On December 22, 2017, President Trump signed the massive federal income tax overhaul into law. With this, a higher standard deduction was realized. Much was made of the concern of nonprofits that this would lessen incentives for charitable giving. While this is important, the new law also includes a number of other provisions that could affect these organizations.
Calculating Unrelated Business Taxable Income
The Tax Cuts and Jobs Act (TCJA) has substantially lowered the corporate tax rate to 21%, a significant benefit to any nonprofit that is already paying unrelated business income tax which is imposed at the corporate rate. However, when it comes to calculating the income that is subject to this tax, the new law brings some bad news for nonprofits.
The TCJA requires nonprofits to compute unrelated business taxable income (UBTI) separately for each unrelated business activity and pay tax on any activity with net income. This means that nonprofits cannot use a loss from one unrelated business to offset income from a different unrelated business for the same tax year.
A nonprofit could, however, use one year’s losses on an unrelated business to offset profits in a different year for that business, subject to certain restrictions. For example, if a nonprofit incurred a loss in its bookstore business in 2018, it could use that loss to offset bookstore profits in 2019.
Qualified transportation benefits (for example, transit passes), qualified parking benefits and access to any on-site athletic facility are also includable in UBTI as a result of the TCJA.
The TCJA also imposes a 21% excise tax on nonprofits that pay “excessive” executive compensation. The tax applies to the sum of any compensation (including most benefits) in excess of $1 million paid in the tax year to a covered employee plus certain large payments to that employee upon his or her departure from the organization (known as “excess parachute payments”).
A “covered employee” means a current or former employee reported as one of the five highest paid employees for any taxable year beginning after 2016. Licensed medical professionals are not covered employees for this tax.
But what is an “excess parachute payment”? A payment generally is considered an excess parachute payment if the following apply:
- It’s contingent on the employee’s departure.
- The present value of these payments equals or exceeds three times the base amount, which is the employee’s average annual compensation for the preceding five years.
The excess parachute payment subject to the excise tax is the amount of the parachute payment less the base amount.
While the increase in the standard deduction is expected to reduce the number of taxpayers who itemize and, thus, deduct charitable contributions, it is not the only change that could affect giving.
The TCJA doubles the estate tax exemption to $10 million (indexed for inflation) through 2025. As a result, fewer wealthy individuals will be at risk of paying this tax and fewer people may make the generous donations that would have helped to shrink a taxable estate. Additionally, the TCJA eliminates any deduction for donations made in exchange for the right to buy season tickets to college athletic events.
The TCJA does raise the limit on cash donation deductions from 50% of adjusted gross income to 60%. However, the higher limit may not stimulate much additional giving since cash donations at this level are uncommon.
To finance construction and other capital activities, some nonprofits issue tax-exempt bonds. These typically have lower interest rates in comparison to other bonds. However, investors generally accept this because they are not required to pay income tax on any accumulated interest.
The TCJA, however, repeals the tax-exempt treatment for interest paid on a bond issued to refinance another tax-exempt bond. An “advance refunding bond” is used to pay principal, interest or redemption price on a prior bond and is issued more than 90 days before the date that the bond refund can be redeemed.
As an example, tax-exempt bonds are issued at 4% interest but later it is discovered that the bonds can be refinanced at 3% interest. Under the TCJA, the interest payments on the 3% advance refunding bonds will not be tax-exempt for investors — this means that investors will expect to be paid a higher rate of interest due to their increased tax liability.
Charting the Course Ahead
Despite the advantage of a lower tax rate on unrelated business income, the new income tax law may decrease overall charitable giving and simultaneously increase costs for some nonprofits. Consult your CPA to help chart the best course forward in this changing environment.