H.R. 1 As Economic Policy Part 4 Exempt Organizations

H.R. 1 makes several tweaks to how non-profits are treated at the organizational level, in addition to tweaks in the charitable deduction for individuals and businesses addressed in other posts.

All of these provisions increase tax revenue. The estimated dollar impact of all these provisions combined from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: 24.9

1. Unrelated business taxable income separately computed for each trade or business activity (sec. 512(a) of the Code)

For an organization with more than one unrelated trade or business, the provision requires that unrelated business taxable income first be computed separately with respect to each trade or business and without regard to the specific deduction generally allowed under section 512(b)(12). The organization’s unrelated business taxable income for a taxable year is the sum of the amounts (not less than zero) computed for each separate unrelated trade or business, less the specific deduction allowed under section 512(b)(12). A net operating loss deduction is allowed only with respect to a trade or business from which the loss arose.

The result of the provision is that a deduction from one trade or business for a taxable year may not be used to offset income from a different unrelated trade or business for the same taxable year. The provision generally does not, however, prevent an organization from using a deduction from one taxable year to offset income from the same unrelated trade or business activity in another taxable year, where appropriate. Under a special transition rule, net operating losses arising in a taxable year beginning before January 1, 2018, that are carried forward to a taxable year beginning on or after such date are not subject to the rule of the provision.

This is good tax and economic policy as it prevents a charity being used to conduct for profit business activities from using money losing businesses to shield taxable income from a profitable for profit business it is operating that might otherwise be subject to the unrelated business income tax, to be taxed. This encourages charities to discontinue unprofitable unrelated for profit businesses which is good for the economy, although the impact is probably tiny.

The estimated dollar impact of these provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: 3.5

2. Unrelated business taxable income increased by amount of certain fringe benefit expenses for which deduction is disallowed (sec. 512 of the Code)

Under the provision, unrelated business taxable income includes any expenses paid or incurred by a tax exempt organization for qualified transportation fringe benefits (as defined in section 132(f)), a parking facility used in connection with qualified parking (as defined in section 132(f)(5)(C)), or any on-premises athletic facility (as defined in section 132(j)(4)(B)), provided such amounts are not deductible under section 274.

This provision taxes non-profit fringe benefits for company cars, certain kinds of parking benefits, and athletic facilities at the non-profit as unrelated business taxable income, which basically follows the general notion that non-deductible fringe benefits excluded from employee income, which would otherwise be compensation income to employees, are taxed at the entity level. This isn't unfair and basically closes a loophole.

The estimated dollar impact of these provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: Not calculated separately from parallel provision for for profit businesses discussed in a future part of this series. Probably on the order of 0.2.

3. Excise tax on excess tax-exempt organization executive compensation (sec. 4960 of the Code)

Under the provision, an employer is liable for an excise tax equal to 21 percent (the corporate tax rate) of the sum of (1) any remuneration (other than an excess parachute payment) in excess of $1 million paid to a covered employee by an applicable tax-exempt organization for a taxable year, and (2) any excess parachute payment (under a new definition for this purpose that relates solely to separation pay) paid by the applicable tax-exempt organization to a covered employee.

Accordingly, the excise tax applies as a result of an excess parachute payment, even if the covered employee’s remuneration does not exceed $1 million. 

For purposes of the provision, a covered employee is an employee (including any former employee) of an applicable tax-exempt organization if the employee is one of the five highest compensated employees of the organization for the taxable year or was a covered employee of the organization (or a predecessor) for any preceding taxable year beginning after December 31, 2016. An “applicable tax-exempt organization” is an organization exempt from tax under section 501(a), an exempt farmers’ cooperative, a Federal, State or local governmental entity with excludable income, or a political organization.

Remuneration means wages as defined for income tax withholding purposes, but does not include any designated Roth contribution. Remuneration of a covered employee includes any remuneration paid with respect to employment of the covered employee by any person or governmental entity related to the applicable tax-exempt organization. A person or governmental entity is treated as related to an applicable tax-exempt organization if the person or governmental entity (1) controls, or is controlled by, the organization, (2) is controlled by one or more persons that control the organization, (3) is a supported organization during the taxable year with respect to the organization, (4) is a supporting organization during the taxable year with respect to the organization, or (5) in the case of a voluntary employees’ beneficiary association (“VEBA”), establishes, maintains, or makes contributions to the VEBA.

However, remuneration of a covered employee that is not deductible by reason of the $1 million limit on deductible compensation is not taken into account for purposes of the provision. Under the provision, an excess parachute payment is the amount by which any parachute payment exceeds the portion of the base amount allocated to the payment. A parachute payment is a payment in the nature of compensation to (or for the benefit of) a covered employee if the payment is contingent on the employee’s separation from employment and the aggregate present value of all such payments equals or exceeds three times the base amount. The base amount is the average annualized compensation includible in the covered employee’s gross income for the five taxable years ending before the date of the employee’s separation from employment.

Parachute payments do not include payments under a qualified retirement plan, a simplified employee pension plan, a simple retirement account, a tax-deferred annuity, or an eligible deferred compensation plan of a State or local government employer.

The employer of a covered employee is liable for the excise tax. If remuneration of a covered employee from more than one employer is taken into account in determining the excise tax, each employer is liable for the tax in an amount that bears the same ratio to the total tax as the remuneration paid by that employer bears to the remuneration paid by all employers to the covered employee.

Remuneration is treated as paid when there is no substantial risk of forfeiture of the rights to such remuneration. In addition, the definition of remuneration for this purpose includes amounts required to be included in gross income under section 457(f), with "substantial risk of forfeiture” is based on the definition under section 457(f)(3)(B) which applies to ineligible deferred compensation subject to section 457(f). Accordingly, the tax imposed by this provision can apply to the value of remuneration that is vested (and any increases in such value or vested remuneration) under this definition, even if it is not yet received.

The bill exempts compensation paid to employees who are not highly compensated employees (within the meaning of section 414(q)) from the definition of parachute payment, and also exempts compensation attributable to medical services of certain qualified medical professionals from the definitions of remuneration and parachute payment. For purposes of determining a covered employee, remuneration paid to a licensed medical professional which is directly related to the performance of medical or veterinary services by such professional is not taken into account, whereas remuneration paid to such a professional in any other capacity is taken into account. A medical professional for this purpose includes a doctor, nurse, or veterinarian.

This provision to treat as corporate profits excess compensation paid to senior government officials, political organization officials, farm co-op officials, and certain other charities (IRC 501(c) instead of 501(c)(3) charities), is a generally appropriate way to discourage excessive compensation for officials in the netherworld between a full fledged non-profit public charity and for profit corporations. It could become an issue at some point as inflation drives up senior executive compensation that isn't excessive, but prevents undue executive self-enrichment that takes advantage of the tax free status of the entities that they work for as executives.

The estimated dollar impact of these provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: 1.8

4. Excise tax based on investment income of private colleges and universities (new sec. 4968 of the Code)

The provision imposes an excise tax on an applicable educational institution for each taxable year equal to 1.4 percent of the net investment income of the institution (as defined in section 4942(j)(3)); (2) be publicly supported for at least 10 taxable years; (3) have a governing body no more than 25 percent of whom are disqualified persons and that is broadly representative of the general public; and (4) have no officers who are disqualified persons. ) for the taxable year. Net investment income is determined using rules similar to the rules of section 4940(c) (relating to the net investment income of a private foundation).

For purposes of the provision, an applicable educational institution is an institution: (1) that has at least 500 tuition paying students during the preceding taxable year; (2) that is an eligible education institution as described in section 25A of the Code; (3) that is not described in the first section of section 511(a)(2)(B) of the Code (generally describing State colleges and universities); and (4) the aggregate fair market value of the assets of which at the end of the preceding taxable year (other than those assets that are used directly in carrying out the institution’s exempt purpose) is at least $500,000 per student. For these purposes, the number of students of an institution is based on the daily average number of full-time students attending the institution, with part-time students being taken into account on a full-time student equivalent basis. The provision modifies the definition of "applicable educational institution" to include only institutions more than 50 percent of the tuition paying students of which are located in the United States. For this purpose, the number of students at a location is based on the daily average number of full-time students attending the institution, with part-time students being taken into account on a full-time student equivalent basis.

It is intended that the Secretary promulgate regulations to carry out the intent of the provision, including regulations that describe: (1) assets that are used directly in carrying out the educational institution’s exempt purpose; (2) the computation of net investment income; and (3) assets that are intended or available for the use or benefit of the educational institution.

For purposes of determining whether an institution meets the asset-per-student threshold and determining net investment income, assets and net investment income include amounts with respect to an organization that is related to the institution. An organization is treated as related to the institution for this purpose if the organization: (1) controls, or is controlled by, the institution; (2) is controlled by one or more persons that control the institution; or (3) is a supported organization or a supporting organization during the taxable year with respect to the institution.

For purposes of determining whether an educational institution meets the asset-perstudent threshold and for purposes of determining net investment income, assets and net investment income of a related organization with respect to the educational institution are treated as assets and net investment income, respectively, of the educational institution, except that:

1. No such amount is taken into account with respect to more than one educational institution; and

2. Unless the related organization is controlled by the educational institution or is a supporting organization (described in section 509(a)(3)) with respect to the institution for the taxable year, assets and investment income that are not intended or available for the use or benefit of the educational institution are not taken into account. For example, assets of a related organization that are earmarked or restricted for (or fairly attributable to) the educational institution would be treated as assets of the educational institution, whereas assets of a related organization that are held for unrelated purposes (and are not fairly attributable to the educational institution) would be disregarded.

In terms of direct economic effect, a 1.4% tax on the investment income of the 50-100 private colleges and universities with the largest per student endowments is a drop in the bucket, and even the impact on the endowments themselves is tiny, almost a rounding error in their annual rate of return.

It is also worth noting that the impact falls on institutions that have extremely wealthy alumni and students who are, on average, from very affluent families, so making them beneficiaries of charity is problematic, even though the funds taxed would otherwise be invested in highly productive human capital investments. And, there is nothing about investing itself, that is inherently a charitable activity.

So, economically, it is irrelevant.

On the other hand, symbolically, singling out elite higher educational institutions from an otherwise blanket tax free status of non-profit entities is just another part of an overall Republican war on higher education, some provisions of which were found in earlier versions of the tax bill but trimmed in the Conference Committee, that reflects the fact that a majority of Republicans surveyed currently see higher education as doing more harm than good.

The estimated dollar impact of these provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: 1.8

5. Repeal of advance refunding bonds (sec. 149(d) of the Code)

The provision repeals the exclusion from gross income for interest on a bond issued to advance refund another bond.

Municipal bonds are tax free and intended to allow state and local governments to debt finance on a subsidized basis. Congress decides here that prepayment of existing bonds is not a worthy purpose. 

Municipalities may be strategic losers in high finance conflicts between municipal bondholders and municipal finance underwriters under this provision, but it doesn't impact the economic fundamentals much and arguably closes off an abuse of the provision.

The estimated dollar impact of these provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: 17.4

6. Repeal of tax credit bonds (secs. 54A, 54B, 54C, 54D, 54E, 54F and 6431 of the Code)

The provision prospectively repeals authority to issue tax-credit bonds and direct-pay bonds.

This provision reaches the judgment that changing the timing of tax credits is not a purpose that should benefit from a tax exemption. It is a not entirely unreasonable position and may thwart some big dollar private-public partnerships, but arguably partnerships that are unduly benefiting the private partner. This may reduce economic growth slightly, especially in infrastructure and real estate development, but not in an illegitimate way that changes the fundamental economics of those transactions.

The estimated dollar impact of these provisions from 2018-2027 on federal revenues (in billions of U.S. dollars) is as follows: 0.2