The Tax Cuts and Jobs Act (the “Act”) was enacted on December 22, 2017, and is generally effective for taxable years beginning on or after January 1, 2018. The Act represents a substantial change to current tax law. While most of the Act’s changes impact for-profit businesses and individuals, the Act includes new provisions and amendments to prior law that also impact tax-exempt organizations. This client alert summarizes key provisions of the Act that effect tax-exempt organizations.
The Act imposes a tax of 21% on the amount of compensation exceeding $1,000,000 plus excess parachute payments paid by certain tax-exempt organizations to their top 5 highest compensated employees. The tax is payable by the tax-exempt organization employing the recipient of the compensation or excess parachute payment. Organizations subject to the tax include those exempt from tax under Section 501(a) of the Internal Revenue Code, which would include many hospital systems and universities as well as other types of tax-exempt organizations; certain state or local governmental entities, the income of which is excluded from taxation under Section 115 of the Internal Revenue Code; farmers’ cooperative organizations described in Internal Revenue Code Section 521(b)(1) and political organizations described in Internal Revenue Code Section 527(e)(1). Excess parachute payments are payments contingent upon an employee’s separation from service if the amount of the payment exceeds 3 times the employee’s average annual compensation for a 5-year period ending on the date of the separation from service.
Many charitable organizations that provide compensation to executives in excess of $1,000,000 have historically faced public scrutiny over their compensation packages. Now, these organizations will need to defend their compensation practices to donors and other constituencies in light of the additional cost of such practices.
Private College and University Endowment Excise Tax
A private college or university will pay a 1.4% excise tax on its net investment income if the private college or university:
- had at least 500 tuition-paying students in the preceding taxable year,
- more than one-half of those students are located in the United States, and
- the aggregate fair market value of the college’s or university’s assets at the end of the preceding taxable year (not including assets used directly in carrying out the institution’s exempt purposes) is at least $500,000 per student.
Net investment income is generally interest, dividends, rents, payments with respect to securities loans, and royalties less deductions for ordinary and necessary expenses incurred in producing this income. A private college or university generally must take into account net investment income of related organizations for purposes of determining its tax liability.
Unrelated Trade or Business Income
While tax-exempt organizations are generally required to carry on activities that further their exempt purposes, many of these organizations engage in some activity that is not related to their exempt purposes. Net income from these unrelated activities is subject to the unrelated business income tax. Prior to the Act, an organization that engaged in multiple unrelated trades or businesses could offset income from one unrelated trade or business by losses or deductions of another unrelated trade or business to compute an aggregate amount of net income subject to the unrelated business income tax. The Act has added a provision to Section 512 of the Internal Revenue Code that includes new rules for calculating unrelated business taxable income for taxable years beginning after December 31, 2017. The new provision requires that unrelated business taxable income be calculated on a separate unrelated trade or business basis. In addition, the net operating losses of one unrelated trade or business cannot be used to offset income from another unrelated trade or business.
The Act amended certain provisions of Internal Revenue Code Section 170, which allows taxpayers to deduct charitable contributions. Prior to enactment of the Act, the amount of charitable contributions that an individual could deduct was generally limited to 50% of the individual’s adjusted gross income with certain modifications. The Act increases the adjusted gross income limitation for cash contributions from 50% to 60%. Under prior law, taxpayers could also deduct 80% of the amounts paid to a college or university for athletic event seating rights. The Act disallows this deduction.
Generally, gross income does not include interest from bonds issued by state or local governments. Private activity bonds are bonds issued by a state or local government to provide financing to private businesses or individuals. The gross income interest exclusion also applies to private activity bonds if the bonds are issued for certain permissible purposes, including bonds issued to benefit 501(c)(3) organizations. Earlier versions of the Act provided for the repeal of private activity bonds. The Act, however, did not include a repeal of private activity bonds, thereby maintaining an important and lower-cost source of financing for capital projects undertaken by 501(c)(3) organizations.
Under prior law, interest from an advance refunding bond issued by a state or local government or for the benefit of a 501(c)(3) organization was also excluded from income. An advance refunding bond is generally a bond issued to pay principal, interest or redemption price on a prior bond issue if the refunding bond is issued more than 90 days before the redemption of the refunded bond. The Act repeals the interest exclusion for advance refunding bonds issued after December 31, 2017.