Tax Reform Impact on Exempt Organizations and UBTI
Jessica Keefe and Ryan McDonell, CPA
26 September 2018
The Tax Cuts and Jobs Act (“TCJA”) tax reform policy, which passed at the end of 2017, has not only impacted individuals and businesses but also tax-exempt and non-profit organizations. One of the most significant tax-exempt areas impacted by the TCJA is the taxation of unrelated business taxable income (“UBTI”).
UBTI is income from a trade or business regularly generated by a tax-exempt organization that is not substantially related to the performance of the organization or its exempt purpose or function.
An example of UBTI is a tax-exempt university earning advertising income from a local athletics newsletter produced
by the university. In this case, the purpose of the newsletter is to keep alumni and faculty informed of local athletics as well as increase attendance and solicit contributions. This advertising income is outside of the university’s exempt purpose of providing an education to students and is therefore considered to be UBTI.
Tax-exempt organizations with UBTI must file Form 990-T which is an Exempt Organization Business Income Tax Return to report unrelated business income over $1,000 and to calculate tax on the income. In the example referenced above, the university would have to file a Form 990-T if their advertising income exceeds $1,000.
Prior to the TCJA, UBTI was taxed at a rate of 35%, however, for tax years beginning after December 31, 2017, UBTI will be taxed at a rate of 21%. This 21% is equal to the new C corporation tax rate enacted by the TCJA. Fiscal year tax-exempt
organizations with income earned during both rate periods will need to use a blended tax rate during the year of rate change. A lower tax rate is a benefit for tax-exempt organizations, but unfortunately, this is not the only change to UBTI.
Tax-exempt organizations that are involved in more than one unrelated trade or business are now required to separately calculate UBTI for each type of unrelated trade or business. Using the example above, if the university not only has advertising income but also incurs expenses by sponsoring tickets and for travel costs of alumni attending sporting events, the university will have two separate activities requiring UBTI calculations. Since the advertising and sponsorship activities
are reported separately, the losses generated from the sponsorship activity may not be used against the taxable advertising income. The unused losses are carried forward as a net operating loss (“NOL”).
Under the TCJA, a NOL generated after January 1, 2018, may only be carried forward, NOL carrybacks are no longer allowed. These losses may be carried forward indefinitely until the same activity that generated the loss has net income. However, even after the unrelated trade or business turns a profit, only 80% of the NOL may be used to offset net income. This TCJA change ensures that exempt entities will have to pay tax on at least 20% of taxable income, even when a carryforward NOL is present.
Additionally, it is important for tax-exempt organizations to note that benefits offered to employees are also now required to be reported as UBTI if not treated as taxable compensation to the employee. The IRS deems fringe benefits as UBTI and accordingly, tax-exempt organizations will have to recognize income on non-deductible qualified business expenses. Examples of these fringe benefits may include the use of athletic facilities, subsidized meals, entertainment, commuter passes, and tuition assistance. Exempt organizations may consider treating these benefits as compensation to employees to be reported
on their W-2, however, while this would preserve the expense for the tax-exempt organizations, the tax burden would be shifted to the employee in the form of taxable wages.
The increased likelihood of paying tax on UBTI is especially unfortunate because tax-exempt organizations can expect a decrease in donor support beginning in 2018. As part of the TCJA for individual taxpayers, various itemized deductions were either repealed or limited while the standard deduction amount nearly doubled. These changes may result in nearly 90% of taxpayers claiming the standard deduction in lieu of itemizing. Since charitable contributions to qualifying exempt organizations is currently an itemized deduction, the incentive and value in making donations is reduced for individuals.
However, there have been political efforts which would incentivize individuals to continue making donations. The proposed “Universal Charitable Giving Act,” seeks to move the deduction for charitable contributions to the first page of the Form 1040. This would allow individuals taking the standard deduction and those that itemize to claim a deduction for a portion of charitable contributions, which would be particularly impactful post-tax reform. This proposal remains open in the House of Representatives.
A study by the Tax Policy Center estimates that charitable giving will decrease overall by $12 to $20 billion in 2018 due to tax reform changes. In consideration of this fact, non-profit entities previously reliant on charitable giving may need to consider alternative unrelated business ventures to keep money coming in to fund operations. However, as referenced above, these unrelated business activities may result in taxable income.
Additionally, according to the Tax Policy Center, large drops in charitable giving may result in an estimated loss of up to nearly a quarter million jobs, thereby also decreasing the work done by non-profits by billions of dollars each year. Unless legislation or another mechanism is put into place to expand the availability of the charitable contribution deduction for individuals, some tax-exempt organizations will have to turn to unrelated business activities in order to cover the costs of operations. Alternatively, exempt entities may want to adjust their marketing campaigns to focus more on high net worth individuals that will still take advantage of itemized deductions, post-tax reform.
Contact your accountant today to discuss how tax reform may affect your tax-exempt organization.
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