset current-year income up to 80 percent of UBTI, but only for that specific activity.
UBTI AND EMPLOYEE FRINGE BENEFITS: QUALIFIED TRANSPORTATION COSTS
Certain transportation benefits previously were treated as tax-exempt to employees and tax deductible to employers.
TCJA denies employers a deduction for expenses paid or incurred to provide employees certain transportation and commuting fringe benefits after December 31, 2017. To create parity between taxable and tax-exempt organizations, the Act requires tax-exempt organizations to increase their UBTI by the amount of qualified transportation fringe benefits (“QTF”) that would be nondeductible if they were subject to the same deduction disallowance rules as taxable entities. So in effect, tax-exempt entities now must pay tax of up to 21% on the amount of any disallowed fringe benefit expenses.
The Internal Revenue Service issued interim guidance regarding the treatment of QTF benefit expenses paid or incurred after December 31, 2017. The new rules assist tax-exempt organizations in determining the amount of parking expenses that are no longer tax deductible.
Section 512(a)(7) states that “unrelated business income shall be increased by any amount for which a deduction is not allowed under IRC 274 and which is incurred by such organization for any qualified transportation fringe parking benefit up to a value of $260 per month indexed for inflation.” So any QTF over this amount is considered taxable compensation.
Determining the portion of parking that is taxable will depend on whether the nonprofit entity pays a third party for employee parking, or if it owns or leases its own facilities. Therefore:
- If the nonprofit pays a third party for employee parking spaces, the amount paid will be subject to tax to the extent it is not included in employee compensation.
- If employee parking is provided on space owned or leased by the nonprofit, a four-step process and reasonable allocations will need to be applied. The updated guidance specifically states that costs, not value, must be used in determining the unrelated income associated with parking benefits. Costs to be considered are rent, maintenance, snow removal, security, insurance, repairs, taxes, interest, utilities, leaf and trash removal, but not depreciation.
The four step process is as follows:
Step 1- Determine the parking spots that are reserved for employees. Reserved spots can be designated with signage or located in a separate facility, not open to the public. Taxpayers had until March 31, 2019, to remove any signage or other restrictions, and doing so was considered retroactive to January 1, 2018. If there are reserved employee spaces, the percentage of these spots relative to total parking spots should be multiplied by total parking costs. The result will be considered unrelated business income.
Step 2- Determine the primary use of the remaining parking spots. If it can be determined that the primary use, or greater than 50%, of the remaining spots is for the general public, then no amount needs to be allocated to employee parking for this portion of the parking lot. Primary use must be tested during regular business hours on a typical business day. However, if usage varies significantly from day-to-day, an average or other reasonable method can be used. For purposes of this calculation, the general public includes patrons, visitors, patients, students, congregants or delivery persons. Employees, partners or independent contractors are not to be considered part of the general public. Volunteers were not addressed in the update.
Step 3- Determine the number of spots reserved for nonemployees. These spots would be designated in some manner as being visitor/customer parking areas. If there are reserved nonemployee spots, the nonprofit should determine the percentage of its parking lot that is used for this purpose. It would then multiply this percentage by its total parking costs to determine the amount of parking that will not be considered unrelated business income.
Step 4- The nonprofit should use a reasonable method to allocate costs to employee parking that is not deemed to be predominantly used by the public under step 2. The Notice states that employee use should be based on normal business hours on a typical day.
Based on this four-step process, it was possible for some taxpayers to eliminate or reduce any unrelated business income by removing signage related to reserved employee parking by March 31, 2019, but if the parking facilities are not used predominantly by the public, some amount of parking will still be taxed. Taxpayers will need to determine their parking costs and a reasonable percentage of employee usage. If there are multiple lots in the same geographic area, they can be aggregated to determine costs and usage percentages. Multiple lots in different geographic areas cannot be combined for the purpose of this calculation.
UBTI AND TRANSITION RELIEF
IRS Notice 2018-100 waives the addition to tax on unrelated business income, based on the underpayment of estimated income tax required to have been paid by December 31, 2018, to the extent that the underpayment was due to changes in the tax treatment of qualified transportation fringe benefits. To be eligible for this relief, an organization must not have been required to file a Form 990-T for the tax year preceding its first tax year ending after December 31, 2017.
This relief is limited to tax-exempt organizations that timely file and timely pay the amount reported on Form 990-T. An organization claiming the waiver must indicate “Notice 2018-100” on the top of its Form 990-T.
EXCISE TAXES FOR LARGE UNIVERSITY ENDOWMENTS
Private colleges and universities are treated as public charities and, like most nonprofits, were exempt from paying income tax on their investment income.
For tax years beginning after December 31, 2017, Section 4968 imposes a 1.4% excise tax on the net investment income of private colleges and universities with large endowments. Specifically, it impacts private colleges and universities with: (i) at least 500 students; (ii) more than 50% of whom are in the U.S.; (iii) investment assets of at least $500,000 per student.
An expansive interpretation of Section 4968 defines and clarifies the endowment tax as follows:
- The proposed regulations would tax interest, dividends, rent, and royalties earned by a college or university from any asset it holds, including assets used in furtherance of a college or university’s educational mission.
- The proposed regulations also suggest that rent paid by students to live in college dormitories, rent paid by other nonprofits for use of the institution’s academic buildings for academic purposes, and royalties from intellectual property produced by university faculty may all be subject to the endowment tax.
- The proposed regulations determine which private colleges and universities are subject to the excise tax by defining:
- “Applicable Educational Institutions” as educational institutions with at least 500 “tuition-paying students” and with endowments of at least $500,000 per student in the immediately preceding taxable year.
- “Tuition Paying Students” as students who receive full scholarships from the educational institution. In other words, colleges or universities cannot rely on government or third party aid to help defray any part of the student’s tuition. So in effect, students who obtain federal, state, or private grants, regardless of whether those students in fact pay tuition, would be considered tuition-paying students. Additionally, scholarship payments provided by third parties, even if administered by the educational institution, are considered payments of tuition.
Interpretations of Section 4968 set forth in the proposed regulations do not appear to be set in stone, as the IRS was accepting comments from colleges and universities until October 1, 2019.
EXCISE TAXES FOR HIGHLY COMPENSATED NONPROFIT EMPLOYEES
The fair value of compensation to executives at tax-exempt organizations is required to be reasonable, which is typically the value that would be paid for like services by a similar nonprofit under comparable circumstances. Any compensation determined to be
in excess of these reasonable rules results in excise taxes under intermediate sanctions and possibly loss of exemption under the Private Inurement rules.
In addition to prior law, under §4960 of the TCJA, tax-exempt organizations are subject to a 21% excise tax on the total of (1) the remuneration (other than an excess parachute payment) greater than $1 million paid to a covered employee, and (2) any excess parachute payment (as defined) paid to a covered employee. A covered employee is any applicable tax-exempt organization employee (or former employee) if the employee is one of the organization’s five highest-compensated employees for the tax year or any preceding tax year after December 31, 2016.
Remuneration under the law is defined as all wages subject to income tax withholding, including amounts that must be included in gross income, but excludes designated Roth IRA or 401(k) contributions. Compensation does not include wages paid to licensed medical professionals (including veterinarians) for performance of medical and veterinary services.
In Notice 2019-09, the IRS provided interim guidance on a number of definitions and concepts that needed explanation in this complex code section. The notice clarifies that the period for measuring remuneration and parachute payments is the calendar year that ends with or within the taxable year of the employer, which is generally the same method used for reporting compensation on the Form 990. The Notice also expands on remuneration from retirement plans such as 457(f) plans. Such compensation is treated as paid when it is no longer subject to a risk of forfeiture (i.e., when it vests).
DONOR DISCLOSURE: DO WE OR DON’T WE?
The IRS recently announced proposed regulations to end the requirement for non-charitable nonprofits to disclose the names of donors and amounts given. More specifically, tax-exempt organizations described by section 501(c), other than section 501(c)(3) organizations, are no longer required to report the names and addresses of their contributors on the Schedule B of their Forms 990 or 990-EZ. The donor disclosure requirements for 501(c)(3) and 527 organizations are not affected by the change.
One of the concerns with the elimination of the disclosure requirement is that organizations will no longer have to identify sources of funding for 501(c)(4) social welfare organizations,
e 501(c)(5) labor organizations, and 501(c)(6) business leagues, whereby funders for political campaigning will no longer be known.
The elimination of the disclosure requirement on Schedule B of Form 990 or 990-EZ takes place immediately as it applies to information returns for taxable years ending on or after December 31, 2018.
Public comments will be due on or about December 9, 2019.
Since the passage of TCJA, individual lawmakers, supported and lobbied by nonprofit sector advocates and practitioners, have introduced legislation to try to repeal some of the more burdensome elements to the law, as well as to bring reform and even introduce additional nonprofit policy. While the effort to”fix” the law does have momentum, action on this legislation now turns to the Senate. We remain hopeful that acknowledgement of the negative impact of the TCJA within the nonprofit sector will enable unfavorable tax policies to be amended. However, with an election year upon us and bipartisan bickering front and center, we aren’t holding our breath that Congress will pass meaningful tax fixers or repeal in the coming tax year. Therefore, it is prudent for tax-exempt organizations to prepare, comply with and stay abreast of changes as they happen. For questions on how these or other new tax provisions apply to your
tax-exempt organization, please contact your Marcum tax-exempt professional.