New tax law raises concerns Don’t let the “commerciality doctrine” trip you up Pluses and minuses of paying your board News for Nonprofits
NONPROFIT AGENDAS APRIL/MAY 2018
Sechler CPA, P.C. Carolyn Sechler
firstname.lastname@example.org 921 East Orange Drive, Phoenix, AZ 85014 Tel: 602.230.2700/Fax: 602.230.2705 www.azcpa.com
New tax law raises concerns
assage of the new federal income tax law in late December 2017 has brought into reality a variety of concerns nonprofits raised as the bill worked its way through the U.S. House of Representatives and Senate. In addition to the increased standard deduction that’s expected to depress charitable giving, the final Tax Cuts and Jobs Act (TCJA) includes several other provisions that had prompted objections from charities.
Calculating UBTI The TCJA significantly reduces the corporate tax rate — to 21%. This change will benefit nonprofits paying unrelated business income tax, because the tax is imposed at the corporate rate. However, the income subject to the tax could go up for some nonprofits. Under the TCJA, nonprofits must calculate their unrelated business taxable income (UBTI) separately for each unrelated business. As a result, they can’t use a loss from one unrelated business to offset income from another unrelated business for the same tax year. But they can use one year’s losses on an unrelated business to reduce their taxes for that business in a different year (subject to certain restrictions). In addition, the law includes certain fringe benefits in UBTI. Nonprofits now must include in UBTI any expenses incurred to provide employees with qualified transportation fringe benefits (for example, transit passes), a parking facility used in connection with qualified parking fringe benefits and any on-site athletic facility. And under the TCJA, reimbursements to employees for moving expenses or any activity considered to be entertainment can’t be excluded from that employee’s taxable compensation.
Excise tax on excess compensation The TCJA creates a 21% excise tax on nonprofit executives’ compensation (including most benefits and any payments from related organizations) in excess of $1 million considered paid to a covered employee plus certain large payments made to that employee when he or she leaves the organization (known as “excess parachute payments”). “Covered employees” refers to current or former employees who are among the five highest paid employees for the taxable year or who were covered employees in 2017 or later. Once considered a covered employee, an individual will always be a covered employee. A payment generally is considered an excess parachute payment if: 1. I t’s contingent on the employee’s departure, and 2. Th e total present value of all such payments to the employee equals or exceeds three times his or her average annual compensation for the preceding five years. The excise tax applies to the amount of the parachute payment, less the average annual compensation.
Reduced charitable giving incentives The near doubling of the standard deduction is expected to reduce the number of taxpayers who itemize their deductions and, therefore, the number who can deduct their charitable contributions. The TCJA includes further disincentives to giving. The law could hurt major contributions because it increases the estate tax exemption to $10 million, annually indexed for inflation, through 2025. Some wealthy individuals make major gifts to reduce their taxable estates, and the larger exemption means they won’t need to shrink their estates as much to avoid the tax. The TCJA also repeals the deduction for donations made in exchange for the right to buy tickets to college athletic events. While the TCJA raises the limit on cash donation deductions from 50% of adjusted gross income (AGI) to 60%, that change isn’t predicted to have much of an impact. Cash donations of even 50% of AGI are already uncommon.
Certain tax-exempt bond interest repealed Tax-exempt bonds usually pay lower interest rates than other bonds. The tax-exempt nature of the interest makes such bonds attractive to investors despite the lower rates. A bond that is issued to pay principal, interest or the redemption price on an earlier bond issue is called an “advance repayment bond.” The TCJA repeals the tax-exempt treatment for interest paid on advance repayment bonds that are issued to repay bonds with more than 90 days remaining before the redemption date. For example, if you issue tax-exempt bonds at 5% interest but subsequently learn you can refinance the bonds at 4% interest, the interest payments
What didn’t make it into the Act Some of the provisions that caused concern among nonprofits didn’t make it into the final tax act. They include: Johnson Amendment repeal. The House of Representatives’ version of the TCJA would have repealed a prohibition against nonprofits engaging in political campaign activity. Many nonprofit leaders had mobilized in opposition to this repeal. Private activity bond tax-exempt treatment termination. The House bill would have eliminated the tax-exempt treatment of interest on the private activity bonds some organizations use to finance capital projects. Expanded donor-advised fund reporting. Under the House bill, sponsors of donor-advised funds (DAFs) would have been required to report additional information on their Forms 990, including the average amount of grants made from DAFs during the taxable year. Excise tax rate on private foundation net investment income. The TCJA left out a House provision establishing a streamlined rate of 1.4%, sticking instead with the two current rates of 1% and 2%.
on the 4% advance repayment bonds won’t be tax-exempt for investors. You’ll probably need to pay more interest to cover the investors’ increased tax liability.
Next steps Although the final guidance and procedures have yet to be issued by the IRS, the TCJA may have some negative repercussions for your organization going forward. Consult with your CPA now to determine the best steps to minimize any potential damage to your bottom line — and your ability to accomplish your mission. n
Don’t let the “commerciality doctrine” trip you up
f there’s one thing many nonprofits have learned in the past decade, it’s the danger of becoming overly dependent on donations to sustain operations. That lesson has prompted some organizations to look for other revenue sources, including opening their own businesses. But even business activities related to your exempt purpose could fall prey to the commerciality doctrine, resulting in the potential loss of your exempt status.
What defines commerciality? The commerciality doctrine is a court-created outgrowth of the operational test. Both were formulated to address concerns over nonprofits competing with for-profit businesses that shoulder a tax burden nonprofits can avoid. The operational test generally requires that a nonprofit be both organized and operating exclusively to accomplish its exempt purpose. It also requires that no more than an “insubstantial part” of its activities further a nonexempt purpose. An organization can operate a business as a substantial part of its activities as long as the business furthers the organization’s exempt purpose. Courts developed the commerciality doctrine while applying the operational test. They have ruled that organizations were operated for nonexempt commercial purposes based on the commercial manner by which they conducted their activities. In other words, the organizations’ activities were substantially the same as those of commercial entities. The IRS or the courts consider several factors when evaluating commerciality, including whether the nonprofit is competing with for-profit commercial entities. They also examine how the organization
has established pricing policies: It shouldn’t set prices to maximize profits. And they look at the extent and degree of below-cost services provided, rather than at fair market value or cost. Other factors include: u Reasonableness of financial reserves (nonprofits
shouldn’t accumulate unreasonable reserves),
u Use of commercial promotional methods such
u Whether the business is staffed by volunteers or
u Whether unprofitable programs are discontinued, u Whether the business sells to the general public,
rather than to a discrete charitable class (for example, other nonprofits or a disadvantaged population), and
u The extent of charitable donations. (Donations
should represent a significant percentage of a nonprofit’s total support.)
No single factor is decisive. Courts and the IRS weigh all of the relevant circumstances when making their determinations.
The doctrine at work
What about UBIT issues?
The commerciality doctrine isn’t merely an obscure tax principle that rarely comes into play. The IRS has been closely scrutinizing nonprofits’ commercial activities in recent years as more organizations have dipped their toes into social enterprises.
Of course, loss or denial of your organization’s exempt status isn’t the only risk when you open a business. You could pass muster under the commerciality doctrine but end up liable for unrelated business income tax (UBIT). Much depends on how significant the business activities are to your organization as a whole.
Just last year, the IRS denied a marine science organization’s application for exemption because it didn’t operate for an exempt purpose. The agency found that the organization neither solicited nor received voluntary contributions from the public and that a substantial amount of its income came from fees paid for services. The IRS concluded that the organization operated in a commercial manner. By operating in such a manner, the organization furthered a substantial nonexempt purpose. Therefore, the IRS ruled, the organization wasn’t operated for an exempt purpose and wasn’t entitled to tax-exempt status.
Revenue that a nonprofit generates from a regularly conducted trade or business that isn’t substantially related to furthering the organization’s tax-exempt purpose may be subject to UBIT. Several exceptions apply, though.
Proceed with caution As the 2017 case demonstrates, the commerciality doctrine is alive and well. If you’re thinking about launching a new business to drum up additional revenues, consult with your CPA to reduce the risk of running into potential exemption and tax issues. n
Pluses and minuses of paying your board
ave you considered compensating board members for their services, thinking you might be able to attract better qualified leaders? Compensation could be in order, but first you should weigh the pros and cons of this decision.
Making a change Here are several factors to consider before making the change from volunteer to paid board leadership: Specialized expertise. Offering compensation can help attract board members with specialized expertise, such as in fundraising or finance, or one who’s a well-regarded community leader. Giving
board members a stipend also could give your nonprofit an edge when competing with the generous compensation that for-profits can offer their board members. Recognition of time and effort. Compensation could be in order, if your board members are expected to invest significant time and effort in the position. Offering pay can promote professionalism and help create an obligation to perform on the board member’s part. It also might incentivize meeting attendance and accountability, and make it easier for individuals from different cultures, classes and ages to participate.
The independence factor. Independence is indispensable when setting the amount of, or formula for, board compensation. The compensation should be set by independent directors (who aren’t among those to be compensated), or by an independent governance or compensation committee with insight from an independent consultant. The amount should be comparable to that paid by similar nonprofits, as determined by compensation surveys or other data. Whoever sets the amount should be guided by a formal compensation policy. A negative message. On the minus side, paying members to serve on your board of directors can simply look bad. Donors expect their funds to go to program services, and board compensation represents resources diverted from your organization’s mission. IRS implications. The IRS looks carefully at whether arrangements between nonprofits and their board members create a conflict of interest. And, board members receiving compensation of more than $10,000 aren’t independent members of the board by the IRS’s definition. (Reimbursing for expenses under an accountable plan, on the other hand, isn’t considered compensation for purposes of measuring independence.) Any compensation arrangements must comply with the Internal Revenue Code’s private inurement and excess benefit regulations, as well as the IRS rules about “reasonable compensation.” Failure to do so can result in steep excise taxes, penalties and even the loss of your organization’s tax-exempt status. Legal implications. In some states, volunteer board members are protected from legal liability, while compensated members may not be. You’ll need to check your state’s laws.
Fleshing out a policy Your compensation policy should include clear objectives outlining how compensating board members benefits the organization (for example, by allowing you to attract a member with financial expertise). It should specify which board members are eligible for compensation (the chair, the officers or all members) and how compensation is structured (for instance, flat fee, retainer or per-meeting fee). The policy also should address expectations for the board members in exchange for their compensation. Expectations can be described, for instance, in terms of number of meetings attended, hours worked or qualifications and experience. Make sure that you document everything. You’ll want written evidence of a formal board vote approving the policy and the compensation amounts, related discussion and copies of the data the board relied on to make its decisions.
Play by the rules After debate, your organization may decide that board compensation could be a useful tool in attracting the caliber of board members your nonprofit seeks. If you come to that conclusion, just be sure to adhere to your nonprofit’s internal policies and IRS rules. n
NEWS FOR NONPROFITS Report digs into Millennials’ work for causes Phase 2 of the Millennial Impact Report, an annual study of younger adults’ engagement with charitable causes (supported by the Case Foundation), looks at the group’s cause-related interests and actions and what’s behind them. Among other things, the researchers found that those Millennials who’ve been the most passionate about causes and social issues have become considerably more active and vocal since the 2016 U.S. presidential election. Less than one-third of the respondents think the country is moving in the right direction. But the majority of those who responded still look to institutions, including government, to correct course and address the causes and issues they care about. They demonstrate this faith in institutions through actions like voting and contacting political representatives. The top cause or social issue for Millennials in 2017 was civil rights and racial discrimination, bumping education and health care from 2016’s top perch. According to the report, members of this demographic are overwhelmingly interested in the social issues relevant to quality of life for the largest part of the population. The report also includes recommendations on how nonprofits can put its insights to work. You can read it at themillennialimpact.com. n
Charity Navigator expands information Charity Navigator is now making concise impact reports for 2,400 charities available to users at no charge. Site visitors can view the website’s financial analysis developed from each organization’s Form 990 filings, as well as impact reports prepared by the charities and supplied by GuideStar, Classy and GlobalGiving. These three organizations collect information on nonprofits’ results and progress toward achieving their goals. The reports won’t affect Charity Navigator’s star or numerical ratings. But they will give organizations an opportunity to show the value of their work and help donors assess the impact of their donations. n
2017 Giving Tuesday smashes record Were you among the recipients of the record-breaking kitty on the latest annual giving day? The 2017 #GivingTuesday Data Project reports that $274 million was raised from 2.4 million online contributions. Donations on November 28 marked an increase of $97 million, or 55 percent, over 2016. According to the project, people in more than 150 countries participated, with an average gift size of about $111. The movement, launched in 2012, generated more than 1 million social media mentions in 2017, resulting in almost 22 billion social media users exposed to at least one mention. The most common topics discussed in those mentions included human services, education, health, the environment and animals, as well as the societal benefits of giving. n
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Sechler CPA, P.C. 921 East Orange Drive Phoenix, AZ 85014 www.azcpa.com