The Tax Cuts and Jobs Act (Tax Act) makes numerous direct changes to tax-exempt organization taxation, as well as major changes to individual and corporate taxation that will indirectly affect tax-exempt organizations. Significant disruption to the taxation landscape for tax-exempt organizations is under way.
There have been several changes to tax law that may affect the amount of contributions available to the charitable sector in the foreseeable future. The Tax Act nearly doubles the standard deduction, therefore the number of households that are expected to itemize will decrease from about 30 percent to 5 percent. Thus, there is expected to be a decrease in charitable giving because individuals will not be itemizing and receiving a deduction on their tax returns for these contributions. According to the Council on Foundations, the potential loss is estimated to be as high as $26 billion in contributions per year. The impact may be offset by an increase in the charitable deduction limit for cash contributions from 50 percent of adjusted gross income to 60 percent.
Furthermore, the threshold for taxable estates and gifts increased from $5 million to $11.2 million, and eventually disappears as of Dec. 31, 2025. The effect of the increase in the threshold will be to lessen the incentive to donate portions of an estate to charity because more property can be transferred tax-free to beneficiaries.
Unrelated Business Income Modifications
For tax years beginning after Dec. 31, 2017 – except when there is a net operating loss (NOL) carryover from a tax year beginning before Jan. 1, 2018 – tax-exempt organizations may not use losses from one unrelated trade or business to offset income from another unrelated trade or business. Gains and losses from each unrelated business activity have to be calculated separately. The Tax Act currently does not define what is considered to be a separate activity, therefore distinguishing various activities may be difficult. An example may be that a taxable loss on an investment cannot be netted against taxable rental income. Absent further guidance from the IRS, organizations will need to use professional judgment in isolating current unrelated activities. The process may include auditing the unrelated activities to determine if all expenses and allocations are reasonably assigned to each activity (overhead allocations need to be activity specific), tracking any NOLs created before Jan. 1, 2018, and tracking segregated NOL schedules for each activity on a prospective basis.
Effective for amounts paid or incurred after Dec. 31, 2017, the Tax Act requires tax-exempt organizations to report the costs of certain fringe benefits as unrelated business income (UBI) where the benefits are provided by the organization to their employees and are not included in the employees’ taxable income. The fringe benefits subject to this provision include qualified transportation (commuter highway vehicle, transit passes), parking reimbursements, and on-site gyms. Assuming an employer intends to continue providing these benefits, there are two possible approaches: continue to pay the fringe benefit and report the UBI on Form 990-T, or make the benefit taxable to the employee by including it in wages on Form W-2.
Another UBI impact is the lower 21 percent corporate tax rate that will be applied to overall taxable income. The new tax law also limits the NOL deduction to 80 percent of taxable income (determined by excluding the NOL deduction itself), and disallows any NOL carryback, though it does allow for indefinite carryforwards.
Excise Tax on Employee Compensation
There is a provision in the tax law that seems designed to put tax-exempt organizations on par with taxable entities when it comes to compensation in excess of $1 million for top executives. The top five highest-compensated employees of exempt organizations will now be subject to a 21 percent excise tax rate on taxable wages in excess of $1 million. Taxable wages do not include qualified plan benefits such as Section 125 benefits or amounts set aside for retirement plan contributions. Taxable wages will include nonqualified plan deferrals when vested, whether or not payments have been made.
Tax-exempt organizations that must comply include all organizations determined to be exempt under Section 501(a), farmers’ cooperative organizations exempt under Section 527(b)(1), governmental entities with excludable income under Section 115(1), and political organizations described in Section 527(e)(1). Compensation paid by related organizations must be included in the analysis of executive compensation as well. Controlling and controlled organizations, including supporting organizations, organizations under common control, and sponsoring organizations of Voluntary Employees’ Beneficiary Associations (VEBAs) must also take their executives’ compensation into consideration.
These highest-compensated employees, deemed “covered” employees, are evaluated on an annual basis, starting with the year ending Dec. 31, 2017. Covered employees must be assessed both on an entity-by-entity basis and as part of a controlled group. Predecessor organizations must also have their executives’ compensation examined. Covered employees include each year’s top five highest-compensated employees. Once an employee meets the covered employee definition, he or she will always be labeled a covered employee, and future compensation will be taxed as such. It is entirely possible that an organization may have to pay excise tax on more than five employees’ compensation in a given year.
Payments upon separation of service, defined as “excess parachute payments” of covered employees will also bear an excise tax, based on a calculation that is three times the employees’ most recent five-year average compensation. Any amount of the present value of the payment stream that is over the calculated amount will also be subject to the 21 percent excise tax.
Excise Tax on Endowments
Another provision, which was not unexpected by many, was the introduction of a 1.4 percent excise tax on net investment income for private colleges and universities. Educational institutions with at least 500 students must pay the excise tax if the organization’s “nonrelated” assets (those not directly used in carrying out the organization’s education purposes) are valued at the close of the preceding tax year as being at least $500,000 per full-time student. The number of students is based on the daily average of full-time students. Part-time students are counted on a full-time equivalent basis. Net investment income is determined under rules set out in Section 4940(c), which was originally designed solely for private foundations. Only those colleges and universities with truly substantial endowments, such as Ivy League schools, will be affected. This provision is expected to apply to as few as 30 colleges across the country.
Advance Refunding Bonds
Advance refunding bonds are bond issues used to pay off another outstanding bond issue, but not within the 90 day requirement for current refunding. For advance refunding bonds issued after Dec. 31, 2017, the interest paid to advance refund bond investors is now taxable.
The Tax Act expands the use of Section 529 education savings plans to include deductions for certain elementary and secondary public, private, or religious school expenses. Tuition up to $10,000 per year will be “qualified higher education expenses” for purposes of using 529 plan funds.
The application of many of these provisions will require additional guidance from the Department of the Treasury and the IRS. Tax-exempt organizations should evaluate how the changes could affect their business operations and develop a proactive plan to address the impacts.
Kerri N. Bogda, CPA, is senior manager, tax services, at Baker Tilly Virchow Krause LLP in York. She can be reached at firstname.lastname@example.org.
Stephanie M. Hollick, CPA, is a senior manager at Baker Tilly Virchow Krause in Williamsport. She can be reached at email@example.com.