Yes! The TCJA made major changes to not only the way nonprofits will be taxed, but potentially how they will operate when the TCJA takes effect. In an effort to create “parity” with the way for-profit organizations are taxed, the TCJA will leave nonprofits facing huge challenges in an effort to comply with the new tax act.
Unrelated Trade or Business
- As of January 1, 2018, the TCJA will impose a flat corporate tax rate of 21%. Although this is an overall tax rate decrease, many nonprofit organizations had taxable income of less than $50,000 in the past and enjoyed taxation at 15%. Therefore, there will be an increase in tax liability for many organizations. In addition, nonprofits organized as trusts will also see a decrease in the tax rates at the upper level.
- Organizations that operate more than one unrelated trade or business will need to separately calculate unrelated taxable income, including determination and use of any net operating loss for each trade or business. Essentially, organizations will need to segregate and report the income or loss from each separate unrelated trade or business, like different “silos” of activity. The organization cannot utilize a loss from any one segregated activity to offset income from another segregated activity!
- Unrelated business taxable income will include any expenses paid or incurred by a nonprofit organization for qualified transportation fringe benefits, a parking facility used in connection with qualified parking, and any on-premises athletic facilities. This provision is unusual in that it does not impose a tax on an item of net income but rather on an expense of the nonprofit organization. Nonprofits will need to determine whether they will pay unrelated business income tax on these types of employee fringe benefits or treat the benefits as taxable compensation to their employees.
- Nonprofit corporations will no longer be able to carry back losses from years that began after December 31, 2017. In addition, net operating losses generated in years beginning after December 31, 2017, and carried forward to subsequent years are limited to 80% of the taxable income from the activities in the future year. Although the losses can carry forward indefinitely (there is no longer a 20-year limitation on the carryforward), they can be used only against income from the same activity (i.e., “silo” effect).
There are still many unanswered questions in this area, such as, “What constitutes a separate trade or business?” In addition, will there be transition relief as a result of the lack of timely guidance on these areas? We are already more than six months into 2018, and estimates have been due; however, without guidance on how to calculate the amounts due, it is difficult to properly estimate tax payments. The IRS is considering possibly postponing enforcing the rules above because nonprofit organizations have many questions regarding how the TCJA will affect their organization. We will continue to monitor the status of this potential reprieve.
Excise Tax on Tax-exempt Organization Executive Compensation
A publicly held corporation generally cannot deduct more than $1 million of compensation in a taxable year for each “covered employee.” A new provision in the TCJA applies that general rule to nonprofit organizations and is applicable for tax years beginning after December 31, 2017. Under the provision, a nonprofit employer is liable for an excise tax equal to 21% of the sum of:
- Compensation in excess of $1 million paid to a covered employee.
- Any excess parachute payment paid to a covered employee.
For purposes of this provision, a covered employee is someone (including any former employer) who is one of the organization’s five highest-compensated employees for the taxable year or was a covered employee of the organization for any preceding taxable year beginning after December 31, 2016. A parachute payment is a compensation payment to (or for the benefit of) a covered employee if the payment is contingent on the employee’s separation from employment and the aggregate present value of all such payments equals or exceeds three times the base amount (average annualized compensation includible in the covered employee’s gross income for the five taxable years ending before the date of the employee’s separation from employment).
One carve-out from these rules is that a licensed medical professional (i.e., physician, nurse, or veterinarian) who performs services directly related to the performance of medical or veterinary services by such professional is not considered when determining who the covered employees are. If the medical professional performs services in a capacity other than for medical services (like an administrative role), compensation must be allocated between both services to determine whether the person is considered a covered employee or not.
When determining total compensation, you need to include compensation from “related organizations.” However, the term “related organization” has not been defined by the IRS. Several different definitions exist in various IRS code sections.
Excise Tax on Investment Income of Private Foundations
For taxable years beginning after December 31, 2017, the TCJA imposes a 1.4% excise tax for each tax year on the net investment income of an applicable institution. Net investment income is determined using rules similar to those relating to the net investment income of a private foundation, which includes gains from the sale of securities or investment property.
This tax will apply to an eligible education institution as defined in Section 25A(f)(2) (private college or university) and has:
- At least 500 tuition-paying students who are located in the United States.
- At least $500,000 in assets (other than those assets which are used directly in carrying out the institution’s exempt purpose) per student.
When determining whether an institution meets the asset-per-student threshold and calculating net investment income, an institution’s “related organization” is included in the amounts used. For this purpose, “related” includes organizations that:
- Control or are controlled by the institution.
- Are controlled by one or more persons who control the institution.
- Are a supported/supporting organization during the taxable year with respect to the institution.
The IRS recently released guidance, Notice 2018-55, that will allow institutions which sell property at a gain to use the property’s fair market value at the end of 2017 as its basis for figuring the tax on a resulting gain. In many cases, this new stepped-up basis rule will reduce the amount of gain subject to the new excise tax.
Some unanswered questions are the calculation of basis in joint ventures, what is considered assets used directly in carrying out the institution’s exempt purpose, and a better definition of who this excise tax applies to.
Repeal of Advance Refunding Bonds
Code Section 103 generally provides that gross income does not include interest received on state or local bonds. State and local bonds are classified as either governmental bonds or private activity bonds. Governmental bonds are bonds from which the proceeds are used primarily to finance governmental facilities or the debt is repaid with governmental funds. Private activity bonds are bonds in which the state or local government serves as a conduit by providing financing to nongovernmental persons. Bonds that are issued to finance the activities of charitable organizations [described in IRC Section 501(c)(3)] are one type of private activity bond.
The exclusion from income for interest on state and local bonds applies to refunding bonds; however, there are limits on advance refunding bonds. A refunding bond is defined as any bond used to pay principal, interest, or a redemption price on a prior bond issue (the refunded bond). Different rules apply to current as opposed to advance refunding bonds. A current refunding occurs when the refunded bond is redeemed within 90 days of its issuance. Conversely, a bond is classified as an advance refunding bond if it is issued more than 90 days prior to its redemption. Proceeds of advance refunding bonds generally are invested in an escrow account and held until a future date when the refunded bond may be redeemed.
The TCJA eliminated advance refunding bonds, which limits a nonprofit organization’s ability to refinance as the market changes. This means nonprofits are left holding bond debt obligations with set interest rates and are unable to change those rates without affecting the exclusion from gross income for interest on a bond issued to advance refund another bond.
This applies to advance refunding bonds issued after December 31, 2017. This change was abrupt and left very little time for nonprofits to plan. Now financial consultants are looking at advance refunding alternatives, which include using taxable bonds or buying back some of the outstanding bonds.
This provision has been extremely difficult for large nonprofit hospital systems that rely on bond issues to finance their capital improvements and expenditures.
The TCJA diminished the number of households claiming an itemized deduction for their gifts to nonprofits by doubling the standard deduction. It is estimated that almost 95% of all taxpayers will be unable to claim deductions for charitable gifts. In addition, the TCJA roughly doubled the estate tax exemption to $22 million for couples, which most likely will discourage tax-motivated charitable bequests from wealthy households. These provisions are in effect for contributions made in taxable years beginning after December 31, 2017.
Another provision of the TCJA is to limit the aggregate amount of state and local taxes (property and income) to a total of $10,000 per year. Recently, some states have begun considering proposals that would allow taxpayers to make transfers to funds controlled by state or local governments in exchange for credits against the state or local taxes the taxpayer is required to pay. The aim of these proposals is to allow taxpayers to characterize such transfers as fully deductible charitable contributions for federal income tax purposes while at the same time using those transfers to satisfy state or local tax liabilities.
The IRS has responded with Notice 2018-54, putting such proposals on notice that it intends to propose regulations addressing the federal income tax treatment of certain payments made by taxpayers for which those taxpayers receive a credit against their state and local taxes. The IRS reminds taxpayers that federal law controls the proper characterization of payments for federal income tax purposes.
The summary above of the various changes that are part of the TCJA will undoubtedly hit nonprofit organizations very hard. Whether there will be transitional relief related to any of these provisions because of the lack of timely guidance is unknown. All nonprofit organizations need to look thoroughly at the possible effects the changes above will have on them and proactively project what their liability may be. The TCJA has made planning for the future more complex for nonprofit organizations.