11 July 2025 Final reconciliation legislation modifies provisions affecting tax-exempt entities
On July 4, 2025, President Donald Trump signed into law H.R.1 (the Act), which contains tax provisions and revenue offsets accompanying extensions of Tax Cuts & Jobs Act (TCJA) provisions that were set to expire at the end of 2025. Several provisions in the Act specifically apply to tax-exempt organizations. IRC Section 4960 imposes a 21% excise tax on an applicable tax-exempt organization and its related organizations that pay, collectively, over $1 million in compensation or pay an excess parachute payment to the exempt organization's covered employees. Covered employees are defined as one of the exempt organization's five highest compensated employees in any tax year beginning after December 31, 2016. The Act amends IRC Section 4960(c)(2) to modify the definition of covered employee to include any current or former employee of an applicable tax-exempt organization, or any predecessor of such an organization, during any tax year beginning after December 31, 2016. This provision removes the five-employee limit on the number of highest compensated employees for any given tax year that are considered covered employees of the exempt organization, thereby expanding the number of covered employees whose compensation could subject the organization to excise tax. For organizations whose five highest compensated employees in a given year have compensation under $1 million, this provision eliminates the need to track their covered employee status. Under prior law, a tax-exempt organization with all its employees in a single legal entity could have fewer covered employees than it would have if its employees were employed by separate legal entities, a disparity that the Act eliminates. The Act does not change the definition of "remuneration" for determining what portion of a covered employee's compensation is taxable, nor does it eliminate the exclusion from remuneration of compensation paid to a licensed medical professional for the performance of medical or veterinary services. Tax-exempt organizations should review their compensation policies and procedures to determine the Act's impact on their excise tax liability under IRC Section 4960 and prepare to accrue for additional excise taxes beginning in the 2026 tax year. In particular, exempt organizations should update their procedures to account for all employees as "covered employees" — not just their five highest compensated employees in a given tax year — and prepare to pay excise tax on the annual compensation above $1 million (paid by an exempt organization and/or its related organizations) of all such employees. IRC Section 4968 imposes a 1.4% excise tax on the net investment income of an "applicable educational institution." Net investment income is determined using rules like those in IRC Section 4940(c) for determining the net investment income of a private foundation for purposes of the IRC Section 4940(a) excise tax. An "applicable educational institution" is an eligible education institution described in IRC 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 IRC 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 at 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 include those of an organization that is related to the institution. An organization is 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 IRC Section 509(f)) or a supporting organization (as described in IRC Section 509(a)(3)) during the tax year with respect to the institution. The 1.4% excise tax on applicable educational institutions under IRC Section 4968 remains the same if an applicable college or university's investment assets are greater than $500,000 and not more than $750,000 per student. For applicable colleges or universities whose investment assets exceed $750,000 per student, the excise tax increases to:
The Act modifies the definition of "applicable educational institution" by replacing "500 or more tuition-paying students during the preceding tax year" with "3,000 or more tuition-paying students during the preceding tax year," thereby reducing the number of universities to which the excise tax applies. The Act expands the definition of "net investment income" of an applicable educational institution to include (1) interest from student loans; and (2) royalties from patents, copyrights, and other intellectual property and intangible property, to the extent those assets resulted from federally subsidized work of students or faculty members in their capacity as such with the applicable educational institution. The Act does not otherwise modify the definition of "net investment income," which is still determined under rules similar to those of IRC Section 4940(c). The Act requires colleges and universities subject to the excise tax to report on their Forms 990 for a given tax year their number of tuition-paying students — for purposes of determining whether they had more than 3,000 tuition-paying students during the tax year — and the number of students they took into account in calculating non-exempt use assets per student. The Act requires Treasury to develop anti-abuse guidance, to prevent a college's avoidance of the IRC Section 4968 excise tax by restructuring its endowment funds or making other arrangements to reduce or eliminate the value of its assets or net investment income. The Act does not include an exception for "qualified religious institutions," which appeared in the initial House tax bill. Nor does the Act change the definition of "student" to exclude foreign students, as proposed in the initial House tax bill. The Act's changes to IRC Section 4968 are generally more taxpayer-friendly than those of the initial House Tax bill. Under the Act, the excise tax rate is graduated from 1.4% to 8%, depending on the amount of an institution's non-exempt assets per student. The maximum rate of 8% is considerably less than the maximum 21% rate included in the initial House tax bill. The Act removed the provision in the initial House bill that would have excluded foreign students from the denominator of the asset-per-student calculation, which would have subjected more educational institutions to the tax. Not all of the Act's changes to the initial House tax bill were taxpayer-friendly; specifically, the Act removes the excise tax exemption for "qualified religious institutions" that was included in the initial House bill. For educational institutions subject to the graduated tax rate increase, the increased tax liability could significantly affect their financial planning and budgeting. The changes to IRC Section 4968 will require colleges and universities to implement or modify systems to track and monitor the size of their investment assets per student and, if applicable, determine the amount of the tax and report student numbers on their annual Form 990. While the threshold for applicability of the excise tax has increased from 500 to 3,000 tuition-paying students, the definition of net investment income has also expanded to include student loan interest and federally-subsidized royalty income — leading to increased tax exposure and compliance considerations. Educational institutions that are or may be subject to the tax should analyze their numbers of tuition-paying students and students charged (but not necessarily paying) tuition, and their amount of non-exempt use investment assets, for purposes of determining the applicability and tax impact of IRC Section 4968. Because the Act does not apply until tax years beginning after December 31, 2025, educational institutions have time to consider accelerating gains on investments, using investment assets to pay off debt, restructuring foreign investments to defer income realization, or taking other actions to reduce future excise tax liabilities. However, the Act requires the IRS to develop anti-abuse guidance to prevent avoidance of the tax through restructuring of endowment funds or making other arrangements to reduce or eliminate investment income. Accordingly, future regulations for the new law likely will restrict a college's ability to restructure its investment portfolio to minimize the tax. IRC Section 170(b)(1) allows individuals to deduct their charitable contributions during a given tax year, subject to certain limits, without those contributions needing to exceed a minimum threshold. Charitable contributions not utilized in a particular filing year (because they exceed the applicable ceiling) are available for a five-year carryforward period. IRC Section 170(b)(2)(A) allows a corporation to deduct its charitable contributions during a given tax year, up to 10% of its taxable income for the year, without its contributions needing to exceed a minimum threshold. Charitable contributions not utilized in a particular filing year (because they exceed the 10% ceiling) are available for a five-year carryforward period. The Act maintains the individual and corporate charitable contribution ceilings. However, it creates a 0.5% floor for charitable contributions made by individuals who itemize their deductions, and a 1% floor for corporate charitable contributions. Therefore, an individual itemizer's deductible charitable contributions for a given tax year will be limited to contributions that exceed 0.5% of the individual's taxable income in that year, while a corporation's deductible charitable contributions for a given tax year will be limited to contributions that exceed 1% of its annual taxable income. These new charitable contribution floors were added to the Act as revenue raisers, to offset the cost of the Act's tax cut extensions. According to the Joint Committee on Taxation (JCX-34-25; JCX 35-25), the 1% floor on deductions for corporate charitable contributions is expected to raise $16.6 billion in revenue, while the 0.5% floor on deductions for individual itemizers' charitable contributions is expected to raise $63 billion in revenue. The new floors could disincentivize some donors from making charitable gifts. However, the Act also provides an incentive for increasing charitable contributions that IRC Section 501(c)(3) organizations could highlight to their donors — a taxpayer may carry over to future tax years contributions disallowed by the 1% or 0.5% floor in any tax year in which the taxpayer's contributions exceed the applicable charitable contribution ceiling. For example, if a corporation made charitable contributions during a given that year that exceeded 10% of its taxable income for that year, it could carry over to future years the 1% of its contributions in that year that were below the charitable contribution deductibility floor. Such corporation could be incentivized to make charitable contributions exceeding the 10% ceiling in order to carry over the disallowed portion of its contributions to a future tax year. Tax-exempt organizations that incur unrelated business taxable income should consider how to increase their deductible charitable contributions under the Act. For instance, an exempt organization should consider making charitable contributions that exceed 1% of its taxable income for a tax year, so that it may deduct some portion of those charitable contributions. Similarly, it should consider making charitable contributions that exceed 10% of its taxable income for a tax year, so that it will be eligible to carry forward the portion of its contributions that fell below the 1% floor and could not be deducted as charitable contributions for that year. Exempt organization-related provisions included in the initial House bill but not included in the Act A provision that would have reinstated IRC Section 512(a)(7), requiring tax-exempt organizations to increase their UBTI by the amount paid or incurred to provide their employees certain transportation fringe benefits, was included in the initial House tax bill but excluded from the Act. A provision that would have narrowed the research exclusion in IRC Section 512(b)(9) for organizations operating primarily to carry out fundamental research made available to the public was included in the initial House bill but not included in the Act. A provision that would have included in UBTI any royalties from selling or licensing an exempt organization's name or logo was included in the initial draft of the House bill but was removed from the bill by the House Budget Committee and not included in the Act. A provision to replace the flat 1.39% excise tax on the net investment income of private foundations with a tiered excise tax rate structure (between 1.39% and 10%) was included in the initial House bill but excluded from the Act. A provision to amend the excess business holding rules so that certain voting stock repurchased by a business would be treated as outstanding stock was included in the initial House bill but not included in the Act. A provision that would have expanded the definition of terrorist organizations to include "terrorist supporting organizations" was included in the initial draft of the House bill but was removed from the bill by the House Budget Committee and not included in the Act.
Document ID: 2025-1423 | ||||||
