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How the Tax Cuts and Jobs Act Will Affect Tax-Exempt Organizations

The House and Senate conferees reached an agreement on a single version of the Tax Cuts and Jobs Act (“TCJA”) last week, which was approved by both the House and Senate on Tuesday, December 19, 2017.
The President signed the bill into law today.  While most of the publicized focus is on the impact of new tax rates for individuals and corporations, the ability of many individuals to itemize fewer deductions going forward and the termination of the individual mandate for health insurance under The Affordable Care Act, other changes in the Internal Revenue Code (“IRC”) will directly affect tax-exempt organizations. Some of the more significant items affecting tax-exempt organizations are outlined below.

No Unrelated Business Income Deduction for Certain Fringe Benefit Expenses

Effective for amounts paid or incurred after December 31, 2017, under new IRC §512(a)(7), certain employee fringe benefit payments are treated as unrelated business income unless they would be deductible under IRC §274.  These fringe benefit expenses include:

  • Any qualified transportation fringe benefit (IRC §132(f));
  • Any parking facility used in connection with qualified parking (IRC §132(f)(5)(C)); or
  • Any on-premises athletic facility (IRC §132(j)(4)(B)).

To be deductible under IRC §274 and, thus, for unrelated business income purposes, these fringe benefit expenses must be “directly connected” or “associated” with the taxpayer’s trade or business.

This provision was introduced as part of the TCJA to make the deductibility of these fringe benefit expenses for tax-exempt organizations that report unrelated business income consistent with that of for-profit taxpayers which, under the TCJA, are now not permitted to deduct these benefits unless “directly connected” or “associated” with the taxpayer’s trade or business.

Unrelated Business Income Activities Must be Calculated Separately

Effective for tax years beginning after December 31, 2017, under new IRC §512(a)(6), losses from one unrelated trade or business are not permitted to be used to offset income derived from a different unrelated trade or business.  Net income and losses generated by unrelated business activities will be required to be calculated and applied separately.

As outlined in new IRC §512(a)(6), for tax-exempt organizations that have more than one unrelated trade or business activity to report:

  • Unrelated business taxable income including for purposes of determining any net operating loss deduction, is computed separately with respect to each separate unrelated trade or business activity, and not including the specific deduction that applies for dioceses, religious orders, or conventions or associations of churches under IRC §512(b)(12) (IRC §512(a)(6)(A));
  • The tax-exempt organization’s unrelated business taxable income is the sum of the unrelated business taxable income so computed with respect to each unrelated trade or business activity, less the specific deduction under IRC §512(b)(12) (IRC §512(a)(6)(B)); and
  • Unrelated business taxable income for any such trade or business activity outlined in the previous item must not be less than zero (IRC §512(a)(6)(C)).

Ultimately, this provision ceases an organization’s ability to utilize losses from one unrelated trade or business income generating activity to offset income from another unrelated trade or business activity. This provision could have a significant negative impact on tax-exempt organizations that operate more than one unrelated trade or business activity.  It is important to note, however, that the new corporate tax rate under the TCJA has been lowered from 35% to 21%.  Tax-exempt organizations that are subject to unrelated business income tax will pay tax at the prevailing corporate income tax rate; 21% effective for tax years beginning after December 31, 2017.

It is possible that losses from different types of “alternative investment” activities may not be used to offset income from other types of “alternative investment” activities, however, this will need to be addressed in the ensuing Treasury Regulations.

Net Operating Losses

Tax-exempt organizations that file a Form 990-T, Exempt Organization Business Income Tax Return, to report unrelated business income activities and have net operating losses will be affected by the change in rules under the TCJA for net operating losses since these organizations are taxed as corporations.

Under the TCJA, net operating losses will no longer be able to be carried back to previous tax years; however, they will be able to be carried forward indefinitely.

In addition, the TCJA will limit the net operating loss deduction to 80% of the tax-exempt organization’s unrelated business taxable income.  Accordingly, tax-exempt organizations will no longer be able to fully offset unrelated business taxable income with net operating losses available.

Excise Tax on Investment Income of Private Colleges and Universities

Effective for tax years beginning after December 31, 2017, new IRC §4968 imposes a 1.4% excise tax on the net investment income of an “applicable educational institution”.  The excise tax will be computed under IRC §4940(c) which provides that net investment income is the amount of investment income and capital gains in excess of allowable deductions; and does not include tax-exempt interest and related deductions.

An applicable educational institution is an eligible educational institution defined under IRC §25A(f)(2) which:

  • Had at least 500 tuition-paying students in the preceding tax year of which more than 50% were located in the United States;
  • Is not described in the first sentence of IRC §511(a)(2)(B); generally state colleges and universities; and
  • Had an aggregate fair market value of assets at the end of the preceding tax year of at least $500,000 per student. This does not include assets which are used directly in carrying out the institution’s tax-exempt purposes.

It is important to note that the number of students of an eligible educational institution must be based on the daily average number of full-time students attending the institution with part-time students taken into account on a full-time equivalent basis.

In addition, any assets and net investment income of a related organization are treated as assets and net investment income of the eligible educational institution.  A related organization includes any organization that:

  • Controls, or is controlled by, the eligible educational institution;
  • Is controlled by one or more persons that controls the eligible educational institution; or
  • Is a supported organization under IRC §509(f)(3) or an organization described in IRC §509(a)(3).

Excise Tax on Excess Compensation

For tax years beginning after December 31, 2017, new IRC §4960 imposes a 21% excise tax, for which the employer is liable, on “remuneration” in excess of $1 million or an “excess parachute payment” made to “covered employees” of an “applicable tax-exempt organization”.

A covered employee is defined under IRC §4960(c)(2) as any current or former employee of an applicable tax-exempt organization that (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 organization for any tax year after December 31, 2016.

Under IRC §4960(a), remuneration is treated as paid when no substantial risk of forfeiture exists.  Remuneration, as outlined in IRC §4960(c)(3)(A), includes wages (but not designated Roth contributions) and amounts that are required to be included in gross income under IRC §457(f).  Remuneration does not include amounts paid to a licensed medical professional unless the remuneration paid to the licensed medical professional is for services in any other capacity other than that of a licensed medical professional.  Additionally, remuneration of a covered employee also includes remuneration paid by a related organization of the applicable tax-exempt organization.

Under IRC §4960(c)(4)(C), if the covered employee receives remuneration from more than one employer, each employer will be liable for a portion of the 21% excise tax equal to the amount of remuneration paid by the employer divided by the total amount of remuneration paid by all such employers to the employee.

IRC §4960(c)(5)(A) defines an excess parachute payment as the amount that exceeds the excess of any “parachute payment” over the “base amount” allocated to the payment.  A parachute payment is any payment made to a covered employee if (1) the payment is contingent on the employer’s separation from employment with the employer; and (2) the aggregate present value of the compensation is at least three times the base amount.  The base amount is determined similar to a golden parachute payment under IRC §280G(b)(3).

Parachute payments do not include payments:

  • Described in IRC §280G(b)(6) related to qualified plan exemptions;
  • Made under or to an annuity contract under an IRC §403(b) or §457(b) plan;
  • Made to a licensed medical professional; or
  • Made to an individual that is not a highly-compensated employee under IRC §414(q).

This provision was included in an attempt to put tax-exempt organizations on an equal footing with for-profit organizations that are generally not permitted to deduct remuneration in excess of $1 million paid to its covered employees.

Repeal of Advance Refunding of Tax-Exempt Bonds

Effective for advance refunding bonds issued after December 31, 2017, the exclusion from gross income of the interest on a bond that is issued to advance refund another bond is no longer available.  Accordingly, this provision could potentially limit a tax-exempt organization’s ability to refinance outstanding debt under an advance refunding since the benefit would no longer be available under IRC §103.

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