Lingering TCJA Tax Considerations for Not-for-Profits (article)
After the first full year under the new tax reform law, one thing is clear: Several tax reform provisions may make tax reporting more difficult for not-for-profit organizations.
The tax law commonly referred to as the Tax Cuts and Jobs Act (TCJA) passed into law quickly, leaving ambiguities about how some of its provisions would be implemented. Not-for-profits received some more clarity at the end of 2018 around how to apply some of the TCJA’s changes, but little in the way of relief. Most organizations should still expect to spend more time with certain segments of tax-related reporting, including quantifying and segmenting their sources of unrelated business income (UBI) and evaluating their qualified transportation fringe benefits.
The following provides an update on what not-for-profits can expect when it comes to complying with some of these more onerous TCJA provisions.
Unrelated Business Income (UBI) & Transportation Fringe Benefits
The TCJA added two new Internal Revenue Code entries that could have a significant impact on an organization’s UBI. The TCJA added a provision, Section 274(a)(4), that makes certain transportation-related fringe benefits—Qualified Transportation Fringes—nondeductible. Qualified Transportation Fringes (QTF) are nondeductible even when provided by the employer in-kind, through a bona fide cash reimbursement arrangement, or through a compensation reduction agreement.
At the same time, the TCJA added Section 512(a)(7), which specifies that an organization must increase its UBI for any expense that is not deductible under Section 274 and which is paid or incurred by such organization for any QTF, which includes employer provided parking. There is one exception: UBI is not increased by qualified transportation fringe expenses connected with an unrelated trade or business regularly carried on by the organization.
The change to QTF treatment for not-for-profits became effective for amounts paid or incurred after Dec. 31, 2017. So, fiscal year-end entities would need to consider six months of applicable QTF expenses for their year ending June 30, 2018.
Practically speaking, the TCJA change means common employer-provided transportation related expenses now create UBI. This includes transit passes given to an employee, qualified parking (defined as parking provided to an employee on or near the organization or on or near a location from which an employee commutes to work), and transportation provided in a shuttlebus or other “commuter highway vehicle.”
Additional QTF Guidance
In Notice 2018-99, the IRS provided more guidance on how not-for-profit organizations calculate their QTF expenses. It specified that for payments to a third party to lease parking spaces, the UBI inclusion is the cost paid to the third party for that privilege. If the cost of the employee transportation benefit exceeds $260 per month, the excess is treated as compensation, and is excluded from UBI.
For organizations that own or lease all or a portion of a parking facility, a four-step process is applied to determine the amount of UBI that qualified parking would generate.
- Step 1: Determine the percentage of reserved employee spots in relation to total parking spots and multiply that percentage by the total parking expenses for the parking facility. The product is the UBI inclusion. Note that until March 31, 2019, organizations may re-designate reserved spots retroactively to Jan. 1, 2018.
- Step 2: Determine the primary use of the remaining spots, meaning, a not-for-profit will need to determine if the “primary use” is to provide parking for the general public. Primary use means greater than 50 percent of actual or estimated use of the parking spots in the parking facility. If the primary use of the remaining spots is to provide parking to the general public (ex. clients, patients, visitors, students), then the remaining parking expenses avoid UBI.
- Step 3: Consider parking spaces reserved for nonemployee use, such as visitors and customers. The expense of the spots for nonemployee use will not contribute to an organization’s UBI.
- Step 4: Consider remaining use and allocable expenses by determining how many parking spots are used by employees during typical working hours on a typical working day, and determining the expenses allocable to that use. Expenses allocable to employee use are then included in UBI.
The change to QTF will likely result in more organizations being required to file the Form 990-T. Tax-exempt organizations must file the Form 990-T if gross income, included in computing UBI, is $1,000 or more. Organizations filing will also need to consider tax return extension requests, estimated tax payment requirements, and state tax requirements.
IRS Notice 2018-100 provided transition relief for federal estimated income tax payments that were due in 2018 for tax-exempt organizations that provided QTFs that would have necessitated estimated UBI tax payments.
Unrelated Business Income Tax Strategies May Need Revisiting
Prior to the TCJA, not-for-profit organizations with multiple income-producing trades or businesses could use losses from one source of UBI to offset gains in another, effectively reducing the overall amount of UBI the organization generated during a year. The TCJA added Section 512(a)(6), which requires not-for-profit organizations to report UBI for each unrelated business or trade separately. Organizations may only carryforward net operating losses (NOLs) generated from a separate trade or business to offset income from the same trade or business in future tax years.
Notice 2018-67 clarifies that not-for-profit organizations must make a “reasonable, good-faith interpretation” of which unrelated trades or businesses’ taxable income streams must be calculated separately. Using the NAICS (North American Industry Classification System) codes or the fragmentation principle are considered reasonable methods according to the IRS. Income from the trade or business will be reduced by directly connected expenses. Allocation of overhead must be done on a “reasonable basis,” similar to the process used for a dual-use facility allocation.
Net Operating Losses & UBI
Organizations will also need to consider the changes the TCJA made to NOLs. Losses generated after Dec. 31, 2017, can offset up to 80 percent of taxable income. Unused NOLs generated prior to the TCJA’s effective date can be carried forward and used to offset UBI. Carrybacks are no longer permitted.
Notice 2018-67 clarifies that a not-for-profit can group its partnership investment income together and treat it as a single trade or business if the interests in the partnerships pass either a de minimis test or a control test.
- To pass the de minimis test, partnership interest of profit interest is 2 percent or less and no more than 2 percent capital interest.
- The control test is based on partner control within the partnership. If the exempt organization partner holds less than a 20 percent capital interest and it does not have control or influence over the partnership, investment income can be aggregated.
The notice also includes a transition rule that enables not-for-profits to treat each partnership as a separate trade or business and not look through the partnership to lower tier partnerships. The partnership investment activity transition rule applies to partnership interests acquired prior to Aug. 21, 2018.
GILTI and UBI
Notice 2018-67 also stipulates that global intangible low-tax income (GILTI) is treated as a dividend and generally excluded from UBI.
Planning for the UBI Changes
Not-for-profit organizations may need to readjust their approach to managing their UBI. For starters, they may consider adding more time to their year-end reporting function to separately account for each source of UBI. Organizations may also choose to transfer separate, unrelated operating businesses to a taxable subsidiary, which could help relieve the administrative burden and open the door to potential tax savings.
Before making any changes to the structure of your organization’s UBI activities, please consult your tax advisor, as not all exempt organizations will benefit from restructuring. Private foundations have restrictions on excess business holdings and no organization wants to lose the current exclusion from UBI on passive income.
All organizations that expect to generate more than $1,000 in UBI should take note of the change to the corporate tax rate. Under the pre-TCJA graduated corporate tax rate, organizations with a small amount of UBI may have qualified for a 15 percent tax rate for their UBI. With TCJA, the 21 percent rate would apply, which means some organizations may actually see a tax increase.
Executive Compensation Changes
The TCJA expands the 21 percent excise tax under Code Section 4960 to highly compensated employees of not-for-profits. The excise tax applies to compensation that exceeds $1 million as well as excess parachute payments.
Compensation for purposes of Section 4960 includes:
- Wages defined under Section 3401(a), including base salary, bonuses, taxable fringe benefits (similar to amounts reported on Form W-2)
- Excludes current deferrals under Section 401(k), 403(b) plans, 457(b) plans
- Includes amounts taxable under Section 457(f) when there is no further substantial risk of forfeiture
- Excludes compensation of licensed medical professional for medical services performed
The tax is on covered employees, which includes the top five highest compensated employees for the prior taxable year. Once an employee is determined to be “covered” under Section 4960, the employee remains “covered” moving forward. Compensation from related organizations is aggregated.
Parachute payments are defined as payments that are contingent upon an employee’s separation of employment. They are considered excess when:
- The aggregate present value of the payments equals or exceeds three times a “base wage”
- “Base wage” is average annualized compensation over five years
Not-for-profit organizations with employees receiving excess compensation (referred to as excess remuneration in the Code) must pay the excise tax and report it by filing IRS Form 4720 on a fiscal-year basis. Excess remuneration paid and excess parachute payments made in the calendar year ending within the organization’s fiscal (taxable) year are treated as paid for that taxable year. Additional information about how to apply Section 4960 can be found in IRS Notice 2019-09.
For assistance with evaluating these and other tax planning ramifications from the TCJA, please contact us.
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