Not-for-profit organizations will face some critical challenges as the new tax law begins to take effect. The Tax Cuts and Jobs Act (TCJA) had to be paid for in order to be passed, and a result, new taxes were added to offset the costs of the 40 percent reduction in corporate tax rates and 20 percent deduction to owners of pass-through entities. The largest revenue-raising provisions were imposed on multinational companies and certain business deductions were eliminated, but a handful changes will directly affect not-for-profit organizations. These include:
- Private college/university endowment excise tax (estimated to raise $1.8 billion)
- Unrelated business taxable income (UBTI) separation for each activity (estimated to raise $3.5 billion)
- Repeal of charitable deduction for college seating rights (estimated to raise $2.0 billion)
- Excise tax on excess executive compensation (estimated to raise $1.8 billion)
Not-for-profit organizations will want to review the provisions that have both an indirect and direct impact on their operations in order to prepare for the tax changes coming their way.
How Individual Tax Provisions Affect Not-For-Profit Organizations
Individuals will generally receive reduced marginal tax rates under the TCJA. Maximum rates drop from 39.6 percent to 37 percent starting in 2018. Tax cuts for individuals are temporary; they are currently set to sunset in 2026.
Along with the marginal tax cuts come other changes that also expire at the end of the individual tax cut period, including an enhanced charitable contribution provision. The TCJA raises the adjusted gross income (AGI) limit on cash contributions to public charities from 50 to 60 percent, potentially allowing taxpayers to claim greater current deductions for contributions to charity. At the same time, the standard deduction is increased to $12,000 for single filers, and $24,000 for joint returns. Increasing the standard deduction is expected to cause fewer people to itemize their deductions. To the extent that an itemized deduction is no longer available for many taxpayers, the tax incentive for charitable giving is eliminated.
Another provision that will affect not-for-profit organizations is the doubling of the estate and gift tax exemptions through 2025. The exemption threshold increases to $11 million for individuals and $22 million for couples. The planned giving and development offices of public charities should look at new ways to incentivize donors to consider the future needs of charities in their community now that there is less of a tax incentive to give as part of their estate.
Changes to the Affordable Care Act
Health care organizations were dealt a blow with an individual tax provision that eliminates the penalty for individuals who fail to maintain minimum health coverage. The provision effectively repeals the individual mandate and will take effect in 2019. Healthcare providers may see an increase in bad debt and uncompensated care if individuals choose not to have health insurance coverage any longer.
All organizations may also note an increase in health insurance premiums as younger and healthier populations may choose to opt out of health insurance coverage.
How Corporate Tax Provisions Affect Tax-Exempt Organizations
One of the biggest and most expensive provisions in the TCJA was the reduction in the corporate tax rate from a maximum rate of 35 percent to a flat rate of 21 percent. Not-for-profit organizations that report unrelated business income will measure UBIT using the 21 percent rate for tax years beginning after Dec. 31, 2017.
The new tax law also repeals the corporate AMT. However, prior year minimum tax credits can offset regular tax liabilities going forward and for tax years falling between 2017 and 2022, prior year minimum tax credits are refundable.
On the flip side, the law limits net operating loss (NOL) use to 80 percent of taxable income. NOLs also cannot be carried back under the TCJA. NOLs generated from tax years beginning prior to Jan. 1, 2018, remain subject to previous limitations.
Tax Law Provisions Specifically Targeting Tax-Exempt Organizations
Unrelated Business Taxable Income
The new law requires that not-for-profit organizations segregate unrelated business income activities effective for tax years beginning after 2017. Organizations that carry on more than one unrelated trade or business will be required to separately calculate UBTI for each line of unrelated trade or business.
Taxable losses from one unrelated trade or business shall no longer offset taxable income from another unrelated trade or business. NOLs will be carried forward indefinitely for each separate loss-producing activity, they can no longer be carried back. These changes do not apply to NOLs from tax years beginning prior to Jan. 1, 2018.
Qualified transportation fringe benefits, qualified parking and access to on-site athletic facilities expenses are now to be reported as unrelated business taxable income. The UBTI designation is effective for amounts paid or incurred after Dec. 31, 2017.
Excise Tax on Compensation
Though likely only affecting large not-for-profit organizations, the TCJA imposes an excise tax on executive compensation. An excise tax of 21 percent (same as the corporate tax rate) is calculated on each covered employee’s compensation that is greater than $1 million. A covered employee is:
- Top five highest compensated employees for a tax year, and
- Employees who were “top five” in a previous tax year beginning after 2016
The excise tax applies to total compensation including compensation paid by related organizations. In these situations, the excise tax would be prorated between organizations. Excess parachute payments would be included when there is no substantial risk of forfeiture as defined in Section 457(f)(3)(B). Compensation for licensed medical professionals for medical services performed is excluded from the excise tax.
Net Investment Income Tax on Private Colleges and Universities
Effective for tax years beginning after Dec. 31, 2017, private colleges and universities will be subject to a 1.4 percent net investment income tax if they have at least 500 full-time students and assets of at least $500,000 per full-time student. The net investment income tax calculation excludes assets used directly in the exempt purpose of the college or university but would include assets and net investment income of related organizations.
Starting after Dec. 31, 2017, the interest paid on advance refunding bonds (certain bonds issued to advance refund another bond) will now be taxable income to the purchaser. Bonds issued before Dec. 31, 2017 will still be tax-exempt.
How Not-for-Profit Organizations Can Prepare for Tax Reform
Organizations should go through all of these provisions and evaluate how they may impact your organization:
- UBTI: Consider the revenue streams from unrelated business activities and note the direct and indirect expenses associated with the activity. Consider preparing separate income statements for each activity in order to calculate potential estimated tax payments that may be due since income can no longer be sheltered by unrelated losses from other unrelated business activities.
- Donations: Consider modifying your appeal for donations to optimize tax deductibility. Expect that donations in 2018 may be slightly lower than 2017 as a result of the changes to the standard deduction and the estate tax threshold.
- Health Care Coverage: In the coming years, the cost to provide health insurance may increase for all employers as a result of the repeal of the individual mandate. Organizations should build an increase in health insurance costs into their future budget plans.
- Tax-Exempt Bonds: If your organization was considering an advance refunding bond issue to refund a prior bond issue, please discuss the tax ramifications with your tax provider and bond counsel.
States may have tax regulations that differ from the federal requirements, so organizations should also be mindful of the difference and compliance requirements. Organizations should also keep in mind that further federal clarification and guidance related to these provisions may be forthcoming. The tax legislation was passed quickly and clarification of certain provisions may be needed.
For more information on the tax reform bill and its application to you and your organization, please contact your not-for-profit tax professional.
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