November 6, 2017 House tax reform bill includes significant changes for exempt organizations The tax reform bill released by the House Ways and Means Committee on November 2 (Tax Cuts and Jobs Act) includes many provisions that would directly and indirectly affect tax-exempt organizations. Several provisions would likely increase the tax burden on these organizations, such as the changes to the unrelated business income tax and the excise taxes on endowments and compensation. Other provisions would simplify private foundation taxation and provide exceptions to business holding limitations and political activity by churches and other houses of worship. In addition, the reforms to the individual, corporate and bond tax systems would affect exempt organizations through their effect on charitable giving, financing of activities and the operation of taxable businesses and deferred compensation plans. See also Tax Alert 2017-1831 for a general discussion of the bill's provisions, Tax Alert 2017-1840 for a detailed discussion of the individual provisions, and Tax Alert 2017-1841 for a detailed discussion of the compensation and benefits provisions. Exempt organizations provisions: unrelated business income tax Unrelated business taxable income increased by amount of certain fringe expenses for which deduction is disallowed Current law Tax-exempt organizations, like taxable entities, may provide their employees with transportation fringe benefits, and on-premises gyms and other athletic facilities, free from income tax at both the employer and employee level. Taxable entity employers may deduct the costs of such benefits, while tax-exempt entities do not need to deduct those costs. In either case, employees may exclude the values of those benefits from their taxable incomes. Provision The provision would impose tax on tax-exempt entities with respect to transportation fringe benefits, and on-premises gyms and other athletic facilities. Specifically, the provision would treat the funds used to pay for such benefits as unrelated business taxable income, thus subjecting the values of those employee benefits to a tax equal to the corporate tax rate. This is a companion provision to changes to the deductibility of these benefits for taxable entities. Effective date The provision would be effective for amounts paid or incurred after 2017. Implications The provision is intended to mirror a companion provision for taxable entities, which would change the deductibility of certain fringe benefits. The taxable entity provision would make certain benefits non-deductible; this provision attempts to replicate the effect of that change for tax-exempt entities by treating the costs of those benefits as taxable income. This would introduce additional complexities for tax-exempt entities, particularly for those that may have a policy against engaging in activities subject to unrelated business income tax (UBIT) but historically have provided employees with transportation fringe benefits or access to on-premises gyms and other athletic facilities. Clarification of unrelated business income tax treatment of entities treated as exempt from taxation under Section 501(a) Current law When an organization that is tax-exempt under Section 501(a) derives income from a trade or business that is not substantially related to its exempt purposes, the income is generally subject to UBIT. It is unclear, however, if the UBIT rules apply to certain state and local government entities (such as public pension plans) that are exempt under Section 115(1) as well as under Section 501(a). Provision Entities that are tax-exempt under Section 501(a) would be subject to UBIT on unrelated business taxable income, regardless of whether they are also exempt under another Code Section. Effective date The provision would be effective for tax years beginning after 2017. Implications This provision would remove any ambiguity for "dual status" government-affiliated entities under the respective exemption under Section 501(a) and Section 115(1) and could increase UBIT liabilities for these entities. For example, because of the UBIT partnership look-through rules, dual-status entities invested in partnership vehicles with business activities in lower-tiered partnerships could now face UBIT on such investments, adversely affecting the yield they currently enjoy. Exclusion of research income limited to publicly available research Current law Under current law, UBIT does not apply to income derived from a research trade or business in the following cases: (1) research performed for the US government, federal agencies, or a state or local government, (2) research performed by a college, university or hospital for any person, and (3) research performed by an organization operated primarily for the purposes of carrying on fundamental research the results of which are freely available to the general public. Provision The provision would amend the third situation to make explicit that organizations may only claim the exclusion for income from research that they make freely available to the general public. For companies that perform both public and private research, the provision would clarify that the exclusion does not apply to income from private research, even if the company's income comes primarily from research made freely available to the public. Effective date The provision would be effective for tax years beginning after 2017. Implications The provision clarifies the UBIT modification under Section 512(b)(9). Exempt organizations provisions: excise taxes Simplification of excise tax on private foundation investment income Current law Under Section 4940, private foundations are subject to a 2% excise tax on their net investment income, with a reduced 1% excise tax applicable if the foundation makes distributions equal to the averages of their distributions from the previous five years, plus 1%. Provision The provision would remove the two-tier rate system and replace it with a single 1.4% excise tax rate on a private foundation's net investment income. Effective date The provision would be effective for tax years beginning after 2017. Implications If enacted, the provision would simplify the excise tax based on a private foundation's net investment income under Section 4940. Private operating foundation requirements relating to operation of art museum Current law The 30% excise tax under Section 4942 on certain private foundation undistributed earnings does not apply to private operating foundations (i.e., generally, private foundations that use donations to fund their own charitable activities rather than to simply make grants to other charities). Provision An art museum would not be recognized as a private operating foundation unless it is open to the public for at least 1,000 hours per year. Effective date The provision would be effective for tax years beginning after 2017. Implications Section 501(c)(3) art museums claiming status as a private operating foundation, but that have limited availability to the public, have recently been questioned by Congress. This provision appears designed to address certain Congressional concerns by imposing specific public-access requirements. Art museums claiming private operating foundation status may need to revise their operations accordingly. Excise tax based on investment income of private colleges and universities Current law The Section 4940 excise tax on net investment income that applies to private foundations does not apply to public charities, including colleges and universities with substantial investment income. Provision The provision would add Section 4969 to impose a 1.4% excise tax on the net investment income of certain private colleges and universities (the same rate as proposed for private foundations). The excise tax would not apply to state colleges and universities, and an exception would apply for private colleges and universities with fewer than 500 students or assets (other than those used directly in carrying out the institution's educational purposes) valued at less than $100,000 per full-time student. However, on November 6, 2017, the House Ways and Means Committee adopted Chairman Kevin Brady's (R-TX) Amendment to the Chairman's Mark of the "Tax Cuts and Jobs Act" by a 24-16 vote. As part of this amendment, the threshold amount was changed to cause the excise tax to be applicable only if the fair market value of the institution's assets (other than those used directly in carrying out the institution's exempt purposes) is less than $250,000 per student (raised from the original amount of $100,000). Effective date The provision would be effective for tax years beginning after 2017. Implications This provision would effectively treat certain private universities as private foundations subject to the Section 4940 excise tax on their net investment income, even though the university may itself be classified as a public charity. Exception from private foundation excess business holding tax for independently-operated philanthropic business holdings Current law In general, under Section 4943, a private foundation that owns more than a 20% interest in a business enterprise is subject to an excess business-holdings tax equal to 10% of the value of the excess holding. A private foundation that does not divest itself of the excess holding by the end of the tax period becomes subject to a 200% excise tax on the excess holding. Provision The provision would exempt private foundations from the excess business-holdings tax if they met the following conditions: (1) the foundation owns all of the business enterprise's voting stock; (2) the private foundation acquired all of its interests in the business enterprise other than by purchasing it; (3) the business enterprise distributes all of its net operating income for any given tax year to the private foundation within 120 days of the close of that tax year; (4) the private foundation's substantial contributors (or their family members) are not directors, officers, trustees, managers or certain employees or contractors of the business enterprise; (5) a majority of the private foundation's board of directors are not also officers or employees of the business enterprise or members of the family of a substantial contributor to the private foundation; and (6) there is no loan outstanding from the business enterprise to a substantial contributor of the private foundation or a family member of such contributor. Effective date The provision would be effective for tax years beginning after 2017. Implications This provision would provide relief from the Section 4943 excise tax in specific scenarios in which a private foundation receives a donation of a business enterprise that in turn distributes all of its net operating income to its private foundation owner. Excise tax on excess tax-exempt organization executive compensation Current Law Tax-exempt organizations must report employees' compensation in income in the tax year in which the compensation is paid or the year in which nonqualified deferred compensation amounts subject to Section 457(f) become vested. Tax-exempt organizations generally are not subject to limitations or taxation on the compensation amounts paid to executives, other than the limitation on private inurement and potential sanctions under Section 4958 if the executive's compensation is considered excessive relative to the value provided to the organization. Taxable businesses, unlike tax-exempt organizations, are subject to limitations on compensation paid to employees in certain circumstances. Under current law, publicly held C corporations are limited to a compensation deduction of $1 million paid to certain executives, subject to applicable exceptions. In addition, taxable corporations may be subject to an excise tax and deduction limitation for severance and other compensation that is considered an excess "parachute payment." Provision The provision would impose an excise tax on tax-exempt organizations equal to 20% of remuneration payments in excess of $1 million and any excess parachute payments paid to a "covered employee." A covered employee is one of the five highest compensated employees for the tax year or an employee in this category in the preceding tax year. For purposes of this provision, a tax-exempt organization means any organization that for the year: (a) Is exempt from taxation under Section 501(a); (b) is a farmers' cooperative organization described in Section 521(b)(1); (c) has income excluded from taxation under Section 115(1); or (d) is a political organization described in Section 527(e)(1). Remuneration includes all cash and compensation in a medium other than cash, except for payments to a tax-qualified retirement plan or other amounts that are excludable from the employee's gross income (i.e., Form W-2, box 1 wages). An excess parachute payment is an amount paid to a covered employee upon the employee's separation from employment in an amount with a present value that exceeds three times the employee's base amount. Excluded from the definition of an excess parachute payment are payments under qualified plans, or any payment under or to an annuity contract described in Section 403(b) or a plan described in Section 457(b). Effective Date The provision would be effective for tax years beginning after December 31, 2017. Implications Similar to the changes related to taxation of fringe benefits, this provision would mirror the limitations on compensation deductibility for certain taxable entities. It would impose an excise tax on compensation paid by tax-exempt entities that exceed amounts that would be deductible for a publicly held C corporation. If this provision were enacted, it would have a significant financial impact on tax-exempt organizations that employ highly compensated executives. Tax-exempt organizations should review the current and nonqualified deferred compensation arrangements to assess when they may become subject to the excise tax. Organizations that maintain unvested nonqualified deferred compensation arrangements may need to consider whether it would be permissible within the tax rules and beneficial to accelerate the vesting and payment of the deferred compensation to avoid the application of the excise tax. Going forward, tax-exempt organizations that may be subject to this provision would need to closely monitor the amount and timing of compensation payments to their executives. Other exempt organizations provisions Allowing churches to make statements relating to political campaigns in ordinary course of religious services and activities Current law Section 501(c)(3) exempt organizations are prohibited from "participating in, or intervening in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office." Provision Under the provision, entities described in Section 508(c)(1)(A) would not fail to be treated as organized and operated exclusively for a religious purpose as the result of such political campaign participation, assuming the speech is in the ordinary course of the organization's business and the incremental expenses are de minimis. Effective date The provision would be effective for tax years ending after date of enactment. Implications The provision would allow churches and similar houses of worship to make statements supporting or opposing candidates for public office, excepting them from the general prohibition on this type of activity. Congress and constituents have been debating whether this restriction, often referred to as the Johnson Amendment, should remain as-is, be repealed altogether, or modified. The provision takes the latter approach, modifying it for a limited subset of organizations. Additional reporting requirements for donor-advised fund sponsoring organizations Current law Section 501(c)(3) public charities may establish funds to which donors may contribute and thereafter offer nonbinding advice on the fund's distributions or investments (donor-advised funds). Donors who contribute to these funds may generally claim a charitable-contribution deduction, even though the funds may not be distributed for a significant amount of time. There is no requirement for charitable organizations with such funds to make distributions within a particular time, and donor-advised funds are not subject to net investment excise taxes. Provision The provision would require organizations to annually disclose on their Form 990 return whether they have a policy on the frequency and minimum level of distributions of their donor-advised funds (and include a copy of that policy). They must also disclose the average amount of grants made from their donor-advised funds as a percentage of the value of assets held in those funds as of the beginning of the tax year. Effective date The provision would be effective for returns filed for tax years beginning after 2017. Implications The provision reflects the ongoing debate over whether donor-advised funds are making sufficient distributions to charity and whether they should be subject to minimum distribution requirements and attempts to gather more information on the issue. If the provision is enacted, donor-advised funds can expect additional Form 990 reporting requirements. Provisions affecting charitable giving Charitable contributions Current law Current law allows a taxpayer who itemizes deductions to claim deductions for charitable contributions made by the last day of the tax year. The deduction is limited to a certain percentage of the taxpayer's AGI, which varies depending on the type of property contributed and the type of tax-exempt organization to which the donation is made. Generally, deductions for contributions to public charities, private operating foundations and some non-operating foundations are limited to 50% of the donor's AGI. Contributions to private foundations may be deducted up to the lesser of: (1) 30% of AGI; or (2) the amount by which the 50%-of-AGI limitation for the tax year exceeds the amount of charitable contributions subject to the 30% limitation. Deductions of up to 30% of AGI may be claimed for capital gain property contributed to public charities, private operating foundations and certain non-operating private foundations. For donations of capital gain property to non-operating private foundations, deductions may be claimed for the lesser of: (1) 20% of AGI; or (2) the amount by which the 30%-of-AGI limitation exceeds the amount of property subject to the 30%-limitation for contributions of capital gain property. Excess contributions may be carried over for up to five years (15 years for qualified conservation contributions). To claim a charitable deduction for a contribution of $250 or more, the taxpayer generally must provide the IRS with a contemporaneous written acknowledgement by the donee organization. This requirement does not apply if the donee organization files a return with the required information. Provision The provision would change a number of rules applicable to the charitable contribution deduction, including: — Imposing a 60%-limitation for cash contributions to public charities and certain private foundations — Repealing a rule that allows a charitable deduction of 80% of the amount paid for the right to purchase tickets for athletic events — Adjusting the deduction for mileage driven for charitable purposes to a "rate [that] takes into account the variable cost of operating an automobile" — Repealing the exception that relieves a taxpayer from obtaining and providing a contemporaneous written acknowledgement for contributions over $250 if the donee organization files a return with the required information Effective date The provision would be effective for tax years beginning after 2017. Implications Although the provision would increase AGI limitations and provide inflationary adjustments to the charitable mileage rate, the increase in the individual income tax standard deduction in the Tax Cuts and Jobs Act may provide less of an incentive for many taxpayers who would no longer itemize deductions to donate to charitable organizations. Further, taxpayers who used to rely on the charity's reporting of their charitable contribution on the charity's information return would no longer be able to use this method for substantiating their gift of $250 or more. Instead, the taxpayer would have to request a separate acknowledgment from the charity to claim a charitable deduction. Colleges and universities may have a difficult time compelling their alumni and others to make a charitable contribution to secure the right to purchase tickets to their sporting events since the charitable deduction associated with such payments would no longer be allowed. Increase in credit against estate, gift, and generation-skipping transfer tax; Repeal of estate and generation-skipping transfer taxes Current law Current law generally applies a top tax rate of 40% to property inherited through an estate. If a donor makes a gift of property during life, a top gift tax rate of 40% applies to any gift that exceeds the annual per-donee gift tax exclusion ($15,000 for 2018). If the donor gives property directly to grandchildren, for example, a generation-skipping tax applies, also at the 40% rate. The first $5 million in transferred property (the basic exclusion) is exempt from any combination of estate, gift and generation-skipping taxes. Transfers between spouses are generally exempt from these taxes, and a surviving spouse may carryover (add) to his own basic exclusion any portion of his spouse's basic exclusion that has not been exhausted. A beneficiary who receives property from an estate receives a stepped-up basis in the property, but a donee who receives a gift from a living donor takes a carryover basis in the property. Provision With regard to the estate tax, the provision would: (1) double the basic exclusion amount to $10 million, indexed for inflation; (2) repeal, beginning after 2023, the estate and generation-skipping taxes; and (3) retain the stepped-up basis for estate property. With regard to gift tax, the provision would: (1) lower the gift tax to a top rate of 35%; (2) retain the $10 million basic exclusion; and (3) retain the $14,000 annual exclusion. Both exclusion amounts would be indexed for inflation. Effective date The provision would be effective for tax years beginning after 2017 and would repeal the estate tax after 2023. According to JCT, the changes would reduce revenues by $172.2 billion over 2018-2027. Implications If less taxpayers are subject to the estate tax, some taxpayers may be less inclined to make charitable bequests. Tax exempt bond reforms Current law Section 103 excludes from gross income the interest on any state or local bond. This includes qualified private activity bonds, which are defined under Section 141 and expanded upon in Section 145 to include bonds for the benefit of 501(c)(3) entities (including not for profit hospitals, colleges, universities and schools). The exclusion presently includes interest on certain bonds used for professional stadiums. Sections 54, 54A-54F and 54AA allow holders of certain bonds (tax credit bonds) a credit against their income taxes in the amount determined under those Sections. Any use of issue proceeds to advance refund private activity bonds other than qualified Section 501(c)(3) bonds disqualifies the interest from the Section 103 exemption for all bonds in the issue. The Section 103 exemption is also forfeited for interest on bonds that advance refund governmental or qualified Section 501(c)(3) bonds unless certain requirements are met. Provision The provision would repeal the exclusion from gross income for interest on all qualified private activity bonds and for interest on any bond issued to advance refund a tax-exempt bond. In addition, the provision would repeal, prospectively, all the existing authority for issuing tax credit bonds. The provision would also repeal the federal tax exemption for interest on bonds issued to finance the construction of, or capital expenditures for, a professional sports stadium or arena used for sports exhibitions, games or training for five days or more in a calendar year. Effective date The repeal of the exclusion from gross income for interest on qualified private activity bonds and advance refundings and the repeal of all existing authority for issuing tax credit bonds would be effective for such bonds issued after December 31, 2017. The repeal of tax exemption for interest on professional sports stadium bonds would be effective for bonds issued after November 2, 2017. Implications The proposed changes in the law for tax-exempt bond financings would basically stop all future tax exempt financings for everything except state and local government direct use and place a higher cost of borrowing upon all other tax exempt entities. In addition to reducing the available options for organizations seeking ways to finance their future capital expenditures, it appears that non-governmental entities would not be able to refinance current outstanding debt except as a current refunding and retain their tax-exempt benefit. ——————————————— — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg. ———————————————
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