Authored by Brian Jacobson, Mark Heroux, Larry Mohr and Julius Green
On Dec. 22, 2017, President Donald Trump signed the Tax Cut and Jobs Act (the Act) into law. The bill went through numerous changes and revisions before both the House and Senate came to an agreement and passed the legislation. The Act is the most comprehensive change to the U.S. tax code since 1986. Almost every individual, business, and tax-exempt entity is in some way affected by the new rules. The Act reduces the corporate income tax rate to 21 percent, transitions the U.S. to a territorial tax system, provides for a one-time repatriation of foreign earnings and makes extensive changes to individual taxation rules.
While the Act will simplify taxes for many Americans, many businesses and tax-exempt entities will find the computation of taxable income even more complex than in the past. Most of the provisions of the Act are effective for tax years beginning after Dec. 31, 2017.
The Act makes numerous direct changes to tax-exempt entity taxation, as well as, major changes to individual and corporate taxation that will indirectly affect tax-exempt organizations. Several punitive and controversial provisions were proposed in the Senate and House versions of the bill that were not included in the final legislation. This alert will address the important changes that are included in the Act that impact tax-exempt organizations as well as highlight a few of the provisions not included in the Act that may be included in future legislation.
Provisions impacting charitable contributions
The changes to individual and corporate tax rates and deductions have the potential to greatly impact charitable contributions. Under the Act, the standard deduction for individuals and married couples filing jointly will nearly double. The increase is from $6,350 to $12,000 for individuals and $12,700 to $24,000 for married couples. It is estimated that this change will reduce the total percentage of taxpayers who itemize from 30 percent to 5 percent. The corporate tax rate will also decrease from 35 percent to 21 percent. For both individuals and corporations, when tax rates go down, the after-tax cost of charitable contributions goes up. One of the results of the increased standard deduction and the lower individual and corporate tax rates will likely be a decrease in overall charitable contributions. Some estimates suggest an overall decline in charitable contributions between 4.5 percent and 9 percent. The overall decrease could reach as high as $26 billion per year.
The Act increases the charitable deduction limit for cash contributions by individuals from 50 percent to 60 percent of adjusted gross income. The increased deduction percentage is intended to incentivize giving. However, the increase in the standard deduction, elimination of certain itemized deductions, and the lower tax brackets may offset any donation increase that the new 60 percent deduction limit creates.
The Act also disallows the quid pro quo of donations for the right to purchase tickets at college athletic events. The Act provides that a donor may no longer deduct payments made to a college or university in exchange for the right to purchase tickets at athletic events. Under the previous tax rules, a taxpayer could take an 80 percent charitable deduction for the cost of this right. The Act is likely to have a negative impact on colleges and universities with high profile athletic programs.
The new law doubles the gift and estate tax exemption for estates and gifts made after Dec. 31, 2017 from $5 million to $10 million (indexed for inflation – $11.2 million for 2018), sunsetting on Dec. 31, 2025. The generation skipping tax also increases the exemption to $10 million (indexed for inflation – $11.2 million for 2018) and sunsets on Dec. 31, 2025. The increase in these exemptions lessens the incentive to donate portions of the estate to charity because more property can now be transferred to beneficiaries tax-free.
Excise tax on employee compensation
Under the Act, tax-exempt entities will be liable for a 21 percent excise tax on compensation in excess of $1 million for the top five highest paid employees and on certain excess parachute payments. Compensation includes the value of all remuneration (including benefits) paid in a medium other than cash. Compensation does not include amounts paid to a tax-qualified retirement plan and amounts excludable from gross income. Excess parachute payments, defined to include payments contingent on an employee’s separation of employment with the employer (i.e. severance payments), to any employee are subject to the 21 percent excise tax. Licensed medical professionals are excluded from these compensation rules to the extent the payment relates to the performance of medical or veterinary services by such professional. The excise tax was enacted to align the rules of tax-exempt entities with for-profit public companies, which are not allowed to deduct the portion of salary costs that exceed $1 million for certain individuals. It is important to note that the Act does not grandfather compensation paid under a pre-existing contractual agreement.
Excise tax on endowments
The Act imposes a 1.4 percent excise tax on net investment income of private colleges and universities with at least $500,000 in endowment assets per full-time student and at least 500 students. The original bill would have set the threshold at $250,000 per student. Under this final version, only 27 universities are expected to be subject to the excise tax. However, this provision signals Congressional intent to address the growing concern about the rising cost of tuition by many schools that have large endowments. This provision could be expanded over time as Congress continues to look for revenue raisers. The Treasury is expected to promulgate regulations that further clarify the calculation of endowment assets. Under the previous law, only private foundations were required to pay an excise tax on their net investment income. The Act focuses on private universities and colleges with very large endowments.
Unrelated business income offsets
The Act no longer allows tax-exempt entities to take the business losses from one economic activity and deduct them from the income generated by another economic activity. Each business activity will be taxed separately. Previously, organizations could offset income and losses between multiple unrelated business activities. The Act may inhibit tax-exempt organizations from starting a new line of business because they will no longer be able to deduct the expected losses against the income of another business activity. However, tax-exempt entities with unrelated business activity income will benefit from the new lower corporate tax rate of 21 percent.
Unrelated business income fringe benefits
The Act requires tax-exempt organizations to report as unrelated business income the costs of qualified transportation fringe benefits (except qualified bicycle commuting reimbursement), parking, facilities, and onsite gyms provided to employees. The tax on these fringe benefits becomes effective for amounts paid or incurred after 2017, and does not apply to the extent the amount paid or incurred is directly connected with an unrelated trade or business regularly carried on by the organization. The previous law did not tax fringe benefits related to onsite gyms and qualified transportation. The stated intent of the change is to make the tax treatment of these fringe benefits consistent with that of for-profit entities, which would not be able to deduct these benefits under the Act.
Under the previous law, section 501(c)(3) organizations could use qualified 501(c)(3) bonds to finance facilities. Qualified 501(c)(3) bonds are an important financing option used by charities and others for headquarters, buildings, schools, and other facilities. Section 501(c)(3) organizations were also able to use advance refunding bonds to refinance outstanding debt at lower interest rates. The final version of the Act preserves qualified section 501(c)(3) bonds, which was a significant win for the charitable sector, however, the Act included a provision that disallows use of advance refunding bonds. Additionally, interest paid to advance refunding bond investors is now taxable.
Education saving rules
The Act allows deductions for certain elementary or secondary public, private, or religious school expenses for tuition up to $10,000 per year to be a “qualified higher education expense” for section 529 plans. The amount of distributions from all qualified tuition programs with respect to a beneficiary during any taxable year is limited to $10,000 in the aggregate. The limit is effective for distributions made after 2017.
Other provisions applicable to tax-exempt entities
The Act repeals the deduction for local lobbying expenditures.
The Act specifically excludes from the definition of tangible personal property items such as cash, gift cards, and other nonpersonal property (such as vacations, lodging, and tickets to theater or sporting events) for purposes of qualifying as employee achievement awards. Watches and pens and similar tangible personal property of limited value are still allowed as employee achievement awards under the Act.
Several noteworthy provisions were omitted from the enacted legislation. Among the omitted changes were the following provisions:
- Repeal of the “Johnson Amendment.” The omitted provision would have allowed a section 501(c)(3) organization to make statements relating to political campaigns during the ordinary course of its regular and customary activities without jeopardizing the organization’s tax-exempt status.
- Blended Rate for Private Foundations. Another notable omission was a House bill provision that would have reduced the section 4940 excise tax on private foundation net investment income from 2 percent to 1.4 percent.
- Private Foundation Exception from Excess Business Holding Rules. Another House bill provision would have created an exception for certain businesses controlled by private foundations that donate their proceeds to charity.
- Repeal of qualified tuition reduction programs. The House bill proposed to tax the value of any reduction in tuition provided to an employee (or person deemed to be an employee) of a qualified educational institution.
While these and other provisions were omitted from the Act, they may appear in future legislation as Congress continues to look for revenue raisers and/or respond to continued concerns that these provisions seek to remedy.
The new tax law significantly changes the taxation landscape for tax-exempt entities. Tax-exempt organizations should evaluate how the changes could affect them and develop a plan to address the changes. The new rules for individuals and corporations may leave many charitable organizations with reduced critical revenue from gifts or charitable donations in the coming years. Tax-exempt entities must proactively plan to address the impact of the new tax law on their business operations.
We will continue to provide updates as the Treasury Department promulgates regulations designed to provide further guidance regarding the Act.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.