The United States has proven to be the most generous country in the world. Approximately 91% of high net worth households give to charity. On average, high net worth donors gave $25,509 to charity in 2015. By comparison, general population households gave $2,520 on average. Charitable Giving Statistics, NPTrust, (2018) (http://www.nptrust.org/philanthropic-resources/charitable-giving-statistics). In 2016, the largest source of charitable giving came from individuals at $281.86 billion, or 72% of total giving; followed by foundations ($58.28 billion/15%), bequests ($30.36 billion/8%), and corporations ($18.55 billion/5%). In 2016, the majority of charitable dollars went to religion (32%), education (16%), human services (12%), grantmaking foundations (11%), and health (9%).
How will the passage of the Tax Cuts and Jobs Act of 2017 (hereinafter “the Act”) affect American generosity? And, what will happen to executive compensation and employee benefits?
Tax Reform’s Potential Impact on Nonprofits and Charitable Giving: §63
Generally, people donate more when there are incentives to do so. Many who formerly itemized their deductions may see that it is no longer beneficial to do so under the Act. This will likely lead to a reduction in overall charitable giving – taxpayers who itemized their deductions were responsible for 82% of charitable giving in 2017. How the Tax Rewrite Could Impact Charitable Giving, NPR (Dec. 3, 2017) (https://www.npr.org/2017/12/03/568206410/how-the-tax-rewrite-could-impact-charitable-giving). The Joint Committee on Taxation estimates that itemized deductions will drop by $95 billion in 2018, and this reduction is estimated to shrink nonprofit giving by $13 billion or more each year. Key Provisions in House/Senate Tax Reform Bills, National Council of Nonprofits, (Dec. 15, 2017), (https://www.councilofnonprofits.org/sites/default/files/documents/comparison-house-senate-tax-bills-nonprofits.pdf). The reason for the drop is that the Act reduces the tax savings from charitable donations, effectively raising the “price” of giving as people shift to lower tax brackets. In general, the charitable tax deduction subsidizes private giving by reducing the out-of-pocket cost of making a contribution. For example, a taxpayer in the 28% tax bracket who gives $100 to a favorite charity cuts his or her tax bill by $28 with a charitable tax deduction, in effect reducing the out-of-pocket cost of the donation to $72. Emerging Issues in Philanthropy, The Urban Institute (http://www.taxpolicycenter.org/sites/default/files/alfresco/publication-pdfs/310256-The-Cost-of-Giving-How-Do-Changes-in-Tax-Deductions-Affect-Charitable-Contributions-.PDF). After the Act, as people fall into new lower tax brackets, the charitable tax deduction subsidy is also reduced. High-income households, who effectively donate the most to charities, will see the smallest impact on the charitable tax deduction subsidy under the Act. Michael Hicks, Relax, Tax Reform Won’t Hurt Charitable Giving, IndyStar (Jan. 8, 2018) (https://www.indystar.com/story/opinion/2018/01/08/hicks-relax-tax-reform-wont-hurt-charitable-giving/1013117001/). For this reason, the wealthier taxpayers’ use of the charitable deduction is less likely to be affected by the Act than those taxpayers in lower tax brackets. It is also important to note that individuals who make donations motivated by their belief in the work done by nonprofits, not the value of the charitable tax deduction subsidy, likely will give regardless of the reduction or loss of a tax deduction.
One of the beneficial provisions in the Act for charitable giving is the increase in total deduction an individual can utilize. Previous to the Act, contributions to public charities were deductible up to 50% of the taxpayer’s adjusted gross income (computed without regard to net operating loss carrybacks), and contributions to certain private foundations, veteran’s organizations, fraternal societies, and cemetery organizations were limited to 30% of the taxpayer’s adjusted gross income (computed without regard to net operating loss carrybacks). After the Act, contributions to public charities and certain private foundations are deductible up to 60% of the taxpayer’s adjusted gross income – which is up 10%. The 30% cap remains in effect for most private foundations.
Estate and Gift Tax: § 2010
The estate and gift tax creates a strong incentive for the super-wealthy to donate their wealth to charity and form charitable trusts, rather than to pay tax. Doubling the estate and gift tax exemption (from $5.5 million to $11 million) under the Act will mean that far fewer wealthy taxpayers will incur estate and gift tax when leaving or gifting money to their heirs. And, those who still are required to pay estate and gift taxes will have more of their transferred wealth exempted from taxation. The higher exemption is expected to reduce charitable contributions by about $4 billion per year. The New Tax Law and Its Impact on Nonprofits-Part 1, NEO Law Group, ((Jan. 7, 2018), (http://www.nonprofitlawblog.com/tax-cuts-and-jobs-act-new-tax-law-impact-on-nonprofits-fundraising/). When the estate tax was repealed in 2010, charitable bequests dropped by 37% from 2009 numbers, and then rose by 92% in the following year (2011) when the estate tax was reinstated. Keep the Estate Tax, The New York Times, (Oct. 25, 2017), (https://www.nytimes.com/2017/10/25/opinion/estate-tax.html?mtrref=www.google.com&gwh=96D91C08E66DDAA2691ADF0C19ABBE05&gwt=pay&assetType=opinion).
Unrelated Business Income: § 511
Recall that Unrelated Business Income (hereinafter “UBI”) is incurred when an exempt organization: 1.) engages in a trade or business (commercial activity); 2.) the trade or business is regularly carried on; and 3.) the commercial activity is not substantially and importantly related to the organization’s exempt purpose. See I.R.C. § 513 and Treas. Reg. § 1.513-1. UBI can result in income tax payable to the IRS by the charity.
The calculation of UBI has changed under the Act. The Act disallows exempt organizations from using business losses from one economic activity and deducting them from the gains of another economic activity. In essence, losses from one unrelated trade or business will only be available to offset income from that activity. Organizations can, however, use one year’s losses on the same unrelated business to reduce taxes on another year’s operation of the same unrelated business. This change will likely result in many exempt organizations paying more tax on UBI.
Changes in the corporate tax rate will apply to taxation of UBI. Previously, the tax rate was 15% on the first $50,000 of taxable income, gradually increasing to 35%. Under the Act, UBI is subject to a flat rate 21% in tax. Exempt organizations with net taxable UBI below approximately $91,000 will experience a tax increase rather than a decrease.
Executive Compensation: § 4960
The Act creates a 21% excise tax on the compensation of any “covered employee” earning in excess of $1 million. The term “covered employee” means any employee (including any former employee) of an exempt organization, if the employee: 1.) is one of the five (5) highest compensated employees of the organization for the taxable year; or 2.) was a covered employee in any preceding taxable year after Dec. 31, 2017. Covered employees will most likely include an Executive Director/CEO, CFO, and perhaps other upper-level management positions. The Act essentially labels any compensation exceeding $1 million as excessive instead of presuming “reasonableness” if the compensation is benchmarked to peer organizations and approved by the Board of Directors prior to payment. This change will largely affect nonprofit hospitals and healthcare entities, private colleges and universities, and other large exempt organizations.
It is important to note that the 21% excise tax likely will not apply to executives at public colleges and universities. The IRS has long taken the view that states and political subdivisions avoid income tax under the doctrine of implied statutory immunity. Section 4960 states that an applicable exempt organization includes any organization with income “excluded from tax under section 115(1).” Unless otherwise specified in the Internal Revenue Code, states and their political subdivisions are not taxpayers under the Code, and their income is not gross income within the meaning of Section 61. Public universities do not pay federal income tax because they are either an integral part of a state or political subdivision, or possess themselves sufficient powers, such as police power, to qualify as a political subdivision. Despite this, the Act does not include statutory language that would make public universities subject to taxation under Section 4960. In order to make public colleges and universities subject to the 21% excise tax on executive compensation, Section 4960 would need to be amended to include a provision that would specifically subject public colleges and universities to the tax. See Ellen P. Aprill, Congress Fumbles the Ball on Section 4960 (https://medium.com/whatever-source-derived/congress-fumbles-the-ball-on-section-4960-guest-post-by-ellen-aprill-18a2dbf98c5f).
In addition, a 21% excise tax is imposed on excess parachute payments, defined as “a severance payment, including transfer of property, to any highly compensated employee, that is greater than three times the individual’s average salary for the previous five years.” Highly compensated employees include employees who received compensation exceeding $120,000 in 2018.
Employee Benefits: § 132
Fringe Benefits: Certain fringe benefits are no longer deductible by employers, including commuter transportation, mass transit passes, parking facilities, and onsite athletic facilities (gym, pool, tennis court, golf course, etc.). Exempt organizations providing such benefits must report the expenditure as UBI unless the benefit is directly connected to a taxable activity already included on Form 990-T.
Temporary Family and Medical Leave: The Act creates a paid family and medical leave credit for tax years after December 31, 2017, and before January 1, 2020. The employer must provide at least two (2) weeks (but not more than twelve (12) weeks) of paid leave at a rate that is at least 50% of the employee’s ordinary wages. In addition, the employee must have been employed for at least one (1) year prior to the paid leave, and the employee’s prior year compensation cannot have exceeded $72,000. Leave mandated or paid for by a state or local government does not count for purposes of the federal credit.
Employee Achievement Awards: Awards for things such as length of service or an exemplary safety record that are awarded as part of a meaningful presentation, can be excluded from the employee’s taxable income as long as they are not disguised compensation.
Employer Entertainment Deduction: In general, the Act provides for stricter limits on the deductibility of business meals and entertainment expenses. Under the Act entertainment expenses incurred or paid after December 31, 2017 are nondeductible unless they fall under the specific exceptions in Code Section 274(e). One of those exceptions is for “expenses for recreation, social, or similar activities primarily for the benefit of the taxpayer’s employees, other than highly compensated employees” (i.e. office holiday parties are still deductible). Business meals provided for the convenience of the employer are now only 50% deductible whereas before the Act they were fully deductible. Barring further action by Congress those meals will be nondeductible after 2025.
ACA Individual Mandate: While the Act repeals the Affordable Care Act’s individual mandate, the employer mandate remains in effect. This means obtaining health coverage will be purely voluntary for individuals starting in 2019. Despite this, employers with more than 50 full-time employees will still be required to provide health coverage for their employees or face stiff penalties.
Private Activity Bonds:
Private activity bonds provide a significant amount of capital financing for many exempt organizations. The Act eliminated the exclusion from gross income of interest received on advanced refunding of private activity bonds.
Contemporaneous written acknowledgement of contributions:
A donor wishing to deduct a charitable contribution of $250 or more must obtain a contemporaneous written acknowledgement from the organization receiving the donation. Previously, if the donor failed to retain a copy of the acknowledgement, the donor could attempt to substantiate his/her donation by using the charity’s Form 990, Schedule B.