In the rush to understand the changes made by the 2017 federal tax reform law (P.L. 115-97, known as the Tax Cuts and Jobs Act (TCJA)), tax-exempt organizations may not yet have had time to consider how the federal changes may affect state taxes. Similarly, state taxing authorities and state tax practitioners may be so wrapped up in the state and local tax (SALT) implications of the TCJA for individuals or regular C corporations (especially changes affecting the 2017 tax year) that they may not yet have had time to consider the SALT implications of tax reform for tax-exempt organizations.
Significant changes to federal unrelated business income under TCJA
A tax-exempt organization is generally subject to federal income tax only on unrelated business income (UBI) — generally, income that is unrelated to the organization's tax-exempt purpose. The TCJA made several significant changes to the definition and structure of federal UBI, effective for tax years beginning after Dec. 31, 2017. One such change is the new "siloing" rule, under which a tax-exempt organization must track its income and expenses from each separate unrelated trade or business, and losses derived from one unrelated trade or business may not offset the income from another unrelated trade or business (Sec. 512(a)(6)).
As of this writing, federal guidance defining what constitutes a separate unrelated trade or business had not yet been issued. The TCJA provides a transition rule for net operating losses (NOLs) incurred prior to tax year 2018, which allows these losses to still be used to reduce aggregate UBI (TCJA §13702(b)). However, losses incurred in tax years beginning on or after Jan. 1, 2018, must be separately tracked and may reduce UBI only from that separate trade or business.
For an example of the complexities that could arise under the siloing rule, consider a tax-exempt organization that has passive investments in passthrough entities (e.g., private equity or other funds) that generate UBI taxable to the organization:
- The organization's total UBI from all its passive investments might be considered one trade or business;
- Each Schedule K-1 received from a passthrough entity might constitute a separate trade or business;
- Perhaps several Schedules K-1 may be grouped together as a separate trade or business — such as those from real estate funds — while others may constitute other silos or separate trades or business; or
- Certain investments (e.g., those in which the tax-exempt partner has less than a 10% ownership interest) may not constitute trades or businesses at all.
More complicated still, how should the organization aggregate or allocate its costs incurred in relation to its passive investments if some or all such investments constitute separate trades or businesses? No matter the ultimate guidance on determining separate unrelated trades or businesses and related expenses, tax-exempt organizations will face an increased administrative burden to properly track these items. In addition, there could be different results for state income tax purposes (discussed below).
The other major federal UBI change under the TCJA is a new category of UBI that is actually the reclassification of an expense as income (almost akin to a contra asset account, in accounting terminology), and it may represent a trap for the unwary fiscal-year filer because it is effective for amounts paid or incurred after Dec. 31, 2017 (i.e., not tax years beginning after Dec. 31, 2017). Specifically, amounts paid or incurred for certain qualified transportation benefits (including qualified parking) that were reportable on federal Form 990, Return of Organization Exempt From Income Tax, for information purposes as an expense in the conduct of the organization's exempt purpose, are reclassified as taxable UBI reportable on federal Form 990-T, Exempt Organization Business Income Tax Return, pursuant to Sec. 512(a)(7).
This change appears to be the result of an effort to put tax-exempt organizations on par with regular taxable employers that have been disallowed deductions related to these fringe benefit expenses under the TCJA. Because a deduction could not be similarly disallowed for a tax-exempt organization (these costs having only appeared on an information return, Form 990, and not the income tax return for UBI, Form 990-T), Congress chose to tax these expenses as a new category of UBI. (As an aside, time will tell whether taxable transportation fringe benefits constitute a separate trade or business for purposes of the siloing rule.)
Potential state treatment of the federal changes to UBI under TCJA
When it comes to SALT, the first question when federal income tax law changes is whether a state conforms to the Code section(s) implicated — in this case, Secs. 512(a)(6) and (a)(7). States generally conform to the Code either on a rolling basis (meaning they adopt Code changes as soon as they are made law, unless the state enacts legislation to decouple from specific provisions) or on a fixed-date/static basis (meaning they adopt the Code as of a particular date, and the state legislature must act to incorporate subsequent federal changes into the state tax code). States are approximately evenly divided between these two methodologies. Many states with static Code conformity update their conformity date each year, while others (California and New Hampshire among them) tend to have long gaps between Code conformity adoption dates.
Delaware, Kentucky, New Jersey, Pennsylvania, and Texas have chosen not to tax UBI and therefore do not conform to Sec. 512. In the more than 40 state taxing jurisdictions that do impose an income tax on UBI, the starting point for computing the tax is generally either line 30 (unrelated business taxable income (UBTI) before NOL deduction) or line 34 (UBTI) of federal Form 990-T. These states require certain modifications to federal taxable income to arrive at state taxable income, and while a few may have a modification to decouple from a certain subsection of Sec. 512 (see, e.g., Cal. Rev. & Tax. Code §23732), most of these states conform entirely to the federal definition of UBI. Depending on their Code conformity method (rolling vs. fixed-date) and legislative action taken to date, states may conform to Sec. 512 as in effect before or after the TCJA.
In the rolling conformity states, the changes made to Sec. 512 under the TCJA take immediate effect, unless or until the state takes legislative action to decouple. It remains to be seen how many fixed-date conformity states will update their Code conformity date. Some fixed-date conformity states have not proposed any Code conformity legislation so far this year. Some fixed-date conformity states have enacted legislation updating the state's conformity date to pre—federal tax reform (e.g., to the Code as in effect on Dec. 21, 2017) and some to post—federal tax reform (e.g., Feb. 9, 2018, to capture the extenders in the Bipartisan Budget Act of 2018, P.L. 115-123). Some of the latter nonetheless decouple from significant aspects of federal tax reform.
State legislatures, unlike the federal government, must balance their budgets annually, making them more circumspect in adopting federal changes (even those that are expected to have positive dynamic effects on state tax revenues over the next few years) without carefully considering the effects on state tax revenues in the current fiscal year. In grappling with Code changes on the personal and C corporation side, many states are taking a hard look at the revenue-raising aspects of the TCJA vs. items that would decrease state tax revenues, with the latter being a target for decoupling. Understandably, states — which receive the bulk of their income tax revenues from individuals rather than corporations (let alone tax-exempt organizations) — have not had much time to focus on the tax reform changes affecting tax-exempt organizations.
In the states that end up conform- ing to the new siloing rule under Sec. 512(a)(6), attempting to apply the rule at the state level will be a challenge; it may even be impossible without a change to state law. The reason is that for state corporate income tax purposes, income and losses from the conduct of multiple unitary businesses within a single legal organization are generally permitted to offset one another, and the methodology for determining the amounts sourced to a particular state is through the state's allocation and apportionment rules. In the words of Walter Hellerstein:
The two principal constitutional restraints with special relevance to the division of the corporate income tax base — the unitary business principle and the fair apportionment requirement . . . — are reflected in most states' corporate income tax regimes. The unitary business principle finds expression in the line that the states have drawn between allocable and apportionable income; the fair apportionment requirement is embodied in the formulas that the states have adopted to divide apportionable income among the states with power to tax it. [Hellerstein, Hellerstein, and Swain, State Taxation ¶9.01 (Thomson Reuters/Tax & Accounting 3d ed. 2001, with updates through December 2017)]
Arguably, unless a state adopts specific guidance that requires and provides a mechanism for siloing separate UBI trades or businesses, tax-exempt organizations may end up with a less strict state result when it comes to the siloing rule, with no siloing required for state taxable income computation purposes.
Another aspect to consider is that, for federal income tax purposes, tax-exempt corporations are subject to the same 80% NOL deduction limitation as regular C corporations under the TCJA, effective for NOLs incurred in tax years beginning after Dec. 31, 2017. Therefore, separate trade or business NOLs will need to be tracked for purposes of the 80% limitation as well as the siloing rule (while pre-2018 NOLs may be used against aggregate UBI and are not 80% limited). Another item of note for fiscal-year filers is that although the TCJA repealed the federal NOL carryback period and changed the 20-year NOL carryforward to an unlimited carryforward, this change applies to NOLs incurred in tax years ending after Dec. 31, 2017 (e.g., the new carryback/carryforward provisions would capture an NOL incurred in a fiscal year beginning July 1, 2017, and ending June 30, 2018), while the 80% usage limitation applies to losses incurred in tax years beginning on or after Jan. 1, 2018.
Again, the tracking of siloed NOLs may not be necessary for state tax purposes, as described above. Further, certain states may adopt the 80% limitation on NOL usage by keying off limitations under Sec. 172 in the computation and use of state NOLs (or by conforming to the federal NOL through the use of line 34 of Form 990-T), and other states may not. Many states specifically enumerate their NOL carryforward and carryback periods in their statutes and would need to take legislative action to conform to the new federal unlimited NOL carryforward; this is also true in states that still permit an NOL carryback. States may be slow to adopt an unlimited NOL carryforward period if the expected impact to state tax revenues is large.
The new fringe benefit UBI under Sec. 512(a)(7) is a revenue-raiser and therefore presents an unlikely target for decoupling in a given state's Code conformity bill. Where taxpayers may run into issues, though — if not specifically addressed by a state that otherwise conforms to Sec. 512(a)(7) — is how to source UBI for state allocation and apportionment purposes. The fringe benefit UBI is likely apportionable income arising in the normal course of business, but, arguably, it is not a "sale" or "other receipt" and therefore should not be included in either the numerator or the denominator of the sales factor. If so, this new UBI may be included in the state tax base and multiplied by the organization's other existing apportionment factors.
If the new fringe benefit UBI is the organization's only source of apportionable income (assuming any UBI from debt-financed passive investment activities is allocable income) and/or the organization does not otherwise have the right to apportion its income (e.g., because its UBI-generating activities occur in a single state), then the amount of new fringe benefit UBI included on its "home" state income tax return should be 100%. If the new fringe benefit UBI relates to benefits provided in multiple states (e.g., the organization has parking lots for employee use in multiple states) and is the organization's only source of apportionable income, then the organization may need to consider some other reasonable method for apportioning the UBI to multiple states (particularly if it is a single-sales-factor state where any property or payroll associated with those parking lots is not considered and the sales factor is otherwise zero).
Excise taxes on excess compensation and investment income of certain private colleges and universities
In addition to the UBI changes discussed above, two new excise taxes are imposed on tax-exempt organizations under the TCJA (as amended by the 2018 Bipartisan Budget Act) for tax years beginning after Dec. 31, 2017:
- An excise tax of 1.4% on the investment income of certain private colleges and universities that have more than 500 tuition-paying students — 50% or more of whom are located in the United States — and assets (other than those used directly in carrying out the institution's exempt purpose) of at least $500,000 per student (new Sec. 4968).
- An excise tax of 21% on compensation paid in excess of $1 million to certain tax-exempt organizations' current and former (for any tax year beginning after Dec. 31, 2016) five highest-paid employees and on certain excess severance payments (new Sec. 4960).
Note that the term "former" in this context refers to employees who were formerly one of the "high five" and therefore must continue to be tracked for excise tax purposes.
For state tax purposes, the question is whether a given state's Code conformity is sufficient to give a state the right to impose either of the above-described excise taxes on tax-exempt organizations. The short answer is no. States that impose income tax on the UBTI of tax-exempt organizations do so based on income tax imposition statutes authorized and enacted by their state legislatures. A state's conformity to the Code in terms of calculating state taxable income does not afford the state the right to impose a new tax on a different base, such as the new excise taxes imposed at the federal level under Secs. 4960 and 4968. Thus, a state would need to enact a similar excise tax for that tax to apply at the state level. To date, the authors are not aware of pending legislation that would adopt such an excise tax in any state.
Unintended, tangential effects of federal tax reform on state transaction taxes
On the personal income tax side, one of the TCJA's changes relates to donations by individuals to tax-exempt institutions of higher education in exchange for a right to purchase seating at an athletic event in the institution's athletic stadium(s). Previously, 80% of the donation was tax-deductible. Effective for tax years beginning after Dec. 31, 2017, the TCJA — by operation of Sec. 170(l) — makes none of the donation deductible, regardless of whether the donor exercises the athletic seating right.
The disallowance of a charitable contribution deduction under Sec. 170(l), not surprisingly, will likely affect itemized deductions that flow through from an individual's federal return onto his or her state personal income tax return. An unintended consequence outside the income tax arena, though, relates to state taxes on admissions or retail sales of tickets to athletic events like those targeted by the amended Sec. 170(l). Certain states provide an exemption from admissions or retail sales tax for an otherwise taxable athletic event only for the amount donated that is tax-deductible to the purchaser under Sec. 170 (see, e.g., Georgia Letter Ruling No. LR SUT-2014-9 (June 26, 2014) and N.C. Gen. Stat. §105-164.4G(f)(2)).
Tax-exempt organizations affected by the nondeductibility of donations under Sec. 170(l) are likely aware by now of the need to review their policies and procedures to more clearly bifurcate amounts donated in relation to seating rights, but they may not yet have thought about admissions or retail sales tax consequences. If the states that tie their admissions or retail sales tax exemption to Sec. 170 now apply tax to donated amounts that are no longer deductible under Sec. 170(l), the tax-exempt organization — as the "vendor" — must collect those taxes, or it could be on the hook for uncollected taxes. And one can imagine that attempting to collect admissions or retail sales tax on large donations that include seating rights would likely not be well-received by donors.
Waiting on answers
At this point, there are more questions than answers when it comes to both the federal and state tax implications of tax reform for tax-exempt organizations. Hopefully, there will be more clarity on all fronts by the time tax year 2018 returns come due. All can agree that tracking state Code conformity will be much more important during the coming months than it has been in prior years.
These articles represent the views of the author(s) only, and do not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
Mary Van Leuven is a director, Washington National Tax, at KPMG LLP in Washington.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.