What Not-For-Profits Need to Know About Tax Reform

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The following article is published with permission from Plante Moran, and is authored by Lynne Huismann, David Lowenthal, and Amy Ciminello. Plante Moran is one of the nation's largest certified public accounting and business advisory firms, providing clients with financial, human capital, operations improvement, strategic planning, technology selection and implementation, and family wealth management services. The original article can be found on their website here.

Provisions directly impacting exempt organizations

The following six provisions are going to have a direct impact on not-for-profit organizations.

  1. Unrelated business taxable income separately calculated for each trade or business activity
    • Current law: Losses generated by unrelated trade or business activities — i.e. those activities not substantially related to the organization’s charitable, educational, or other exemption-related function — can be used to offset income generated from other unrelated trade or business activities, if all activities are reported under the same tax-exempt filing entity, with the exception of group return filings.
    • Summary of provision: A net operating loss deduction is allowed only from the unrelated trade or business from which the loss arose.
    • Effective date: Taxable years beginning after Dec. 31, 2017.
    • Impact: For organizations with more than one unrelated trade or business, the net operating loss deduction must be determined separately for each trade or business and will not be allowed to offset income from others.
      For net operating losses arising in a taxable year beginning before Jan. 1, 2018, there is a special transition rule that exempts those losses from being subject to the rule.
      Defining the buckets of unrelated trade or businesses is not clear as the provision currently stands. More guidance will be necessary to understand allowable activity classifications.
    • To prepare: Consider whether unrelated business activities should be structured in a taxable C corporation within the tax-exempt organization structure. Taxable C corporations are not subject to the loss basketing provisions.
  2. Excise tax on tax-exempt organization executive compensation
    • Current law: Deduction limits on executive compensation exist for for-profit entities, but historically, there hasn’t been a limit for tax-exempt organizations.
    • Summary of provision: The tax reform bill imposes a tax of 21 percent on compensation to covered employees with remuneration in excess of $1,000,000, plus any excess parachute payment paid to any covered employee.
    • Effective date: Taxable years beginning after Dec. 31, 2017.
    • Impact: All tax-exempt organizations will need to identify covered employees who meet the $1,000,000 threshold.
      A covered employee means a current or former employee who: (1) is one of the five highest compensated employees of the organization for the tax year, or (2) was a covered employee of the organization (or any predecessor) for any preceding taxable year beginning after Dec. 31, 2016.
      One exception to this provision is compensation for medical services. This includes compensation paid to a licensed medical professional, including veterinarians, for providing medical or veterinary services.
      Compensation paid by related organizations is included in the calculation to determine if an individual meets the definition of a covered employee.
      Compensation paid by the organization or a related organization that is subject to substantial risk of forfeiture is not counted towards the $1,000,000 threshold. But, the tax imposed by this provision can apply to the value of compensation that is vested (and any increases in value or vested remuneration), even if it’s not yet received.
      The employer, not the employee, is liable for the tax imposed.
    • To prepare: Exempt organizations may want to consider how executive compensation arrangements are structured with respect to the excise tax.
  3. Excise tax based on investment income of private colleges and universities
    • Current law: To date, investment income of private colleges and universities hasn't been subject to an excise tax.
    • Summary of provision: The tax reform bill imposes a tax equal to 1.4 percent of net investment income of an applicable institution for the taxable year.
    • Effective date: Taxable years beginning after Dec. 31, 2017.
    • Impact: Educational institutions must determine if they fall under the provision.
      Applicable institutions are defined as
      1. Those having at least 500 tuition-paying students during the preceding taxable year
      2. Those having more than 50 percent of tuition-paying students located in the United States
      3. Any college or university that is not defined as a state college or university
      4. Those with an aggregate fair market value of assets (other than those assets used directly in carrying out the institution’s exempt purpose) of at least $500,000 per student at the end of the preceding taxable year
    • To prepare: Determine whether your organization, and any related organization, meets the definition of applicable institution. If so, you can calculate the impact based on assets and net investment income.
  4. Repeal of substantiation exception in case of contributions reported by the donee
    • Current law: Donors are required to obtain a contemporaneous written acknowledgment for contributions of $250 or more. A potential exception included in the Internal Revenue Code would allow donors to avoid obtaining this acknowledgment if the donee files a certain required tax return under a process to be defined in regulations. To date, final regulations providing such a process have not been issued.
    • Summary of provision: The bill repealed this exception; an alternate filing by the donee cannot substitute for a written acknowledgment.
    • Effective date: Applies to contributions made in taxable years beginning after Dec. 31, 2016.
    • Impact: Substantiation for any contribution of $250 or more is still required for taxpayers to take a deduction for the contribution on their tax return. The taxpayer must substantiate the contribution with a contemporaneous written acknowledgment of the contribution by the donee organization that includes:
      1. The amount of cash and description (but not value) of any property other than cash contributed.
      2. Whether the donee organization provided any goods or services in consideration, in whole or in part, for any property.
      3. A description and good faith estimate of the value of any goods and services provided in exchange for any contribution.
  5. Repeal of deduction for amounts paid in exchange for college athletic event seating rights
    • Current Law: In general, payments to a charity are not deductible when a taxpayer receives or expects to receive a substantial return benefit. But, special rules apply to certain payments to higher education institutions if the payor receives the right to purchase tickets for or seating at an athletic event, allowing a portion of the payment to be treated as a deductible charitable contribution.
    • Summary of provision: No charitable deduction may be taken for any amount if the payor receives the right to purchase tickets for or seating at an athletic event.
    • Effective date: Applies to contributions made in taxable years beginning after Dec. 31, 2017.
  6. Unrelated business taxable income increased by amount of certain fringe benefit expenses for which deduction is disallowed
    • Current Law: No current provision exists.
    • Summary of provision: Unrelated business taxable income will be increased by any expenses paid or incurred by a tax-exempt organization for a qualified transportation fringe benefit, a parking facility used in connection with qualified parking, or any on-premises athletic facility provided such amounts are not deductible as business expenses.
    • Effective date: Effective for amounts paid or incurred after Dec. 31, 2017.

Provisions indirectly impacting exempt organizations

These six provisions are expected to impact many exempt organizations in indirect ways:

  1. Standard Deduction
    • Current law: The standard deduction for individual taxpayers on Form 1040 in 2017 is $6,350/$12,700 for single and married filing jointly, respectively.
    • Summary of provision: The standard deduction for individual taxpayers on Form 1040 in 2018 will be $12,000/$24,000 for single and married filing jointly, respectively.
    • Effective date: Taxable years beginning after Dec. 31, 2017.
    • Impact: Taxpayers reduce their income by the greater of their standard deduction or itemized deduction. It's projected that with the higher standard deduction, fewer taxpayers will itemize, and itemized deductions include charitable contributions. Many philanthropy experts fear charitable contributions will decline due to the loss of the specific charitable contribution deduction.
    • To prepare: Analyze donations to determine whether your organization receives significant numbers of smaller donations from middle-class individuals, who may need additional incentive to give absent the charitable contribution deduction.
  2. Increased estate and gift tax exemption
    • Current law: The federal estate and gift tax unified credit exclusion amount is currently $5.49 million per person, with estates taxed at rates up to 40%. Bequests to charitable organizations are allowed to reduce the amount of an individual's estate that is subject to tax.
    • Summary of provision: The bill increases the exclusion to $10 million, adjusted for inflation. It is projected to be approximately $11 million for the 2018 tax year.
    • Effective date: The exclusion is increased for descendants dying, and gifts made, after 2017 and before 2026.
    • Impact: Philanthropy experts were concerned about the possibility of the estate tax being eliminated, as they projected that the repeal would have significantly reduced the incentive to make bequests to charitable organizations. There is still concern that the increased exclusion amount, although temporary, may also reduce the use of charitable bequests in estate planning.
  3. Increased charitable contribution limitation
    • Current law: Individuals (and some trusts) may donate up to 50 percent of the taxpayer's adjusted gross income to charity. Amounts in excess of the limits are carried over for up to five years.
    • Summary of provision: Individuals (and some trusts) will be able donate up to 60 percent of the taxpayer’s adjusted gross income to charity, and amounts in excess of the limits are carried over for up to five years.
    • Effective date: Effective for taxable years beginning after Dec. 31, 2017.
    • Impact: Taxpayers who regularly meet or exceed charitable contribution limits will be able to donate more.
    • To prepare: Organizations should be sure to identify generous donors who may be even a bit more generous under the new provision.
  4. Reduced barriers on medical expenses
    • Current law: Individuals can deduct medical expenses in excess of 10 percent of the adjusted gross income.
    • Summary of provision: Individuals will be able to deduct medical expenses in excess of 7.5 percent of adjusted gross income during the 2017 and 2018 tax years. For tax year 2018 and thereafter, medical expenses will not be added back to the alternative minimum tax calculation.
    • Effective date: Effective for taxable years beginning after Dec. 31, 2016 and ending before Jan. 1, 2019. The alternative minimum provision is effective for taxable years beginning after Dec. 31, 2017.
    • Impact: Medical expenses will be more easily deductible because of the lower 7.5 percent threshold and decoupling of expenses from the alternative minimum tax.
    • To prepare: Senior care and healthcare organizations that bill individual taxpayers have an opportunity to market the improved tax impact of payment for services.
  5. Potential reduction in state budgets
    • Current law: Individuals can deduct an unlimited amount of state and local taxes.
    • Summary of provision: Individuals will only be able to deduct up to $10,000 of state and local taxes.
    • Effective date: Effective for taxable years beginning after Dec. 31, 2017.
    • Impact: Many economists view the state and local tax deduction as an indirect subsidy by the federal government. There is concern now that, absent this subsidy, state and local governments will find it harder to increase taxes on individual taxpayers. This could lead to funding shortages in state and local governments and corresponding cuts to social service programs.
    • To prepare: Social service organizations in states with known financial issues should keep close watch on their state and local funding sources and be prepared to seek out alternate funding sources if necessary.
  6. Reduced corporate and unrelated business income tax rate
    • Current law: The corporate tax, including the tax on unrelated business income, is subject to a progressive rate structure from 15 percent to 35 percent.
    • Summary of provision: The corporate tax, including the tax on unrelated business income tax, will be subject to a flat rate of 21 percent.
    • Effective date: Effective for taxable years beginning after Dec. 31, 2017.
    • Impact: Organizations that have more than $100,000 of net unrelated business taxable income may be in for a significant tax cut.
    • To prepare: Consider the impact of potentially lower rates with the offsetting limitation of netting activities with a gain and with a loss under the UBI basketing rule.

Provision that didn't make the cut As the tax reform legislation made its way through Congress over the past few months, several provisions were proposed in earlier iterations that ultimately didn't make it into the final bill. Key provisions you may have heard — and had concerns — about but that were eliminated include:

  • Under the House bill, the tax-exempt status of qualified private activity bonds would have been repealed. The exempt status of these bonds was retained in the conference bill.
  • The House bill would have changed the 2 percent excise tax on private foundation investment income (1 percent if the foundation continually increases its percentage of grants paid, compared to its asset value, over time) to a flat 1.4 percent.
  • The House bill proposed eliminating the prohibition on charitable organizations participating or intervening in political campaigns on behalf of, or in opposition to, any candidate for public office — a.k.a. the "Johnson amendment." Since the amendment wasn't included in the final bill, charitable organizations remain subject to the prohibition against political activities.
  • The House bill included a provision that would have eliminated an exclusion of qualified tuition reductions for certain education provided to employees (and spouses and dependents) of certain educational organizations from employees’ income, thereby making the value of free or reduced tuition taxable to employees.
  • Current law provides an exclusion from unrelated business income for all research carried out by an exempt organization operated primarily for purposes of conducting fundamental research, the results of which are freely available to the general public. The House bill would have applied this exclusion only to income from fundamental research results that are freely available to the public. The existing exclusions from unrelated business income for certain other types of research income remain in place.
  • Sponsoring organizations that hold donor-advised funds (DAFs) typically allow donors to make recommendations for distribution of the funds. These recommendations, however, are subject to overall control by the sponsoring organization. Although currently no distribution requirement exists for DAFs, Congress has historically expressed concern about little to no charitable distributions being made from the funds over time.
  • The House bill sought to require sponsoring organizations to include information on their Form 990 disclosing information about: (1) the average amount of grants made from DAFs during the year, as a percentage of the value of assets held, as well as (2) whether the organization has a DAF policy on the frequency and minimum level of distributions from funds. Sponsoring organizations would have been required to attach a copy of its policy to its Form 990.

Exempt organizations have a lot of digesting and analysis to do when it comes to tax reform. You'll need to fully understand both the direct and indirect impacts of the provisions as well as how to prepare — quickly, in many cases — to minimize (or amplify) the impact.
As always, if you have any questions, feel free to give us a call.