Tax Update for Not-for-Profit Organizations

The most recent tax reform legislation has affected almost every taxpayer in every industry, and not-for-profits were no exception. The tax bill, known as the Tax Cuts and Jobs Act, altered a few key laws that exempt organizations have relied on for years. Understanding these changes can help not-for-profit leaders plan for the 2018 tax year and beyond.

Changes in Unrelated Business Income Rules

Unrelated Business Income (UBI) can be a contentious subject for not-for-profit executives because it is often a filing and financial burden on the organization. When not-for-profits perform business activities that are unrelated to their organizations’ missions, the resulting revenues (UBI) may be taxable. Congress chose to tax UBI at the corporate rates to keep not-for-profits on an even playing field with for-profit corporations. All UBI earned in calendar year 2018 will be taxed at the new rate of 21 percent, and UBI earned in 2017 will be taxed using the previously applicable progressive rates that ranged from 15 to 39 percent. Fiscal year entities reporting income from both 2017 and 2018 will utilize a blended tax rate.

The tax reform bill altered the UBI rules in one other way – it instituted a “silo approach” to claim unrelated business losses. Under this approach, the UBI from each trade or business is calculated separately, and unused losses can only offset future incomes from that particular trade or business. No longer can a loss from one business activity offset the future income from another.

In August 2018, the IRS released Notice 2018-67 that clarified a few more items related to UBI:

Definition of a Trade or Business

When netting unrelated business losses using the silo approach, the definition of a trade or business requires a “reasonable, good-faith interpretation” of existing legislation. One example of a good-faith interpretation includes using the North American Industry Classification System six-digit codes. The tax code does not include a separate definition for UBI purposes.

Partnership Interests

IRS created an interim rule allowing exempt organizations to aggregate qualifying partnership interests as comprising a single trade or business for purposes of the silo rules.  For the interest to qualify, the directly-held interest in the partnership must meet either a new de minimis test or a new control test.

Net Operating Losses (NOLs)

Consistent with corporate tax law, post-2017 net operating losses from unrelated business activities can no longer be carried back to offset prior year UBI. They can, however, be carried forward indefinitely to offset future years’ UBI.

Notice 2018-67 also explained that NOLs generated in pre-tax reform periods can offset future UBI from any business activity. In other words, pre-tax reform NOLs are not bound by the silo approach.

Calculation of UBI from Employer Provided Transportation Benefits

Beginning in 2018, transportation fringe benefits (employer provided parking or mass transit passes) provided to employees will increase an entity’s UBI. In past years, this benefit was not taxable. Notice 2018-99 clarifies the calculation but leaves some issues unanswered.

These tax reform changes may affect how much UBI your organization reports. So, not-for-profits need to make sure their estimated taxes sufficiently cover the potential tax liability.

Excise Tax on Executive Compensation

A 21 percent excise tax is imposed on not-for-profits that pay their executives certain compensation over $1 million or certain parachute payments.  

Covered employees include any employee or former employee of an Applicable Tax-Exempt Organization (ATEO) if the employee:

1. Is one of the top five highest compensated employees that year; or
2. Was the organization’s (or a predecessor’s) covered employee for any tax year beginning after December 31, 2016.

ATEOs are defined as specific exempt entities, including 501(b) and 501(c) organizations, government entities, farmers’ cooperatives and 527(e)(1) political organizations.

Excess compensation is generally defined as (a) compensation above $1 million, or (b) parachute payments that are more than three times their base compensation in the event of a separation. There are specific exclusions to these general rules, so review Notice 2019-9 carefully before making this calculation.

Excise Tax on Private Colleges

A 1.4 percent excise tax of an organization’s net investment income is imposed on certain private colleges and universities. These colleges must have at least 500 full-time students and endowment assets whose average value exceeds $500,000 per student. While this tax can be significant, it is likely to affect only a handful of taxpayers in 2018 and 2019.

As not-for-profit tax law morphs, so will the tax plans of not-for-profits. Contact us to discuss your organization’s specific needs.

© 2019