What’s New for Tax Exempt Organizations
How the Nonprofit World Fared With the Tax Cuts and Jobs Act of 2017
Tax Cut and Jobs Act (TCJA) will impact almost every type of business organization. The following is a summary of provisions that nonprofit entities should be aware of:
UNRELATED BUSINESS TAXABLE INCOME (UBTI)
Beginning January 1, 2018, organizations carrying on more than one unrelated business activity must now separately calculate UBTI for each activity, a term referred to as “siloing.” As a result, losses from one trade or business may not be used to offset income derived from another trade or business. In enacting the legislation, Congress did not provide the exact criteria for determining how this is to be applied. Lingering open questions remain, such as:
- How does the nonprofit determine if a particular activity is a separate unrelated trade or business?
- Should investment holdings in multiple partnerships be considered one unrelated trade or business, or should they be treated separately?
- How should expenses for multiple unrelated trades or businesses be allocated?
On August 21, 2018, the Internal Revenue Service released Notice 2018-67 which provides temporary guidance on some of these points.
IS IT A SEPARATE TRADE OR BUSINESS?
The Notice provides that exempt organizations may rely on a reasonable, good-faith interpretation of Internal Revenue Code Sections 511 through 514, until final regulations are issued, when determining whether an exempt organization has more than one unrelated trade or business. Specifically, the proposed regulations state that “reasonable, good-faith interpretation” includes using the North American Industry Classification System (NAICS) 6-digit codes. The NAICS is a classification
system for collecting, analyzing, and publishing statistical data related to the U.S. business economy. Exempt organizations that file Form 990-T to report UBTI are already using this code system when describing the organization’s unrelated trade or business.
The Notice also provides interim and transition rules for aggregating income from partnerships and debt-financed income from partnerships. An exempt organization may aggregate its UBTI from its interest in a single partnership with multiple trades or businesses conducted directly or through lower tier partnerships (“Qualifying Partnership Interest”) if one of two tests is met:
- A de minimis test, which the exempt organization satisfies if it holds directly no more than 2% of the capital and profits of the partnership; or
- A control test, which the exempt organization satisfies if it directly holds no more than 20% of the capital interest and lacks “control or influence” over the partnership.
In addition, a tax-exempt organization that acquired a partnership interest prior to August 21, 2018, may treat each partnership interest as a single trade or business, regardless of whether it meets either test or there is more than one trade or business directly or indirectly conducted by the partnership (or lower-tier partnerships).
Tax-exempt organizations will benefit from reviewing their existing investment partnerships to determine (a) whether the interests satisfy either the de minimis or control tests and, (b) if it does not meet either test, what impact siloing each individual investment may have on the organization’s overall UBTI.
UNRELATED DEBT-FINANCED INCOME
The income from qualifying partnership interests permitted to be aggregated under the interim rule includes any unrelated debt- financed income that arises in connection with the qualifying partnership interest that meets the requirements of either the de minimis test or the control test (noted above).
The Notice provides an example illustrating the application of this interim rule:
A tax exempt organization has an interest in a hedge fund that is treated as a partnership for federal income tax purposes, the interest is a "qualifying partnership interest" that meets the requirements of the de minimis test, and the hedge fund regularly trades stock on margin. Ordinarily, the dividends from such stock and any income (or loss) from the sale, exchange, or other disposition of such stock would be excluded from UBTI. However, because all or a portion of the stock’s purchase is debt-financed, the exempt organization would be required to include all or a portion (depending on the debt-basis percentage applied) of the dividend income and any income (or loss) from the sale of the stock in UBTI. For the purpose of the interim rule, the exempt organization may aggregate unrelated debt-financed income generated by the hedge fund with any other UBTI generated by any of the hedge fund’s trades or businesses that are unrelated trades or businesses with respect to the exempt organization.
Similarly, any unrelated debt-financed income that arises in connection with one partnership interest may be aggregated with UBTI that arises in connection with other partnership interests.
While the IRS suggests that it "may be appropriate" to aggregate partnership interests in this manner, it is also requesting commentary regarding the treatment.
NET OPERATING LOSSES (NOL)
Prior to the Tax Cut and Job Act, an NOL could be carried back up to two tax years and forward up to 20 tax years to offset taxable income. The Tax Cut and Job Act made extensive changes to net operating losses including limiting post-2017 NOLs to the lesser of (1) the aggregate NOL carryovers to such year, plus the NOL carrybacks to such year, or (2) 80% of taxable income computed without regard to the deduction generally allowable. The changes to the NOL provisions would also affect tax exempt organizations with unrelated trade or business income and, in particular, such organizations with both pre-2018 and post-2017 NOLs.
UNRELATED BUSINESS INCOME TAX ON FRINGE BENEFITS TO EMPLOYEES
The Tax Cuts and Jobs Act of 2017 enacted a provision whereby tax exempt organizations that provide their employees with qualified transportation fringe benefits that are not included in their employees’ taxable income (i.e.. parking reimbursements, mass transit passes, on-premises athletics facilities, etc.) must now include the value of such benefits as UBTI subject to unrelated business income tax. In other words, an expense is yielding unrelated business income tax.
In further guidance, Notice 2018-67 provides that UBTI arising from tax-exempt organizations’ parking and transportation benefits is not subject to the "silo" rule. Effectively, the tax exempt organizations, engaged in more than one unrelated trade or business, would be allowed to net their parking and transportation expenses against any other UBTI. This does not help many charities, churches, or other Section 501(c)(3) groups that are subject to unrelated business income tax for the first time under the new law, but it does provide some relief for organizations with multiple unrelated business income activities. The Notice does not provide any guidance with regard to computing the unrelated revenue.
To avoid the UBTI liability, an employer organization can consider providing such benefits as taxable income to the employees, discontinue providing the benefits, or increase pay to its employees.
NEW EXCISE TAX FOR LARGE UNIVERSITY ENDOWMENTS
An excise tax of 1.4% will be imposed on the net investment income of some private college and university endowments, where there is an enrollment of more than 500 students and an asset threshold of at least $500,000 per full-time student. The new law also makes a slight modification to the definition of "applicable educational institution," which now includes only institutions with more than 50% of tuition-paying students located in the United States.
NEW EXCISE TAX ON HIGH SALARIES
An excise tax of 21% will be imposed on wages in excess of $1 million for any covered employee of a nonprofit entity. This tax, paid by the organization, is applicable to compensation in excess of $1 million for employees of a tax exempt organization who are one of the five highest-paid employees for the taxable year. A special exclusion applies to compensation paid to licensed medical professionals.
The excise tax applies to any "excess parachute payments," which is compensation contingent upon termination of employment where the aggregate present value of the payments exceeds three times the employee’s average annual compensation.
This change is intended to bring nonprofit salary taxation into line with tax policies regulating for-profit corporations.
PHILANTHROPIC ENTERPRISE ACT OF 2017
The Philanthropic Enterprise Act was signed into law on February 9, 2018, largely impacting the private foundation sector by changing the excess business holding rules which generally prohibit a private foundation from owning more than 20% of a for-profit company, by imposing significant penalties for ownership exceeding this threshold. The bill was championed by Newman’s Own Foundation, which owns a 100 percent of No Limit, LLC, the for-profit that produces and sells the Newman’s Own brand of food products. The new law now allows a foundation to own 100 percent of a company if operated independently and all of its profits go to charity.
The new law effective, December 31, 2017, opens many opportunities for founders of companies that want to devote all profits from their businesses to charity by allowing them to place their companies under the ownership of a private foundation.
OTHER KEY OBSERVATIONS AND POTENTIAL ACTION STEPS:
Other TCJA changes that impact individuals will also have a direct impact on charities. For example, the individual adjusted gross income limitation was increased to 60%, from 50%, for cash contributions made to public charities by individuals. Tax exempt organizations should promote this benefit with donors to increase funding.
Complete guidance is still lacking in many areas of this new law; therefore, tax exempt organizations must carefully evaluate and strategically implement the best options to prevent any threat to their tax exempt status or cause unintended penalty consequences. To learn more about upcoming guidance and for advice on the impact of the Tax Cuts and Jobs Act of 2017 to your organization, contact your not-for-profit specialist at Marcum.