The Tax Act contains a number of provisions that significantly affect tax-exempt organizations, in some cases to degrees not seen in decades. In addition, several provisions may indirectly affect tax-exempts, for example, by changing individuals' incentives for charitable giving or by increasing burdens on charities to fill gaps left by anticipated cuts in state and local social programs. Furthermore, several provisions that did not make it into the final law are important to note, perhaps as harbingers of things to come. The new provisions are generally effective for taxable years beginning after December 31, 2017.
Key Provisions Directly Affecting Tax-Exempts
Excise tax on certain payments to highly compensated employees. Tax-exempt employers will pay new taxes on certain amounts paid to highly compensated employees. New Section 4960 of the Code generally imposes an excise tax of 21% (the new corporate rate) on certain remuneration paid to any of an organization's five highest paid employees for a taxable year and to anyone who was a covered employee for any preceding taxable year beginning after December 31, 2016.
The excise tax is imposed on any remuneration paid by the organization to a covered employee for a taxable year in excess of $1 million and also on any “excess parachute payment” paid by the organization to a covered employee. A “parachute payment” is compensation paid to a covered employee that is contingent on the employee's separation from employment if the aggregate value of such payments equals or exceeds a threshold amount. This threshold amount is generally the employee's average annualized compensation from the employer for the five taxable years prior to the employee's separation from employment (referred to as the “base amount”) multiplied by three. The excess parachute payment subject to the excise tax is the amount by which the parachute payment exceeds one times the employee's base amount.
Section 4960 excludes from the excise tax amounts paid for medical or veterinary services (but not administrative services relating to a medical or veterinary practice). In addition, only payments to individuals who are highly compensated employees (as defined in section 414(q)) are treated as parachute payments.
Remuneration from related organizations generally is combined for purposes of calculating the excise tax, and in the case of related organizations, each employer is liable for its own proportionate share of the excise tax. Tax-exempt organizations will need further guidance in determining whether an entity is a related organization for this purpose.
Treasury regulations will be promulgated as needed to prevent avoidance of the new excise tax, including through the performance of services as a contractor (rather than as an employee). Complex institutions such as academic medical centers are likely to require further guidance regarding the calculation of the excise tax, for example, in the allocation of the tax among different entities (particularly where doctors and veterinarians split their time between patient care and other responsibilities).
This new excise tax will apply in addition to the existing “Intermediate Sanctions” rules of Section 4958, which impose penalties for so-called excess benefit transactions (which usually means compensation found to be more than reasonable). The new Section 4960 imposes the 21% excise tax on excess parachute payments and other remuneration over $1 million even if the overall amount is reasonable under the Section 4958 Intermediate Sanctions rules. A distinction worth noting: The new Section 4960 imposes the 21% excise tax on the tax-exempt employer, while the Intermediate Sanctions rules of Section 4958 tax the person receiving excess compensation and, in some cases, those individuals who were responsible for approving the excessive amount.
The new Section 4960 applies to tax-exempt organizations concepts similar to those applied to taxable corporations under existing Sections 162(m) and 280G of the Code, which disallow deductions to taxable corporations for remuneration paid to covered employees in excess of $1 million and excess parachute payments paid in connection with a change in control of the corporation.
New tax on private nonprofit college and university endowments. The Tax Act creates a 1.4% excise tax on net investment income of large private colleges and universities, similar to the excise tax imposed on private foundations. State colleges and universities are not subject to this new tax.
Specifically, new Section 4968 of the Code imposes the 1.4% excise tax on the net investment income of any private nonprofit college or university with assets (other than assets used directly in carrying out the institution's exempt purpose) of at least $500,000 per full-time student and more than 500 students, at least half of whom are located in the United States. It is thought that approximately 35 colleges and universities in the United States currently fall into this category, with more likely to become subject to the tax in years to come. Furthermore, even those with smaller endowments have voiced concern over the new tax, as it is perceived to create barriers for initiatives to increase financial aid and expand other programs. The new rules include net investment income of organizations controlled by or under common control with a private college or university, thereby curtailing the ability of a college or university to avoid taxation via corporate structuring.
Upcoming Treasury regulations are expected to provide guidance on several important issues, including the definition of “net investment income” and the method of determining which assets are considered investment assets as opposed to assets used directly to carry out educational and charitable purposes.
Significant changes to the unrelated business income tax. The Tax Act changes the computation of tax on unrelated business taxable income (UBTI). Under new Section 512(a)(6) of the Code, a tax-exempt organization must compute UBTI separately for each unrelated trade or business and may no longer aggregate totals (income and deductions). This is a major change from prior law, where a tax-exempt organization could aggregate income and deductions (including deductions for net operating losses) from its various unrelated trades and businesses. Under a transition rule, if a tax-exempt organization has existing net operating losses from unrelated trade or business activity for tax years before 2018, those losses may be carried forward and used to offset its taxable income.
Organizations will need guidance in many instances on which activities may be considered a single trade or business under the new law. For example, it is unclear whether similar UBTI-generating investments handled by different portfolio managers would be considered one or multiple trades or businesses. It also appears that the existing tax return (Form 990-T) is not compatible with the new rules and will need immediate modification.
These new UBTI rules are likely to increase tax liability for many organizations; however, some factors may mitigate that effect. Organizations with very small amounts of UBTI may continue to benefit from the single $1,000 deduction. Furthermore, the new 21% corporate tax rate will apply to charitable corporations, some of which have paid up to 35% in prior years.
New tax on costs of certain employee fringe benefits. A change to the way tax-exempt organizations treat certain fringe benefits provided to employees also affects the computation of UBTI. The new Section 512(a)(7) of the Code provides that a tax-exempt organization's UBTI will be increased by any amount paid or incurred for any qualified transportation fringe, any parking facility used in connection with qualified parking, and any on-premises athletic facility. These amounts are included only if they are not directly connected to a regularly carried on unrelated trade or business. This provision takes the unusual step of taxing the organization on an amount expended rather than an amount received. It is thought to be analogous to the Tax Act's changes to Section 274 of the Code prohibiting taxable employers from taking a deduction for the same types of expenses. (Read our discussion on the Tax Act's changes to Section 274.)
Additional New Rules Affecting Tax-Exempt Organizations
Charitable Contribution Deductions
Several changes are now in effect relating to the charitable contribution deduction for individual and corporate taxpayers under Section 170 of the Code.
Increased AGI limitation for certain charitable contributions. For individual taxpayers who itemize deductions, the Tax Act raises the deductible limit to 60% (up from 50%) of adjusted gross income (AGI) on cash contributions to public charities, private operating foundations, flow-through foundations and certain governmental units. The Tax Act also repeals the “Pease limitation” on itemized deductions that under prior law limited deductions for high-income individuals. This provision expires at the end of 2025.
Increased standard deduction. While some high-income individuals will have an incentive to increase charitable contributions, the Tax Act renders the charitable deduction meaningless for a large majority of individual taxpayers. This is because the Tax Act increases the standard deduction for individuals to $12,000 (up from $6,500) and for married couples filing jointly to $24,000 (up from $13,000). Under some estimates, over half of taxpayers will no longer itemize starting with tax year 2018 and thus may have an incentive to reduce charitable contributions. These new limits expire at the end of 2025.
Elimination of charitable contribution deduction for contributions related to athletic event seating. Under prior law, holders of college athletic event seating rights (the right to buy tickets to athletic events) could deduct 80% of the amount paid for those rights. The Tax Act eliminates this charitable contribution deduction and in effect treats college athletic fans as ticket purchasers rather than donors.
Elimination of the exception to contemporaneous written acknowledgment requirement. The Tax Act repeals as of 2017 an unused provision of the Code that would have allowed organizations to avoid issuing written substantiation to donors by including the same information required on the written substantiation on Form 990 or Form 990-PF. This provision was not in use, because it required the issuance of Treasury regulations that were never finalized.
Increase in Estate Tax Exclusion
The Tax Act doubles the exclusion from the federal estate tax (to about $11 million for individuals and about $22 million for couples, depending on the inflation adjustment) for decedents dying after December 31, 2017, and before January 1, 2026. These higher exclusions are likely to reduce philanthropy related to estate planning.
State and Local Tax Deduction Limitations
The Tax Act limits state and local income and property tax deductions from federal taxes to a total of $10,000. This provision has caused much concern, particularly in high-tax states, and may result in state and local tax cuts as local lawmakers attempt to respond to citizen concerns. Tax cuts may in turn result in budget cuts, including cuts to social programs, thereby increasing burdens on charities who operate and fund social programs.
As of this date, certain states (such as California and New York) are considering legislation to allow taxpayers to make voluntary donations to funds established by the state, which donations would then be credited against the taxpayer's state and local tax liabilities. The donation would be fully deductible as a charitable contribution for federal income tax purposes, thereby avoiding the limitation on deductibility of state and local taxes. It is unclear whether the IRS will address this issue.
Affordable Care Act (ACA) Individual Mandate
The Tax Act eliminates the individual mandate of the ACA, removing the penalty for individuals not carrying health insurance. Nonprofit hospitals and other health-related charities may see an increased burden due to serving patients without health insurance coverage.
Proposals Not Included in the Tax Act
A number of provisions were included in earlier proposals but did not appear in the final version of the Tax Act. Tax-exempt organizations would be well-advised to remain aware of these issues, as these provisions may be included in future legislation.
Political campaign activities. The House version of the bill would have repealed the so-called Johnson Amendment, which imposes an absolute prohibition on political campaign activities by Section 501(c)(3) organizations. Had the Johnson Amendment been repealed, Section 501(c)(3) organizations, including churches, synagogues and mosques, would have been allowed to carry out a limited amount of political campaign activity.
Intermediate sanctions. A proposed amendment to Section 4958 of the Code, which, as described above, addresses excess benefit transactions, would have eliminated the “rebuttable presumption” of reasonableness safe harbor under which organizations may gain a level of comfort in determining executive compensation and other payments by following a prescribed procedure. However, the rule remains the same.
Private foundation rules. An earlier version of the bill would have eliminated the two-tier excise tax on private foundation investment (Section 4940 of the Code) in favor of a single 1.4% tax similar to that newly imposed on college and university endowment net investment income. This rule would have reduced the tax burden for a large number of private foundations, but the provision was not included in the Tax Act, and Section 4940 maintains the 2% excise tax (subject to reduction to 1%) for private foundations. Another proposal would have loosened the excess business holdings rules of Section 4943. A third proposal affecting private foundations would have required certain museums to remain open to the public for a minimum number of hours, but this also was not enacted.
UBIT on certain royalty payments. A proposal would have treated certain income from the licensing of the name or logo of a tax-exempt organization as unrelated business income subject to UBIT. This caused concern among tax-exempts, as many organizations have for years entered into licensing and royalty payment arrangements that comply with current law.
State and local government pension plans. A proposal would have eliminated the UBTI exemption for government pension plans, but this provision was not enacted.
Donor advised funds. No changes were made to the laws affecting donor advised funds, but a proposal would have imposed additional reporting and payout requirements. Significant issues concerning donor advised funds have arisen in recent years and may appear again in the future.
Tax-free tuition benefits. A proposal receiving much media attention would have repealed the tax-free treatment of tuition benefits for graduate students and other educational institution employees (and their dependents), as well as of educational assistance programs.
Professional sports leagues. A proposal would have amended Section 501(c)(6) of the Code to make professional sports leagues ineligible for tax-exempt status. This is an ongoing area of controversy.
Private activity bonds. A proposal would have repealed tax exemption for private activity bonds, which are widely used by tax-exempt organizations for building and expansion projects. Had it been included, the provision would have eliminated a popular financing opportunity, and investors would no longer have a tax incentive to purchase private activity bonds.
Volunteer mileage rate. A proposal would have permitted the volunteer auto mileage rate to be adjusted for inflation but was not enacted. This would have helped to reduce the cost of volunteering.