Editor’s note: On January 12, 2021, the IRS released final regulations for Internal Revenue Code Sec. 4960, which provided certain nonprofit organizations with more clarity around the 21 percent excise tax on annual compensation exceeding $1 million for the five highest paid executives and certain separation pay or “golden parachute” packages paid to those employees. The final regulations will apply for tax years beginning after December 31, 2021 and define rules to determine the amount of excess compensation, calculating the tax due and decide what qualifies as a parachute payment. Click here to read the final regulations in full and contact your RKL advisor to discuss your nonprofit’s specific circumstances and applicability.
Editor’s note: Effective December 20, 2019, nonprofit parking and transportation benefits will no longer be counted as unrelated business taxable income. This full repeal was part of the Taxpayer Certainty and Disaster Tax Relief Act of 2019 and is retroactive for 2018 and 2019.
Most of the headlines about tax reform focus on the individual and for-profit business provisions. Nonprofit leaders may wonder how the Tax Cuts and Jobs Act (TCJA) will affect their finances and operations. Let’s examine two key ways tax reform directly impacts tax-exempt organizations.
Direct nonprofit tax reform impact: Unrelated business income
Tax reform changes how unrelated business income (UBI) is calculated and taxed.
Starting in 2018, nonprofits must calculate UBI on each trade or business individually, rather than the previous aggregated method. The definitions for trade or business in the TCJA are currently unclear – for example, do investments in multiple real estate partnerships count as one trade or business or must each partnership be counted separately? This is just one of the many areas of tax reform that will require additional clarification as regulations are drafted by the IRS.
Under tax reform, UBI will now be taxed at the new corporate rate of 21 percent, instead of the previous multi-level rate schedule. The financial impact of this rate change depends on the size of the nonprofit. Smaller organizations with less than $90,000 of taxable income will now pay more due to the switch, while larger organizations will see a smaller tax burden.
Net operating losses (NOLs) from prior years may still be used to offset all UBI tax. Tax reform sets new rules for NOL carryforwards at 80 percent of taxable income. Keep in mind, all new NOLs must be calculated by trade or business and can no longer “cross pollinate.”
Tax reform also expands the definition of UBI to include certain fringe benefits offered to employees, like transportation, parking or on premise athletic facilities.
How nonprofits can prepare for UBI change
Under the new UBI tax calculation and rate, nonprofit leaders must ensure they are allocating the appropriate general or shared expenses to each trade or business to maximize benefit. Other options, such as moving multiple taxable trade or business activities into a wholly owned corporation to offset profitable activities with loss activities, should be considered with the consultation of a tax advisor.
With regard to certain fringe benefits now considered as UBI, nonprofits should consider increasing wages and eliminating qualifying benefits from pay plans to avoid an additional tax burden. Your tax advisor can demonstrate the pros and cons of such a decision.
Direct nonprofit tax reform impact: Excise taxes
To bring nonprofit pay in line with public company compensation rules, the TJCA created a new 21 percent excise tax on annual compensation of $1 million or higher to an organization’s top five highest compensated employees. This new excise tax also applies to certain “golden parachute” separation pay packages. Medical services provided by doctors, nurses and veterinarians are excluded from this new tax, which is the obligation of the nonprofit, not the employee.
There are a lot of details to unpack around this new excise tax, related to issues like separation pay calculation and remuneration, so make sure to discuss your nonprofit’s unique situation with your tax advisor.
Additionally, the net investment income of some private colleges and universities are subject to a new 1.4 percent excise tax. Institutions with at least 500 students (over half of which are based in the U.S.) and prior year assets of at least $500,000 per full-time student will be hit with this new tax. This asset threshold calculation does not include assets used to carry out a school’s educational purpose, but it does include assets and net investment income of all organizations related to the private university.
How nonprofits can prepare for excise taxes
To continually assess the annual impact of the compensation excise tax, nonprofit leaders should keep close track of “covered employees” and “remuneration” from related entities to determine liability. One tactic worth discussing with your tax advisor is whether or not certain individuals above this pay threshold can be paid partly or in full by an affiliate not deemed a related party.
RKL to monitor implementation
As mentioned earlier, many of the ambiguous or unclear areas of tax reform will be fleshed out during the rule-writing process. RKL’s team of professionals dedicated to serving the not-for-profit industry are monitoring this process with an eye to nonprofit impact and will provide additional updates and clarifications as more information becomes available.
In the meantime, contact Douglas L. Berman, CPA, RKL’s Not-for-Profit Industry Group leader, with any questions regarding tax reform’s impact on nonprofits or for assistance preparing for the new tax landscape for organizations. Visit RKL’s Tax Reform Resource Center for more information and insights.