United States: Tax Reform And The Potential Impact On Tax-Exempt Organizations

Nicole M. Elliott and Kathleen M. Nilles are both Partner's in our Washington D.C., office

HIGHLIGHTS:

  • As preparations for tax reform continue in Washington, D.C., it appears increasingly likely that tax reform will have a significant effect on tax-exempt organizations, particularly those exempt under Section 501(c)(3).
  • Although the details and timing of tax reform remain uncertain, prior tax reform proposals, proposals by President Donald Trump and the "Blueprint" released by House Speaker Paul Ryan give some indication of what is "on the table" and what the future may hold.
  • Tax-exempt organizations should continue to monitor tax reform and stay alert to the possible ramifications as well as continue to educate policymakers and exert legislative pressure.

Both the Trump Administration and key leadership in the U.S. House of Representatives and Senate are continuing their focus on tax reform. Although details are being withheld until the Republican leadership in the House, Senate and the White House all agree on a plan, it is likely that tax reform will have a significant effect on tax-exempt organizations. The effect on tax-exempt organizations will likely flow from the expected changes in the tax code (such as rate reduction) that will impact the level of charitable giving to these organizations. There may also be changes that have direct application to the operations and financing of exempt organizations.

Background

While the details and timing of tax reform remain uncertain, a review of prior tax reform proposals (such as a complete package of tax reform proposals introduced by a former Ways and Means chairman), proposals by President Donald Trump and the "Blueprint" released by House Republican leaders give some indication of what the future may hold.

In February 2014, then-Rep. Dave Camp (R-Mich.), Chairman of the House Ways and Means Committee, released discussion draft legislation for comprehensive tax reform. The nearly 1,000-page draft, the "Tax Reform Act of 2014," proposed significant changes to the tax code, many of which would have directly impacted tax-exempt organizations. The draft legislation was subsequently introduced as a bill (H.R. 1, 113th Congress, Dec. 10, 2014) but never made its way into law.

Two years later, in June 2016, Rep. Paul Ryan (R-Wis.), the former Chairman of the House Ways and Means Committee and now the House Speaker, released his Blueprint for comprehensive tax reform, a key component of "A Better Way: A Vision for a Confident America." Unlike the voluminous and detailed Camp proposal, the Blueprint is only 35 pages long and does not contain legislative language or detailed proposals. In addition, unlike the Camp proposal, the Blueprint does not contain any specific changes directly applicable to tax-exempt organizations. The Blueprint briefly discusses charitable giving, noting that the tax code should continue to encourage donations, while simplifying compliance and record-keeping as well as making the tax benefit for charitable giving effective and efficient.

Similarly, the tax proposals of President Trump (both during his presidential campaign and post-election) do not contain any specific changes directly applicable to tax-exempt organizations. Rather the Trump proposals address tax reform in broad strokes, with a focus on lowering the tax rates for individuals and businesses.

Given strong Republican desire for tax reform, the hard work has begun to turn conceptual frameworks into draft legislation. It is expected that the House, led by the Ways and Means Committee, may dust off some of Camp's legislative text and that several of his proposals could well be included in tax reform introduced in the fall.

Changes Potentially Impacting the Level of Charitable Giving

Some of the changes in all three proposals that would have indirect, but significant, consequences for tax-exempt organizations (particularly tax-exempt organizations dependent on charitable giving) are:

  • Lower Individual Income Tax Rates and Increase the Standard Deduction. The Camp proposal, the Blueprint and President Trump seek to reduce the tax rates applicable to individual taxpayers. In addition, these three proposals seek to increase the standard tax deduction available to individual taxpayers. For example, under current law, a taxpayer married filing jointly can take a standard deduction of $12,700, but the Camp proposal would have increased this to $22,000. Similarly, the Trump and Blueprint proposals would increase the standard deduction to $24,000. (Note: President Trump's tax proposal during the campaign would have increased the standard deduction for a married couple filing jointly to $30,000. The proposal that President Trump released in April 2017 would double the standard deduction, and remarks made at the time of its release indicate that amount would be $24,000.)
  • Repeal of Estate Tax. President Trump's proposal and the Blueprint would also repeal the estate tax. This could discourage charitable gifts made during life and bequests at death.

Some changes impacting charitable contributions that are contained only in the more detailed Camp proposal include:

  • 2 percent floor. The Camp proposal contained a 2 percent floor on deductions, meaning individual taxpayers can deduct charitable contributions only to the extent that they exceeded 2 percent of their adjusted gross incomes (AGI).
  • AGI Percentage Limitations. Currently, individual taxpayers are limited in the amount they can deduct for charitable contributions made to tax-exempt public charities to 30 percent or 50 percent of each taxpayer's AGI, depending on the type of contribution (i.e., cash or non-cash). The Camp proposal would have limited the deduction to 40 percent, regardless of the type of contribution.
  • Payout Requirement for Donor Advised Funds (DAFs). Under the Camp proposal, DAFs would have been required to distribute all contributions within five years or face a 20 percent excise tax on the amount not distributed.
  • Type II and Type III Supporting Organizations. The Camp proposal would have repealed the provisions relating to these organizations, meaning they would have to qualify as a Type I supporting organization, as another type of public charity or be reclassified as a private foundation.

Changes Directly Applicable to Tax-Exempt Organization Operations and Financing

The Camp bill also contained these additional changes directly applicable to exempt organization operations and financing:  

  • Excise Tax on Excessive Executive Compensation. The Camp proposal would tax – at a rate of 25 percent – any compensation in excess of $1 million paid to any one of the five highest compensated employees of an exempt organization.
  • Unrelated Business Income Tax. Currently, tax-exempt organizations can calculate unrelated business income tax (UBIT) based on the gross income of all business activities, minus the deductions connected with carrying on those activities. This means that losses generated by one activity can be used to offset the gains from another. Under the Camp proposal, UBIT must be computed separately for each trade or business, so losses from one business line would not be able to be used to offset income from another unrelated business.
  • Excess Benefit Transaction Rules. Currently, disqualified persons and managers who engage in excess benefit transactions with tax-exempt organizations are subject to an excise tax. The Camp proposal expands who could be subject to the tax, imposing an entity-level tax of 10 percent on organizations if an excess-benefit excise tax is imposed on a disqualified person. The Camp proposal also eliminates the current rebuttable presumption of reasonableness for transactions with disqualified persons. The elimination of the rebuttable presumption of reasonableness will make it more difficult for organizations to ensure that their executive and physician compensation packages will not be subject to the tax.
  • Termination of Private Activity Bonds, Including 501(c)(3) Bonds. Currently, interest on private activity bonds (PABs) is excluded from gross income – and thus exempt from tax. Governmental entities may issue PABs to finance projects owned and operated by 501(c)(3) organizations, such as universities and hospitals. Qualified 501(c)(3) bonds are an important source of funding for capital projects, including new healthcare facilities and student housing, by nonprofit organizations. The Camp bill would terminate the tax benefits for interest on all newly issued PABs, including qualified 501(c)(3) bonds, based on the questionable supposition that "the Federal government should not subsidize the borrowing costs of private businesses allowing them to pay lower interest rates, while competitors ... must pay a higher interest rate on the debt they issue."

It remains to be seen whether any of these 2014 proposals will be included in the 2017 version of tax reform.

Considerations for Tax-Exempt Organizations

Although the details and timing of tax reform remain uncertain, and it is unclear which, if any, of the above Camp proposals will make it into legislative text, tax-exempt organizations should continue to monitor tax reform and stay alert to the possible ramifications as well as continue to educate policymakers and exert legislative pressure. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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