In this Ropes & Gray podcast, Morey Ward, counsel in the tax-exempt group, is joined by Kendi Ozmon, Gil Ghatan and Brittany Cvetanovich, colleagues who also focus their practices on representing tax-exempt organizations, to provide listeners with an update on the provisions of the Tax Cuts and Jobs Act (the "TCJA"), that specifically target tax-exempt organizations. They will review major guidance issued on these provisions in 2018, and will also discuss some questions about the TCJA that remain unanswered.
Morey Ward: Hi, everyone, and thanks for joining us for this Ropes & Gray podcast. I'm Morey Ward, counsel in our tax-exempt group. I am joined by my colleagues Kendi Ozmon, Gil Ghatan and Brittany Cvetanovich, who also focus their practices on representing tax-exempt organizations. Today's podcast is called "Tax Reform and Its Impact on Exempt Organizations, One Year In." This is meant to provide listeners with an update on the provisions of the Tax Cuts and Jobs Act (the "TCJA"), that specifically target tax-exempt organizations, including some major guidance issued on these provisions in late 2018. We'll also mention some questions about the TCJA that remain unanswered.
Brittany and Gil will begin by talking about some changes to the rules on unrelated business taxable income, (or "UBTI"). Brittany will address questions about the new "silo" rule for calculating UBTI, and Gil will talk about the new tax on parking expenses. We'll then turn the focus of our discussion to two excise taxes the TCJA imposed on exempt organizations. Kendi will talk with me about the excise tax on executive compensation, and we'll wrap up with an update on the excise tax on certain college and university endowments.
Morey Ward: So, Brittany, let's talk about UBTI first. I've heard a lot about silos and buckets and baskets this past year. Are we harvesting grain or calculating UBTI?
Brittany Cvetanovich: These are all references to UBTI, Morey, and I've heard all three of those terms in talking about the new Section 512(a)(6). It modified the UBTI rules to require any tax-exempt organization that has more than one unrelated trade or business to compute its UBTI separately for each of those unrelated trades or businesses, starting with tax years beginning in 2018. Under prior law, organizations added up all of their gross income from unrelated trade or business activities, then subtracted all of their expenses allocable to those activities, arriving at a single net UBTI figure. That allowed net losses from an unprofitable activity to offset net income from a profitable one. But under the new rule, organizations need to analyze their unrelated activities, and sort them into various trades or businesses, calculating UBTI separately for each business. Hence the "bucket" and "basket" terminology – you're sorting your activities into baskets of like activities. Calculating UBTI separately for each business then "silos" any net losses from that business so that they can only be used against future income from that business, instead of being available to offset other sources of UBTI.
Morey Ward: I know the TCJA didn't define what constituted "a trade or business," which had exempt organizations worried that the definition could be very granular, resulting in enormous compliance costs from having to closely analyze and categorize each separate business activity. Have we had any clarity on that definitional question?
Brittany Cvetanovich: Well, we've had some. In August, the IRS issued Notice 2018-67, which says that organizations can "rely on a reasonable, good-faith interpretation" of the UBTI rules as a whole when they're grouping their trade or business activities, this is pending issuance of further guidance. The IRS said it will consider an organization's groupings to be reasonable and in good faith if they use the six-digit codes of the North American Industry Classification System, or the NAICS. These codes are in a 900+ page book that classifies businesses for statistical purposes, and while certain tax forms like the 990-T have called for taxpayers to describe their business activities using NAICS codes in the past, actual tax liability has not previously depended on which code was used. So this is a new use of the NAICS codes.
Morey Ward: Will it be simple for exempt organizations to use the NAICS codes to group their unrelated business activities?
Brittany Cvetanovich: Well, there are a couple of difficulties with the codes. First, the codes appear to subdivide some businesses, like certain rental real estate businesses, into multiple fragments. Second, there are some activities, like managing endowment investments, that may not fit terribly well into any of the codes. Recent comments to the IRS have pointed out these limitations, so it remains to be seen whether Treasury and the IRS will stick with the NAICS codes in further guidance.
Morey Ward: And what about partnership investments – didn't the Notice provide some special rules here?
Brittany Cvetanovich: Yes, the Notice included an "interim rule" that, without getting too into the weeds, generally allows organizations to group together in one basket all interests they hold in partnerships if they own 20% or less of the capital interest in the partnership and they do not have control or influence over the partnership. But in determining percentage interest, the organization has to aggregate its interests together with those of its disqualified persons, its supporting organizations and its 50% controlled organizations. This means that an organization with a substantial number of disqualified persons, like governing board members, or with significant supporting organizations, may find the rule of limited usefulness.
Morey Ward: It sounds like there are some questions raised by the Notice. Is this an area where we expect further guidance?
Brittany Cvetanovich: Yes, I think we'll be seeing more guidance from Treasury and the IRS on the silo rule. The Notice said that the IRS is considering issuing a new rule that permits all investment activities of an exempt organization to be grouped together into a single silo, as long as the organization does not significantly participate in the partnership's trades or businesses. A rule like that could really simplify the analysis for exempt organizations that are applying the new silo rule to their investment activities. So at this point, many organizations and associations are providing comments to the IRS and Treasury that encourage adoption of that type of rule, and outline possible definitions for what types of investments should qualify. Also, the criticism of the NAICS codes from the exempt organization community has been so pronounced that I think the IRS will need to address the community's concerns on that front.
Morey Ward: Thanks, Brittany.
Morey Ward: So Gil, at the time of our previous broadcast in April last year, there were a lot of questions waiting to be answered regarding the new unrelated business income tax rule for qualified transportation fringe benefits. Do we have answers to any of those questions?
Gil Ghatan: We do Morey. After keeping us waiting for most of the year, Treasury and the IRS released some very helpful guidance in Notice 2018-99 in mid-December. As a quick reminder, we're talking now about new section 512(a)(7), which provides that, for a tax-exempt employer, UBTI is increased by any amounts for which a deduction would have been disallowed under section 274 if the employer were taxable and which are paid or incurred by the tax-exempt organization for any qualified transportation fringes, (or "QTFs"), any parking facility used in connection with qualified parking, or any on-premises athletic facility.
Clearing up one area of much confusion, the Notice provides that parking facility expenses are an expense of providing a QTF and so would give rise to UBTI. At the same time, the Notice also provides that depreciation is not a parking facility expense, removing one of the biggest potential amounts from the equation. The Notice further establishes a generous safe harbor for determining the parking facility expenses attributable to qualified parking, which generally looks at whether the primary use of parking spots is for employees or for the general public. Together, the safe harbor and the exclusion of depreciation from parking facility expenses should serve to limit the potential UBTI exposure stemming from qualified parking.
Morey Ward: Well that should generally be welcome news to tax-exempt employers.
Gil Ghatan: Indeed. The Notice also walks through how to determine the UBTI liability when an employer pays for parking at a third party facility. Most interestingly, while the notice does not generally embrace the employee QTF dollar exclusion as a method for calculating an employer's UBTI liability, in the case of parking at a third party facility, the notice states that the employee exclusion amount serves as a cap on the employer's UBTI inclusion. The notice also implies that this cap may be available with respect to other QTFs.
Morey Ward: A cap on UBTI from QTFs would be very helpful.
Gil Ghatan: Yes, it would. But because section 512(a)(7) refers to the employer's cost of providing the QTF and not the value of the QTF excluded from the employee's income, it remains unclear whether the employee QTF exclusion amount is available as a cap on UBTI when the employer's cost of providing a QTF does not necessarily equal the value excluded from income by the employee. So we'll need further guidance on how to actually implement this potential cap.
Morey Ward: What about pre-tax employee contributions? Have we gotten any more clarity on that question?
Gil Ghatan: So what we're talking about here is a situation in which an employer allows its employees to elect to reduce their compensation on a pre-tax basis, up to the amount of the QTF exclusion each month, with the elected amount being made available for use toward QTFs. Treasury and the IRS have been consistent on this issue since they first updated Publication 15-B last March. Their view, reiterated in the parking notice, and which is consistent with long-standing regulations for the QTF rules, is that a compensation reduction agreement (informally referred to as a pre-tax election) constitutes an employer expense for the provision of a QTF.
Morey Ward: Well, if not entirely welcome news in all respects, it certainly sounds like the notice has helped fill in some of the gaps. Before we move on, are we expecting additional guidance on the parking tax, or did the notice answer all the major questions?
Gil Ghatan: Treasury and the IRS are planning to issue proposed regulations. Hopefully those regulations will flesh out further the potential cap on UBTI based on the value of the QTF excluded from the employee's income. We also need some guidance on the interplay between an employee's pre-tax election and parking at an employer owned or leased facility. And of course, the notice was primarily focused on parking. We still need guidance on calculating UBTI from the provision of other types of QTFs, such as transportation in a commuter highway vehicle.
Morey Ward: Thanks Gil. Turning now to another new tax that impacts a large group of tax-exempt organizations, Kendi, I know some lengthy guidance was released at the end of December on the new excise tax on executive compensation. Can you give us an overview of some key issues that guidance resolves?
Kendi Ozmon: Sure, Morey. Treasury and the IRS released a notice on New Year's Eve that answers a number of basic interpretive questions related to the new excise tax under section 4960, which imposes a 21% tax on certain compensation arrangements that exceed $1 million as well as certain severance arrangements, called "excess parachute payments." A couple key points relate to timing.
For one thing, the notice clarifies which taxable year an employer needs to use to measure how much compensation has been paid for purposes of determining whether the tax applies. It's the calendar year that ends with or within the employer's tax year. So, if the employer's fiscal year ends June 30, 2019, you look to calendar year 2018 to measure how much compensation was paid.
Second, the notice provides some relief with respect to compensation paid before the effective date of section 4960. The tax is effective for the first taxable year beginning after December 31, 2017. However, the notice makes clear that compensation that was paid or that vested before the effective date of the tax is not subject to the excise tax. So going back to our employer with a June 30th year end, the tax is effective for its tax year beginning July 1, 2018, and for the first year, you would look only to compensation that was paid or that vested between July 1, 2018 and December 31, 2018, which is the calendar year that ends within the employer's tax year.
Morey Ward: Weren't there some questions about how compensation paid by related organizations is taken into account for purposes of the excise tax? Does the notice address this?
Kendi Ozmon: Yes, the notice goes into some detail about related organizations. When looking to whether an employee's compensation exceeds $1 million, or whether an employee has received an excess parachute payment, you need to look not only to compensation paid by the tax-exempt employer, but also to compensation paid to that individual by related organizations. Related organizations include, among others, organizations that control the tax-exempt employer as well as organizations controlled by the tax-exempt employer. But we didn't have a definition of "control" for this purpose. The notice adopts a greater than 50% control test. It also clarifies that for-profit entities and governmental entities can be related organizations.
Morey Ward: It sounds like it could get pretty complicated to figure out which employees' compensation is subject to the excise tax when you have a large system of entities, with employees providing services to various entities within the system. What about actually paying the tax? Are related organizations liable for some portion of the tax?
Kendi Ozmon: Yes, if the related organizations are also considered employers of the individual, then they are liable for their proportionate share of the excise tax, based on the ratio of compensation paid by each employer to total compensation paid to the employee.
Morey Ward: So figuring out whether there is an employment relationship seems important. Does the notice explain how to determine this?
Kendi Ozmon: It does and this is an important point because in order for the excise tax to apply in the first place, an individual must be considered a "covered employee" of a tax-exempt organization. The notice tells us that only common law employees are considered covered employees, so organizations need to look to tax law principles to determine whether a common law employment relationship exists.
Morey Ward: You mentioned the term "covered employee" – does the notice provide any more detail about how to determine who is a covered employee?
Kendi Ozmon: Yes. A point the notice emphasizes is that once an individual has been determined to be a covered employee, that person is always considered a covered employee. So even though an organization needs to figure out its list of top 5 most highly compensated employees every year, it also needs to keep track of all of the people who were determined to be covered employees in prior years. If any of those people are paid over $1 million or receive excess parachute payments, the excise tax applies.
Morey Ward: Isn't there an exception for performing medical services? Does the notice provide any more detail on that?
Kendi Ozmon: Yes, the notice makes clear that in order for compensation paid to a medical professional to be excluded when determining the organization's covered employees and when calculating the excise tax, the compensation must be for performing direct medical services. Administrative, teaching, and research services aren't generally considered direct medical services, so if a portion of a medical professional's compensation is paid for non-medical services, the employer needs to establish a reasonable, good faith allocation of compensation between medical and non-medical services.
Morey Ward: Ok, thanks, Kendi, for that update on some of the mechanics of the executive compensation excise tax. One last question: Is there something in the notice about an exception from the tax if an employee provides only limited services to a tax-exempt employer?
Kendi Ozmon: I'm glad you asked, Morey, because this has been a source of some confusion and is an area where we really need more guidance. The notice contains a section heading called "limited services exception," but if you read that part of the notice carefully, it's not a general exemption from the tax, but more of a mechanism for ensuring that multiple tax-exempt employers aren't treating the same individual as a covered employee, where the employee is performing limited services among a group of tax-exempt employers. Someone within that group of tax-exempt employers is still going to bear the tax. But we definitely need further explanation from the IRS on what it was trying to get at with this "limited services exception" and how to apply it.
Morey Ward: Thanks, Kendi.
Morey Ward: Next, I'm going to provide a brief update on what's happening with Section 4968. This is the new 1.4% excise tax on the net investment income of certain colleges and universities. As a reminder, the tax applies to a limited number of private colleges and universities. To be subject to the tax, a school must meet the two criteria:
First: Have at least 500 tuition-paying full-time equivalent students in the previous year; and
Second: Have assets of at least $500,000 per student, excluding assets that are used directly in carrying out the institution's exempt purpose.
Estimates vary a bit, but it's likely that the provision applies to no more than approximately 40 colleges and universities at this point.
As I said, the tax is imposed on "net investment income," which is gross investment income plus net capital gain, less the expenses associated with earning that income.
The first official TCJA guidance from IRS and Treasury addressed a key question for institutions facing implementation of the new tax. The Notice, issued last June, provides a one-time "step up" to fair market value for assets held as of December 31, 2017. More specifically, the Notice provides that, for purposes of determining an institution's investment gains, the tax basis of property held by a college or university on December 31, 2017 is deemed to be no less than the property's fair market value as of December 31, 2017. This basis adjustment provision is intended to exclude from an institution's net investment income any gain attributable to appreciation in the value of the institution's investment assets prior to the effective date of the new tax. Schools are permitted to rely on this part of the notice before regulations are issued.
The notice also states that IRS and Treasury intend to issue regulations providing that losses from the sale of property will generally be allowed only to the extent of gains from those sales, with no capital loss carryovers or carrybacks permitted.
Gil Ghatan: It sounds like the notice provided some good news for colleges and universities impacted by the tax. Are we waiting for other guidance?
Morey Ward: Definitely. There are several issues that would benefit from guidance. Schools need to understand who is a "tuition-paying student" for purposes of the tax. This is a key point, since it will determine whether some schools are subject to the tax. We're also hoping to get guidance on what constitutes an "exempt purpose asset" and what entities are "related organizations." Again, both of these definitions will impact the threshold applicability of the tax, so they matter to schools that aren't sure if they are subject to the tax. In addition, schools are hoping to get guidance on how to calculate the tax. For example, what types of income are treated as gross investment income?
Well, that's it for this Ropes & Gray podcast on "Tax Reform and Its Impact on Exempt Organizations, One Year In." Thanks Kendi, Gil and Brittany for joining me and sharing these insights. For more information, please visit our website, www.ropesgray.com, and of course, if we can help you navigate any of these developments, please don't hesitate to get in touch. Thanks for listening.
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