Tax Reform’s Effect on Tax-Exempt Organizations
Author: Rebekuh Eley
As year-end approaches, tax reform remains a priority for President Donald Trump and congressional Republicans. At this point, many details of what may ultimately become new tax law were revealed in the release of the Tax Cuts and Jobs Act of 2017 (TCJA) by the House on November 6 and Senate on November 9. However, several opportunities exist that could alter the bill’s course before the targeted Christmas deadline for President Trump’s signature. The provisions contained in the current versions of the House and Senate bills aren’t likely to be the same as what might ultimately be enacted.
If enacted, the following provisions within the bills may have a significant effect on exempt organizations.
Excise Tax on Executive Compensation
Both the House and Senate bills would create a 20 percent excise tax on compensation in excess of $1 million paid to any of an exempt organization’s five highest-paid employees. The tax also would apply to the portion of parachute (or separation) payments three times greater than the five-year average of the employee’s salary. Parachute payments don’t include retirement benefits. This tax would be imposed on all forms of compensation, including noncash benefits, except for payment to tax-qualified retirement plans and amounts otherwise excludible from gross income.
Private College & University Excise Tax
Private colleges and universities would be subject to a 1.4 percent excise tax on net investment income under the new law proposed by the House and Senate. This provision only would apply to institutions with 500 or more students—clarified by the Senate as tuition-paying students—and assets with a value of at least $250,000 per full-time student, not including those directly used in carrying out the institution’s educational purpose. The income and assets of organizations related to the university also are included in the calculation of net investment income and asset-per-student threshold.
Additional Reporting for Donor-Advised Funds
The House bill would require sponsoring organizations to annually disclose on the Form 990 the average amount of grants made from donor-advised funds and their policies with respect to the frequency and minimum level of distributions from those funds. This policy would be included on the Form 990.
Private Foundation Excise Taxes
The House bill includes several provisions applicable to private foundations. First, the two-tier excise tax rate system on private foundations would be eliminated. Instead, a single rate of 1.4 percent would apply to the foundation’s net investment income.
The House proposal imposes additional requirements for an operating foundation that functions as an art museum. To qualify as an operating foundation, the museum must be open to the public during normal business hours and for at least 1,000 hours during the taxable year.
The last House proposal affecting private foundations is an exception to the excess business holdings rules for philanthropic business holdings. The excess business holdings tax would not apply if:
- The private foundation owns 100 percent of a donated business
- All profits are distributed annually to the private foundation
- The operations are independent with respect to any overlap of the business’s board with the private foundation’s board and substantial contributors
Also, loans from the business to the substantial contributor would be prohibited. The proposal makes it clear this exception only is for private foundations and wouldn’t apply to donor-advised funds or supporting organizations.
Private Activity Bonds
Another provision likely to have an indirect effect on tax-exempt entities concerns private activity bonds (PAB). Under current law, PAB proceeds are used to finance the activities of private parties while the state or locality that issues the bond enjoys indirect benefits. PABs must fall under specific categories to qualify for this tax-exempt status, e.g., small issue bonds, exempt facility bonds, mortgage bonds and 501(c)(3) bonds. If the House bill is enacted, interest on all PABs issued after 2017 would be included in income and subject to tax. This provision would not affect previously issued bonds.
The House bill would remove the limitation that tax-exempt entities must refrain from “participating in, or intervening in” political campaigns as long as such political speech is in the ordinary course of the organization’s business and any associated expenses are minimal. This provision would be effective for tax years beginning after December 31, 2018, and expire after December 31, 2023.
Unrelated Business Income
Both the House and Senate bills include several provisions for unrelated business income (UBI). The House bill clarifies UBI will be applicable, although the income would otherwise be excluded under a different code section, such as income derived by an essential government function. Research income only would be excluded for research that makes its results freely available to the public. The current exclusion for research performed for government agencies or research performed by colleges, universities or hospitals for any person would be removed.
Both the House and Senate noted the effect of aggregating gross income and deductions in the UBI calculation. Specifically, this occurs when the loss from one activity is used to offset the income from another. The House bill addresses this by proposing UBI be increased by the amount of certain fringe benefit expenses for which a deduction is disallowed. This includes expenses for qualified transportation fringe benefits, parking facilities used in connection with qualified parking or any on-premises athletic facility. The Senate bill addresses the aggregation “issue” by proposing income and losses be calculated on an activity basis. The loss from one activity can’t offset the income from another. The loss may be carried forward to be used on any future net income for that activity.
Both the House and Senate bills propose to increase the charitable deduction limitation for cash contributions from 50 percent of adjusted gross income to 60 percent. There also are several other provisions dealing with individual limitations and deductions beyond this article’s scope that would need consideration when assessing the effect of this proposal.
Donations to colleges and universities in exchange for the right to purchase tickets or seating at an athletic event would not be considered deductible contributions under either proposal.
The House bill includes a provision to change to the standard mileage rate versus the charitable mileage rate in determining the charitable deduction for charitable travel.
Excess Benefit Transaction
The Senate bill proposes several changes to the excess benefit rules that would penalize the organization and its managers. If a disqualified person is subject to the initial tax under the immediate sanctions rules, the organization also would be subject to a 10 percent excise tax on the excess benefit. There would be opportunities to abate this tax if participation in the transaction wasn’t willful and due to reasonable cause. The organization would need to establish minimum due diligence standards or other reasonable standards.
The minimum due diligence standards would replace what was previously the rebuttable presumption of reasonableness contained within the intermediate sanctions rules. Currently, the rebuttable presumption of reasonableness standards are approval of the transaction by an independent governing body, a comparability factor and adequate documentation of the decision. Under the proposal, these standards would be considered the minimum standards and wouldn’t result in a presumption of reasonableness, meaning the organization should do more than the minimum.
Managers also would be subject to the excise tax unless they didn’t knowingly participate in the transaction. Previously, reliance on professional advice meant the manager didn’t knowingly participate. The Senate proposal eliminates this provision, but specifies that professional advice is a relevant consideration in determining if the manager knowingly participated in the transaction. The special rule that a manager that doesn’t act knowingly because he or she relied on the rebuttable presumption of reasonableness standards was eliminated.
The Senate proposal modifies the definition of “disqualified person” to include college and university athletic coaches and investment advisors to donor-advised funds.
Intermediate sanctions rules also would be applicable to Internal Revenue Code Section 501(c)(5) for labor and certain other organizations and 501(c)(6) for business leagues and certain other organizations.
Repeal Exemption for Sports Leagues
The proposed Senate bill repeals the provision that recognized professional sports leagues as 501(c)(6) organizations. The bill takes this one step further to specifically state that section 501(c)(6) “shall not apply to any professional sports league.”
For more detail on some of the provisions included in the House bill, see our November BKD Thoughtware® alert. While the TCJA is likely to face substantial changes before enactment, the possibility of repeal or modification of existing tax breaks makes this a good time to discuss your tax plan and adapt it as tax reform details develop. Our National Office tax team is actively tracking these developments and updating BKD’s Tax Reform Resource Center to share the effects of tax reform-related events as they unfold.