* The views expressed are those of the authors and do not necessarily reflect the views of Ernst & Young, LLP.
After a wintertime flurry of activity, in December 2017 Congress passed and the president signed the most significant tax legislation in the past 30 years. Commonly referred to as the Tax Cuts and Jobs Act (TCJA), the law is generally favorable for tax-paying organizations, with key provisions including a significant reduction in corporate tax rates and the elimination of the corporate alternative minimum tax. However, the law is potentially unfavorable for nonprofit organizations because of reduced incentives for charitable giving and additional income and excise taxes.
Charitable Giving Incentives
The TCJA contains numerous changes to income tax provisions for individuals. Some of these changes create additional incentives for charitable giving, in part by:
- Repealing the limit on itemized deductions, known as the “Pease limitation,” for certain high-income taxpayers
- Increasing the adjusted gross income (AGI) limitation for charitable contributions from 50% to 60%
However, other provisions significantly reduce incentives for charitable giving, in part by:
- Doubling the standard deduction to $24,000 for joint filers ($12,000 for single filers)
- Doubling the basic exclusions for the estate, gift and generation skipping transfer taxes to $10 million (indexed for inflation)
- Eliminating the deduction for amounts paid in exchange for college event seating rights
On balance, as a result of these changes it is likely that many more individuals will take the standard deduction rather than itemize deductions on their annual income tax returns. Because individuals who take the standard deduction would not benefit from the charitable deduction (available only to those who itemize), many will have less incentive to make charitable contributions. Similarly, because the amount excluded from the estate tax has doubled, fewer estates will need to utilize charitable gifts to reduce assets subject to the estate tax. Although these changes were not necessarily intended to affect nonprofit organizations, and some commenters assert that overall charitable giving will rise due to taxpayers’ larger paychecks (as tax withholding is now lower) and economic activity, the new rules still alter gift-giving incentives.
The extent of the TCJA’s impact on a nonprofit organization will depend on its body of donors. A nonprofit that relies on smaller, individual donations may feel the effects more acutely than a nonprofit that receives most of its support from organizations or wealthy donors who continue to itemize their deductions and are subject to the estate tax.
New Taxes
In addition to provisions that alter individual giving incentives, and therefore that may affect the contributions an organization receives, the TCJA contains several new taxes, and changes to the unrelated business income tax (UBIT), that directly increase the tax burden on nonprofit organizations.
One new tax is imposed on “excess” compensation paid to a nonprofit organization’s highest-paid employees. Each year the organization must determine its five highest paid employees and add them to its list of “covered employees.” Once on the list, an individual stays on the list, even if that person is not among the top five for a future year. If the organization pays more than $1 million in annual taxable wages to a covered employee, the organization must pay a 21% tax on the amount over $1 million paid during a tax year. It must also pay a tax on certain severance payments to a covered employee. The compensation being measured includes compensation from related entities.
For certain private colleges and universities with large endowments, there is a new 1.4% tax on net investment income. This tax is similar to the investment income tax paid by private foundations, but also encompasses certain assets and income of related and closely affiliated entities.
The UBIT rules have been changed in two ways that will likely increase the amount of tax paid. First, unrelated business taxable income (UBTI) must now be calculated separately for each trade or business, rather than in the aggregate. This means that losses from one unrelated trade or business cannot offset taxable income from a separate unrelated trade or business.
Second, if a nonprofit provides transportation, parking, and/or certain athletic facility benefits to employees, and excludes these benefits from the employee’s income as a qualified fringe benefit, it is treated as having an additional amount of UBTI equal to the expenses it incurs in providing the benefits. Treating expenses as taxable income is an unusual concept, but is designed to put tax-exempt entities in a similar position to taxable entities, which lost deductions for the same types of fringe benefits under the TCJA.
Although these changes will likely increase many organizations’ UBTI, the tax rate on that income will be lower for most nonprofits, which will pay tax on UBTI at the new, lower corporate rate of 21%.
Living with the Changes
These provisions will likely increase administrative costs and tax burdens for tax-exempt organizations, while at the same time reducing incentives for individuals to support them through donations. Affected organizations should assess how they can take practical steps to minimize these new burdens.
Understand and mitigate impact through modeling
By modeling the potential impact of the TCJA provisions that apply, an organization can more effectively evaluate how it might restructure benefits, compensation, or fundraising activities to minimize its tax liability. This modeling may also be important for purposes of making adequate disclosure on an organization’s financial statements and Form 990.
Engage in the regulatory process
There are several key details missing from the TCJA statutory language, gaps that will need to be filled in by the Treasury Department and IRS through regulations and other guidance. While they are developing this guidance, it is possible (and beneficial) for organizations to engage in the regulatory process. Treasury and the IRS have limited information on how the new law and accompanying regulations will affect nonprofit organizations’ individual situations. This presents an opportunity for nonprofits to engage with guidance writers and provide input on how the new provisions can be reasonably interpreted to minimize programmatic, financial and administrative burden. To engage, one need not work solely through associations; individual comments are also valued, particularly because the number of comments is often taken into account by the Treasury and IRS when developing guidance. Comments may be submitted to the Treasury and IRS at any time, even before proposed regulations are issued.
If the potential impact of the tax law on your organization or how to respond to the new law remains unclear, outside help from a tax professional may be the best course of action.