Tax Cuts and Jobs Act provisions and other recent developments affecting tax-exempt organizations

The Tax Cuts and Jobs Act (the Act or TCJA) became law approximately eight months ago, significantly impacting tax-exempt organizations. Read our insights below and learn more about the critical changes from the TCJA and other recent developments affecting tax-exempt entities as you plan for your organization’s response to the provisions.

Unrelated business taxable income: offset/activities rule

Introduction

The Tax Cuts and Jobs Act (TCJA) addressed several issues that affect tax-exempt organizations. Among the most significant changes was the new calculation method to determine unrelated business taxable income (UBTI). UBTI is defined as gross income from an unrelated trade of business regularly carried on by an exempt organization less allowable deductions.

Prior to the TCJA, an organization that derived gross income from the regular conduct of two or more unrelated trades or businesses less the aggregate deductions were permitted to report combined net taxable income from those activities. This method allowed organizations to substantially reduce total UBTI.

The TCJA changes the aggregate method by adding section 512(a)(6), which requires exempt organizations with one or more unrelated trades or businesses to compute UBTI for each separate activity. A deduction from one trade or business for a taxable year is no longer permitted to be used to offset income from a different trade or business.

The IRS published Notice 2018-67 on Aug. 20, 2018 to provide some guidance on this so-called “offset” rule. Notice 2018-67 provides interim guidance on UBTI grouping and other UBTI-related tax reform provisions including debt-financed UBTI and net operating loss (NOL) ordering rules.

Reasonable, good-faith interpretation

There is no general statutory or regulatory definition of what constitutes a trade or business. Until proposed regulations are issued, Notice 2018-67 permits exempt organizations to rely on a reasonable, good-faith interpretation of sections 511 through 514 when determining if the organization has more than one unrelated trade or business.

Acknowledging that solely using a "facts and circumstance" approach could be too burdensome for both organizations and the IRS, the Notice states that the IRS will consider the use of the North American Industry Classification System (NAICS) codes to be a reasonable, good-faith attempt at grouping unrelated trades and businesses. NAICS codes are currently required on Form 990-T to describe an organization's unrelated trade or business. For example, all of an exempt organization’s advertising activities and related services (NAICS code 541800) might be considered one unrelated trade or business activity, regardless of the source of the advertising income.

Another reasonable methodology included as an example in Notice 2018-67 was the so-called “fragmentation rule” that may also be useful in identifying separate trades or businesses. The fragmentation rule states that a trade or business does not lose its character simply because it is operated within a larger context of exempt activities. For example, a hospital pharmacy may have both UBTI (sales to the general public) while performing the exempt purpose of providing medicine to patients at a convenient location. The Notice does not make it clear how to apply the fragmentation rule in determining how to identify separate (or combined) trades or businesses.

Interim rules for partnership investments

In addition to the reasonable, good-faith standard, the Notice provides two rules specifically for aggregating partnership interests and activities for purposes of the UBTI grouping rule.

Exempt organizations may aggregate UBTI from an organization's interest in a single partnership that reports multiple trades or businesses, including trades or businesses conducted by lower-tier partnerships, as long as the directly held interest in the partnership meets the requirements of either the de minimis test or the control test (described below). Additionally, this interim rule permits the aggregation of all qualifying partnership interests as comprising a single trade or business.

De minimis test

The de minimis test is met if an exempt organization directly holds no more than 2 percent of the profits interest and no more than 2 percent of the capital interest in a partnership. An exempt organization may rely on the Schedule K-1 to determine the percentage interest in the partnership. When determining this percentage, the interest of certain related organizations with regard to the same partnership will be taken into account.

Control test

A partnership interest meets the control test if the exempt organization: (1) directly holds no more than 20 percent of the capital interest; and (2) does not have "control or influence" over the partnership. Whether an exempt organization has "control or influence" over the partnership is determined by facts and circumstances.

Unrelated debt-financed income

Under the interim guidance provided by Notice 2018-67, the IRS suggests that an exempt organization may be able to report unrelated debt-financed income from one qualifying partnership interest with UBTI from separate qualifying partnership interests.

For example, an exempt organization has an interest in a hedge fund that is treated as a partnership. The organization's interest is a qualifying partnership interest that meets the requirements of the de minimis test and the hedge fund regularly trades stock on margin. The exempt organization may aggregate unrelated debt-financed income generated by the hedge fund with any other UBTI generated by the hedge fund’s activities that are unrelated trades or businesses with respect to the exempt organization. Similarly, any unrelated debt-financed income that arises in connection with one partnership interest may be aggregated with UBTI that arises in connection with other partnership interests.

While the IRS suggests that it “may be appropriate” to aggregate partnership interests in this way, they also request comments regarding the treatment. As a result, regulations may be issued that present a different position on the part of the government.

Transition rule

Notice 2018-67 provides a transition rule for partnership interests acquired prior to Aug. 21, 2018 whether or not the interest qualifies under the de minimis or control tests. The IRS recognized that a previously acquired partnership would be difficult to modify without incurring costs. The transition rule, therefore, permits an exempt organization to treat such partnership interest as one single trade or business for purposes of section 512(a)(6) regardless of the number of trades or businesses conducted by the partnership or lower-tier partnerships.

NOL ordering

According to the Notice, NOLs generated before Jan. 1, 2018 are not subject to the grouping limitation. However, the Notice states that any NOLs after 2017 should be calculated and used before any NOL carryovers from before 2018.

Transportation and fringe benefits

The Notice indicates that the IRS does not consider employee transportation or parking benefits that may be reported on the Form 990-T as a result of the TCJA to be an unrelated trade or business. The implication is that UBTI stemming from transportation and parking benefits is not subject to the grouping rule or the NOL ordering rules.

Summary

Before the release of Notice 2018-67 on Aug. 20, 2018, exempt organizations had no guidance on how to group unrelated trades or businesses for UBTI purposes. The Notice does not provide any definitive rules on the process, but it does give valuable insight to the IRS' general thoughts. By defining "activity” with broad strokes, the Notice allows organizations and their advisors the opportunity to prepare more fully for the Dec. 31, 2018 year-end.

There is still much to be determined with regard to the final treatment under these rules and we must now await the issuance of regulations to determine the government’s position.

Qualified transportation fringe benefits

For tax years beginning prior to Jan. 1, 2018, for-profit and tax-exempt employers providing qualified transportation fringe benefits tax-free to employees would enjoy the benefit of a deduction of the related expenses under section 274 of the Internal Revenue Code. The TCJA amended section 274 to disallow for-profit employers from taking a deduction for these costs for tax years beginning after Dec. 31, 2017. Qualified transportation fringe benefits include transportation in a commuter highway vehicle, transit passes, qualified bicycle commuting reimbursements and qualified parking. To equalize the playing field between for-profit and tax-exempt employers, section 13703 of the TCJA added section 512(a)(7), which requires tax-exempt organizations to add an amount associated with providing certain fringe benefits to its employees to their UBTI, if the amount would be nondeductible under the revised section 274.

The TCJA provided little guidance as to how this rule change would be treated with regard to tax exempt organizations, fueling much speculation as to how to determine the amounts associated with qualified transportation fringe benefits. Is the amount the actual cost incurred by the employer (per employee) in maintaining its own parking facility, or the payment by the employer for the use by employees of a third-party facility? Some have argued that the amount would be a function of the “value” of the benefit to the employee; that is, what the employees would have to pay if they sought their own parking arrangements. That argument would suggest that the value of the parking benefit (and therefore UBTI) would be greater for exempt organizations in urban areas than it would be for more rural employers.

At its core, the change in rules reflect Congress’ intent to tax those employee benefits that are deemed to be personal rather than business expenses. Commuting expenses such as transit passes and parking are the personal responsibility of employees and, if paid by employers, without being taxed result in disguised compensation.

Since its enactment, neither the IRS nor the Treasury Department have provided much guidance with regard to the treatment of this now-taxable fringe benefit despite the fact that the law has been in place for eight months as of this writing. Absent such guidance, this article represents our best counsel on the likely treatment of the amounts associated with providing parking for employees.

We reported in May 2018 that the TCJA defined qualified parking as “parking on or near the employer’s business premises, or on or near a location from which the employee commutes to work by public transit and the associated expenses, transit passes and vanpool benefits.” The report discusses the impact of IRS publication 15-B, which provides for no deduction for “qualified transportation benefits (whether provided directly by (the employer), through a bona fide reimbursement arrangement, or through a compensation reduction agreement) incurred or paid after December 31, 2017.” Based upon this position, the first example in the report concluded that when a tax-exempt employer owns the facility where its employees park and sponsors a compensation reduction arrangement, the employer will likely have deemed income equal to the value of the pre-tax parking benefit to its employees, plus any expenses incurred with maintaining the facility. The second example in the report concluded that the results would be the same if the tax-exempt employer utilizes a public parking facility. In this case, the term “value” would essentially be the amount the employee defers on a regular basis to pay for the cost of parking. While the employer could argue the amount the employee chooses to defer into this arrangement is compensation, publication 15-B establishes the IRS’ position to bifurcate compensation expense and expense for qualified parking and disallows the latter, which would be deemed UBTI to the tax-exempt employer.

There are several additional scenarios which have been raised in absence of IRS guidance as to the applicability of section 512(a)(7), which are described below.

Example 1: employer-owned parking lot – value of parking indeterminable

A tax-exempt employer provides tax-free parking privileges to both employees and patrons of the organization in a surface lot owned by the organization and adjacent to its place of business. There are no additional, identifiable costs to maintain the lot as it relates to qualified parking for its employees, and there are no other parking lots in the immediate or surrounding area that charge for parking, as the organization is located in a rural area.

While the TCJA has not explicitly addressed this type of facility, the benefits for parking in a lot like this will likely not be captured under section 512(a)(7). Under section 132(f), qualified parking provided to an employee on or near the business premises of the employer is considered a nontaxable employee fringe benefit excludible from compensation. However section 512(a)(7) indicates UBTI should include amounts that meet the following two-prong test:

1. amounts not deductible under section 274 for for-profit employers and
2. amounts which are paid or incurred by a tax-exempt organization for any parking facility used in connection with “qualified parking,” as defined in section 132(f) above.

While the rural tax-exempt employer in this example is providing qualified parking to its employees, it can be argued that if there are no additional, identifiable costs to provide such parking to its employees, there would likely be no deemed UBTI under section 512(a)(7), as the first prong of the test would not be met. In addition, there appears to be no determinable value to the employee for parking in a rural employer-owned lot, raising the question of whether the employee is even receiving a qualified parking fringe benefit under section 132, and further supporting that position.

Example 2: employer-owned parking lot – metropolitan area

Assume the same facts as in example 1, except that the tax-exempt employer is located in a metropolitan area instead of a rural area. The employer does not charge its employees or patrons to park in the surface lot, but there are other lots nearby that charge for parking, of which a value can be determined. There are no additional, identifiable costs to maintain the lot for its employees.

This type of arrangement is a bit more gray, although it also would likely not be subject to UBTI inclusion under the two-prong section 512(a)(7) test. Similar to example 1, there appear to be no costs that would be disallowed under section 274 in the case of a for-profit employer. One distinction between the two examples, however, is that in a metropolitan area there is generally a value attributable to free parking. It is unclear whether the IRS will stake a position that UBTI will be based upon incurred costs of the employer or the value of the benefit provided to the employee. Unfortunately, as of now, there is only speculation as to whether this scenario would be excluded from 512(a)(7), and we recommend discussing your specific set of facts with your Baker Tilly tax advisor to determine the most reasonable and appropriate position to take for your organization.

In both examples 1 and 2, one could challenge the first test of the statute and argue that if the organization incurs no additional outlays to provide parking specifically to its employees, there would be no disallowed expenses under section 274, and therefore, no amount of deemed income added to UBTI. By focusing on the expense to provide the benefit to employees, the tests appear to distinguish between the cost to maintain a parking lot or facility for the employees and for the general programs or functions of the organization. 

Example 3: employer rents office space through a lease – parking spaces included

Assume the same facts as example 2, except the tax-exempt employer rents its building/office space, and the rent includes designated parking spaces which are available for use by all of its employees. Other tenants pay similar rent that includes parking spaces for their employees. This arrangement would arguably not fall under the rules of section 512(a)(7); that is, as long as the tax-exempt employer’s rent does not include an additional charge for the parking spaces its employees use, and the employer does not reserve the parking spaces for its highly compensated employees as defined under section 414(q). It is important to note that the lease agreement would need to be reviewed in order to determine whether the employer’s rent is exclusive of an additional charge for parking. In addition, the IRS could further argue that the organization should attempt to break out the portion of the rent relating to the parking for its employees, the amount of which could be deemed UBTI under the statute.

Example 4: employer rents office space through a lease – pays an additional fee for parking

Assume the same facts as example 3, except that the lease includes a provision for the tax-exempt organization to pay an extra $1,000 a month to include parking spaces for its employees. The organization does not discriminate in favor of its highly compensated employees for the parking spaces. This arrangement would most likely be captured under section 512(a)(7), since the organization incurs identifiable, additional charges to provide tax-free parking for its employees. Under this assumption, the organization would incur an additional $12,000 of UBTI. Again, the provisions of the individual lease agreement should be reviewed to properly classify any additional amount paid.

These arguments, while not supported by guidance, imply that if no additional costs are incurred by the tax-exempt organization to either provide or maintain a parking lot or facility to its employees, no expenses would be disallowed under section 274 if the organization were a for-profit employer, and therefore, no amount of deemed UBTI would result for the tax-exempt organization under the tests in the statute. If the organization pays for a lot for its employees to park tax-free or incurs additional, identifiable costs to make the parking facility available for its employees, those expenses would likely be disallowed under section 274, and therefore, deemed UBTI under section 512(a)(7). Until more guidance is released, this appears to be reflective of the actual language of the statute.

Considerations for fiscal year organizations

Section 512(a)(7) applies to amounts paid or incurred after Dec. 31, 2017. For organizations whose fiscal year ends fall on a date other than Dec. 31, there is some uncertainty as to how the deemed UBTI generated from section 512(a)(7) will be reported on their 2017 Form 990-T, the applicable tax rate on that income, and estimated payment requirements.

Until further guidance is released, the IRS recommends that UBTI resulting from section 512(a)(7) be reported as “other income” on the 2017 Form 990-T (line 12). In addition to the ordinary and necessary business expenses generated by the taxable activity, certain expenses that could most likely offset the deemed income would include prior year tax preparation fees related to the Form 990-T (if applicable), charitable contributions (subject to the 10 percent of taxable income limitation), and any prior year net operating loss deduction.

As only costs paid or incurred after Dec. 31, 2017 are subject to the provisions of section 512(a)(7), the applicable tax rate would be the 21 percent corporate tax rate enacted under the TCJA. Fiscal year organizations should work with their tax advisors on how to report the income on the Form 990-T and apply the applicable rate, especially if they have other sources of UBTI that might be taxed at a blended rate.

Estimated tax payments

Tax-exempt organizations must make estimated payments if the total estimated unrelated business income tax for the tax year is $500 or more. For a fiscal year organization, the payments are due by the 15th day of the 4th, 6th, 9th and 12th months of the tax year. For a fiscal year ended June 30, the quarterly payments would be due Oct. 15, Dec. 15, March 15 and June 15.

Estimated payment due dates example

Organization ABC has a fiscal year end of June 30, and has never filed a Form 990-T. It determines that section 512(a)(7) is applicable for payments made between Jan. 1, 2018 and June 30, 2018, which are estimated to be $100,000. The estimated tax on that income at a 21 percent rate after the specific deduction is $20,790. Organization ABC would be required to make estimated payments for its fiscal year ended June 30, 2018. Those payments would have been due March 15, 2018 and June 15, 2018, respectively.

If an organization determines it may be subject to the rules set forth in 512(a)(7) and did not make any estimated payments on the required dates, it can make catch-up payments immediately or with the filing of the extension of the Form 990-T. The organization may, however, be subject to an underpayment penalty as discussed below.

Underpayment penalty

If an organization is required to make estimated payments and does not, or determines that its actual tax liability is higher than the estimates paid on the required dates listed above, it may be subject to the underpayment penalty under section 6655, at a rate determined under section 6621(a)(2). That rate is the sum of the federal short-term rate for the first month in each calendar quarter plus 3 percentage points. For the quarter ending June 30, 2018, that rate is 5 percent. While the underpayment penalty rules would generally apply here, tax-exempt organizations could likely take the position that, given the uncertainty in the rules outlined by the TCJA, they may be eligible for abatement of such penalties until more guidance is issued.

Deferral of provisions

There are currently numerous commentaries, proposals and draft bills in process requesting for the repeal, clarification or postponement of the effective date of section 512(a)(7) for certain tax-exempt organizations. Tax-exempt organizations and tax advisors alike are waiting patiently for regulations from the Secretary of the Treasury to advise and help clarify the changes made by the TCJA. Until further guidance is released, the most conservative response to the changes under section 512(a)(7) would be to compute any estimated tax liability for the organization based upon any tax-free transportation fringe benefits provided to employees; make timely, estimated tax payments; and file for the necessary extension of the Form 990-T and related state tax form.

Should a bill be passed or the effective date of the provisions under section 512(a)(7) be postponed after such payments are made or extensions filed, organizations can request a full refund of taxes paid by either filing an amended Form 990-T, or requesting a federal quick refund on Form 4466. The Form 4466 can be filed if the overpayment of tax is at least 10 percent of the actual tax liability and at least $500. The IRS would also be required to pay interest on the overpayment at a rate determined under section 6621(a)(1). That rate is the sum of the federal short-term rate for the first month of each calendar quarter plus 2 percentage points. For the quarter ending June 30, 2018, that rate is 4 percent.

501(c)(4) donor disclosure: IRS rules donor names and addresses no longer required to be reported

In July 2018, the IRS released Rev. Proc. 2018-38. This revenue procedure modifies the information code section 501(a) tax-exempt organizations are required to report (with the exception of code section 501(c)(3) or code section 527 organizations) that are required to file an annual Form 990 series return. These tax-exempt entities are no longer required to disclose names and addresses of donors; however, they must continue to collect and keep this information in their books and records and make it available to the IRS upon request.

This ruling particularly affects code section 501(c)(4), social welfare organizations, which can engage in political activity (ruling also applies to c7, c8, and c10 organizations). The ruling provides personal freedom, reduction in compliance costs and privacy. The concern raised by many pro-transparency groups involves the lack of transparency and the ability for donors (including foreign donors) who seek to influence elections to operate without accountability.

Currently, the Montana Department of Revenue and Montana Governor Steve Bullock are suing the Treasury Department and the IRS. The suit states, "If the IRS knows that an organization is engaged in political activity, and receives a disclosure that the organization's only significant contributors are foreign nationals, then the IRS is well positioned to identify and stop the violation. Absent the names and addresses of the significant contributors, however, the IRS is less capable of making such a determination." The suit also contends that Rev. Proc. 2018-38 is in violation of the Administrative Procedure Act, "without notice and without giving the public any opportunity to comment," therefore, rendering the changes unlawful.

The revised reporting requirements of this revenue procedure will apply to information returns for taxable years ending on or after Dec. 31, 2018. Thus, the revised reporting requirements generally will apply to returns that become due on or after May 15, 2019.

Meals and entertainment expenses under the TCJA

The Tax Cut and Jobs Act of 2017 (TCJA) made significant changes to the tax treatment of meals and entertainment expenses. In short, the TCJA disallows a deduction for a number of previously deductible expenses for meals and entertainment.  However, the TCJA does not affect the deduction or exclusion for all of these expenses.

The “new” section 274 contains two basic rules: (1) entertainment expenses are generally not deductible; and (2) meals are deductible at 50 percent. These two basic rules are subject to a number of exceptions. It is currently not clear whether many types of expenses fall within a general rule or an exception.

The IRS has yet to issue guidance on these new rules, and taxpayers and their advisors are somewhat outraged with the changes to section 274(d). 

Similar to for-profits, tax-exempt entities are caught in the web of meals and entertainment regulation. There is a lot more gray in an area that has historically been the subject of much dispute. The chart below provides a high-level review of typical meal and entertainment expenses before and after the TCJA. 

Note: The chart does not reflect tax advice and should not be relied upon to avoid the imposition of penalties.

With the change in tax law, the accounting books and records of an organization will become even more important beginning with the 2018 tax year. By creating separate general ledger accounts (such as those listed below) to properly categorize meal and entertainment expenses when they are incurred, a taxpayer will be better prepared to address compliance during tax return preparation, and will be better prepared to defend a deduction if questioned by the IRS.

A sample listing of the types of categories that you may wish to use:

• Entertainment
• Entertainment – mileage
• Meals
• Meals – celebratory
• Travel – airfare
• Travel – lodging
• Travel – mileage
• Travel – other
• Nondeductible dues
• Professional dues and meetings
• Sponsorships

The changes to the deduction for meals and entertainment increase the reporting burden on all organizations including tax-exempts. Organizations should focus on getting ahead of these changes, identifying areas of potentially nondeductible meals and entertainment expenses, and make decisions about how the organization wants to report expenditures that fall within gray areas of the new law.

Club dues

The Baker Tilly Meals and entertainment expenses for 2018 article dated March 21, 2018 defined nondeductible dues of for-profit employers to include amounts paid or incurred for membership to any club organized for business, pleasure, recreation or any social purpose. This would include dues paid to social or country clubs, even those exempt from federal tax under section 501(c)(7).

Most employers have and will continue to include the value of membership dues to such clubs in the member employee’s compensation if used for a social or recreational purposes. Conversely, some employers exclude the value of membership dues to social or country clubs under the working condition fringe benefit exclusion (section 132(d)), if the employee utilizes the club for strictly business purposes, e.g., meetings or dinners with donors. Exclusion under section 132(d) has always been uncertain; however, this position could have been further supported if, for example, the club provided an acceptable meeting space that could not be found at the organization, or the club provided certain features imperative to the meeting and not provided by the organization.

Under the TCJA’s stricter stance on business versus recreational usage, dues paid on behalf of employees to social or country clubs – even if the primary purpose of the club membership is business-related – would no longer be excludable from the employee’s compensation. Employers and employees will have a much more difficult time in establishing a position that there is a business purpose.

Club dues example

QRS Charity pays annual dues of $3,000 to Country Club A to allow its chief executive officer (CEO) to meet with donors for dinner and networking, or primarily for business purposes. Prior to the TCJA, the charity could make the argument that because the primary purpose of the membership to the Country Club A  was to conduct business meetings, the $3,000 would be a tax-free employee benefit and excludable from the CEO’s wages. Under the provisions of the TCJA, the $3,000 would most likely need to be added to the CEO’s wages, even if the conduct of the CEO and usage of the club remains the same going forward.

South Dakota v. Wayfair Inc.

The U.S. Supreme Court ruling in the Wayfair case has turned the rules of nexus for state sales tax on its head. And tax exempt organizations are not immune from the decision.

On July 21, 2018, the U.S. Supreme Court ruled South Dakota’s economic nexus laws constitutional. The decision overturned Quill Corporation v. North Dakota (504 U.S. 298 (1992)), that for more than 25 years required “physical presence” for states to require a business to register and collect sales and use tax.

Specifically, the ruling upheld rules requiring sellers without physical presence in the state to collect and remit sales tax if:

1. the seller’s annual gross revenue from the sale of goods or services into South Dakota exceeds $100,000; or
2. the seller has 200 or more separate transactions annually in the state

The South Dakota v. Wayfair Inc. ruling now opens the door for states to require online and remote retailers to collect sales tax on transactions in the state, based on an “economic” presence such as dollar threshold of sales or number of transactions in the state. Taxpayers will no longer be afforded protection previously provided under the Quill ruling when a retailer had no physical presence in the state.

For remote sellers, including tax-exempt organizations, developing a well-thought-out plan to respond to Wayfair, rather than registering in all jurisdictions where they have sales, will be critical to cost-effective multistate sales tax compliance.

For more information, or to learn how Baker Tilly tax specialists can help, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.