Associations avoided the harshest proposals but should be aware of several important new tax issues.
The new Tax Cuts and Jobs Act of 2017 (the Act), signed into law by President Trump on December 22, 2017, contains several features that will adversely affect many Section 501(c)(6) tax-exempt nonprofit membership organizations such as trade associations and professional societies (associations).
This alert summarizes those new features in the law. It should be recognized that several harsher issues for associations and other tax-exempt organizations were raised and considered by the U.S. Congress but not ultimately enacted in the legislation. These proposals included ending tax-exempt treatment of royalty income, elimination of non-qualified deferred compensation arrangements for employees of exempt organizations, and imposition of “intermediate sanctions”/“excess benefit” penalties on payments of above-market-rate amounts to “insiders” of associations (though the penalties can still apply against insiders and entities with substantial influence over Section 501(c)(3) and 501(c)(4) organizations, including related associations, and the more general “inurement” principle remains applicable to associations). The new features that do affect associations, and that were part of the Act, include these:
1. Separate Computation of Unrelated Business Income for Multiple Businesses
The Act requires exempt organizations subject to unrelated business income tax (UBIT) to compute taxable income from multiple unrelated trades or businesses separately, eliminating the ability to offset income from one unrelated business with losses from another. This rule also applies to the computation and carryover of any net operating loss (NOL), meaning that affected organizations may have to track and possibly let NOLs from one or more unrelated businesses sit idle and unused indefinitely while having to pay tax on net income from profitable unrelated businesses. The Act does, however, allow NOL carryovers from taxable years beginning prior to 2018 to be applied to offset the combined unrelated business taxable income from all separate businesses, subject to a separate provision of the Act that precludes NOLs from offsetting more than 80 percent of taxable income in a single taxable year. The new rule is effective for taxable years beginning in 2018 and later.
2. Tax on Excessive Tax-Exempt Organization Executive Compensation
The Act attempts in selected situations to equalize the effect of deduction disallowances on for-profit and tax-exempt organizations. For example, publicly traded business corporations have long been subject to a deduction disallowance for certain executive compensation over $1 million (modified in some respects by the Act). Under this equalization principle, for any “covered employee” (generally, any of the top five compensated employees) of an applicable tax-exempt organization, the Act imposes on the organization a 21 percent excise tax on the sum of: (a) annual remuneration above $1 million, plus (b) certain separation payments that exceed three times an average base salary measure (“excess parachute payments”). The excess parachute payments provision can apply to compensation well below $1 million, although there are several types of employee benefits that are excluded from this measure, and medical professionals (as further described below) and non-highly compensated individuals are generally exempt.
An “applicable tax-exempt organization” covered by these rules is any organization exempt under section 501(a) of the Code, farmer’s cooperatives, section 527 political organizations, and certain government-affiliated exempt organizations. “Remuneration” subject to the $1 million limitation includes “wages” as defined for purposes of income tax wage withholding, as well as certain nonqualified deferred compensation that is treated as paid when there is no longer a substantial risk of forfeiture, but does not include designated Roth contributions. Licensed medical and veterinary professionals are generally excluded from the tax with respect to both the remuneration limit and excess parachute payments to the extent of payments for medical or veterinary services.
There are a number of special rules that broaden the reach of the tax. For example, covered employees include persons who were formerly covered employees of the organization or any predecessor entity for any taxable year beginning in 2017 or later. Also, remuneration from the applicable tax-exempt organization is combined with remuneration from employment at related organizations and governmental entities, with “related” generally meaning entities: (i) controlling or controlled by the organization, or under common control with the organization, (ii) that are supported or supporting organizations of the organization under section 509 of the Code, or (iii) with respect to a voluntary employees’ beneficiary association (VEBA), any organization or governmental entity that establishes, maintains or makes contributions to the VEBA. In such a case, the tax liability is shared proportionately between the related entities. Finally, there is an anti-avoidance provision that permits the IRS to issue regulations to prevent “avoidance of such tax through the performance of services other than as an employee or by providing compensation through a pass-through or other entity.” The tax is effective for taxable years beginning in 2018 and later.
3. Inclusion of Non-Deductible Fringe Benefits in Unrelated Business Income
In another provision intended to treat for-profit and tax-exempt organizations similarly, the Act causes the costs of certain employee fringe benefits that the Act has made nondeductible to a for-profit employer to be treated as unrelated business taxable income to a tax-exempt employer. The new rule applies to qualified transportation fringe benefits including amounts paid or incurred by the organization for vanpools, transit passes, and qualified parking, as well as costs related to operating qualified parking facilities and on-premises athletic facilities. The rule does not apply to costs directly associated with an unrelated trade or business. The Act further directs that rules shall be issued to address allocation of depreciation and other costs associated with parking and on-premises athletic facilities. The provision is effective for taxable years beginning in 2018 and later.
It should also be recognized that the Act contains several features that many consider to be actually or potentially adverse to public charities, as distinguished from associations, because they may discourage charitable giving. Those provisions are not addressed here, but they include increasing the standard deduction and increasing the amounts exempt from federal estate and gift taxes.