On December 22, 2017, the Tax Cuts and Jobs Act (i.e., the tax reform act) was signed into law. As various industries begin to assess the potential impact, below is a preliminary outline of certain key provisions of the act that specifically affect tax-exempt healthcare organizations as well as some practical takeaways and outstanding questions.
(1) Excise Tax on Certain Employees Compensated in Excess of $1 Million
Summary of Changes
- Effective for tax years beginning in 2018 and thereafter, tax-exempt organizations (including, most notably, Section 501(c)(3) organizations) are required to pay a 21% excise tax on remuneration paid to covered employees in excess of $1 million per tax year.
- Covered employees include the organization’s top five highest paid employees in the current tax year and any individual who was formerly a top five highest paid employee in any prior year (starting with 2017 tax years) determined on an “entity by entity” basis (i.e., each organization will have its own five highest paid employees).
- Remuneration includes salary, bonus/incentive compensation, most deferred compensation as well as any excess parachute payments.
- Excess parachute payments include amounts to be paid to a highly compensated employee contingent on the employee’s severance of employment to the extent that the total present value of such amounts exceeds three times the employee’s average annual base compensation (measured over the prior five tax years).
- Amounts paid to licensed medical professionals (e.g., physicians, nurses, etc.) attributable to the performance of medical services are not included in remuneration for purposes of calculating the excise tax.
- All remuneration paid to a covered employee by the tax-exempt organization and by any related person with respect to employment of such individual is aggregated for purposes of determining the applicability and extent of the excise tax.
- Related person means any person or governmental entity that: (1) controls, is controlled by or under common control with the applicable tax-exempt organization; (2) is a Section 509(a)(3) supporting/supported organization of the applicable tax-exempt organization; and (3) in the case of a voluntary employees’ beneficiary association (“VEBA”), establishes, maintains, or makes contributions to the VEBA.
- To the extent remuneration paid by multiple related employers is taken into account for calculating the excise tax, each employer is liable for a proportional share of the excise tax liability based on the amount of remuneration paid by each.
- The Secretary of the Treasury is directed to promulgate regulations to prevent avoidance of the excise tax, including avoidance through classification of workers as other than employees or paying compensation via a pass-through entity or other type of entity.
- While publicly traded companies are subject to a similar compensation limit (denial of business expense deduction), tax-exempt organizations are now seemingly at a competitive disadvantage as compared to privately held businesses in terms of attracting and compensating senior executives and other employees paid in excess of $1 million per year.
- The excise tax will presumably impact tax-exempt organization compensation trends going forward and, accordingly, compensation surveys and other comparability data used to support and inform compensation determinations by tax-exempt organizations (i.e., organizations willing or able to pay excess compensation and incur excise tax liability may be limited by market trends).
- Tax-exempt organizations should determine now whether any employees will trigger the excise tax going forward and explore available options to mitigate the impact thereof (e.g., redesigned payment/vesting schedules, renegotiated compensation amounts, revised parachute payment provisions, conditional reduction/renegotiation clauses if excise tax triggered in future years, etc.).
- For example, might tax-exempt organizations consider consolidating highly compensated employees into one organization as to limit the number of covered employees that could trigger the excise tax?
- Would excise tax liability (i.e., a proportional amount thereof) extend to affiliated/related taxable or pass-through entities to the extent remuneration paid by such entities is aggregated and triggers the excise tax?
- If some or all of an organization’s top five highest compensated employees are physicians (whose compensation is attributable to medical services and thus not subject to the excise tax), would that technically limit the extent to which other highly compensated employees trigger the excise tax?
- To the extent medical professionals are paid for both professional and administrative services, how must an employer allocate between the two for purposes of calculating potential excise tax liability?
- Should both compensation and excise tax liability be taken into account in determining whether overall compensation is reasonable (e.g., for Section 501(c)(3) compliance and Section 4958 excess benefit transaction purposes)?
(2) Changes to Unrelated Business Income/Deduction Aggregation Rules
Summary of Changes
- Effective for tax years beginning in 2018 and thereafter, subject to a transition rule for net operating losses arising prior to such tax years that are carried forward, tax-exempt organizations with more than one unrelated trade or business must calculate net unrelated business income tax liability separately for each such trade or business (i.e., taxable income less deductions specifically attributable to such activity) with no offset/aggregation among them.
- Net losses/deductions from one unrelated trade or business cannot be used to offset income from another unrelated trade or business (and the associated unrelated business income tax liability) as previously permitted.
- Tax-exempt organizations with more than one unrelated trade or business should assess whether losses/deductions from one have historically offset income from another.
- Tax-exempt organizations may need to revisit and confirm the reasonableness and accuracy of the methodology used to allocate overhead and other general expenses among the organization’s tax-exempt activities and unrelated business activities.
- Tax-exempt organizations with offsetting unrelated business revenues/losses might consider transferring such operations to an affiliated taxable corporation/association in which aggregation thereof is permitted.
- Nevertheless, the reduction in the corporate income tax rate would similarly benefit tax-exempt organizations that pay unrelated business income tax, previously at higher rates.
- How must organizations distinguish between/separate their multiple unrelated trades or businesses, especially where such activities are related and have overlapping assets, locations, personnel, etc.? In other words, how will a separate unrelated trade or business be determined/defined?
- Will these changes (and other relevant tax reform changes) encourage and/or hasten the sale of profitable unrelated trades or businesses by tax-exempt organizations to taxable buyers?
(3) Certain Fringe Benefits subject to Unrelated Business Income Tax
Summary of Changes
- To the extent paid/incurred on or after January 1, 2018, certain fringe benefits paid or incurred by tax-exempt organizations are generally subject to unrelated business income tax.
- Such fringe benefits include qualified transportation fringe benefits, parking facilities used in connection with qualified parking and any on-premises athletic facilities.
- The foregoing does not apply to the extent such amounts are paid/incurred directly in connection with an unrelated trade or business.
- The Secretary of the Treasury is directed to promulgate regulations specifically on how to allocate depreciation and other costs with respect to parking and athletic facilities.
- This change corresponds with a limitation/repeal of certain similar deductions for taxable organizations.
- Tax-exempt organizations providing any of these fringe benefits may need to revisit the relevant economics and reevaluate whether such benefits still make sense in light of the additional tax burden.
- It appears that many tax-exempt organizations that maintain a parking lot for employees could be subject to unrelated business income tax on certain associated expenses.
- Would a tax-exempt employer that maintains a parking facility be subject to tax if it charges employees (and the public) for parking?
- How will parking facility expenses be allocated if the facility has multiple types of users (e.g., employees, vendors/independent contractors, visitors, students, medical staff physicians, public, etc.)?
- Will these changes encourage tax-exempt organizations to discontinue, repurpose and/or sell their existing parking and/or athletic facilities?
(4) Repeal of Advance Refunding Bonds
Summary of Changes
- For bonds issued on or after January 1, 2018, interest on certain bonds issued to refund a tax-exempt bond (i.e., advance refunding bonds) is no longer excludable from gross income
- Advance refunding bond rules had previously allowed tax-exempt refunding bonds to be issued more than 90 days before the redemption of the tax-exempt refunded bond (with the proceeds typically invested in an escrow account pending redemption).
- Current refunding bonds are still permitted on a tax-exempt basis, which require that the refunded bond be redeemed within 90 days of issuance of the refunding bond.
- How will the tax-exempt private activity bond market be impacted by the changes? For example, will such bonds be made “callable” earlier?
(5) Excise Tax on Investment Income of Private Tax-Exempt College/University Endowment Funds
Summary of Changes
- Effective for tax years beginning in 2018 and thereafter, applicable educational institutions are subject to a 1.4% tax on net investment income.
- Applicable educational institution means an institution that meets each of the following requirements:
- Has at least 500 tuition paying students, more than 50% of whom are located in the United States;
- Is an eligible education institution as described in Section 25A of the Internal Revenue Code (“Code”) (with reference to Section 481 of the Higher Education Act);
- Is not a State college or university under Section 511(a)(2)(B) of the Code; and
- Has assets (not including those assets that are used directly in carrying out the institution’s exempt purpose) with an aggregate fair market value in excess of $500,000 per student.
- Assets and investment income of certain related organizations are combined with those of the institution for purposes hereof, with the following exceptions:
- No related organization amounts are taken into account with respect to more than one institution; and
- Unless the related organization is controlled by, or is a Section 509(a)(3) supporting organization of, the institution, assets and investment income that are not intended or available for the use or benefit of the educational institution are not taken into account (e.g., if earmarked, restricted or otherwise held for unrelated purposes).
- A related organization means an organization that: (1) controls, is controlled by or is under common control with the institution; or (2) is a Section 509(a)(3) supporting/supported organization of the institution.
- The Secretary of the Treasury is directed to issue regulations that specifically address, among other things, defining assets used directly in carrying out the educational institution’s exempt purpose, computation of net investment income and defining whether assets are intended or available for the use or benefit of the institution.
- Tax-exempt health systems with affiliated universities, nursing colleges or other educational institutions should closely review their affiliations and assets to determine whether the above thresholds are met and whether any assets/investment income must be aggregated with those of the institution.
- Close attention should be paid to foundations or other supporting organizations of affiliated educational institutions as well as other affiliated organizations with significant excess funds or liquid assets that could arguably be deployed for the benefit of the educational institution.
- How must assets be deployed to be considered carrying out the educational institution’s purposes and over what time frame?
- Can applicable educational institutions set up affiliated organizations that are not supporting organizations and are not controlled by the institution in order to hold funds for specific purposes such that they are not included for purposes of measuring investment the institution’s income and assets?
- How will unrestricted liquid assets of a health system with an affiliated educational institution be treated when the primary activities of the system are related to healthcare, not education?
(6) Charitable Contribution Limit Increase
Summary of Changes
- For contributions made in tax years beginning after December 31, 2017, the individual limit on the deductibility of cash contributions to tax-exempt public charities and certain other organizations is increased from 50% to 60% of adjusted gross income.
- Tax-exempt organizations, including hospitals and affiliated foundations, might be able to solicit increased donations, particularly from high net worth individuals or others contributing up to deductibility limits.
- This may be offset by the reduced benefits of deductibility on account of lower individual tax rates/brackets and a higher standard deduction.
(7) Certain Proposed Changes NOT Included in the Final Bill
Elimination of Tax-Exemption for Private Activity Bonds
- The House version of the bill would have repealed the exemption for income on interest paid on qualified private activity bonds (often utilized for financing by Section 501(c)(3) organizations).
- The final bill did not include such a repeal but did include a repeal of the tax exemption for advance refunding bonds often used in conjunction with tax-exempt private activity bond financing (see details above).
Repeal of Rebuttable Presumption of Reasonableness Protection; Additional Excise Taxes on Excess Benefit Transactions
- Although not included in the final bill, Congress previously considered including a provision that would have imposed additional excise taxes (i.e., intermediate sanctions) directly on tax-exempt organizations that engage in excess benefit transactions with disqualified persons (i.e., insiders) under Section 4958 of the Code.
- Although previously considered, Congress ultimately declined to effect changes that would have made it easier for the IRS to impose Section 4958 excise taxes directly on tax-exempt organization managers (i.e., officers, directors and trustees).
- Congress also considered including, but ultimately declined to include, a provision eliminating the “rebuttable presumption of reasonableness,” which affords tax-exempt organizations protection against incurring Section 4958 excise taxes if the organizations meet additional reasonableness evaluation, determination, approval and documentation requirements.
Modification of “Johnson Amendment” Prohibiting 501(c)(3) Campaign Activities
- A provision in the House version of the bill would have permitted Section 501(c)(3) organizations to engage in limited political campaign activities by making political statements as long as such statements: were made in the ordinary course of regular and customary activities in carrying out the organization’s exempt purpose; and did not cause the organization to incur more than de minimis incremental expenses.
Taxation of Name/Logo Licensing Income/Royalties
- Congress had previously considered including a provision that would have imposed unrelated business income taxes on tax-exempt organizations earning income/royalties from licensing their names or logos.
New Markets Tax Credits Repeal
- The House version of the bill would have eliminated the “new markets tax credit” (applicable to certain equity investments in a qualified community development entity), which has served as an advantageous financing mechanism allowing tax-exempt organizations to fund various types of projects in low-income communities.
- The new markets tax credit is otherwise set to sunset starting after 2019 and to completely expire after 2024.