On Feb. 26, 2014, Rep. Dave Camp (R-MI), the chairman of the U.S. House of Representative’s Ways & Means Committee, released a discussion draft of a forthcoming “Tax Reform Act of 2014” (the “Draft”). The Draft’s broad reforms include changes to the Internal Revenue Code (IRC) that directly impact tax-exempt organizations, as well as donors to charitable organizations. The budget effect of these changes is an additional $8 billion in tax revenue for tax years 2014 through 2023.
The provisions of the Draft:
- Simplify but impose additional limits on the itemized deduction for charitable contributions.
- Impose a new excise tax on organizations paying more than $1 million in compensation to certain employees.
- Expand the impact of the unrelated business income tax and modify the types of income subject to the unrelated business income tax.
- Modify and supplement several excise tax provisions applicable to public charities, private foundations and donor advised funds.
- Eliminate tax exemption for certain types of organizations.
- Eliminate Type II and Type III supporting organizations.
- Adjust some of the rules that affect qualified retirement plans maintained by tax-exempt organizations.
- Require electronic filing of annual returns for all tax-exempt organizations.
The Draft also proposes changes to the rules for Section 501(c)(4) organizations, which will be discussed in a subsequent release.
Itemized Deduction for Charitable Contributions
The Draft proposes several taxpayer-friendly changes to the itemized deduction for charitable contributions, but also imposes new limits on the deduction. Under the changes, taxpayers would be able to deduct charitable contributions made after the close of the tax year but before the due date of the return for that year (April 15 for calendar year taxpayers). The Draft also simplifies the complex percentage limitations on the amount of the income tax charitable deduction that may be used in a tax year by imposing a single limit of 40 percent of adjusted gross income for both cash contributions and contributions of capital gain property to public charities and certain private foundations — gone are the 50 percent and 30 percent limitations. Similarly, the limitation for contributions to private foundations not covered by the new 40 percent limitation would be 25 percent, instead of the current 30 percent limitation for cash contributions and 20 percent limitation for contributions of capital gain property.
The Draft limits the income tax charitable deduction by imposing a 2 percent floor on charitable contributions and limiting the amount that can be deducted for a contribution of appreciated property to the donor’s adjusted basis in the contributed property. Charitable contributions would be deductible only to the extent that they exceed 2 percent of the donor’s adjusted gross income. This floor applies first to contributions subject to the new 25 percent limitation, then to qualified conservation contributions and finally to contributions subject to the new 40 percent limitation.
Contributions of property will generally result in a deduction equal to the donor’s adjusted basis in the contributed property. However, contributions of certain types of property (including publicly traded stock) will still be deductible at fair market value, less any short-term capital gain or ordinary income that would have been recognized had the donor sold the property at fair market value.
Excise Tax on Employee Compensation
The Draft imposes a new 25 percent excise tax on organizations that pay $1 million in compensation to certain employees. The tax applies to the amount of “remuneration” in excess of $1 million, where “remuneration” means wages but not Roth contributions, plus any excess “parachute payments.” Parachute payments are payments that are contingent on an employee’s separation from the organization and which exceed 3 times the employee’s average annual compensation.
The tax only applies to compensation paid to an organization’s “covered employees.” Only an organization’s 5 highest compensated employees are “covered employees” for purposes of this tax. For covered employees that are compensated by multiple related organizations (such as a public charity and a supporting organization), an employee’s compensation from related organizations may be taken into account in determining whether the employee’s aggregate compensation exceeds the $1 million threshold.
Unrelated Business Income Tax
The Draft includes one taxpayer-friendly change to the unrelated business income tax (UBIT) provisions — an increase in the specific deduction against UBIT from $1,000 to $10,000 — while at the same time extending the overall scope and impact of the UBIT rules. According to the Joint Committee on Taxation (the “Joint Committee”), the Draft’s proposed modifications to the UBIT provisions will raise approximately $5.5 billion in additional tax revenue for tax years 2014 through 2023.
Conducting Multiple Unrelated Trade or Business Activities. The Draft eliminates an organization’s ability to offset unrelated business taxable income from one trade or business with losses from another unrelated trade or business. Under the proposed provisions, organizations will have to compute their unrelated business taxable income separately for each trade or business activity and would no longer be able to aggregate their income and losses derived from such activities. Although this change will affect only organizations conducting multiple unrelated trades or businesses, the Draft will significantly impact such organizations’ UBIT calculations and tax liabilities.
Corporate Sponsorships. The Draft makes significant changes to the treatment of corporate sponsorships for UBIT purposes. As proposed, if an organization uses or acknowledges the name or logo of a sponsor’s product line, the sponsor’s payment will be treated as per se unrelated trade or business income. Additionally, if an organization receives more than $25,000 of qualified sponsorship payments for any one event, the use or acknowledgement of the sponsor’s name or logo must appear with the names of a “significant portion” of the other donors to the event.
Miscellaneous Changes. The Draft also expands the impact of the tax by tweaking a number of UBIT rules:
- Organizations that may be exempt from tax under provisions of the IRC other than Section 501(a) would be subject to UBIT (such as organizations exempt under Section 115).
- The sale or licensing of a name or logo of an exempt organization would be treated per se as an unrelated trade or business, and any income derived from such licensing would be included in the organization’s unrelated business taxable income.
- Income derived from a research trade or business would be excluded from UBIT only if the results of the research are freely available to the public.
- Gain or loss resulting from the sale of distressed property would be included in UBIT calculations.
- Trusts making charitable contributions would be limited in deducting those contributions, for purposes of UBIT calculations, to 10 percent of the trust’s unrelated business taxable income.
Private Foundation Excise Taxes, Donor Advised Funds and Excess Benefit Transactions
The Draft modifies a number of excise tax rules applicable to tax-exempt organizations, including changes to the excess benefit transaction rules, the private foundation self-dealing rules and the private foundation net investment income tax. It also imposes new distribution requirements on donor advised funds and private operating foundations. Although the Joint Committee estimates that these modifications will have a negligible impact on revenue, the effects of these modifications may be keenly felt by affected organizations.
Excess Benefit Transactions. The Draft broadens the scope of the excise tax on excess benefit transactions to apply to organizations exempt under IRC Section 501(c)(5) (labor organizations) and IRC Section 501(c)(6) (business leagues). It also adds a new organizational-level tax. In addition to the taxes currently imposed on disqualified persons and organization managers, a new 10 percent excise tax would be imposed on an organization that is involved in an excess benefit transaction. This new tax can be avoided if the organization demonstrates that it followed certain “minimum standards of due diligence” to prevent the provision of an excess benefit to a disqualified person. The proposed minimum standards mirror the current requirements for establishing the rebuttable presumption of reasonableness — approval of the transaction by an independent body after considering comparability data.
Significantly, the Draft eliminates the rebuttable presumption of reasonableness for purposes of imposing the excess benefit transaction excise tax on disqualified persons and an organizations’ directors and officers, which increases the risks associated with compensation and other transactions with disqualified persons. In addition, the Draft eliminates the ability of directors and officers to rely on professional advice as a safe harbor against the excise tax. Finally, the Draft expands the definition of “disqualified persons” for purposes of this tax to include athletic coaches and investment advisers.
Private Foundation Self-Dealing. The Draft imposes a new 2.5 percent excise tax on private foundations that engage in self-dealing, in addition to the excise taxes currently applicable to disqualified persons and directors and officers. As with the changes to the safe harbor for purposes of the excess benefit transaction rules, the Draft eliminates the professional advice safe harbor available to directors and officers of private foundations.
Donor Advised Funds. The Draft imposes new distribution requirements on donor advised funds. Under the proposed rules, donor advised funds must distribute contributions within five years of receipt or pay an excise tax equal to 20 percent of any undistributed contribution, beginning in the sixth year. Generally, qualified distributions made by donor advised funds will be restricted to public charities — distributions to supporting organizations or other donor advised funds will not qualify.
Private Operating Foundations. The Draft also imposes a new distribution requirement on private operating foundations. Private operating foundations would be required to satisfy the minimum distribution requirements applicable to private nonoperating foundations under IRC Section 4942.
Tax on Net Investment Income of Private Foundations and New Tax on Certain Colleges and Universities
The Draft would make two changes to the tax imposed on the net investment income of private foundations under IRC Section 4940. The Draft simplifies the tax by reducing it from 2 percent to 1 percent for all private foundations and eliminating the provisions that currently allow private foundations to reduce the tax to 1 percent only if they meet certain requirements. The Joint Committee estimates that this reduction in the tax rate will result in a loss of approximately $1.6 billion in tax revenue for tax years 2014 through 2023.
This reduction in revenue is offset by the Draft’s second proposed change to the net investment income tax, which would impose the tax on the net investment income of private colleges and universities, which are currently public charities and not subject to any tax on their net investment income. The tax will apply only to those organizations with assets (other than assets used directly in carrying out exempt purposes) that equal or exceed $100,000 per student. The Joint Committee estimates that this provision will raise approximately $1.7 billion in additional tax revenue for tax years 2014 through 2023.
Elimination of Tax Exemption for Certain Organizations and Elimination of Type II and Type III Supporting Organizations
Under the Draft, the following organizations would no longer qualify for tax exemption:
- Professional sports leagues.
- Certain insurance companies.
- Some workmen’s compensation insurance organizations.
In addition, the Draft eliminates Type II and Type III supporting organizations. These organizations would be required to meet other requirements for public charity classification or be reclassified as private foundations.
Altogether, these provisions are estimated by the Joint Committee to raise approximately $2.2 billion in additional tax revenue for tax years 2014 through 2023.
Increase in Penalties and New Penalties for Managers
The Draft increases a number of penalties applicable to tax-exempt organizations:
- Failure to File an Annual Return. The daily penalty increases from $20 to $40 for smaller organizations, and from $100 to $200 for organizations with gross receipts exceeding $1 million. The penalty on directors and officers increases from $10 to $20.
- Failure to Make Annual Returns Available for Public Inspection. The daily penalty increases from $20 to $40.
- Failure to Make an Application for Exemption or Notice of Status Available for Public Inspection. The daily penalty increases from $20 to $40.
- Failure of Certain Charitable Trusts and Terminating Organizations to File Returns. The daily penalties increase from $10 to $20 for terminating organizations and trusts other than split-interest trusts. The daily penalty for split-interest trusts increases from $100 to $200.
- Failure to File a Reportable Transaction Disclosure. The daily penalty increases from $100 to $200.
The Draft also imposes a new penalty on the “managers” of any organization that substantially understates its income tax that is attributable to the organization’s unrelated business income tax liability. The penalty equals 5 percent of the underpayment attributable to the understatement. For this purpose, “manager” includes officers, directors, trustees, employees and any other individual under a duty to perform an act in respect of which the underpayment occurred. If there are multiple managers liable for the new penalty, such persons share the liability. The penalty is capped at $20,000.
The Draft imposes a similar penalty if an accuracy-related penalty is imposed for understatement of a reportable transaction. The new penalty equals 10 percent of the portion of the underpayment relating to the reportable transaction, and applies to “managers” of the organization. The definition of “manager” follows the definition described above. The penalty is capped at $40,000.
Qualified Retirement Plans
There are a number of proposals that would affect qualified retirement plans maintained by tax-exempt organizations.
The special contribution limits that currently apply to Section 403(b) retirement plans would be eliminated, including:
- The ability of participants with more than 15 years of service to contribute up to an additional $3,000 per year.
- The ability of employers to make contributions of up to $52,000 (as indexed for inflation) for up to five years following an employee’s termination of service.
- The ability of churches to make contributions of up to a maximum of $10,000 per year to participants who do not have any taxable income (subject to a lifetime maximum of $40,000).
Instead, Section 403(b) plans would be subject to the same contribution limits that apply to Section 401(k) plans. Based on 2014 limits, this would be an annual limit of $52,000 on total employer and employee contributions, an annual limit on employee deferrals of $17,500 and an annual limit of $5,500 on catch-up contributions by employees age 50 and older.
Section 401(k), 403(b) and 457(b) plans would be required to offer Roth accounts. Under current law, employers have the option of offering such accounts. In addition, employees would be permitted to contribute up to only one-half of the applicable dollar limits on employee contributions to a traditional account (i.e., a non-Roth account). Based on the 2014 annual limits, employee contributions to traditional accounts would be limited to $8,750 in elective deferrals and $2,750 in catch-up contributions for participants age 50 or older. Amounts in excess of these half-limits would be required to be credited to a Roth account. Alternatively, employees could annually contribute up to the full amount of elective deferrals and catch-up contributions to a Roth account only.
Taxpayers with modified adjusted gross income of more than $400,000 for single filers and $450,000 for joint married filings would be subject to a special 10 percent “surtax” on certain “tax preferences.” Included in the list of tax preferences are employer and employee pretax contributions to employer-defined contribution retirement plans (such as Section 403(b) and 401(k) plans) and employer-provided health benefits (including contributions to health savings accounts).
The Draft imposes a new electronic filing requirement on all tax-exempt organizations required to file an annual return.
Nonprofit and Tax-Exempt Organizations Group
Our nonprofit and tax-exempt organizations group provides advice and guidance that enable charities and other nonprofits to operate more efficiently and effectively in today’s increasingly complicated, regulated and competitive environment.
Our education attorneys represent public and private colleges and universities. This representation includes statutory and regulatory compliance and investigation work relating to the Higher Education Act of 1965 and federal student aid programs. It also includes issues relating to NCAA investigations, faculty tenure, financing expansion, low-income housing, 501(c)(3) and other tax issues, student lending compliance and investigations, intellectual property, students and academics, housing, governance, endowment management and construction.
Fiduciary Advisory Services and Private Wealth Services
McGuireWoods’ fiduciary advisory services and private wealth services teams stand ready to advise individuals, financial institutions, and other clients about planning, tax, and fiduciary matters. McGuireWoods’ private wealth services group has been ranked by Chambers, the international rating service for attorneys, as one of the top wealth management legal practices in the country for several years. Please click here for a full listing of our lawyers and their locations.
Employee Benefits and Executive Compensation Group
Our employee benefits lawyers provide comprehensive services to a wide range of clients, including publicly held companies, small and large privately held companies, tax-exempt organizations and educational institutions.