December 18, 2017 Final tax reform bill includes significant changes for tax-exempt organizations The final version of the "Tax Cuts and Jobs Act" (the Final Bill), which reconciles the differences between the earlier House and Senate versions, includes a number of provisions that would directly and indirectly affect tax-exempt organizations. The direct effects include an excise tax on executive compensation, changes to the calculation of unrelated business taxable income, and limitations on tax-exempt bonds. The indirect effects result from changes to the charitable donation deduction and estate and gift taxes, which alter some of the incentives for charitable giving. A number of broader business provisions included in the Final Bill would also affect tax-exempt organizations. For instance, the reduction in the corporate tax rate could help corporate unrelated business income taxpayers. There are also numerous changes to employee benefit provisions. For a general discussion of the provisions included in the Final Bill, see Tax Alert 2017-2130. Notably, a number of tax-exempt organization provisions included in the earlier House and Senate versions of the bill were not included in the Final Bill. In addition to discussing the items included in the Final Bill, this Alert briefly highlights some of the significant provisions originally proposed and excluded from the Final Bill. For more detailed discussions of all previously proposals in the House and Senate bills see Tax Alerts 2017-1844 and 2017-1943, respectively. Exempt organizations provisions: Unrelated business income 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 those activities and subtracts the aggregate of deductions from the aggregate gross income. 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 add new Section 512(a)(6), which requires 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 for the trade or business from which the loss arose. Effective date The provision would be effective for tax years beginning after December 31, 2017. Under a special transition rule, net operating losses arising in a tax year beginning before January 1, 2018, that are carried forward to a tax year beginning on or after such date would not be subject to the new provision. 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 pass-through entities) would likely increase a tax-exempt organization's overall UBIT burden. This might 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 before being undertaken. 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 and employees may exclude the values of those benefits from their tax able incomes. Provision The provision would add new Section 512(a)(7), which imposes tax on tax-exempt entities with respect to qualified transportation and qualified parking fringe benefits, and any on-premises athletic facilities. Specifically, the provision would generally treat the funds used to pay for such benefits as unrelated business taxable income, provided the amounts are not deductible under Section 274. In effect, this subjects the expenses 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 December 31, 2017. Implications The provision is intended to mirror a companion provision for taxable entities, which changes 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. Because of new Section 512(a)(6), it appears that the aggregate amount of these fringe benefits provided by the tax-exempt entity would be categorized as a separate unrelated trade or business for income tax reporting purposes. NOT INCLUDED IN THE FINAL BILL: Clarification of unrelated business income tax treatment of entities treated as exempt from taxation under Section 501(a) ("dual status" entities) 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). Prior proposal not included in the Final Bill The original House bill included a provision stating that entities tax-exempt under Section 501(a) would be subject to UBIT on unrelated business taxable income, regardless of whether they were also exempt under another Code Section. The Final Bill does not include this provision. NOT INCLUDED IN THE FINAL BILL: Tax on name/logo royalties Current law Income from the licensing of an organization's name or logo is generally royalty income and exempt from UBIT. Prior proposal not included in the Final Bill A prior version of the Senate bill included a provision that would treat any sale or licensing by a tax-exempt organization of its name or logo as an unrelated business, and income generated would be subject to UBIT. The Final Bill does not include this provision. Exempt organizations provisions: excise taxes Excise tax on excess tax-exempt organization executive compensation Current law Taxable employers and other service recipients generally may deduct reasonable compensation expenses. In some cases, however, compensation exceeding specific levels is not deductible. For a publicly held corporation, subject to certain exceptions, the deduction for a tax year for compensation of "covered employees," defined as 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). In addition, a corporation generally cannot deduct a portion of the aggregate present value of 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 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 21% of the sum of the: (1) remuneration (other than an excess parachute payment) over $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 did 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 were one of the five highest compensated employees of the organization for the tax year or were 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 income excludable under Section 115; or a Section 527 political organization. Remuneration would be treated as paid when no substantial risk of forfeiture of the rights to such remuneration existed. A "substantial risk of forfeiture" is based on the definition under Section 457(f)(3)(B), which applies to ineligible deferred compensation subject to Section 457(f). Accordingly, the tax imposed by this provision could apply to the value of remuneration that is vested (and any increases in such value or vested remuneration) under this definition, even if it were not yet received. In addition, the definition of "remuneration" for this purpose includes amounts required to be included in gross income under Section 457(f). The provision would exempt compensation paid to employees who are not highly compensated employees (within the meaning of Section 414(q)) from the definition of parachute payment, and would also exempt compensation attributable to medical services of certain qualified medical professionals from the definitions of remuneration and parachute payment. For purposes of determining a covered employee, remuneration that is paid to a licensed medical professional and directly related to the performance of medical or veterinary services by that professional is not taken into account, while remuneration paid to that professional in any other capacity is taken into account. A medical professional for this purpose includes a doctor, nurse or veterinarian. Effective date The provision would apply to all tax years beginning after December 31, 2017. Implications The provision would have a significant financial impact on applicable tax-exempt organizations that employ highly compensated individuals. Applicable tax-exempt organizations should review their employee's total compensation arrangements to assess when they may become subject to the excise tax. Organizations would need to maintain detailed records on potentially many individuals due to the provision's requirement that, once an employee is a "covered employee," the employee remains a covered employee. 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. Importantly, for health care organizations, compensation paid to qualified medical professionals, provided it is paid for services rendered in the course of providing medical or veterinary services, would not be included in the remuneration subject to the tax. Going forward, tax-exempt organizations that could be subject to this provision would need to closely monitor the amount and timing of compensation payments to their executives. Organizations should refer to a forthcoming Alert from EY's Compensation & Benefits group for more details on this provision. 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 a new Section 4968 and 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" is an eligible education institution described in Section 25A(f)(2) (relating to the Hope and Lifetime Learning credits) that: (1) has at least 500 tuition-paying students during the preceding tax year, more than 50% of whom are located in the US; (2) is not described in the first section of Section 511(a)(2)(B (i.e., generally describing state colleges and universities); and (3) has assets with an aggregate fair market value of at least $500,000 per student at the end of the preceding tax year (other than those assets that are used directly in carrying out the institution's exempt purpose). The number of students of an institution is 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. Also, certain organizations that may not consider themselves to be a "private college or university" could end up being subject to this tax. This could include academic medical centers that come within the definition. NOT INCLUDED IN THE FINAL BILL: Simplification of excise tax on private foundation investment income Current law Private foundations are subject to a 2% excise tax on their net investment incomes, but may reduce the excise tax rate to 1% by making distributions equal to the averages of their distributions from the previous five years, plus 1%. Prior proposal not included in the Final Bill The original House bill included a provision that would consolidate the excise tax on net investment income into a single rate of 1.4%, and the 1% and 2% rates would be repealed. This is not included in the Final Bill. NOT INCLUDED IN THE FINAL BILL: Private foundation excess business holdings tax for independently operated philanthropic business holdings Current law Private foundations are subject to a significant excise tax on their excess business holdings (ownership of a business enterprise over certain thresholds). Prior proposal not included in the Final Bill At one time, both the House and Senate bills included a provision that would exempt certain for-profit business holdings from the excise tax if certain limiting conditions were met and the business contributed its net operating income after taxes to the private foundation; this is not included in the Final Bill. NOT INCLUDED IN THE FINAL BILL: Taxes on excess benefit transactions Current law Disqualified persons who engage in excess benefit transactions with certain tax-exempt organizations (other than private foundations) are subject to an excise tax on the amount of the economic benefit that exceeds the value of the consideration (including the performance of services) received for providing the benefit. Organization managers who approve transactions knowing them to be excess benefit transactions are also subject to tax. Prior proposal not included in the Final Bill A prior version of the Senate bill would have: (1) expanded the tax to apply to Section 501(c)(4), (5) and (6) organizations; (2) added a tax on the organization itself; (3) removed a rebuttable presumption and other protections; and (4) expanded the definition of "disqualified person" to include investment advisors and athletic coaches; this is not included in the Final Bill. Other exempt organization provisions NOT INCLUDED IN THE FINAL BILL: Political statements by Section 501(c)(3) organizations Current law An entity exempt from tax under Section 501(a) and described in Section 501(c)(3) is 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." Prior proposal not included in the Final Bill The original House bill would have permitted organizations described in Section 501(c)(3) to make statements relating to political campaigns if the statements were made in the ordinary course of activities and resulted in de minimis incremental expenses; this is not included in the Final Bill. Tax-exempt bond provisions 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 whose proceeds are primarily used to finance governmental facilities or that are 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 advance 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, for 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. Effective date The provision would apply to advance refunding bonds issued after December 31, 2017. Implications 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. NOT INCLUDED IN THE FINAL BILL: Repeal of private activity bonds The original version of the House bill would have repealed qualified private activity bonds, but this is not included in the Final Bill. Individual taxes The Final Bill contains various changes to individual income taxes that may alter individuals' incentives to make charitable gifts. For more detail, see Tax Alert 2017-2130. Key provisions include: — Setting the standard deduction at $24,000 for joint returns, and $12,000 for single filers — Repealing the Pease limitation on itemized deductions — Increasing the 50% AGI limitation for charitable contributions to 60% — Retaining the estate, gift, and generation-skipping taxes with a doubled $10 million basic exclusion that is indexed for inflation — Eliminating the deduction for college event seating rights effective after December 31, 2017 — Repealing the substantiation exception for certain contributions reported by the donee organization ——————————————— — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg. ———————————————
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