Proposed Tax Code Overhaul Introduced with the Tax Reform Act of 2014

by K&L Gates LLP
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On February 26, 2014, House Ways and Means Committee Chairman Dave Camp released draft (the "Discussion Draft”) that would substantially reform the current U.S. Tax Code (the “Code”). The Discussion Draft contains numerous provisions applicable to tax-exempt organizations and those individuals and entities that donate to them. The Discussion Draft is not expected to pass in 2014, rather it has been characterized by House Speaker John Boehner as “the beginning of [a] conversation” on tax reform. Despite this, we encourage our tax-exempt clients to review the applicable provisions of the Discussion Draft and begin thinking strategically about how they can protect themselves if such provisions were to become law.  Although the Discussion Draft is currently only draft legislation, the provisions affecting tax-exempt organizations highlight areas of the Code that are the subject of Congressional interest.

This alert briefly summarizes the provisions of the Discussion Draft that are directly applicable to tax-exempt organizations and their donors. The full text of the Discussion Draft can be found at Tax Reform Act of 2014. Unless stated otherwise, the provisions would become effective for tax years beginning after 2014.

Changes to Rules on the Unrelated Business Income Tax (“UBIT”)

  1. Clarification of Applicability of UBIT Rules. Income derived from a trade or business regularly carried on by a 501(a) exempt organization that is not substantially related to the performance of the organization’s exempt functions is subject to UBIT unless an applicable exception applies. It is unclear, however, if an entity that is exempt under 501(a) and also exempt under another section of the Code is subject to the UBIT rules. The Discussion Draft would clarify that a 501(a) exempt entity, notwithstanding the entity’s exemption under another provision of the Code, is subject to the UBIT rules.
  2. Elimination of Exemption for Name and Logo Royalties. With some limited exceptions, royalties from use of an exempt organization’s name or logo are not unrelated business income (“UBI”). The Discussion Draft would make an exempt organization’s sale or licensing of its name or logo a per se unrelated trade or business, and the resulting royalties would be subject to UBIT.
  3. Imposition of Separate Computation Requirement. When an exempt organization conducts multiple unrelated trades or businesses, the gross income and related deductions of each is aggregated. As a result, losses generated by one may be used to offset income derived from another. The Discussion Draft would require the net taxable income of each unrelated trade or business to be calculated separately. Losses generated by one could not be used to offset income generated by another.
  4. Narrowing the Research Income Exclusion. Income derived from a research trade or business is exempt from UBIT if the research is: (1) performed for the United States or any State; (2) performed by a college, university or hospital for any person; or (3) performed by an organization operated primarily for the purposes of carrying on fundamental research, the results of which are freely available to the general public. Under the Discussion Draft, the research exemption would be limited to only income from research that is made available to the public.
  5. Equalizing Charitable Contribution Deductions. An organization can deduct certain charitable contributions for purposes of determining income subject to UBIT. For corporations, the deduction is 10% of the entity’s UBI. For trusts, the deduction is 50% of the entity’s UBI. Under the Discussion Draft, the 10% limit would apply to both corporations and trusts. 
  6. Increase of the Specific Deduction. Exempt organizations may claim a $1,000 deduction against gross UBI. Under the Discussion Draft, the deduction would increase to $10,000.
  7. Repeal of Exception for Acquisition of Distressed Property. UBI  includes gains or losses from the sale, exchange, or other disposition of inventory. An exception applies to certain distressed property acquired from a bank. Under the Discussion Draft, this exception would be eliminated.
  8. Modification of the Sponsorship Payment Exception. UBI does not include income received in connection with qualified sponsorship payments. This generally includes any payment made by a business sponsor for which it receives no substantial return benefit other than the use or acknowledgment of its name or logo (or product lines) in connection with the exempt organization’s activities. Under the Discussion Draft, if the use or acknowledgement refers to any of the business sponsor’s product lines, the payment would not be a qualified sponsorship payment. In addition, if an exempt organization receives more than $25,000 of qualified sponsorship payments for any one event, any use or acknowledgement of a sponsor’s name or logo could only appear with, and in substantially the same manner as, the names of a significant portion (determined based on number of donors and contributions) of the other donors to the event. Consequently, if a single business is listed as an exclusive sponsor of an event that generates more than $25,000 in qualified sponsorship payments, the payment from the recognized donor would not be a qualified sponsorship payment.

Creation of New and Modification of Current Penalties

  1. Increase in Information Return and Other Penalties. The IRS imposes penalties on organizations and managers for failure to timely and completely file information returns and for failure to allow for public inspection of annual returns and other publicly available documents. The Discussion Draft would increase the per day penalties, but not the maximum penalty limits. For example, the organization penalty for failure to file an information return would increase from $20 to $40 per day (from $100 to $200 for an entity with more than $1,000,000 in gross receipts). The manager penalty would increase from $10 to $20 per day. The penalty for failure to allow inspection would increase from $20 to $40 per day. The provision would be effective for information returns required to be filed on or after January 1, 2015.
  2. Creation of Manager Accuracy Penalties. Exempt organizations are subject to a 20% accuracy-related penalty with respect to the portion of an underpayment that is attributable to any substantial understatement of UBIT. A separate accuracy-related penalty applies to a reportable transaction or a listed transaction. There is no accuracy tax on managers. Under the Discussion Draft, a 5% penalty would be applied to managers when an organization is penalized for a substantial understatement of UBIT, with a limit of $20,000. There would also be a 10% penalty on managers for an understatement of UBIT related to reportable or listed transactions, with a limit of $40,000.

Changes to Excise Tax Provisions

  1. Modification of Intermediate Sanctions. Disqualified persons and managers of 501(c)(3) public charities and 501(c)(4) organizations who engage in excess benefit transactions are subject to an excise tax on the amount of the economic benefit that exceeds the value of the consideration received by the exempt organization. A disqualified person is subject to a 25% excise tax. With some exceptions, the manager who knowingly participated in the transaction is subject to a 10% excise tax. A manager may avoid the excise tax if the manager relies on appropriate professional advice.  Under the Discussion Draft:

    a. An 10% excise tax would be imposed on an organization when one is imposed on a disqualified person unless the organization can demonstrate that it followed minimum standards of due diligence or that it used other reasonable procedures to ensure that it provided no excess benefit.  Minimum standards of due diligence would be met if the transaction is approved by an independent body of the organization that relied on comparability data prior to approval and documented the basis for approving the transaction.

    b. The excess benefit excise tax rules would expand to apply to 501(c)(5) and 501(c)(6) entities and their disqualified persons and managers.

    c. The rebuttable presumption of reasonableness for disqualified persons and managers would be eliminated.

    d. The manager professional advice safe harbor would be eliminated.

    e. The definition of disqualified persons would be expanded to include athletic coaches and investment advisors.

  2. Modification of Self-Dealing Rules. Disqualified persons and the managers of private foundations who engage in self-dealing are subject to an excise tax. The disqualified person is subject to a tax of 10% of the value of the transaction. A tax of 5% is imposed on the manager who knowingly participated (with some exceptions), up to $10,000 per act. If not corrected, significantly higher taxes are imposed. The manager can avoid the tax if the manager relies on appropriate professional advice.  There is no tax on the private foundation. Under the Discussion Draft, an excise tax of 2.5% would be imposed on the private foundation for self-dealing. The rate would be 10% if the self-dealing involved compensation payments. The manager professional advice safe harbor would be eliminated.
  3. Imposition of Excise Tax on Donor Advised Funds for Failure to Contribute. There is no requirement for donor advised funds to distribute contributions within a certain period of time.  Under the Discussion Draft, a donor advised fund must distribute contributions within five years of receipt. Failure to do so would result in a tax on the sponsoring charitable organization of 20% of the undistributed funds.
  4. Simplification of Excise Tax on Private Foundation Investment Income. Private foundations are generally subject to a 2% excise tax on their net investment income. This may be reduced to 1% by meeting certain requirements.  Exempt operating foundations are not required to pay the excise tax. The Discussion Draft would reduce the excise tax to 1% for all private foundations. The exemption for exempt operating foundations would be repealed.
  5. Repeal of Exception for Failure Distribute Income. Private foundations are generally required to make a minimum amount of qualifying distributions each year. Failure to do so results in an initial excise tax of 30% of the amount that was to have been distributed, with an additional 100% tax on the amount if the distributions are not made the following year. Private operating foundations are exempt from the requirement. The Discussion Draft would repeal the exemption for private operating foundations.
  6. Creation of an Excise Tax on Investment Income of Private Colleges and Universities. Only private foundations and certain charitable trusts are subject to a 2% excise tax on net investment income. Under the Discussion Draft, private colleges and universities with assets of at least $100,000 per full-time (and FTE) student would also be subject to a 1% excise tax on net investment income.
  7. Creation of Excise Tax on Executive Compensation. There is no limitation on the amount that an exempt organization can pay for executive compensation and severance as long as it does not violate rules on private inurement. Under the Discussion Draft, exempt organizations would be subject to a 25% excise tax on compensation in excess of $1 million/year paid to any of its five highest paid employees. The excise tax would apply to all remuneration paid to the person. There would also be an excise tax of 25% on excess parachute payments to the organization’s most highly compensated employees. Parachute payments are payments contingent on the employee’s separation from employment with an aggregate present value of three times the employee’s base compensation. Excess parachute payments are the excess of any parachute payment over the portion of the base amount allocated to such payment. The base amount is the employee’s average annual compensation for the five years preceding separation from employment.

Repeal of Tax Exempt Status Qualification for Certain Types of Organizations

  1. Repeal of Tax Exempt Status of  Professional Sports Leagues and Certain Insurers. Professional sports leagues and certain qualified insurance companies are exempt from tax. Under the Discussion Draft, these entities would no longer be eligible for exemption. 
  2. Modification of Exemption Requirements for Workmen’s Compensation Insurance Organizations. Certain workmen’s compensation insurance organizations are exempt from tax. They can provide benefits to employees outside of the states in which they are created. Under the Discussion Draft, these organizations could only provide workmen’s compensation insurance required by the law of the states in which they are created, organized and operated. 
  3. Repeal of Type II and Type III Supporting Organizations. Section 501(c)(3) exempt organizations are classified either as public charities or private foundations. Organizations that support a public charity may also be classified as public charities, even if they do not qualify for public charity status on their own. To qualify, the organization must have one of the following types of relationships with the supported organization: (1) be operated, supervised, or controlled by it (Type I); (2) be supervised or controlled in connection with it (Type II); or (3) be operated in connection with it (Type III). The Discussion Draft repeals the Type II and Type III classifications. The provision would generally be effective for entities organized after the date of enactment. Type II and III supporting organizations existing on the date of enactment would have until the end of 2015 to qualify as a public charity or a supporting organization (previously a Type I supporting organization) or be treated as a private foundation.

Revisions to Charitable Contribution Requirements

A taxpayer may claim an itemized deduction for charitable contributions up to a certain percentage of the individual’s adjusted gross income (AGI) for contributions made by the last day of the tax year for which a return is filed. The AGI limitation varies depending on the type of property contributed and the type of exempt organization receiving the property. If an individual contributes more than the applicable AGI limits, the excess contribution generally may be carried over and deducted in the following five tax years. Taxpayers may deduct the fair market value of a charitable contribution and may not deduct any amount for which a benefit was received in return, but there are exceptions to these rules. In general, the value of a deduction for intellectual property is limited to the property’s adjusted basis, but the donor is allowed an additional deduction equal to a percentage of the income generated by the intellectual property over the 12 years following the contribution. The Discussion Draft would impose numerous changes:

a. Contributions could be made up until the due date of the individual’s return.

b. The AGI limitations on deductible contributions would be substantially simplified. There would be a single limit of 40% for cash and capital gain property contributions to public charities and certain private foundations. (The limits are currently 50% and 30% respectively.) The contribution limit for cash and capital gain property contributions to organizations not covered by the current 50% limitation rule would be a single limit of 25%. (The limits are currently 30% and 20% respectively.)

c. An individual’s charitable contributions could be deducted only to the extent they exceed 2% of the individual’s AGI.

d. With some exceptions, the amount of any charitable deduction generally would be equal to the adjusted basis of the contributed property.

e. The existing exception to the return benefit rule for college athletic event seating rights would be repealed.

f. Income from intellectual property contributed to a charitable organization would no longer be allowed as an additional contribution.

501(c)(4) Notification Requirements
Entities that operate pursuant to Code section 501(c)(4) are not required to obtain a determination of their tax-exempt status from the IRS. Under the Discussion Draft, an entity that wants to be recognized as exempt under 501(c)(4) would have to notify the IRS that it commenced operations within 60 days of formation. The IRS would then have 60 days to issue an acknowledgement of the organization’s intent to operate as an exempt organization. An organization that does not file would be subject to a penalty of $20/day up to $5,000 and a manager-level penalty. The organization would be required to provide information to support its qualification for exempt status with its first Form 990. (The information required would likely be similar to what is required to be provided on Form 1024.) The provision would apply to entities that are organized after 2014. Current organizations that have not filed a Form 1024 or a Form 990 would be required within 180 days of the date of enactment to meet the new notification requirement and to provide the required information supporting the organization’s qualification for exempt status with the Form 990 for the tax year in which the notice is filed.

 

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