Tax reform for tax-exempt organizations: Changes to unrelated business income Focusing on the Tax Cuts and Jobs Act (H.R. 1)

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1 Tax reform for tax-exempt organizations: Changes to unrelated Focusing on the Tax Cuts and Jobs Act (H.R. 1) Baker Tilly refers to Baker Tilly Virchow Krause, LLP, an independently owned and managed member of Baker Tilly International.

2 Key Objectives > Understand the impact of the Tax Cuts and Jobs Act (TCJA) to unrelated > Understand how changes to the corporate income tax provisions impact tax-exempt organizations > Understand financial statement income tax reporting changes resulting from the TCJA > Identify planning opportunities 2

3 Tax collections from Form 990-T $581 million Top 4% of returns in terms of gross receipts generated $521 million of tax paid. 3

4 Summary tax-exempt organization specific > Compute net income from unrelated activities separately for each activity for tax years beginning after December 31, 2017 > Includes certain employer provided fringe benefit expenses in the definition of unrelated business income 4

5 Summary corporate changes impacting taxexempt organizations > Flat corporate tax rate of 21%* > Alternative minimum tax repealed > Domestic production activity deduction repealed > Depreciation method changes for certain property > Limitation on interest expense deduction > Changes to use of net operating losses *Rate change does not apply to entities organized as a trust 5

6 Potential for multiple trades or businesses Rental activity Passive/ investment activity 6

7 Computing net income from activities separately Before tax reform (ignoring specific deduction) Advertising Schedule K-1 Rental Total Gross income 12,000 1,500 10,000 Expenses (4,000) 0 (15,000) Net Income 8,000 1,500 (5,000) 4,500 Tax rate x 15% Tax 675 After tax reform Net income 8,000 1,500 0 Tax rate x 21% x 21% x 21% Tax 1, ,995 7

8 Business interest deduction limitation > Effective for tax years beginning after December 31, 2017 > Applies to tax-exempt organizations with average annual gross receipts greater than $25 million > Calculation for deductible interest is limited to the sum of: Business interest income 30% of adjusted taxable income > Adjusted taxable income is taxable income before net operating losses, deductions for certain pass-through income, depreciation/amortization/depletion, and business interest expense > Disallowed business interest deductions may be carried forward indefinitely 8

9 Business interest deduction limitation example Year One Year Two Adjusted taxable income (before business interest expense, depreciation/amortization/depletion, net operating loss, deductible expenses under section 199A) 15,000 30,000 30% limitation 4,500 9,000 Business interest expense incurred current year 9,000 10,000 Business interest carryforward from prior years 1,000 5,500 Total business interest expense available 10,000 15,500 Allowable business interest deduction 4,500 9,000 Business interest carryforward to future years 5,500 6,500 9

10 Net Operating Losses Generated before Jan 1, 2018 Generated after Dec 31, 2017 Applies to Consolidated net income Activity that generated the loss Limitation No limit 80% of net income for the activity that generated the loss Carryforward 20 Years Indefinite Carryback 2 Years Not allowed 10

11 Net Operating Loss Example Year 1 Net operating loss (NOL) generated before Jan 1, 2018 of $120,000 Activity net income Net income to apply NOL Activity NOL created Rental (5,000) 0 (5,000) Services to unrelated parties (22,000) 0 (22,000) Advertising 30,000 30,000 0 Fringe benefits 60,000 60,000 0 Schedule K-1 unrelated business 25,000 25,000 0 income Net income 115,000 Pre Jan 1, 2018 NOL (115,000) Net taxable income at 21% 0 11

12 Net Operating Loss Example Year 2 Net operating loss (NOL) generated before Jan 1, 2018 of $5,000 Activity net income Activity NOL Avail Taxable income Activity NOL created/ remaining Rental 8,000 (5,000) 3,000 0 Services to unrelated parties 11,000 (22,000) 2,200* (13,200) Advertising 35, ,000 0 Fringe benefits 62, ,000 0 Schedule K-1 unrelated business (32,000) 0 0 (32,000) income Net income 102,200 Pre Jan 1, 2018 NOL (5,000)** Specific deduction (1,000) Net taxable income at 21% 96,200 *Use of NOL carryforward is limited to 80% of the taxable income of the activity (11,000 (11,000 x 0.8)) = 2,200 **$120,000 pre-2018 NOL less $115,000 used in previous year 12

13 Taxability of transportation fringe benefits > Harmonizes with recent provision under 274 that disallows these deductions on income tax returns of for-profit employers > Applies to amounts paid or incurred after December 31, 2017 > Does not apply to benefits paid that are directly connected with a reported unrelated trade or business 13

14 Fringe benefits subject to unrelated business income > Transportation fringe benefits excludable from employee income under 132(f): Commuter vehicle/van pooling Transit passes/vouchers Qualified parking Qualified bicycle commuting reimbursement* > A facility used in connection with qualified parking > On-site athletic facility expenses *Disallowed as pre-tax reimbursement for tax years after Dec 31, 2017 and before Jan 1, Sunset on disallowance for years after Dec 31, 2025 resulting in unrelated. 14

15 Qualified parking > Parking provided to an employee > Located on or near the employer s business premises > Used by an employee commuting to work Does not include parking on or near property used by the employee for residential purposes 15

16 Before tax reform Fringe benefit expense = Total employer cost $3,120 After tax reform Fringe benefit expense Unrelated business income tax Total employer cost $3,120 $655 $3,775 16

17 Qualified Fringe Benefit Example Employer paid parking through salary reduction or expense reimbursement Free lot* $100/ month $260/ month $315/ month Annual cost 0 1,200 3,120 3,780 Fair market value 0 1,200 3,120 3,780 Non-taxable fringe 0 1,200 3,120 3,120 Taxable fringe (not subject to 21%) Unrelated per employee 0 1,200 3,120 3,120 Tax at 21% per employee Total cost per employee 0 1,452 3,775 4,435 *Free lot in an area where fees are not charged to the general public because the value of the parking is $0; does not apply to metropolitan areas 17

18 Options for fringe benefits > File Form 990-T: Maintain pre-reform benefit Pay 21% on the total expense incurred > No Form 990-T: Eliminate pre-reform benefits Tax employees for the benefit Gross up employees taxable wages for increased taxes > Results in increased payroll taxes for both employer and employees; and > Results in increased income taxes to employees 18

19 Options for Fringe Benefits - Example Eliminate benefit; no gross up to employee Maintain benefit as is, report as UBI Eliminate and provide gross up to employee Original cost per employee $260/month 3,120 3,120 3,120 Gross up to employee fed/state/payroll tax 15% + 5.5% + 6.2% % = 28.15% N/A N/A 1,222 Employer share payroll taxes 6.2% % 239 N/A 332 Unrelated tax per employee N/A 655 N/A Total employer cost per employee 3,359 3,775 4,674 Total taxes paid by employee 28.15% * Total overall cost 4,237 3,775 4,674 Form 990-T required? No Yes No *Taxes paid by employee are paid through the gross-up of $1,222 19

20 On-site athletic facilities Must calculate the FMV of facility use that employees don t pay for and which is not included in the employee s taxable income for any facility that meets all of the following: > Any athletic facility, > Located on the employer s business premises, > Operated by the employer, > Substantially all of the use is by employees of the employer, their spouses and dependent children, and > Discriminates in favor of highly compensated employees 20

21 On-site athletic facilities examples Hospital physical therapy facility > Primarily used by patients for physical therapy and rehabilitation services > Incidentally used by hospital employees and community members > Not added to unrelated business income College fitness center > Primarily used by student athletes involved with sports teams and general student population > Incidentally used by employees > Not added to unrelated business income 21

22 Financial statement disclosures > ASC 740 requires organizations and companies subject to income tax to recognize full financial effect of an enacted tax rate change on their deferred tax items

23 Financial statement disclosures ASC 740 Provision for taxes of for-profit subsidiaries and unrelated example > Corporation A has $100,000 of net operating loss carryovers as of December 31, 2017 > Corporation A recorded a $35,000 federal deferred tax asset using a 35% tax rate > The enactment date of the bill was during 2017, therefore Corporation A will need to reflect its deferred tax asset at the new federal 21% tax rate, or $21,000 > The reduction of deferred tax asset of $14,000 will be recorded as income tax expense in 2017 as a discrete item

24 Planning and minimizing tax exposure > Evaluate current unrelated activities and isolate calculations by activity based on professional judgment until guidance is released > Audit unrelated activities to determine if all reasonable expenses and allocations are assigned to each activity; apply new limits to certain expenses > Potentially revise estimated tax payments for unrelated business taxable income > Update net operating loss schedules 24

25 Planning and minimizing tax exposure > Monitor for Joint Committee on Taxation Blue Book explanation; Treasury Department Notices and Regulations; and Technical Corrections Bill > Evaluate options for providing taxable fringe benefits > Projections to determine if C-Corporation subsidiary structure would help reduce net unrelated business taxable income > Multi-state filers will need to monitor tax law changes at the state level 25

26 Disclosure 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. Baker Tilly refers to Baker Tilly Virchow Krause, LLP, an independently owned and managed member of Baker Tilly International Baker Tilly Virchow Krause, LLP