The 2017 Tax Act (formerly known as the Tax Cuts and Jobs Act) became law on December 22, 2017 and includes changes that can affect nonprofit organizations in a number of ways, including:
- How unrelated business taxable income (UBTI) is calculated.
- The extent to which net operating losses can offset UBTI.
- The potential for an entity-level excise tax on executive compensation payments.
- An excise tax on the endowments of private colleges and universities.
- The level of charitable giving anticipated in light of new deduction limitations.
This advisory discusses how the Act has changed prior law and what nonprofit organizations can expect as the new laws take effect.
Calculating UBTI Separately For Each Trade or Business – New IRC §512(a)(6)
A tax-exempt organization that carried on more than one unrelated trade or business was allowed to compute the UBTI on an aggregate basis. In other words, a tax-exempt organization could offset income and deductions from various unrelated trades or businesses in order to compute how much tax was owed.
Effective for tax years beginning after December 31, 2017, a tax-exempt organization that carries on more than one unrelated trade or business is required to separately compute the UBTI for each trade or business under new Internal Revenue Code (IRC) §512(a)(6). In practical terms, the new law prohibits a tax-exempt organization from using deductions relating to one unrelated trade or business to offset income derived from a separate, unrelated trade or business. In addition, a tax-exempt organization may need to account separately for each unrelated trade or business, which was not required for tax purposes prior to the Act.
As a result of new §512(a)(6), a tax-exempt entity that operates more than one unrelated trade or business may want to consider forming a wholly-owned for-profit subsidiary (taxable as a C Corporation) and operating all of the different trades or businesses in the subsidiary such that profits and losses derived from various unrelated trades or businesses may still be offset against each other, assuming that there is a sufficient profit motive and the trades or businesses are truly unrelated to the organization’s tax-exempt purpose.
UBTI Increased By Certain Fringe Benefits – New IRC §512(a)(7)
A tax-exempt organization was allowed to provide its employees with fringe benefits in the same manner as for-profit entities. These benefits could be provided by a tax-exempt organization to its employees in a manner that was tax free to both the employees and the employer.
Effective for amounts paid or incurred after December 31, 2017, a tax-exempt organization is taxed on the value of certain fringe benefits it provides to its employees. Such fringe benefits include transportation benefits, qualified parking benefits, and access to on-site athletic facilities. The amount of such fringe benefits is treated as UBTI of the tax exempt organization and no deduction is allowed.
This law change may trigger tax exempt organizations to pay higher compensation to its employees, in lieu of providing the fringe benefit, to avoid or reduce its UBTI.
Net Operating Loss Deduction – IRC §172
Net operating losses (NOLs) could be carried forward for 20 years and carried back two years. In addition, there was no limit on the amount of taxable income that could be offset by an NOL.
Effective for NOLs arising in 2018 and thereafter, a NOL can no longer be carried back to any prior tax year and can only offset up to 80 percent of a corporation’s taxable income. In addition, the 20-year carryforward period is eliminated such that NOLs can be carried forward indefinitely.
The greatest impact of amended §172(a) and (b) on tax-exempt organization will result from the 80 percent limitation on the use of NOLs. Tax-exempt organizations that incur NOLs in 2018 and thereafter are no longer able to eliminate all UBTI through the use of NOL carryforwards, because new NOLs can only be used to offset a maximum of 80 percent of taxable income. As a result, tax-exempt organizations would now be subject to the unrelated business income tax on a minimum of 20 percent of their UBTI. However, the manner in which §172 was amended appears to exempt from the 80 percent income limitation any NOL that was incurred in a tax year that began before January 1, 2018. As a result, existing NOL carryforwards can still be used to offset more than 80 percent organization’s UBIT.
Tax on Excess Tax-Exempt Organization Executive Compensation – New §4960
There was no excise tax at the level of the tax-exempt organization on compensation payable to executives. Under the existing excess benefit transaction rules of §4958, which apply to IRC §§501(c)(3) and 501(c)(4) organizations, a 25 percent excise tax can be imposed on the executive if such executive’s compensation is determined to be unreasonable (i.e., the value of the economic benefit provided exceeds the value of the consideration received for providing such benefit). In addition, §53.4958-6 of the Treasury Regulations, provides that the organization can establish a rebuttable presumption that payments under a compensation arrangement are reasonable for purposes of the §4958 excise tax. This requires that the organization follow rigorous due diligence procedures to gather data on compensation paid by other comparable organizations for executives performing comparable duties.
Effective for tax years beginning after 2017, any organization that is exempt from tax under IRC §501(a) will be subject to an excise tax, imposed at the corporate tax rate (currently 21 percent), on excess parachute payments and compensation in excess of $1,000,000 (excluding the excess parachute payment) paid to a “covered employee.” For this purpose, a covered employee is one of the five highest compensated employees of the organization for the taxable year and any employee who was one of the five highest compensated employees in any preceding taxable year (that began after December 31, 2016). In addition, compensation from certain related organizations will be aggregated in reaching the compensation thresholds. There are two notable exceptions to the application of the excise tax: (1) compensation paid to licensed medical professionals and veterinarians; and (2) excess parachute payments made to employees who are not highly compensated within the meaning of IRC §414(q) (generally, 5 percent owners or, for 2018, employees who earn $120,000 per year), as such amounts are excluded from the definitions of compensation and excess parachute payments, respectively.
New IRC §4960 will result in an immediate tax liability for organizations that have highly compensated executives, but tax-exempt hospitals will remain largely unaffected with respect physician compensation paid for medical services. (However, compensation paid to physicians in some other capacity must be taken into account.) Even if a tax-exempt organization has taken steps to invoke the presumption that the compensation is reasonable, such presumption only serves to avoid imposition of the IRC §4958 excise tax on the employee. The new §4960 excise tax still applies, independently, to the tax-exempt organization. Treasury Regulations will be needed to clarify certain of the defined terms set forth in §4960 and to illustrate how the excise tax will apply in specific situations.
Excise Tax Based on Investment Income of Private Colleges and Universities – New IRC §4968
There was no net investment income tax imposed on public charities.
Effective for taxable years beginning after December 31, 2017, private colleges and universities that (1) had at least 500 students during the preceding taxable year; (2) have more than 50 percent of its students located in the United States; and (3) have assets (other than those assets which are used directly in carrying out the institution’s exempt purpose) with an aggregate fair market value of at least $500,000 per student at the end of the preceding taxable year, are subject to a 1.4 percent excise tax on their “net investment income.” New IRC §4968 specifically provides that the “net investment income” shall be determined under rules similar to the net investment income tax applicable to private foundation under the rules of IRC §4940(c). Net investment income generally includes interest, dividends, rents, royalties (and income from similar sources), and capital gain net income, reduced by expenses incurred to earn this income. The assets and net investment income of related organizations are required to be aggregated for purposes of the 1.4 percent excise tax.
New IRC §4968 primarily targets private colleges and universities with large endowments. Nonetheless, for those that are affected, they will now incur a tax liability with respect to income that has previously gone untaxed. Treasury Regulations will be issued to describe: (1) which assets are used directly in carrying out the educational institution’s exempt purpose; (2) the computation of net investment income; and (3) assets that are intended or available for the use or benefit of the educational institution.
Charitable Contributions – IRC §§170(b)(1)(G), 170(l), and 170(f)(8)(D)/(E)
Charitable contribution deductions to public charities and certain private foundations were generally limited to 50 percent of an individual’s adjusted gross income (AGI).
The Act increases the AGI limitation for cash contributions made by an individual taxpayer to 60 percent of the individual’s AGI for taxable years beginning after December 31, 2017 and before December 31, 2026.
Seating at Athletic Events
Prior to the Act, an individual was allowed to deduct 80 percent of the amount contributed to or for the benefit of an educational institution where the individual received the right to purchase tickets for seating at an athletic event in an athletic stadium of such institution.
The Act eliminates this deduction entirely and disallows a deduction for contributions made to educational institutions in exchange for university athletic seating rights, effective for contributions made in tax years beginning after December 31, 2017.
Written Acknowledgement of Contribution
Generally, a taxpayer may not take a charitable deduction for any single contribution of $250 or more without a contemporaneous written acknowledgement from the donee organization.
Prior to the Act, however, there was an exception to this general rule whereby the taxpayer was not required to substantiate a charitable contribution with a contemporaneous written acknowledgement from the charity of his or her donation of $250 or more if the donee organization filed a return reporting the required information.
Effective for taxable years beginning after December 31, 2016, this exception has been repealed by the Act.
Generally, a taxpayer must itemize his or her deductions in order to claim a charitable contribution deduction.
The Act increases the amount of standard deduction, which makes it less advantageous for some individuals to make charitable contributions. For year 2017, the standard deduction was $6,350 for single individuals and married individuals filing separately, $9,350 for heads of households, and $12,700 for married individuals filing a joint return.
Effective for taxable years beginning after December 31, 2017, and before January 1, 2026, the standard deduction is $12,000 for individuals and married individuals filing separately, $18,000 for individuals filing as heads of households, and $24,000 for married individuals filing a joint return. As a result of these changes, donors may choose to “bunch” their gifts (i.e., making larger gifts every two to three years instead of annually) so that the gifts are sufficiently large to allow for itemization. This may result in uneven income flow for nonprofit organizations.
Due to changes made in the new law, tax exempt organizations may want to consider restructuring their executive compensation payments and/or structural changes to minimize UBTI computation. Private colleges and universities should plan their budgets properly taking into consideration the excise tax on the endowments. Individual donors may want to re-strategize their giving plans. Due to the complexity of the new law, charitably inclined individual taxpayers and tax-exempt organizations are strongly encouraged to consult with tax professionals to see what impact the new law has on them.