This article was originally published on January 22, 2018; updated August 14, 2018.
Original proposals in the 2017 Tax Act (known unofficially as the "Tax Cuts and Jobs Act") had threatened to repeal or significantly restrict the Johnson Amendment (prohibiting/limiting charities from engaging in partisan activities), eliminate tax-exempt private activity bonds, further restrict donor-advised funds, repeal an unrelated business income tax exception for royalties from use of an exempt organization's name or logo, increase the excise tax on all private foundations, and convert some art museums to private foundation status. Although those provisions were not enacted, they remain "on the table" as Congress continues to consider additional tax changes.
The changes that were enacted will impact the exempt-organization sector by potentially affecting charitable donations, taxing the investment income of large private colleges and universities, modifying how unrelated business income is taxed, imposing new excise taxes on certain compensation and employee fringe benefit payments, and changing how organizations report some lobbying expenses.
As we go to publication, President Trump is discussing a reduction in capital gains rates, which could have an additional impact on charitable donations, and IRS, Treasury, and tax professionals are continuing to grapple with many uncertainties created by the Act's extensive changes. Looking forward, it is expected that IRS clarification of some provisions may not be forthcoming for some time, given the magnitude of the work that the Act created for the IRS, and the reduced staffing and funding currently impacting the IRS as it seeks to implement and clarify the Act.
Most provisions of the Act are effective for tax years beginning after December 31, 2017, except as noted. All statutory references are to the Internal Revenue Code, as amended, except as noted.
Charitable Contributions May Decline (or Maybe Not).
The Act caused speculation that some changes will decrease or eliminate the federal income tax benefit of making a charitable contribution and that this, in turn, will cause a decrease in contributions. The opposing position speculates that tax savings will increase net income available for charitable contributions and that this, in turn, will cause an increase in contributions. Empirical evidence from prior tax rate reductions seems to show that immediately after implementation of rate reductions there may be a slight decrease in charitable contributions, but any such decrease is short-lived and reversed over the long term. Regardless of the impact that tax rates may or may not have on donations, development directors and others involved in raising charitable funds continue to stress the importance of charities clearly communicating the importance of their missions and providing data demonstrating their success in accomplishing those objectives. Although the following changes may have an impact on donations, those involved in fundraising continue to believe that success is based on establishing an emotional connection with potential donors and demonstrating good stewardship, and that the value of the charitable deduction itself is not a primary factor.
A. Individual Income Tax Changes. As a result of doubling the standard deduction and eliminating or limiting some itemized deductions, it is expected that many individuals will no longer itemize and will, instead, file the short form 1040. This is one of the primary items of simplification in the Act. Those individuals who did not itemize will be unable to take advantage of the charitable income deduction.
B. Income Tax Rates Reduced. Reduction of the top corporate (see below) and most individual income tax rates will decrease the tax savings realized by many who make charitable contributions and are eligible for a charitable income tax deduction.
C. Individual Limitation Increased (§ 170(f)(8)(D)). The 50 percent adjusted gross income limitation for cash contributions made by individuals to public charities and certain private foundations has been increased to 60 percent. The provision automatically expires on January 1, 2026.
D. Estate Tax Exemption Doubled. This will eliminate the usefulness of the charitable estate tax deduction for many taxable estates.
Excise Tax Based on Investment Income of Private Colleges and Universities (§ 4968).
An excise tax of 1.4 percent is imposed on the net investment income of larger private colleges and universities. The tax applies to private colleges and universities with assets (other than those used directly in carrying out the institution's exempt purpose) of at least $500,000 per student and that have at least 500 students, more than 50 percent of whom are located in the United States.
Unrelated Business Taxable Income ("UBTI") Changes.
A. UBTI Separately Computed for Each Trade or Business Activity (§ 512(a)). Losses from one unrelated trade or business may no longer be used to offset taxable income derived from another unrelated trade or business. Gains and losses have to be calculated and applied separately. There is an exception for unused net operating losses ("NOLs") arising in a tax year before January 1, 2018, that are carried forward.
Unanswered questions about how this provision will be interpreted revolve around how "one unrelated trade or business" will be defined for this provision. For example: how will amounts required to be treated as UBTI (see below) be handled; how will passive investment income be treated; how will multiple activities that constitute the same type of trade or business be treated; and how will expenses be allocated, if used for more than one trade or business?
B. Tax Rate Changes May Increase or Decrease UBTI Tax Imposed. Previous corporate income tax rates ranged from 15 to 35 percent. This provision changes to a fixed rate of 21 percent in all cases.
C. The Net Operating Loss Carryback Is Modified. Most NOLs will not be eligible to be carried back (only forward), and the deduction (going forward) is limited to 80 percent of taxable income.
Compensation Changes Mirror For-Profit Deduction Disallowances.
In a surprising new approach, Congress has decided to raise additional revenue (no doubt helping to pay for tax cuts made elsewhere in the Act) and level the playing field between for-profits and tax-exempts, by forcing tax-exempt organizations to recognize the same tax penalties as their for-profit counterparts that are unable to deduct certain compensatory expenses. This is accomplished in one case by the addition of an excise tax equal to the corporate tax rate and in another by treating disallowed expenses as UBTI.
A. Excise Tax on Excess Tax-Exempt Organization Executive Compensation (§ 4960). Tax-exempt organizations (under Sections 501(a) [entities described in Section 501(c), or (d) or 401(a)]; Section 521(b)(1) [farmer's co ops]; Section 115 [state or local governments or instrumentalities]; or Section 527(e)(1) [political organizations]—each an "applicable tax-exempt organization") will be subject to an excise tax at the corporate income tax rate (21 percent) on the sum of: (1) remuneration (other than an excess parachute payment) in excess of $1 million paid to a "covered employee" in any tax year; and (2) any excess parachute payment (as newly defined by Section 4960(c)(5)) paid by the organization to a "covered employee."
"Remuneration" means "wages," as defined in Section 3401(a), is treated as paid when there is no substantial risk of forfeiture under Section 457(f)(1)(A), and includes amounts required to be included in gross income under Section 457(f), generally (but not ROTH contributions). Remuneration for which a deduction under Section 162(m) is not allowed is not included.
A "covered employee" is an employee (including a former employee) if he or she is one of the five highest compensated employees for the tax year, or was a covered employee of the organization (or a predecessor) in any preceding tax year, beginning after December 31, 2016.
“Remuneration” paid to a licensed medical professional (which includes veterinarians) for medical or veterinary services performed by that professional is excluded. But remuneration paid for services other than for the performance of medical or veterinary services is taken into account.
Remuneration includes that paid by a related person or governmental entity ("related party"), if the related party (1) controls or is controlled by the applicable tax-exempt organization; or (2) is a person or governmental entity controlled by one or more persons who control the applicable tax exempt organization; or (3) is a supported or supporting organization (Section 509(f)(3) or Section 509(a)(3)) with respect to the applicable tax-exempt organization during the taxable year; or (4) in the case of a Voluntary Employee Beneficiary Association ("VEBA") (Section 501(c)(9)), establishes, maintains, or makes contributions to the VEBA.
An "excess parachute payment" is determined by calculating the covered person's "base amount," in accordance with rules previously established in a similar (but different) provision that disallows excess parachute payments of taxable corporations (§ 280G(d)). Essentially, the base amount is the employee's annualized includible compensation for the most recent five taxable years. An excess parachute payment is the amount of any parachute payment that exceeds the base amount (more below) allocated to that payment.
A "parachute payment" is a payment (or payments) in the nature of compensation to (or for the benefit of) a covered employee, (1) contingent on the employee's separation from employment; and (2) if the aggregate present value of the payments contingent on the separation exceeds an amount equal to three times the base amount. The term "payments" includes property transfers and contingent payments, utilizing rules under Section 280G(d)(3) and (4). Contingent compensation payments are determined using a discount rate equal to 120 percent of the "Applicable Federal Rate" under Section 1274(d), compounded semiannually.
B. UBTI Increased by Disallowed Fringe Benefit Expenses (§ 512(a)(7)). Tax-exempt organizations will include, as UBTI (taxed at 21 percent), any amount (1) for which a deduction is not allowed under Section 274 (as amended), and (2) paid by the organization for any qualified transportation fringe (§§ 132(f), 274(a)(4)), any parking facility used in connection with qualified parking (§132(f)(5)(C)), or any on-premises athletic facility (§132(j)(4)(B)). Existing provisions (those identified above, in the Section 132 references) that allow employees to treat such expenses as exempt from income tax are unaffected by the change.
"Qualified transportation fringe" benefits under Section 132(f) include transportation in a commuter highway vehicle, if between the employee's residence and place of employment; transit passes; qualified parking; and qualified bicycle commuting reimbursement. Those terms are further delineated in Section 132(f)(5).
As might be expected, the provision does not apply to the extent that the amount is paid or incurred in an unrelated trade or business that is regularly carried on, since it is reasonable to expect that the normal disallowance of such deductions will apply in that situation.
Although tax-exempt organizations in Oregon are not generally subject to the Oregon corporate excise tax, ORS 317.920 makes clear that those that have federal UBTI are. It thus appears that Oregon tax-exempt organizations subject to the new UBTI on disallowed fringe benefits will also be subject to Oregon corporate excise tax on that phantom income. This raises the issue whether foreign tax-exempt organizations that are doing business in Oregon and have UBTI from disallowed fringe benefits will be required to allocate some of the federal UBTI to Oregon and pay Oregon corporate excise tax and, if so, on what basis. (Will allocations be required simply because the entity is doing business in Oregon, or must the disallowed fringe benefits be provided to Oregon employees?) The answer to these questions presents a critical compliance issue, since it is likely that out-of-state exempt organizations that do not have Oregon-sourced UBTI are likely not currently filing an Oregon corporate excise tax return. Current Oregon corporate excise tax rates run around 7 percent.
In the 2018 edition of IRS Publication 15-B, "Employer's Tax Guide to Fringe Benefits," the IRS specifically stated that a workaround that had been proposed by some practitioners will not work. Specifically, some commentators had suggested that a way around the Section 512(a)(7) excise tax would be to increase an employee's compensation by the value of the disallowed fringe benefits (for example, disallowed transportation benefits) and allow the employee to participate in a salary-reduction agreement that would provide the employee with the option of reducing his or her salary by the same amount and using that amount, under the salary reduction agreement, to purchase the transportation benefits directly. The IRS publication states that "no deduction is allowed for qualified transportation benefits (whether provided directly by you, through a bona fide reimbursement arrangement, or through a compensation reduction agreement) incurred or paid after Dec. 31, 2017."
Interim guidance provided on the IRS website with respect to reporting the UBTI required under Section 512(a)(7) suggests that, for organizations with fiscal tax years beginning in 2017, the amount should be reported on line 12 of the 2017 form 990-T.
Repeal of Deduction for Certain Lobbying Expenses.
Former subsections 162(e)(2) and (7) have been eliminated and the remaining subsections renumbered accordingly. The subsections used to provide two exceptions to the general rule that lobbying expenses are not tax-deductible. The exceptions permitted deductions for certain lobbying before local legislatures or Indian tribal governments. These changes impact the existing Section 6033(e) obligation of exempt organizations to report such disallowed amounts on their forms 990 and to notify those making payments to such organizations that a portion of their payment is ineligible for income tax deduction. The change is effective for amounts paid or incurred after December 22, 2017.