What changes from the passing of the Tax Cuts and Jobs Act (TCJA) on December 22, 2017, will affect your organization? Truth be told, if you’re uncertain, you’re not alone. Fortunately, your trusted advisors at BKD have been busy dissecting changes to the tax law and identifying issues that may impact your organization.
The U.S. Congress, with the TCJA’s passage, has attempted to put not-for-profit organizations on equal footing with for-profit organizations. This article will identify those changes that attempt to bring parity among not-for-profit and for-profit organizations, as well as focus on the top five issues we believe may affect your not-for-profit organization.
It’s widely speculated that changes to the Internal Revenue Code (IRC) that affect individual and estate taxpayers will negatively impact the amount of contributions not-for-profit organizations receive.
Regarding individual taxpayers, the TCJA increased the standard deduction most individual taxpayers are provided to reduce their taxable income if they don’t otherwise itemize their deductions. Under IRC Section 63(c), the standard deduction for taxable years 2018 through 2025 for taxpayers who file as single or married filing separately increased from $6,500 to $12,000; the standard deduction for taxpayers filing as head-of-household increased from $9,550 to $18,000; and the standard deduction for taxpayers who file as married-filing-jointly increased from $13,000 to $24,000. There’s an additional standard deduction of $1,600 for unmarried taxpayers and $1,300 for married taxpayers who are over age 65 or blind.
In addition to the increase in the standard deduction, there were changes to how the itemized deduction is calculated. The most significant change affects taxpayers who itemize their deductions and claim a deduction for state and local taxes paid. This deduction will be limited to $10,000 beginning in 2018. This deduction is the aggregate of (1) state and local real and personal property taxes and (2) state and local income taxes (or state and local sales tax paid, if higher). Another significant change was the elimination of itemized deductions in excess of 2 percent of adjusted gross income. Typical deductions reported here stem from unreimbursed employee business expense, tax preparation fees and investment advisory fees. Lastly, a change for the positive: The Pease limitation, which reduced the amount of itemized deductions by the lesser of (1) 3 percent of the adjusted gross income above a threshold or (2) 80 percent of the amount of the itemized deductions otherwise allowable for the tax year, has been eliminated.
Another positive change is that the cash contribution limitation to qualifying organizations has increased from 50 to 60 percent of adjusted gross income for tax years starting after December 31, 2017. This provision sunsets in 2026.
Regarding estates, the amount an estate can exclude from the estate tax has temporarily doubled from $5.6 million to $10 million under IRC §2010.
With the increase in the standard deduction and the ability to itemize fewer deductions, it’s thought individual taxpayers who are motivated to give to a charitable organization because of the tax deduction received will be less likely to give in the coming years. On the same notion, estates that can use the increase in the basic exclusion amount may be less inclined to give to a charity as the estate may not receive a tax benefit. At this point in time, the effect on not-for-profit organizations is purely speculative. Not-for-profit organizations should review any impact by monitoring their overall cash flow from contributions.
Excise Tax on Executive Compensation
The TCJA created a bright-line test to determine excess compensation paid to employees. Under IRC §4960, an excise tax at a flat rate of 21 percent is imposed on a not-for-profit organization with a “covered employee” whose taxable compensation exceeds $1 million or who receives excess parachute payments. This is the first attempt to bring parity between not-for-profit and for-profit organizations as publicly traded corporations generally can’t deduct compensation to certain covered employees in excess of $1 million to each covered employee.
“Covered employee” is defined as one of the organization’s five highest-compensated employees for the taxable year, or an employee who was a covered employee of the organization for any preceding taxable year beginning after December 31, 2016. Compensation from a related organization is included in determining who is a covered employee and in the calculation of the excise tax liability.
Compensation that will be included in this calculation will include taxable wages and taxable distributions from a nonqualified retirement plan. Nontaxable compensation includes payments under a qualified retirement plan, simplified employee pension plan, a simple retirement account, a tax-deferred annuity such as a §403(b) plan or an eligible deferred-compensation plan of a state or local government employer such as a §457(b) plan.
Excess parachute payments are payments contingent on the employee’s separation from the employment. In determining if an excess parachute payment has been made, an organization will establish a base by averaging the employee’s taxable compensation for the preceding five years and multiplying by three. If the present value of the severance payment equals or exceeds three times the base amount, an excess excise tax at the flat rate of 21 percent will be imposed on the organization. Exclusions apply for medical professionals providing medical services to an organization.
The effect on a not-for-profit organization may be significant from an economic standpoint but also from a personnel perspective, as organizations may have a difficult time recruiting and retaining top employees due to possible budget constraints.
Organizations should evaluate their compensation practices to determine the additional cost of awarding nonqualified deferred compensation plans to employees, as these plans often move compensation in excess of the $1 million threshold. An organization may be able to mitigate burden by managing the timing an employee is vested in a nonqualified plan.
Organizations that offer severance packages should evaluate if the additional tax will apply prior to remittance.
Computation of Unrelated Business Taxable Income
A not-for-profit organization that reports multiple unrelated trade or businesses will see changes to how unrelated business taxable income (UBTI) is calculated on its Form 990-T beginning in 2018. Under §512(b)(12), UBTI for each trade or business is calculated separately. After the UBTI is determined, the organization will sum the positive UBTI for each trade or business to arrive at a total UBTI, which will be multiplied by the new flat rate of 21 percent after taking the specific deduction of $1,000.
Note that the calculation is aggregating positive UBTI. Any unrelated trade or business reporting net losses can’t offset the net income from the other trade or business. Previously, organizations were allowed to net the losses against the net income from multiple trades or businesses.
Net operating loss (NOL) created by a trade or business will be allowed, along with NOL deduction only with respect to that specific trade or business activity. The result of the provision is that organizations must calculate UBTI in a fictional silo. Deductions from one trade or business for a taxable year may not be used to offset income from a different unrelated trade or business for the same taxable year. An activity loss can be carried forward to offset the income from that specific trade or business in a future year.
Further guidance is needed around the definition of “activity.” An organization that earns advertising revenues, has debt-financed income from rental real estate and has three alternative investments has two distinct activities in the advertising and rental real estate. However, it’s less clear how the alternative investments will be treated—will they constitute one activity or three separate activities? Stay tuned for future insights on this topic as soon as the IRS provides additional guidance.
NOLs incurred in tax years ending after December 31, 2017, have an indefinite carryover (an organization can no longer carryback its NOL). NOLs incurred in tax years beginning after December 31, 2017, are limited to 80 percent of taxable income.
A not-for-profit organization planning for these changes should identify each of its trades or businesses and compute the tax effect without the offset of losses. Be mindful that each alternative investment may constitute a separate activity. Organizations with NOLs may have taxable income due to the 80 percent limitation. Organizations that were previously taxed at a 15 percent rate will see a 6 percent increase in taxes owed. However, organizations whose marginal rate is 25 percent or higher can expect a lower tax bill.
UBTI Includes Certain Fringe Benefits
For-profit business also can no longer deduct the cost of providing qualified transportation fringes and other transportation benefits under IRC §274(a)(4). Conversely, not-for-profit organizations must include the cost of providing qualified transportation fringes in their calculation of unrelated business income tax (UBIT) under IRC §512(a)(7). In addition, any on-premises athletic facility must be included in an organization’s UBIT calculation, provided such amounts aren’t deductible under IRC §274.
As of now, on-premises athletic facilities aren’t specifically listed as disallowed deductions under IRC §274 and are therefore not included in UBIT.
IRC §132(f) defines qualified transportation fringes as (1) commuter transportation (between the employee’s home and place of employment) in a commuter highway vehicle, including van pools; (2) transit passes; (3) qualified parking; and (4) qualified bicycle commuting reimbursement.
Not-for-profit organizations will need to evaluate their qualified transportation fringe benefits paid for on behalf of the employees. Qualified parking is probably the most common benefit provided. As such, not-for-profit organizations should assess whether to include the benefits in an employee’s taxable wages or include the benefits on Form 990-T.
Tax-Exempt Bond Financing
Not-for-profit organizations will need to pay close attention to the timing of redemption for their bond refunds to ensure the refunding is classified as current versus advanced, as the income exclusion from gross income for interest on advance refunding bonds was repealed under IRC §103.
A current refunding bond is one for which the refunded bond is redeemed within 90 days of issuing the refunding bond. An advance refunding bond, on the other hand, is one for which the refunding bond is issued more than 90 days before the redemption of the refunded bond.
Congress believes the ability to issue advance refunding bonds allows state and local governments to issue—and have outstanding—two sets of federally subsidized debt associated with the same activity. Furthermore, Congress thought a single activity should have a maximum of only one set of federally subsidized debt, and it removed the ability to issue tax-advantaged advance refunding bonds.
Our March 2018 article “Tax Law Eliminates Advance Refunding” offers further information on this topic. Watch for additional BKD insights as the IRS provides more guidance, and contact Ed or your trusted BKD advisor with questions.