Senate Tax Overhaul Bill Slaps Tax-Exempt Organizations
If you were wondering how Congress feels about the tax-exempt sector, you need look no further than the Senate Chairman’s Mark of the Tax Cuts and Jobs Act (Senate Tax Bill) released late November 9, 2017. In what can only be described as a brutal attack on the nonprofit sector, the Senate has proposed sweeping changes that would have dramatic adverse effects on tax-exempt organizations.
Unlike other recent legislation targeted only at Section 501(c)(3) and 501(c)(4) organizations, the Senate Tax Bill would affect Section 501(c)(5) labor organizations and Section 501(c)(6) business leagues, and all types of tax-exempt organizations would likely have to modify their activities in many respects if the bill were enacted in this initial form. Specific areas targeted by the Senate Committee on Finance include executive compensation, the rebuttable presumption of reasonableness, unrelated business activities, and the scope and degree of exposure to intermediate sanctions excise taxes. Whereas the latest version of the House bill contains relatively few provisions of interest to tax-exempts, the Senate Tax Bill is a “must read” for such organizations.
Here are details on the major proposed changes affecting tax-exempt organizations, as well as additional thoughts on these provisions and their potential impact.
20 Percent Excise Tax on Certain Levels of Executive Compensation
Like the House bill released a few days earlier, the Senate Tax Bill would impose an annual 20 percent excise tax on the total taxable compensation provided by a tax-exempt organization to one of its five highest compensated employees, to the extent that the total exceeds $1 million. This would include any employee who was one of the five highest paid employees in any previous year after 2016. The employer would be liable to pay the tax. All related organizations would be aggregated for the purpose of determining whether the $1 million threshold is exceeded.
In addition, the 20 percent excise tax separately would apply to any “excess parachute payment.” This refers to any payment that is contingent on the employee’s separation from employment, where the aggregate payment is three times (or more) the average annual taxable compensation in the preceding five years. The tax would apply to the amount that exceeds the portion of the base amount applicable to the parachute payment.
Note: A possible interpretation worth watching out for is whether deferred compensation amounts that become payable upon separation from employment would be subject to this golden parachute excise tax. If so, exempt organizations should consider eliminating employment termination as a trigger for payment of deferred compensation (to the extent permitted under these arrangements and under tax law guidance).
Sweeping Changes to Executive Deferred Compensation
The Senate Tax Bill would eliminate pre-tax contributions to Section 457(b) “eligible” deferred compensation plans, starting in 2018. These plans permit separate contributions by highly compensated employees, and by their tax-exempt employers, up to an annual limit similar to that of 401(k) plans and 403(b) annuities (currently $18,000 per year).
In addition, the complex rules for 457(f) deferred compensation arrangements (including the notorious “409A” rules that apply to these arrangements) would be eliminated for all compensation payable after 2017. Any new deferrals of compensation would be made, if at all, only under a simpler structure that would consist of these principles:
Deferred compensation would be taxable when it is no longer subject to a substantial risk of forfeiture (the same general rule as in Section 457(f) now).
“Substantial risk of forfeiture” would be determined only by a substantial future services obligation.
A covenant not to compete would not qualify as a substantial risk of forfeiture in any circumstance.
A severance payment would not qualify as an exception to these rules in any circumstance.
The existing “short-term deferral exception” (which permits payment of compensation as late as two and a half months after the end of the year in which vesting occurs, without that payment having to comply with deferred compensation rules) would continue to apply.
Note: Many existing deferred compensation arrangements would have to be reviewed and revised if they rely in any way on a noncompete as the basis for the substantial risk of forfeiture, particularly since the Internal Revenue Service (IRS) provided in 2016 proposed regulations that a noncompete can validly serve this purpose and delay both vesting and taxation. Note also that severance arrangements payable beyond the year of termination would likely become fully taxable at the outset, even if payments are made over an extended period. Given these restrictions and the loss of 457(b) plans, the use and structure of all deferred compensation arrangements at the executive level will likely have to be reevaluated.
Substantial Restructuring and Expanded Application of Unrelated Business Taxable Income Rules
Two major provisions in the Senate Tax Bill would dramatically change the taxation of activities that generate unrelated business taxable income (UBTI).
Taxation of Each Unrelated Activity in Isolation
For years, Congress has been agitated with tax-exempt organizations acting in a commercial manner and allegedly competing with for-profit businesses. Not content with simply taxing more activities or increasing IRS enforcement of current UBTI rules, the Senate Tax Bill now places tax-exempt organizations at a distinct disadvantage relative to their purported commercial counterparts. Specifically, the Senate Tax Bill requires every tax-exempt organization to calculate its UBTI liability on an activity-by-activity basis. This would mean that no longer could a tax-exempt organization use the losses from one unrelated activity to offset the income from a different, profitable unrelated activity.
Note: If this provision is enacted, consideration should be given to transferring any UBTI activities to a wholly controlled, for-profit subsidiary where gains and losses would offset each other as in every other taxable corporation. If restructured this way, tax-exempt organizations must be mindful of the Section 512(b)(13) rules (income from controlled subsidiaries) and Section 482 principles (compensation for arrangements between controlled entities must be arm’s length and fair market value).
Name and Logo Income Now Taxable
After being ever-so-careful to protect corporate sponsorship payments associated with collegiate athletic events from taxation as UBTI, the Senate is prepared to tax all income derived from the licensing of names and logos of tax-exempt organizations in return for royalties. Accordingly, affinity card arrangements, tax-exempt endorsements and similar arrangements that have historically been non-taxable passive royalties would be taxable as UBTI.
Note: Given the low expenses typically attributable to such activities, and the new proposed provision noted previously that would separately calculate the tax as to each UBTI activity, this change would result in a substantial new tax impact for affected tax-exempt organizations that do not restructure their operations.
Intermediate Sanctions on Steroids
Not content with the current structure of excise taxes on excess benefit transactions (intermediate sanctions), the Senate Tax Bill has significantly increased the scope of intermediate sanctions by subjecting Section 501(c)(5) and 501(c)(6) organizations to these penalty excise taxes, and has toughened the application of these rules by (1) imposing an additional excise tax on the tax-exempt organization involved in an excess benefit transaction (for example, the employer paying unreasonable compensation to a disqualified person), and (2) completely eliminating the long-standing rebuttable presumption of reasonableness. The irony behind the removal of the rebuttable presumption of reasonableness is that Congress specifically requested the US Department of Treasury to draft such provisions in the income tax regulations when intermediate sanctions were first enacted in 1996.
Elimination of Rebuttable Presumption Protections
Since originally drafted, the Treasury Regulations (as directed by Congress) have included procedures for Section 501(c)(3) and Section 501(c)(4) organizations to review and approve transactions with “disqualified persons” (e.g., directors, officers, substantial contributors and others in a position to exercise substantial influence over the affairs of the tax-exempt entity). By following such procedures (specifically, review of the arrangement by board members free of any conflict of interest, reliance by that approval body on comparable market data, and timely and thorough documentation of the approval body’s decision), the applicable organization was entitled to a rebuttable presumption under law that the arrangement was reasonable compensation or fair market value. While not expressly stated by Congress or the regulations when drafted, the clear intent of adding the rebuttable presumption was to encourage good governance practices by tax-exempt organizations and to limit the ability of IRS agents to aggressively raise intermediate sanctions issues on audit given the inherent factual nature of such analysis and the fact that the IRS is not expert in compensation valuations.
The Senate Tax Bill would eliminate the rebuttable presumption and, in its place, would relabel the current rebuttable presumption procedures as “minimal due diligence procedures that do not create a rebuttable presumption.” The essential effect of the proposed provision is to mandate that applicable organizations follow the rebuttable presumption procedures but deprive them of any presumption benefit. If challenged on the reasonableness of compensation, for example, the new approach would require the exempt organization to prove to the satisfaction of the IRS that the compensation was reasonable.
Note: The concept of “minimum standards” of due diligence is odd, because as a legal matter, an organization or body either has exercised satisfactory due diligence or it has not. The creation of “subcategories” of due diligence satisfaction seems like a slippery slope, as it implies that the organization should have done more than it did, even though it exercised due diligence.
Extension of Intermediate Sanctions to Section 501(c)(5) and 501(c)(6) Organizations
Under current law, only Section 501(c)(3) and 501(c)(4) organizations are subject to the intermediate sanctions rules. Under the Senate Tax Bill, however, Section 501(c)(5) and Section 501(c)(6) organizations would also be considered “applicable organizations” subject to these rules. This will be a dramatic change for such tax-exempt organizations, some of which have highly paid executives and do not have “intermediate sanctions ready” approval procedures in place.
Note: While Section 501(c)(6) organizations are subject to the prohibition on private inurement, the inurement proscription in Section 501(c)(6) has always been interpreted in a manner different than the inurement proscription in Section 501(c)(3). Historically, inurement in the Section 501(c)(6) area has focused on whether members of the Section 501(c)(6) organization are improperly benefiting from the net earnings of the tax-exempt organization, not whether executives are overpaid (which is a primary focus under Sections 501(c)(3) and 501(c)(4)). In an indirect way, this provision, if enacted, would make the 501(c)(6) inurement proscription more similar to the inurement proscription in Section 501(c)(3).
Increased Personal Exposure of Organization Managers Who Approve Excess Benefit Transactions
Under existing law, a director, officer or compensation committee member (identified as “organization managers” under the intermediate sanctions rules) is only subject to personal excise taxes under the intermediate sanctions rules if the organization manager knowingly approves an excess benefit transaction (and if certain other conduct standards apply). One of the existing affirmative defenses (to this personal excise tax) available to organization managers is reliance on a reasoned written opinion of an experienced professional advisor. In addition, organization managers are protected from the imposition of personal excise taxes if the organization satisfies the requirements for the rebuttable presumption of reasonableness.
The Senate Tax Bill would remove the reliance on professional advice as an affirmative defense against the imposition of personal penalty excise taxes against organization managers. The Senate Tax Bill also would remove the protection afforded to the manager by the organization satisfying the rebuttable presumption of reasonableness procedures.
New Categories of “Disqualified Persons” Would Be Subject to Intermediate Sanctions
The current intermediate sanctions law creates two types of disqualified persons: statutorily defined disqualified persons, and “facts and circumstances” disqualified persons. Statutorily defined disqualified persons include directors and certain officers. “Facts and circumstances” disqualified persons include anyone who is in a position to exercise substantial influence over the affairs of the organization.
While certain high-profile investment advisors and athletic coaches were probably always “disqualified persons” under the facts and circumstances definition of disqualified person, the Senate Tax Bill would automatically make all investment managers and athletic coaches disqualified persons regardless of whether they are in a position to have substantial influence over the affairs of the organization.
Note: Throughout the history of tax-exempt organizations, Congress has always gone to significant lengths to protect collegiate athletics from adverse applications of the tax laws. This simple provision, along with the other provisions in the Senate Tax Bill affecting collegiate athletics, could be an indication that Congress has finally removed its “kid gloves” with respect to collegiate athletics.
Tax-Exempt Organizations Themselves Would Be Subject to Intermediate Sanctions
The purpose behind intermediate sanctions was to provide the IRS with a consequence short of revocation of tax-exempt status (a penalty rarely invoked by the IRS in such circumstances because of the harm that would result on the exempt purposes served by the organization and on the community served) that would effectively punish the disqualified person who received an improper gain from his or her dealings with the applicable organization. Accordingly, the penalty excise taxes were directed at the disqualified person personally and at any organization managers who knowingly approved the excess benefit transaction.
The Senate Tax Bill would impose a new penalty excise tax on the tax-exempt organization equal to 10 percent of the amount of the excess benefit. Accordingly, with this proposed change, the occurrence of an excess benefit transaction would result in separate penalty excise taxes against the disqualified person, the applicable organization and the organization manager(s) who approved the transaction (assuming the organization manager’s actions were “knowing” and met other conduct standards).
Note: Given that few intermediate sanctions excise taxes have been imposed on disqualified persons, it is not clear what Congress seeks to gain by the inclusion of an excise tax on applicable organizations for such transgressions. Perhaps this signals an intention that, without the protection of the rebuttable presumption of reasonableness, more transactions be treated as excess benefit transactions subject to the broader array of intermediate sanctions excise taxes.
Excise Tax on Investment Income of Private Colleges and Universities
For the past few years, as college tuition has continued to rise and investment advisors to college endowments have received significant levels of compensation based on their investment returns, the increasing size of college endowments has drawn scrutiny from Congress. While many colleges and universities have taken active and very public steps to increase the use of their endowments to support students who could not otherwise afford tuition, the Senate was apparently moved to take stronger action.
The Senate Tax Bill proposes an excise tax of 1.4 percent of the net investment income of private (not state-owned) colleges and universities whose aggregate fair market value of assets (other than those assets used directly in carrying out the institution’s exempt purposes) is at least $250,000 per student. To put that into perspective, generally a private college with an enrollment of 10,000 students would be subject to the tax if its endowment assets exceeded $2.5 billion. The tax applies to the net income of the entire investment portfolio, not just those assets that exceed the per-student threshold amount. The term college or university for this purpose includes the college or university and all other organizations under common control. As currently drafted, investment losses from previous years may not be used to offset gains in a current year.
Repeal of Tax Exemption for Professional Sports Leagues
The tax exemption of professional sports leagues has been in the news of late with the National Football League “voluntarily” relinquishing its tax-exempt status. Historically, such organizations have been accorded tax-exempt status as business leagues under Section 501(c)(6) of the Code, which expressly provides that “professional football leagues (whether or not administering a pension fund for football players)” are entitled to exemption. Over the years, Congress and the IRS have interpreted this phrase to apply to professional sports leagues and associations generally, not just football professional sports leagues.
The Senate Tax Bill proposes that Section 501(c)(6) of the Code be amended not only to delete the phrase “professional football leagues,” but also to add a statement that expressly provides that Section 501(c)(6) “shall not apply to any professional sports league (whether or not administering a pension fund for players).”
Charitable Contributions Involving College Athletic Seating Rights
Historically, contributions to a college or university where the donor received a right to purchase tickets to a college athletic event were partially deductible to the donor as charitable contributions. Specifically, a donor who received such rights in return for a charitable contribution was entitled to take a charitable contribution deduction equal to 80 percent of the donation.
The Senate Tax Bill would amend Section 170(l) of the Code to state that no charitable deduction is allowed for payments to a college or university where the donor receives the right to purchase tickets or seating to an athletic event.
Repeal of Advance Refunding Bonds
The Senate Tax Bill contains one item of good news for Section 501(c)(3) organizations. The House bill released last week proposed to eliminate the tax exemption for interest on private activity bonds, a critical source of capital for 501(c)(3) hospitals, colleges, universities and others. The Senate Tax Bill takes a narrower approach to bond reforms, only subjecting bondholders to income tax on interest received from “advance refunding bonds.” While this change would limit certain types of refinancings, it comes as a welcome relief for charitable organizations reliant on tax-free bonds for their infrastructure and future growth.
It is important to bear in mind that the initial Senate Tax Bill is one step in a long process, and that both the House and Senate versions are likely to undergo many changes as this tax law overhaul advances. However, given the far-reaching implications of these potential changes to the exempt organization sector, the Senate Tax Bill in particular deserves close monitoring.