Tax-Exempt Hospitals & Other Tax-Exempt Healthcare Organizations Not Immune from Federal Tax Reform
As federal tax reform efforts proceed rapidly in both chambers of Congress, tax-exempt hospitals and other tax-exempt healthcare organizations are facing major potential changes. New tax burdens on tax-exempt organizations are among the ways in which the bills would raise revenue to pay for proposed tax cuts for businesses and individuals. Importantly, it is still early in the legislative process, and much may change as Republicans race to have a bill signed into law before the end of the year.
Major changes at stake. Most notably, current proposals include (1) repealing the long-standing exclusion of interest on 501(c)(3) bonds from taxable income – a sea change, which would eliminate critical low-cost financing for hospitals and other tax-exempt organizations, (2) imposing a new tax on tax-exempt organizations paying their executives compensation of over $1 million, and (3) imposing new risks on board members and tax-exempt organizations in determining executive compensation.
Current status of legislation. The House of Representatives is anticipated to vote this week on the bill passed by the House Ways and Means Committee on November 9, 2017, following release of the initial 429-page bill on November 2, 2017. The Senate Finance Committee has not yet released the text of its bill, but has provided a detailed summary here. A new mark-up of the bill is expected to be released soon after press time for this blog post. After both chambers pass a bill, the bills would need to be reconciled before proceeding to a final vote in both chambers. It is important to note that the draft legislation is evolving rapidly with changes occurring seemingly by the hour, including, most recently, the November 14th announcement by Senate Republicans of their intent to include the repeal of the Affordable Care Act’s individual mandate as part of tax reform.
Timing. The proposals below would generally take effect for tax years beginning after December 31, 2017.
The following is a more detailed summary of the proposed provisions of the current House and Senate bills that would most directly impact tax-exempt healthcare organizations.
|Current Law||House of Representatives Ways & Means Committee Bill||Senate Finance Committee Bill||Potential Impact|
|Tax-Exempt Bonds||Interest on “qualified 501(c)(3) bonds” (and other “private activity bonds”) is not taxable to bondholders.||The House bill would repeal the current exclusion of interest on qualified 501(c)(3) bonds from gross income, effective for bonds issued after December 31, 2017.||
No change for qualified 501(c)(3) bonds (and other private activity bonds).
However, the Senate bill would repeal the exclusion from gross income for interest on advance refunding bonds (i.e., bonds issued to advance refund other bonds), effective for advance refunding bonds issued after December 31, 2017.
The House’s proposal to eliminate qualified 501(c)(3) bonds would wipe out a critical source of low-cost financing that hospitals and healthcare facilities (as well as affordable housing organizations, colleges, universities and others) often rely upon to finance capital improvements and construction. Comments have already been submitted by the American Hospital Association and others about the anticipated adverse impacts of this proposal.
|Executive Compensation||Section 501(c)(3) and Section 501(c)(4) tax-exempt organizations are subject to requirements designed to ensure that executive compensation is reasonable and does not exceed fair market value, but no specific dollar cap is currently imposed.||
The House bill would impose a new 20% tax relating to certain executive compensation on all organizations that are tax-exempt under Section 501(a), and on governmental entities that rely on §115(1) for exemption.
Specifically, the tax would be imposed on organizations that pay executive compensation in excess of $1 million per year (with certain exclusions) to any current or former employees who are among the organization’s 5 highest compensated employees for the current tax year, or who fell into such category for any prior tax year beginning after 2016. The tax would also apply to certain severance payments.
|Same as House bill.||
These proposals correspond to existing provisions that limit the deductibility by for-profit businesses of executive compensation and parachute payments.
These proposals are estimated to raise tax revenues of $3.6 billion over 10 years.
Excess Benefit Transaction Rules
(a/k/a Intermediate Sanctions)
· Currently, excise tax penalties (commonly known as Intermediate Sanctions) are imposed on certain persons who benefitted from an “excess benefit transaction.” Penalties can also be imposed on board members who “knowingly” approved the transaction.
· An “excess benefit transaction” is generally a transaction in which an economic benefit is provided by a Section 501(c)(3) or (c)(4) organization to a “disqualified person” (i.e., directors, officers and other insiders) where the economic benefit provided by the tax-exempt organization exceeds the value it received in return, including paying excessive compensation.
· Safe Harbor: Organizations can qualify for a “rebuttable presumption” that compensation is reasonable by following certain steps (e.g., reviewing market comparability data) in determining executive compensation, which shifts the burden to the IRS to prove that the compensation paid was not reasonable.
|No changes to current law.||
· Liability for penalties – Tax-exempt organizations themselves would become subject to a new 10% excise tax for excess benefit transactions, which could apply unless the organization demonstrates that its participation was not willful and was due to reasonable cause.
· Eliminate the Rebuttable Presumption of Reasonableness – The rebuttable presumption safe harbor would be eliminated. Instead, the current rebuttable presumption procedures would be established as minimum due diligence standards.
· Reliance on Professional Advice – The Senate bill would eliminate the rule that board members are not considered to have “knowingly” approved an excess benefit transaction if they relied on professional advisors such as valuation experts. However, reliance on professional advice would still be a factor in determining liability.
· Investment Advisors Now Covered – The Senate bill would expand the Intermediate Sanctions rules to cover investment advisors, by treating them as “disqualified persons.”
· New Organizations Covered – The Senate bill would extend the applicability of the Intermediate Sanctions rule to Section 501(c)(5) and Section 501(c)(6) organizations, which include trade associations.
The Senate proposals raise the stakes significantly for hospitals and other tax-exempt organizations – and their board members– in setting executive compensation and for approving transactions with insiders.
Potentially, the increased risk of personal liability for paying excessive compensation could cause a decrease in executive compensation, which would reduce the ability of tax-exempt organizations to attract and retain top talent. It could also discourage individuals from serving on nonprofit boards.
Overall, the proposals would divert funds from nonprofit activities to finance proposed tax cuts.
|Unrelated Business Income Tax (UBIT) – Expansions & Modifications||
Section 501(c) tax-exempt organizations are generally subject to paying the Unrelated Business Income Tax (UBIT) on certain income that is considered “unrelated” to their tax-exempt mission. Certain types of passive income are generally excluded from UBIT, including royalties.
Taxable income and losses considered to be from separate trade or businesses are generally netted to determine net taxable income (i.e., losses from one unrelated business activity can be used to offset gain from another unrelated business activity, thereby reducing tax liability).
· Fringe Benefits – The House bill would cause the value of certain fringe benefits that tax-exempt organizations provide, including transportation fringe benefits and on-premises gyms, to be treated as unrelated business taxable income to the tax-exempt organization.
· Governmental hospitals – The House bill purports to clarify that government hospitals and certain other governmental entities that rely on both §501(a) and §115(1) for tax-exempt status are subject to UBIT.
· Research Exemption – The House bill would limit the exemption from UBIT that is provided for research income received by organizations that are operated primarily for the purpose of conducting fundamental research, the results of which are freely available to the public.
· Royalties from Name & Logo – Royalty income from licensing an organization’s name or logo would be taxable, overriding the current general exclusion of royalty income from UBIT.
· No Netting of Taxable Income Sources – Organizations would no longer be permitted to offset income from an unrelated business activity with losses from a separate unrelated business activity.
|These proposals would likely result in significant additional UBIT liability for tax-exempt organizations.|
Other noteworthy changes include:
- Charitable Giving Incentives
Neither bill would eliminate the charitable contribution deduction, and certain proposed provisions would strengthen incentives for charitable giving (e.g., increasing the cap on deducting certain cash contributions). However, there is significant concern in the nonprofit sector that overall, the financial incentives for making charitable contributions would decrease materially under the current tax reform bills.
For example, both bills could decrease charitable giving by significantly reducing the number of people who can claim charitable contribution deductions, through reducing the number of individuals who would be eligible to itemize their deductions. Other provisions that could weaken charitable giving incentives include repealing, or limiting the application of, the estate tax. See the joint statementof the National Council of Nonprofits and the Council on Foundations opposing the House bill.
Combined with the proposed repeal of the exclusion of interest on qualified 501(c)(3) bonds from gross income, the anticipated reduction in charitable contributions are likely to exacerbate the financial stress that many tax-exempt hospitals and healthcare institutions are facing today.
- Other Changes Impacting the Nonprofit Sector More Broadly
Other major changes impacting the nonprofit sector more broadly include proposals to:
- loosen the prohibition on Section 501(c)(3) tax-exempt organizations, including churches and other houses of worship, against supporting or opposing political candidates (the “Johnson Amendment”),
- repeal tax-exempt status for professional sports leagues,
- add a new tax on certain larger college and university endowments, and
- streamline the tax on private foundations’ net investment income to a flat 1.4% tax.