Taxing nonprofits
How the Tax Cuts and Jobs Act and other bills affect tax-exempt organizations.
March 29, 2022
By Mary Torretta, JD, and Michelle Weber, CPA
It would have been interesting to be a fly on the wall as Congress labored through drafting and revising the Tax Cuts and Jobs Act (TCJA) in fall 2017. Not only was Congress concerned with figuring out a way to present a balanced piece of tax legislation, but they were also drafting tax rules that would affect all taxpayers, including organizations that do not historically pay large amounts of income taxes: the exempt sector.
Exempt organizations were braced for the worst after the potential changes to the law in the Tax Reform Act of 2014, proposed by Rep. David Camp (R-MI4, 1993–2014), then chair of the House Ways and Means Committee. Organizations were threatened with the possible repeal of the Johnson Amendment, which would have allowed religious organizations to get involved in politics. The amendment was not repealed in the TCJA. Exempt organizations had also braced for the elimination of tax-exempt bonds — but Congress eliminated only private activity bonds. In addition, there was a potential threat to further restrict donor-advised funds and private operating foundations (primarily museums, which are private foundations and not public charities). Congress did not make those changes either.
Well, what did Congress do? They surprised us! Let’s look at the changes to the income and excise tax rules that affect tax-exempt organizations for years 2018 and beyond.
Income taxes
One of the changes that affected nearly every exempt organization was the enactment of Internal Revenue Code (IRC) 512(a)(7). This new section made an amount equal to the cost of tax-exempt employers providing parking and transportation fringe benefits to their own employees subject to unrelated business income taxation (UBIT). That’s right — an expense on the books was subject to income taxation in a way typically reserved only for revenue streams, and the change was costly and unpopular.
But, luckily, this change is now in the past! Nonprofits received a gift in the government funding bill signed by President Trump on Dec. 20, 2019. The $428 billion tax package retroactively repealed the inclusion of transportation fringe benefits in determining unrelated business income and prospectively changed the tax rate paid on net investment income by private foundations.
A nonprofit organization that previously filed Form 990-T and paid tax under the parking tax provision should discuss with their tax advisor the mechanism by which to obtain a refund for amounts paid to date. Further, organizations that used net operating loss (NOL) to offset a parking tax liability should re-evaluate their available NOL. An organization that has made estimated and extension payments associated with the parking tax may consider seeking a refund of the amounts.
Exempt organizations that are corporations are subject to the flat rate of 21 percent instead of the prior graduated rates on UBIT. However, a new code section further modifies the net tax an exempt organization may owe. In the TCJA, Congress also enacted IRC 512(a)(6), referred to now as a “siloing” provision. This new section requires exempt organizations to calculate the tax effect of each taxable revenue stream (and the correlating expenses) separately, disallowing losses from one revenue stream to offset gains earned by another taxable revenue stream. This requirement to “silo” is likely to cause tax-exempt organizations to be in a worse net tax situation than for-profit taxpayers, who are still able to net revenue streams when calculating resultant tax liability. With the elimination of the corporate alternative minimum tax, Congress limited the ways corporations can apply NOL deductions. Now, you can carry forward those losses indefinitely, but you can apply NOLs up to 80 percent of taxable income. Also, in conjunction with IRC 512(a)(6), organizations may only apply post-2017 NOLs against the revenue stream that generated the activity. Old NOLs are grandfathered and can be applied against all silos. The IRS issued guidance in Notice 2018-67 with regard to the siloing and suggested approaches to implementing the rules of this new code section.
Excise taxes
In addition to income taxes, Congress also enacted some new excise taxes via the TCJA. Codified in IRC 4960, Congress now imposes an excise tax on “excess” employee compensation paid by an applicable tax-exempt organization. Now, if an exempt organization compensates an officer or employee more than $1 million in a year, the organization may be liable for this excise tax. In addition, even if compensation is not above the $1 million threshold, an exempt organization may be liable for the excise tax if it pays an officer or employee an excess parachute payment. This excess payment is broadly defined as a payout of more than three times the base amount (a five-year average of compensation) in any given year. There are limits as to what constitutes covered employees, but now organizations need to start keeping lists of such employees. The IRS has issued interim guidance under Section 4960 in IRS Notice 2019-09.
The TCJA also imposed an excise tax on the investment income of some private institutions of higher learning in IRC 4968. If an institution has an endowment worth at least $500,000 per student and has at least 500 tuition-paying students, the college or university is subject to an excise tax equal to 1.4 percent of the investment income. Although relatively few organizations were affected, it put organizations with significant endowments on notice that Congress considers these endowments as money meant to be spent on students, not to serve only as a continual passive revenue stream. Again, the IRS issued guidance via Notice 2018-55 regarding the Section 4968 excise tax.
The government funding bill signed in December addresses private foundation excise tax rules. Under IRC Section 4940, private foundation excise tax rules currently provide for a 1 or 2 percent tax rate on net investment income, depending on the distribution activities of the private foundation. The tax package modifies this provision by replacing the rate calculation with a single 1.39 percent rate. This provision is effective for tax years beginning after Dec. 20, 2019. Private foundations should update their work papers for payment calculations for tax years beginning after Dec. 20, 2019, to ensure the new rate is used for proper calculation of tax due.
Far-reaching effects
Certain exempt organizations are also seeing the impact of the TCJA in ways that were not directly intended to impact them. Changes to the ways in which international income is subject to tax — and additional reporting related to those activities — is having an impact on organizations with direct and indirect foreign alternative investments. Similarly, some exempt organizations are also navigating the recent changes to the rules related to Section 163(j), which relates to the ability to deduct business interest expense. Lastly, it’s important to recognize that the federal tax law changes discussed above have ripple-effect impact on the tax position and reporting by the state jurisdictions.
Conclusion
During this time of drastic tax change, it is very important for tax specialists and organizations to stay close and up to date on the continuing developments, specifically the stream of technical guidance that the IRS is pushing out to the industry as they help us interpret Congress’s actions.
Mary Torretta, JD, is a principal in the national nonprofit tax practice of Grant Thornton LLP in Washington, D.C. Contact her at (703) 847-7659. Michelle Weber, CPA, is a partner in the national nonprofit tax practice of Grant Thornton LLP, in Milwaukee, and sits on the Wisconsin Institute of CPAs (WICPA) Not-for-Profit Accounting Conference Planning Committee. Contact her at (414) 277-1536.