As every nonprofit leader knows, heading an organization that is "tax-exempt" doesn't mean you can ignore tax laws and financial trends. In fact, with a new tax law taking effect and the U.S. economy continuing a record-breaking expansion, it's wise for nonprofit leaders to pay close attention and try to anticipate how their organizations could be impacted.
“Economic conditions are often just as important for nonprofits as they are for profit-based businesses," said Robert Meckstroth, CFA, a portfolio manager at City National Rochdale. “It's crucial to understand what's happening in the economy and the legislature so nonprofit organizations can effectively plan for the future."
With the recent passage of the Tax Cuts and Jobs Act (TCJA), many leaders of tax-exempt organizations are anxious to determine how the new law will affect them. And make no mistake - most will be affected.
The new tax law attempts to more clearly define something known as "unrelated business taxable income (UBTI)." It requires that nonprofits calculate UBTI by activity, and not allow the losses from one unrelated activity to offset the income of another unrelated activity.
For most organizations, an activity is an unrelated business (and subject to unrelated business income tax) if it is a trade or business, regularly carried on, and not substantially related to furthering the exempt purpose of the organization.
For instance, if your educational conferences operate at a loss and your publications represent a net gain for your organization, the conference losses cannot be used to offset the publication gains.
This means that nonprofits will have to carefully track the expenses involved in each of their lines of business to make sure that those expenses are used solely to offset gains from that particular activity. It also may mean that tax-exempt organizations will be at a disadvantage relative to commercial entities, which can still use losses from one activity to offset income from other activities.
Nonprofit leaders may want to ask their tax and financial advisors about whether it would benefit their organizations to establish for-profit subsidiaries in order to aggregate their unrelated business activities, said Marie Arrigo, a CPA who specializes in family offices and nonprofit tax services at the national accounting firm, EisnerAmper.
There's another area of the new law where UBTI will come into play for nonprofits, and that involves a change to the tax treatment of certain employer-provided "fringe benefits" - the extra benefits that supplement an employee's salary.
Currently, three categories of qualified transportation fringe benefits are considered unrelated business income, which is subject to income tax at the organizational level: qualified transportation benefits such as van pooling or vouchers for buses and trains; qualified parking benefits including employer-provided parking or parking reimbursements; and on-premises athletic facilities that are used by employees, their spouses and dependent children.
The impact of this new provision will effectively create UBTI even when the organization has no unrelated trade or business and is paying these specific fringe benefits to employees who are conducting the charitable activities of the organization. .In cases where the employer is engaged in an unrelated business activity, the expenses paid by the employer cannot be taken as a deduction against unrelated business income.
With respect to payment for a transit program with pre-tax dollars, the IRS has taken the position that this is taxable as UBI even if it comes in the form of an indirect expense, such as the employer providing compensation to the employee where part of that compensation is used by the employee to pay for qualified transportation.
Some states require that transit passes be offered by employers to employees, thus forcing employers to pay the unrelated business tax on the benefit they are mandated to offer to their employees.
Arrigo said nonprofit employers may need to consider whether to:
Not only does the new law affect nonprofit organizations' operations, but it also affects their donors in a manner which may make fundraising more challenging.
"The Tax Cuts and Jobs Act's impact on charitable giving by individual donors should be of major concern for nonprofit leaders, as it could affect the sustainability of their organizations," said Arrigo.
Under current tax law, individuals receive a tax benefit from their charitable contributions if they itemize deductions on their tax returns. But with the standard deduction doubling under the new tax law, far fewer individuals are expected to itemize deductions.
In fact, the new act is estimated to reduce the number of households claiming an itemized deduction for their charitable giving by more than half, from about 37 million in 2017 to about 16 million in 2018, according to the Tax Policy Center.
"Charitable deductions remain viable, but it may be more difficult to actually take them, given the increased standard deduction and the scaling back of itemized deductions," Arrigo said. "Nonprofits may see a decline in donations, which may impact the sustainability of the nonprofits. However, major donors who are connected to the mission of the organization may very well remain philanthropic."
For those high-income taxpayers who continue to itemize deductions, the tax law increases the giving limits from 50 percent of adjusted gross income to 60 percent of adjusted gross income, provided that all of the contributions made in the year are cash contributions to public charities. So those individuals may give more to nonprofits to take advantage of the increased deduction, Arrigo said.
However, new strategies for collecting donations will likely be needed to accommodate the possible loss of contributions from middle-income households, whose participation in claiming the charitable deduction is anticipated to fall by two-thirds, from 17 percent in 2017 to just 5.5 percent in 2018, according to the Tax Policy Center.
As nonprofit organizations brace for changes brought on by the new tax bill, the economic picture remains positive.
The U.S. economy is currently enjoying its second longest economic expansion since World War II, including the largest drop in unemployment in any period since then, Meckstroth noted. On top of that, the labor market continues to strengthen, the housing market is contributing positively to economic growth and inflation remains modest.
But while the economy has continued to grow, it's not growing fast. “It's like you're driving a car in traffic, and you can only go 30 miles per hour," Meckstroth said. “You're moving in the right direction, but because of the traffic you're getting there slower than you want to."
The traffic slowing down our current economy is an aging population, Meckstroth explained: “An economy grows by more people joining the workforce or by increasing productivity. But the demographics in this country are getting older and baby boomers are leaving the workforce."
Recent tax reforms may drive some growth in the economy, but U.S. demographics will keep that growth moderate, Meckstroth said. While it's important to capitalize on consumer confidence, which may make people more willing to share their wealth with nonprofits, charitable organizations should plan cautiously.
“Nonprofit organizations should not forecast big changes based on accelerating economic growth," Meckstroth said. “Right now, it's prudent to lower expectations for economic growth because we don't know how long the current expansion can last."
Tax-exempt organizations need to review the new law with their tax advisors to determine which changes impact them and how to best adjust to those changes. Forming a team of specialized professionals including your tax consultant, financial advisor and your organization's key stakeholders is crucial to conceptualizing creative solutions to adapt to the new law and mitigate potential adverse impacts.
This article is for general information and education only. It is provided as a courtesy to the clients and friends of City National Bank (City National). City National does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of the authors or persons quoted as of the date of the article with no obligation to update or notify of inaccuracy or change. This article may not be reproduced, distributed or further published by any person without the written consent of City National. Please cite source when quoting.
City National, as a matter of policy, does not give tax, accounting, regulatory or legal advice. Rules in the areas of law, tax, and accounting are subject to change and open to varying interpretations and readers should seek professional advice.