On December 22, 2017, President Donald Trump signed the Tax Cuts and Jobs Act (TCJA) into law. The TCJA represents one of the most significant revisions to the Internal Revenue Code (IRC) in more than 30 years. Many provisions took effect January 1, 2018, and the TCJA will affect virtually all U.S. taxpayers. Higher education institutions are no exception.
In this article, we’ll spotlight what we believe are the top five tax reform provisions that will affect a significant number of higher education institutions. You’ll find a brief overview of each provision and see a consistent theme that additional guidance is needed in several areas. The American Institute of CPAs recently formally requested immediate guidance on 39 different TCJA provisions to allow taxpayers to appropriately comply with 2017 tax obligations and make informed business and tax planning decisions. The U.S. Department of Treasury and the IRS subsequently released an updated 2018 priority guidance plan listing 18 TCJA-related items they intend to focus on initially. In future BKD insights, we’ll dive deeper into each of the provisions, highlight ongoing developments and discuss planning opportunities.
1. Charitable Contributions
Several provisions were adopted that may affect the amount and type of charitable contributions higher education institutions will receive.
The first provision, which is scheduled to sunset December 31, 2025, is the increased standard deduction amount for individual filers. The standard deduction increased from $12,700 to $24,000 for married taxpayers filing jointly and from $6,350 to $12,000 for single filers. With this change, it’s expected more individual taxpayers will use the standard deduction instead of itemizing their deductions, which is how they claim their charitable contributions.
For individual taxpayers who choose to itemize their deductions, in tax years beginning after December 31, 2017, and before January 1, 2026, the allowable charitable deduction for cash gifts is 60 percent of adjusted gross income, which is an increase from the 50 percent limitation under previous law.
In addition, the special rule that allowed an 80 percent deduction of the amount paid to institutions for the right to purchase tickets to athletic events was repealed. This provision is expected to increase revenue by approximately $2 billion over the next 10 years.
The value of an estate excluded from estate tax also was increased under the TCJA. Starting in 2018, the exemption per person increased to $11.18 million from the 2017 amount of $5.6 million. The increased exemption amount will be adjusted annually by inflation but is effective only through December 31, 2025. Designating a gift to a charitable organization is one way to reduce the value of a taxable estate. However, the increased exemption amount under the new law may leave charities out of future estate plans.
It’s likely to be several years before higher education institutions can analyze the effect the changes mentioned above will have on charitable giving.
2. Excise Tax on Excess Tax-Exempt Organization Executive Compensation
Under IRC Section 4960, an excise tax will be imposed on excess tax-exempt organization executive compensation, effective for tax years beginning after December 31, 2017. The excise tax will be 21 percent of the remuneration paid by an applicable tax-exempt organization—and all related organizations—to any covered employee in excess of $1 million plus any excess parachute payment paid by the organization to any covered employee. Covered employees include the organization’s five highest-compensated employees for the taxable year and any employee who was a covered employee of the organization for any preceding taxable year beginning after December 31, 2016.
While the excise tax on compensation exceeding $1 million should be relatively straightforward to monitor, the excess parachute payment may be less clear. This provision applies without regard to the $1 million threshold when a parachute payment exceeds three times the average annualized compensation to the employee for the five taxable years ending before the date of separation. There are other nuances to this provision we’ll explore further in future insights. If your organization is entering into a separation agreement with a highly compensated employee, this is a provision you should study further to understand its potential implication.
Organizations also should consider the effect of this excise tax on nonqualified deferred compensation arrangements. The excise tax can apply to the value of this remuneration when the deferred amounts are no longer subject to a substantial risk of forfeiture. Covered employees who are normally under the excise tax threshold may be pushed over in years with significant amounts vesting. Careful planning may be necessary to manage this new tax.
You might have noticed a trend of revenue-raising provisions directed at tax-exempt organizations, and this is no exception. The estimated budget effect of this provision over the next 10 years is $1.8 billion.
3. Computation of Unrelated Business Taxable Income
Several provisions were adopted that will change the way unrelated business taxable income (UBTI) and tax are calculated going forward. The first provision replaces the graduated corporate rate structure with a flat
21 percent corporate rate, effective for taxable years beginning after December 31, 2017. Special blended rate rules apply to the 2017 tax return for fiscal year corporations with years ending in 2018.
For institutions that typically reported UBTI of more than $335,000, this change represents a 13 percent rate reduction (14 percent if more than $18.3 million). For institutions reporting a lesser amount of UBTI, the change could actually represent a rate increase. For example, institutions with $50,000 of UBTI previously would have paid tax at a 15 percent rate, so they will see a 6 percent rate increase.
This provision represents the single largest cut under the TCJA with an estimated revenue loss of $1.3 trillion over the next 10 years. Higher education institutions represent a small part of this estimated effect.
Second, under IRC §512, UBTI will be computed separately with respect to each trade or business activity for organizations with more than one unrelated trade or business. Therefore, losses from one unrelated activity won’t be allowed to offset profits from another. This is a revenue-raising provision with an estimated budget effect of $3.5 billion over the next 10 years.
Additional clarity around the definition of an “activity” will be helpful for this particular provision. It seems fairly clear that a higher education institution with UBTI from a bookstore and alternative investments would constitute activities that must be separately tracked. However, the decision becomes less clear when an institution has multiple alternative investments that receive a Schedule K-1. Questions remain about whether each K-1 will need to be separately tracked or if alternative investments can constitute one activity by grouping them, similar to the passive activity rules for individual taxpayers under IRC §469. Having to separately track each investment will create additional work for higher education institutions. Watch for future insights on this topic as additional guidance becomes available.
Third, a provision to limit the net operating loss (NOL) deduction to 80 percent of taxable income for losses arising in taxable years beginning after December 31, 2017, was put in place. It also repeals the two-year carryback of NOLs and 20-year carryforward and instead allows indefinite carryovers.
For organizations that report NOLs on Form 990-T, tracking NOLs will become more complicated, as losses incurred prior to December 31, 2017, will be separately tracked from losses incurred after that date. The requirement to separately report unrelated trade or business activities also will complicate the application of NOLs.
This provision is one of the most significant revenue generators in the TCJA. It has widespread applicability, with an estimated budget effect of $201.1 billion over the next 10 years. Higher education institutions will be a small part of this overall budget effect.
4. UBTI Increased by the Amount of Certain Fringe Benefits
Under this provision, UBTI includes any expenses paid or incurred by a tax-exempt organization for qualified transportation fringe benefits, a parking facility used in connection with qualified parking or any on-premises athletic facility, provided such amounts aren’t deductible under IRC §274. As of now, on-premises athletic facilities aren’t specifically listed as a disallowed deduction under IRC §274 and, therefore, aren’t included in UBTI.
This is one of the most overlooked TCJA provisions, as it could affect nearly all higher education institutions that provide parking to employees. Many organizations could be required to file Form 990-T, Exempt Organization Business Income Tax Return, for the first time. In addition, with the separate tracking of unrelated activities and NOL changes discussed above, organizations may not have losses available to offset this income.
Questions remain about how to calculate the increase to UBTI for disallowed fringe benefits. If an employer owns a parking garage but doesn’t charge students or employees for parking, does this create UBTI for the employee parking? If so, how is the amount determined? If a tax-exempt organization includes an otherwise excludable transportation fringe in an employee’s gross income, will it avoid UBTI treatment? These are all questions we’ll be monitoring and discussing in more detail in future insights as additional guidance becomes available.
This is another revenue-raising provision, but its estimated budget effect wasn’t separately stated from a related provision, which disallows for-profit organizations’ deduction for the fringe benefits listed above. The total estimated budget effect for the loss of the for-profit deduction and increase in UBTI is $17.7 billion over the next 10 years.
5. Excise Tax on Investment Income
This provision imposes a 1.4 percent excise tax on the net investment income of certain private colleges and universities for tax years beginning after December 31, 2017. This tax applies to institutions with at least 500 tuition-paying students—more than 50 percent of whom are located in the U.S.—and assets of at least $500,000 per student. The number of students is based on the daily average number of full-time equivalent students.
The assets considered in this calculation are those not used directly in carrying out the institution’s exempt purpose. For this calculation, assets such as classroom buildings and physical facilities would be excluded. Assets of related organizations also are included in this calculation. Related organizations include controlled or controlling organizations and supported or supporting organizations. Unless the related organization is controlled by the institution or is a supporting organization, only restricted or earmarked assets are included in this calculation.
Questions remain on how income and deductions for this tax will be calculated and how to document the assets that are used to carry out the institution’s exempt purpose.
The estimated budget effect of this provision over the next 10 years is $1.8 billion. This provision is expected to apply to approximately 30 private colleges and universities.
While we’ve attempted to identify the five tax reform provisions most relevant to higher education institutions, there may be other provisions important to your institution. Other tax reform topics you may be interested in include, but aren’t limited to:
- Repeal of the exclusion from gross income for interest on advance refunding bonds
- Effect of net interest expense limitations on UBTI calculations
- Effect of pass-through deduction on charitable trusts holding UBTI investments
- Effect of certain depreciation provisions on UBTI calculations
If you have questions about tax reform, contact Nicole or your trusted BKD advisor. Also, stay tuned for future insights and be sure to visit BKD’s Tax Reform Resource Center.