Tax Reform Implications for Exempt Organization Employers and Employees
For an update on tax reform for exempt organizations, read our article New Guidance Helps Clarify Tax Reform for Exempt Organizations.
On December 22, President Donald Trump signed the most significant tax reform legislation in more than 30 years. While the overhaul has wide-ranging implications throughout American business and society, numerous provisions will affect tax-exempt organizations, including public charities, social welfare organizations, colleges and universities, nonprofit health care organizations, associations, and private foundations.
Key provisions for tax-exempt organizations
- Potential impact on contributions: Perhaps the greatest uncertainty for many charitable organizations is the potential impact on contribution revenue as a result of the increase in the standard deduction and the lowering of tax rates. The Urban-Brookings Tax Policy Center estimates that, while only 26 percent of taxpayers itemized their deductions in 2017, those taxpayers were responsible for 82 percent of charitable giving.
Under the 2017 Tax Act, charitable donations may decrease to the extent that donors are motivated by tax incentives. For example, the standard deduction for married taxpayers filing a joint return increases from $12,700 in 2017 to $24,000 in 2018. The Tax Policy Center estimates that the number of taxpayers who file itemized deductions could drop by almost 40 million by 2019.
- Estate tax exclusion: After December 31, 2017, the estate tax exclusion doubles from $5.6 million to $11.2 million, adjusted for inflation. Combined with reductions in individual tax rates, charitable giving may be of decreased importance for estate planning purposes.
- Limits on deduction for contributions: For tax years after December 31, 2017, the deduction for contributions of cash to public charities and certain other organizations is limited to 60 percent of the individual donor’s adjusted gross income (AGI). Such contributions were previously limited to 50 percent of AGI. The 20, 30, and 50 percent limitations applicable to other donations are unaffected by the new law.
- Change in corporate tax rate: Changes in the corporate tax rate will apply to unrelated business income (UBI). Previously, the rate was only 15 percent on the first $50,000 of taxable income, and it gradually increased to 35 percent. Under the new law, UBI is subject to a flat rate of 21 percent. Nonprofit organizations with net taxable income below approximately $91,000 will experience a tax increase rather than a decrease. For example, a nonprofit reporting $50,000 of net taxable income will see its tax liability increase from $7,500 to $10,500, while an organization reporting $91,000 of net taxable income will see its tax liability decrease from $19,190 to $19,110. The change in tax rates does not apply to tax-exempt organizations established as a trust.
- Separate reporting of taxable income: For tax years beginning after December 31, 2017, nonprofit organizations that report income from more than one unrelated trade or business must compute the net taxable income from each activity separately. Losses from one activity cannot be used to reduce taxable income from another activity. However, the $1,000 specific deduction applies to the combined net income of the organization’s activities, not to each activity separately. Organizations should exercise care when calculating quarterly estimated payments and extension payments.
- Changes in rules for net operating losses: Net operating losses (NOL) generated in tax years beginning before January 1, 2018, may continue to be applied against any UBI, subject to the 20-year carry-forward limitation. However, NOLs generated in tax years beginning after December 31, 2017:
- May not be carried back to prior years;
- May be carried forward indefinitely;
- May only be applied against the same unrelated activity that generated them; and
- May only be used to offset 80 percent of taxable income.
For example, an organization has a net loss on its periodical advertising of $10,000 (Form 990-T Schedule J) and net income of $5,000 from rental income from debt-financed property (Form 990-T, Schedule E). Previously, the organization would report an NOL of $5,000 that could be carried forward 20 years and applied against any type of UBI activity. Under the new law, the organization will report $5,000 of taxable UBI and an NOL of $10,000 that can be carried forward indefinitely, but that can only be applied against net income from periodical advertising.
- An end to certain employer deductions: Certain fringe benefits are no longer deductible by employers, including commuter transportation, mass transit passes, parking facilities, and onsite athletic facilities (gym, pool, tennis court, golf course, etc.). Tax-exempt organizations that provide such benefits must report the expenditure as UBI unless the benefit is directly connected with a taxable activity already included on Form 990-T. The Treasury Department is expected to issue regulations regarding the appropriate calculation. Note that such benefits are still excludible from the employee’s income.
- New rules for bike-riding employees: Bicycle commuting benefits are still deductible by the employer, but they are now included in the taxable income of the employee. Therefore, such an expenditure is not reported as UBI.
- Contemporaneous written acknowledgement of contributions: A donor wishing to deduct a charitable contribution of $250 or more must obtain a contemporaneous written acknowledgement from the organization receiving the donation. Previously, if the donor failed to retain a copy of the acknowledgement, the donor could attempt to substantiate the donation using the donee’s Form 990 Schedule B. For tax years beginning after December 31, 2016, no such exception is acceptable.
- Interest on current refunding bonds: Tax-exempt bonds, including qualified 501(c)(3) bonds, are appealing to investors because the interest is excludible from taxable income. A refunding bond is issued to pay principal or interest, or redemption price on a prior bond. A current refunding bond redeems the prior bond within 90 days, whereas an advance refunding bond is issued more than 90 days prior to the redemption of the prior bond. Advance refunding bonds effectively allowed two sets of federally subsidized debt in connection with a single activity. Under the new tax law, interest on current refunding bonds remains excludible from taxable income, but interest on advance refunding bonds issued after December 31, 2017, is not.
- Repeal of authority to issue tax credit bonds: The holder of a tax credit bond receives federal tax credits instead of interest. Certain tax credit bonds are direct-pay bonds, which allow the issuer to receive a payment directly from the IRS instead of providing the bond holder with a tax credit. After December 31, 2017, the authority to issue tax-credit bonds and the provision for direct-pay bonds is repealed (e.g., forestry conservation, clean renewable energy, energy conservation, zone academy, and school construction). Bonds issued prior to January 1, 2018, are still subject to the previous rules.
- Excise tax on large endowments: In an effort to address private educational institutions where the size of the endowment is out of proportion with the educational mission, the new tax law imposes a 1.4 percent excise tax on the net investment income of private colleges and universities with at least 500 students, of which more than 50 percent are in the United States, and with non-charitable use assets equal to at least $500,000 per full-time equivalent student. The assets and income of related organizations that are available for the use or benefit of the educational institution, including supporting organizations described in IRC section 509(a)(3), are combined for purposes of this excise tax.
- No deduction for athletic tickets: Prior to January 1, 2018, a donor who made a contribution that included the right to buy athletic tickets was entitled to a charitable contribution deduction equal to 80 percent of the payment. After December 31, 2017, no charitable deduction is allowed for such a payment. The disallowance is based on the right to purchase the tickets, regardless of whether the tickets would have been readily available anyway, or whether the individual actually purchased the tickets.
- New executive compensation rules: Tax-exempt employers will be subject to a 21 percent excise tax on compensation in excess of $1 million, including commissions and bonuses, to any covered employee for tax years beginning after December 31, 2017. Compensation does not include Roth elective deferrals but does include 457(f) deferred compensation, including amounts vested even if not received yet. Compensation also includes nonqualified deferred compensation when there is no substantial risk of forfeiture. The excise tax does not cover compensation paid to licensed medical professionals (including veterinarians) in exchange for medical services performed.
Covered employees are the CEO, CFO, and the next three highest-paid employees. Compensation paid to a person who meets the definition of covered employee for a tax year beginning after December 31, 2016, will continue to be subject to the excise tax, even if the employee no longer meets the definition of a covered employee otherwise, for as long as they are their beneficiaries receive compensation. The excise tax is in addition to and independent of the rebuttable presumption of reasonableness standard, and the prohibition on private inurement imposed on certain tax-exempt organizations. If an individual receives compensation from more than one employer, then the excise tax on excessive compensation is calculated proportionately among them.
- Excise tax on parachute payments: A 21 percent excise tax is imposed on excess parachute payments, defined as a severance payment, including transfer of property, to any highly compensated employee, that is greater than three times the individual’s average salary for the previous five years. Highly compensated employees include 5 percent owners at any time during the previous year, and employees who received compensation exceeding $120,000 in 2018 (adjusted for inflation). Parachute payments do not include amounts paid to annuity contracts under 403(b) or 457(b), or amounts paid to licensed medical professionals (including veterinarians) in exchange for medical services performed. Compensation is treated as paid when there is not a substantial risk of forfeiture. Deferred compensation and increases in its value under a 457(f) plan are subject to this excise tax when vested, even if not received.
Key provisions for employers
- Temporary family and medical leave: The tax overhaul creates a paid family and medical leave credit for tax years beginning after December 31, 2017, and before January 1, 2020. The employer must provide at least two weeks (but not more than 12 weeks) of paid leave providing at least 50 percent of normal wages. Leave mandated or paid for by a state or local government does not count for purposes of the credit. The employee must have been employed for at least one year, and the employee’s prior year compensation cannot exceed $72,000 (adjusted for inflation). The credit ranges from 12.5 percent if the employer pays the employee 50 percent of wages, up to 25 percent for 100 percent of wages.
- Treatment of employee loans from retirement plans: Employee loans from a qualified retirement plan are generally not treated as taxable distributions. However, if the individual’s employment is terminated, the unpaid loan balance is treated as a taxable distribution unless it is repaid or rolled over to another plan. Previously, a tax-free rollover had to occur within 60 days , but for tax years beginning after December 31, 2017, the rollover must occur before the extended due date of the individual’s tax return for the year employment was terminated.
- Exclusion of awards from taxable income: Employee achievement awards for such things as length of service or safety records that are awarded as part of a meaningful presentation, can be excluded from the employee’s taxable income as long as they are not disguised compensation. The excludible amount is limited to $400 per person ($1,600 if there is a written plan that doesn’t discriminate in favor of highly compensated employees). For amounts paid after December 31, 2017, the excludible award cannot be made in cash, cash equivalents, gift cards, gift coupons, gift certificates (other than arrangements conferring only the right to select and receive tangible personal property from a limited array of such items pre-selected or pre-approved by the employer), vacations, meals, lodging, tickets to theater or sporting events, stocks, bonds, or other securities. Such awards can be included in compensation as taxable fringe benefits and are subject to payroll tax.
- End to employer entertainment deduction: Expenditures for entertainment, amusement, or recreation, including club dues paid on behalf of employees, are no longer deductible by the employer even if used for business purposes. Previously, the employer could deduct club dues as salary expense as long as the employee included the amount in taxable compensation. Since nonprofit organizations do not generally receive a tax deduction for salary expense, they would generally treat the mission-related portion of club dues as a working condition fringe and exclude them from the employee’s compensation. With the complete elimination of the deduction for social club dues, nonprofit organizations should begin to include such benefits in the employee’s taxable compensation.
- Onsite eating facilities: Expenses incurred after December 31, 2017, for providing food and beverages to employees at on onsite eating facility that qualifies as a de minimis fringe benefit, will be limited to 50 percent, although employees may continue to exclude the entire amount from taxable income.
- Repeal of ACA individual mandate: For months beginning after December 31, 2018, the individual mandate of the Affordable Care Act is repealed, resulting in no penalty on individuals who elect not to obtain health insurance coverage. However, the employer mandate remains in effect, requiring that employers with 50 or more full-time employee equivalents must offer ACA-compliant insurance. Employees may still be subject to individual mandates imposed by certain states, such as California.
- Substantiation of business use of cars, computers, and entertainment: Certain employer-provided items, such as cars, entertainment and recreational property, and computers and peripherals used outside of the office, have the potential for personal use. Employers much substantiate the amount of business usage of such listed property. For property placed in service after December 31, 2017, computers and peripherals are no longer subject to the substantiation requirements.
- End of alimony payment deduction: Alimony payments were formerly deductible by the payer and included in the taxable income of the recipient. For alimony agreements executed after December 31, 2018, the payments are nondeductible by the payer and excluded from the taxable income of the recipient.
- Increase in Section 179 expensing: Internal Revenue Code (IRC) Section 179 allows organizations to expense the cost of certain property rather than capitalizing and depreciating it. The maximum amount is increased from $510,000 for tax years beginning before January 1, 2018, (with dollar-for-dollar reductions if property placed in service exceeds $2.03 million) to $1 million for tax years beginning after December 31, 2017 (with dollar-for-dollar reductions if property placed in service exceeds $2.5 million).
- No deduction for moving expenses: Unreimbursed moving expenses are no longer deductible by the employee. Reimbursed moving expenses will now be taxable to the employee. There is an exception for active-duty members of the Armed Forces who must move pursuant to military orders.
- Elementary and secondary schools now eligible for 529 plans: Nondeductible cash contributions can be made to a qualified tuition program, known as a 529 plan, and accumulate tax-free earnings to be used for qualified higher education expenses. Distributions are not taxable to the beneficiary. Starting with distributions made after December 31, 2017, eligible educational institutions include elementary and secondary schools.
Proposed changes that were not implemented
- The flat 1.4 percent excise tax rate on investment income of private foundations was removed from the final bill. The current tiered system, with brackets of 1 percent and 2 percent, remains in effect.
- The so-called Johnson Amendment remains in place, prohibiting 501(c)(3) organizations from engaging in political intervention.
- The provision to tax royalty income from the licensing of trademarks was eliminated.
- Most provisions for employee tuition benefits remain unchanged, including:
- Employers may deduct $5,250 of tuition assistance per year per employee in pursuit of a degree. The employee may exclude the benefit from taxable compensation (IRC section 127).
- Education that maintains or improves existing job skills to allow employee to remain in current position are a tax-free working condition fringe (IRC section 132(d).
- Scholarship programs remain unchanged (IRC section 117).
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