November 16, 2017 Senate Finance Committee tax reform proposal includes significant changes for tax-exempt organizations The tax reform proposal description released by the Senate Finance Committee (the Senate Plan) includes a number of important changes that would affect tax-exempt organizations. Several additional significant amendments were included in the Senate Finance Committee's Chairman's Mark Modification released late on November 14 (the Chairman's modification). Most changes in the Senate Plan would increase the income or excise tax burdens or otherwise hinder tax-exempt organizations' finances. While some of the changes parallel provisions included in the tax reform bill released by the House Ways and Means Committee (the House bill) a week earlier (see Tax Alert 2017-1844), other provisions in the Senate Plan are new or modified from earlier proposals. The provisions include changes that affect exempt organizations directly, as well as provisions affecting executive compensation, charitable giving and tax-exempt bonds. The Chairman's modification eliminated some provisions from the original Senate Plan, revised others, and added a number of new provisions. Notably, with respect to executive compensation, the Chairman's modification eliminated a provision that would modify the treatment of nonqualified deferred compensation. One of the more notable revised provisions in the Chairman's modification is an amended proposal that would limit the net operating loss deduction to 80% of taxable income (determined without regard to the deduction) for tax years beginning after December 31, 2023. Of interest to tax-exempt organizations, the Chairman's modification also includes a new provision relating to the private foundation excess business holding rules and a couple of new provisions affecting charitable contributions, discussed below. For more detailed information on other areas, please refer to Tax Alert 2017-1907 for a general discussion of the Senate Plan's provisions, Tax Alert 2017-1928 for a detailed discussion of the individual provisions, and Tax Alert 2017-1914 for a detailed discussion of the compensation and benefits provisions. Exempt organization provisions Unrelated business taxable income separately computed for each trade or business 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 unrelated business income tax (UBIT). Under current regulations, in determining unrelated business taxable income (UBTI), an organization that operates multiple unrelated trades or businesses aggregates income from all such activities and subtracts from the aggregate gross income the aggregate of deductions. As a result, an organization may use a deduction from one unrelated trade or business to offset income from another, thereby reducing total UBTI. Section 512(b)(12) permits exempt organizations to take a specific deduction of $1,000 in computing UBTI. Provision The provision would require organizations operating one or more unrelated trades or businesses to compute UBTI separately for each trade or business (without regard to the specific deduction under Section 512(b)(12)). The organization's UBTI for a tax year would be the sum of the amounts (not less than zero) computed for each separate trade or business, less the Section 512(b)(12) specific deduction. An organization would be able to claim a net operating loss deduction only with respect to a trade or business from which the loss arose. This provision is not included in the House bill. Effective date The provision would be effective for tax years beginning after December 31, 2017. Implications The inability to offset losses from one unrelated trade or business against gains from another (or against gains and losses from alternative investments or passthrough entities) would likely increase a tax-exempt organization's overall UBIT burden. This may prompt tax-exempt organizations with multiple unrelated trade or business activities to engage in significant restructuring and other planning, such as moving activities to taxable subsidiaries to minimize the impact. Such restructuring requires careful analysis of all the possible implications prior to being undertaken. Modification of taxes on excess benefit transactions (intermediate sanctions) Current law Excise taxes apply to excess benefit transactions between disqualified persons and Section 501(c)(3) organizations (other than private foundations), social welfare organizations (as described in Section 501(c)(4)) or Section 501(c)(29) organizations. An excess benefit transaction generally is a transaction in which an economic benefit is provided, directly or indirectly, by the applicable tax-exempt organization to or for the use of a disqualified person if the value of the economic benefit provided exceeds the value of the consideration received for providing such benefit. The excise tax is imposed on any such excess. Disqualified persons generally include: (1) persons who were, at any time during the five-year period ending on the date of the transaction, in a position to exercise substantial influence over the affairs of the organization (including officers and directors); (2) a member of the family of such a person; and (3) certain 35% or more controlled entities. There are additional categories of disqualified persons described in Section 4958(f). The excess benefit tax is imposed on the disqualified person and, in certain cases, on the organization's managers who knowingly participated in the transaction. However, it is not currently imposed on the exempt organization. Under the corresponding regulations, in certain cases an exempt organization may avail itself of a "rebuttable presumption" with respect to compensation arrangements and property transfers. Under the rebuttable presumption, payments under a compensation arrangement are presumed to be reasonable, and a transfer of property, or the right to use property, is presumed to be at fair market value, if certain conditions are met by an authorized body of the organization with respect to the determination, approval and documentation of the transaction. If these requirements are satisfied, the IRS may overcome the presumption of reasonableness if it develops sufficient contrary evidence to rebut the probative value of the comparability data relied upon by the authorized body. Under certain special rules, an organization manager's reliance on professional advice generally means that the manager has not knowingly participated in an excess benefit transaction. In addition, an organization manager's participation in a transaction ordinarily is not considered knowing if the transaction meets the requirements of the rebuttable presumption of reasonableness with respect to the transaction. Provision The provision would impose a 10% excess benefit transaction excise tax on the organization, when an initial tax is imposed on a disqualified person — unless the organization's participation was not willful and is due to reasonable cause. No tax on the organization would be imposed if the organization: (1) establishes that the minimum standards of due diligence were met with respect to the transaction; or (2) establishes to the satisfaction of the Secretary that other reasonable procedures were used to ensure that no excess benefit was provided. The provision would also eliminate the rebuttable presumption of reasonableness contained in the regulations. Under the provision, the procedures that presently provide an organization with a presumption of reasonableness would establish instead that an organization has performed the minimum standards of due diligence with respect to an arrangement or transfer involving a disqualified person. However, satisfaction of these minimum standards would not result in a presumption of reasonableness with respect to the transaction. The provision would eliminate the special rule that an organization manager's participation ordinarily is not "knowing" if the manager relied on professional advice — although reliance on professional advice may remain a relevant consideration in determining whether the manager knowingly participated. The provision would also eliminate the special regulatory rule that provides that an organization manager ordinarily does not act knowingly for purposes of the excess benefit transaction excise tax if the organization has met the requirements of the rebuttable presumption procedure. In addition, the provision would modify the definition of a disqualified person for purposes of the excess benefit transaction rules. First, the provision would treat as a disqualified person a person who performs services as an athletic coach for an organization that is an eligible educational institution (within the meaning of Section 25A). Second, the proposal would (1) expand to all organizations that are subject to the excess benefit transaction rules the present-law rule that treats investment advisors to donor advised funds as disqualified persons, and (2) modify the definition of investment advisor for this purpose. Finally, the provision would extend application of the Section 4958 excess benefit transaction rules to tax-exempt organizations described in Sections 501(c)(5) (labor and certain other organizations) and Section 501(c)(6) (business leagues and certain other organizations). This provision is not in the House bill. Effective date The provision is effective for tax years beginning after December 31, 2017. Implications This provision significantly increases the risk of an excess benefit transaction tax being assessed on disqualified persons and organization management by removing the rebuttable presumption of reasonableness and some of the protection for management relying on professional advice. It also introduces a new risk of tax for the organization itself. It also greatly expands the population of transactions that may be subject to tax by including transactions with investment advisors and athletic coaches and imposes the risk on new types of organizations (Section 501(c)(5) and (6) organizations). These changes would require all Section 501(c)(3), (4), (5), (6) and (29) organizations to familiarize themselves with the new structure of the Section 4958 excise tax regime and ever more closely evaluate their transactions with disqualified persons accordingly. Provide an exception to the private foundation excess business holdings rules for 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 excise 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, added by the Chairman's modification and similar to the language in Section 5104 of the House Bill, would create an exception to the excess business holdings rules for certain philanthropic business holdings. Specifically, the tax on excess business holdings would not apply with respect to the holdings of a private foundation in any business enterprise that satisfy certain requirements for the tax year, including: (1) ownership requirements; (2) an "all profits to charity" distribution requirement; and (3) independent operation requirements. The ownership requirements would be satisfied if (1) all ownership interests in the business enterprise are held by the private foundation at all times during the tax year; and (2) all the private foundation's ownership interests in the business enterprise were acquired under the terms of a will or trust upon the death of the testator or settlor. The "all profits to charity" distribution requirement would generally be satisfied if the business enterprise, not later than 120 days after the close of the tax year, distributes an amount equal to its net operating income for such tax year to the private foundation. The independent operation requirements would be satisfied if, at all times during the tax year: (1) no substantial contributor to the private foundation, or family member of such a contributor, is a director, officer, trustee, manager, employee or contractor of the business enterprise (or an individual having powers or responsibilities similar to any of the foregoing); (2) at least a majority of the board of directors of the private foundation are not also directors or officers of the business enterprise or members of the family of a substantial contributor to the private foundation; and (3) there is no loan outstanding from the business enterprise to a substantial contributor to the private foundation or a family member of such contributor. The provision would not apply to: (1) donor advised funds or supporting organizations that are subject to the excess business holdings rules by reason of Section 4943(e) or (f); (2) any trust described in Section 4947(a)(1) (charitable trusts); and (3) any trust described in Section 4947(a)(2) (split-interest trusts). Effective date The provision would be effective for tax years beginning after December 31, 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. Name and logo royalties treated as unrelated business taxable income 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. With certain exceptions, interest, dividends, royalties and certain rents are generally exempt from UBIT. Provision The provision would modify the UBIT treatment of the licensing of an organization's name or logo to subject related royalty income to UBIT. Specifically, the provision would amend Section 513 to specify that any sale or licensing by an organization of any name or logo of the organization (including any related trademarks or copyrights) would be treated as an unrelated trade or business that is regularly carried on by the organization. The provision would also amend Section 512 to stipulate that income derived from any such licensing of a name or logo of the organization would be included in the organization's gross unrelated business taxable income — notwithstanding the provisions of Section 512 that otherwise exclude royalties and other types of passive income from unrelated business taxable income. This provision is not included in the House bill. Effective date The provision would be effective for tax years beginning after December 31, 2017. Implications Tax-exempt entities that rely on licensing of their name or logo to generate income will suffer an increased tax burden. This provision may introduce additional complexities and change the economics for organizations with current licensing agreements in place or those up for renewal. 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 impose a 1.4% excise tax for each tax year on the net investment income of an "applicable educational institution." Net investment income would be determined using rules similar to the rules of Section 4940(c), relating to the net investment income of a private foundation. An "applicable educational institution" would be defined as an institution: (1) that has at least 500 tuition-paying students during the preceding tax year; (2) that is an eligible education institution as described in Section 25A; (3) that is not described in the first section of Section 511(a)(2)(B) of the Code (i.e., generally describing state colleges and universities); and (4) the aggregate fair market value of the assets of which at the end of the preceding tax year (other than those assets which are used directly in carrying out the institution's exempt purpose) is at least $250,000 per student. The number of students of an institution would be based on the daily average number of full-time students attending the institution, with part-time students being taken into account on a full-time student equivalent basis. For purposes of determining whether an institution meets the asset-per-student threshold and determining net investment income, assets and net investment income would include amounts with respect to an organization that is related to the institution. An organization would be treated as related to the institution for this purpose if the organization: (1) controls, or is controlled by, the institution; (2) is controlled by one or more persons that control the institution; or (3) is a supported organization (as described in Section 509(f)) or a supporting organization (as described in Section 509(a)(3)) during the tax year with respect to the institution. Effective Date The provision would be effective for tax years beginning after December 31, 2017. Implications This provision would effectively treat certain private colleges and 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. The provision mirrors a similar provision included in the House bill. The House version of the provision as originally released included an exception for colleges and universities with 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, a later amendment to the House bill increased the threshold to $250,000 per student — consistent with the provision subsequently included in the Senate Plan. The House provision was also amended to apply to assets held by related organizations — as included in the Senate Plan provision. Repeal of tax-exempt status for professional sports leagues Current law Section 501(c)(6) provides tax-exempt status for business leagues and certain other organizations. Since 1966, Section 501(c)(6) has included language exempting from tax "professional football leagues (whether or not administering a pension fund for football players)." The IRS has interpreted this language as applying to all professional sports leagues. Provision The provision would strike from Section 501(c)(6) the phrase "professional football leagues (whether or not administering a pension fund for football players)." The provision would also amend Section 501(c)(6) to stipulate that Section 501(c)(6) "shall not apply to any professional sports league (whether or not administering a pension fund for players)." This provision is not included in the House bill. Effective date The provision would be effective for tax years beginning after December 31, 2017. Implications This provision would force existing professional sports leagues tax-exempt under Section 501(c)(6) to relinquish such tax-exempt status. In the past decade, certain professional sports leagues have ceased to be tax-exempt under Section 501(c)(6), and this provision would remove the option for those that remain tax-exempt. Repeal of advance refunding tax-exempt bonds Current law Section 103 excludes from gross income the interest on any state or local bond. State and local bonds are classified generally as either governmental bonds or private activity bonds. Governmental bonds are bonds the proceeds of which are primarily used 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 providing financing to nongovernmental persons (e.g., private businesses or individuals). Bonds issued to finance the activities of charitable organizations described in Section 501(c)(3) (qualified 501(c)(3) bonds) are one type of private activity bond. The exclusion from income for interest on state and local bonds only applies if certain Code requirements are met. The Section 103 exclusion applies to refunding bonds (i.e., bonds used to pay principal, interest or redemption price on a prior bond issue) but there are limits on "advance refunding" bonds. An advanced refunding occurs when organizations refinance their outstanding debt but cannot call the outstanding debt for at least 90 days after the issuance of the new debt. The Code limits the number of times that a bond can be advance refunded. Generally, governmental bonds and qualified 501(c)(3) bonds may be advance refunded one time. Private activity bonds, other than qualified 501(c)(3) bonds, may not be advance refunded at all. Furthermore, in the case of an advance refunding bond that results in interest savings, the refunded bond must be redeemed on the first call date 90 days after the issuance of the refunding bond that results in debt service savings. Provision The provision would repeal the exclusion from gross income for interest on a bond issued to advance refund another bond. The Senate Plan does not include the private activity bond reforms and tax credit bond repeal proposed in the House bill. Effective date The provision would apply to advance refunding bonds issued after December 31, 2017. Implications Under the Senate Plan, interest from the initial issuance of qualified 501(c)(3) bonds would continue to be tax-exempt, but the interest on any bonds issued as part of an advance refunding of those bonds would not. It appears that entities would not be able to refinance outstanding debt except as part of a current refunding and retain their tax-exempt benefit under Section 103. Compensation provisions affecting exempt organizations Nonqualified deferred compensation (NQDC) When initially released, the Senate Plan had included a provision that would significantly modify the treatment of NQDC. (For a detailed discussion of the specific provision as originally proposed, see Tax Alert 2017-1914.) However, this provision was stricken from the Senate Plan by the Chairman's modification. Excise tax on excess tax-exempt organization executive compensation Current law Taxable employers and other service recipients are generally allowed a deduction for reasonable compensation expenses. However, in some cases, compensation in excess of specific levels is not deductible. In the case of a publicly held corporation, subject to certain exceptions, the deduction for a tax year for compensation of the corporation's principal executive officer or for any of the corporation's three most highly compensated officers other than the principal executive officer is limited to $1 million ($1 million limit on deductible compensation). A "parachute payment" (generally a payment of compensation that is contingent on a change in corporate ownership or control) made to an officer, shareholder or highly compensated individual is generally not deductible if the aggregate present value of all such payments to an individual equals or exceeds three times the individual's base amount (an excess parachute payment). These deduction limitations currently do not affect tax-exempt organizations. Provision Under the provision, an applicable tax-exempt employer would be liable for an excise tax equal to 20% of the sum of the (1) remuneration (other than an excess parachute payment) in excess of $1 million paid to a covered employee by an applicable tax-exempt organization for a tax year, and (2) any excess parachute payment (under a new definition for this purpose that relates solely to separation pay) paid by the applicable tax-exempt organization to a covered employee. Accordingly, the excise tax would apply as a result of an excess parachute payment, even if the covered employee's remuneration does not exceed $1 million. For purposes of the provision, a covered employee would be an employee (including any former employee) of an applicable tax-exempt organization if the employee is one of the five highest compensated employees of the organization for the tax year or was a covered employee of the organization (or a predecessor) for any preceding tax year beginning after December 31, 2016. An "applicable tax-exempt organization" is fairly broad-sweeping and would mean an organization exempt from tax under Section 501(a); an exempt farmers' cooperative; a federal, state or local governmental entity with excludable income; or a political organization. Effective date The provision would apply to all tax years beginning after December 31, 2017. Implications Similar to the House provision on this issue, the provision would have a significant financial impact on applicable tax-exempt organizations that employ highly compensated executives. Applicable tax-exempt organizations should review their executive's total 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. Provisions affecting charitable giving Repeal charitable contribution substantiation exception for contributions reported by donee organization Current law Generally, no charitable contribution deduction is allowed for a separate contribution of $250 or more unless the donor obtains a "contemporaneous written acknowledgement" of the contribution from the charity. However, Section 170(f)(8)(D) includes an exception to this requirement if the donee organization files a return with the information. Provision The provision, added in the Chairman's modification, would repeal the Section 170(f)(8)(D) exception to the contemporaneous written acknowledgment requirement. Effective date The provision would be effective for contributions made in tax years beginning after December 31, 2016. Implications 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. Denial of deduction for amounts paid in exchange for college athletic seating rights Current law Taxpayers generally may claim a deduction for charitable contributions. However, no deduction is generally allowed to the extent a taxpayer receives a benefit in return. Nonetheless, a special rule permits taxpayers to deduct as a charitable contribution 80% of the value of a contribution made to an educational institution to secure the right to purchase tickets for seating at an athletic event in a stadium at that institution. Provision The provision would provide that no charitable deduction shall be allowed for amounts paid to an institution of higher education in exchange for which the payor receives the right to purchase tickets or seating at an athletic event. This provision is similar to the provision included in the changes to the individual charitable deduction described in the House bill. Effective date The provision would be effective for contributions made in tax years beginning after December 31, 2017. Implications Similar to the effect of the House provision, colleges and universities may have a difficult time convincing 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 percentage limit for charitable contributions of cash to public charities 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). Provision The provision would increase the income-based percentage limit (Section 170(b)(1)(A)) from 50% to 60% on the total charitable contribution deduction an individual taxpayer may claim for certain charitable contributions of cash to public charities. This change would allow an individual taxpayer to claim a charitable contribution deduction for cash donations to charity totaling up to 60% of the taxpayer's AGI for the year. Effective date The provision would be effective for tax years beginning after December 31, 2017. Implications Although the provision would increase AGI limitations, the increase in the individual income tax standard deduction (discussed below) may provide less of an incentive for many taxpayers who would no longer itemize deductions to donate to charitable organizations. The Senate Plan does not include one of the Section 170 provisions included in the House bill, namely adjusting the deduction for mileage driven for charitable purposes to a "rate [that] takes into account the variable cost of operating an automobile." Individual taxes For individuals, the Senate Plan would eliminate several itemized deductions, while retaining tax incentives for home mortgage interest and charitable contributions (in slightly modified form). The controversial state and local tax deduction would be repealed entirely. The Senate Plan also would repeal many of the other exemptions, deductions and credits for individuals in the pursuit of rate reduction, simplicity and fairness. The standard deduction would be set at $24,000 for joint returns, and $12,000 for single filers; unlike the House bill, the Senate Plan would not repeal the additional standard deduction for the elderly and the blind. Personal exemptions would be repealed. The estate, gift and generation-skipping taxes would be retained with a doubled $10 million basic exclusion that is indexed for inflation. Implications The increase in the individual income tax standard deduction might provide less of an incentive for many taxpayers who would no longer itemize deductions to donate to charitable organizations. If less taxpayers are subject to the estate tax, some taxpayers may be less inclined to make charitable bequests. ——————————————— — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg. ———————————————
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