The Tax Reform Act of 2014 May Impact Nonprofit Organizations - Part II

by Bob Moreland CPA, Tax Manager – Ohio Office

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Note: This article concludes a two-part series; last week's article covered charitable giving.

On February 26, 2014, House Ways and Means Committee Chairman Dave Camp released an ambitious and wide-ranging draft proposal for tax reform. The draft generally seeks to reduce tax rates and broaden the tax base. The intent of the proposed reform would be to consolidate and simplify numerous tax provisions in an attempt to reduce complexity and avoid taxpayer controversy with the IRS. Here are some of the more significant proposals that would impact tax exempt organizations.

Healthcare Reform

Medical Device Tax: The proposal would repeal the medical device tax, which is a 2.3% excise tax imposed on the manufacturer, producer, or importer of certain medical devices. The excise tax does not apply to eyeglasses, contact lenses, hearing aids, and other medical devices that are generally purchased by the general public at retail for individual use.

Medicine Cabinet Tax:The proposal would restore the ability to use tax-favored medical expense accounts to pay for over-the-counter medication. Prior to the Affordable Care Act, the cost of over-the-counter medicine could be reimbursed from Health Savings Accounts, Archer MSAs, and Health Flexible Spending Arrangements. Presently, these costs are disqualified unless the taxpayer has a specific prescription written by a physician or other legally qualified professional able to write formal prescriptions. Taxpayers may receive tax-free disbursements only for the cost of prescription medication and insulin. Under the proposal, the restriction on using healthcare savings accounts to pay for over-the-counter medication would be lifted.

Executive Compensation and Worker Classification

Excessive Employee Remuneration: Exceptions to the $1 million deduction limit for commissions and performance-based compensation would be repealed. The definition of “covered employee” would be revised to include the CEO, CFO and three other highest paid employees, realigning the definition with current SEC rules. The changes would apply to tax years beginning after 2014.

Worker Classification:Under current law, the determination of whether a worker is an employee or an independent contractor generally is made under a common-law facts and circumstances test that seeks to determine whether the worker is subject to the control of the service recipient. A special safe harbor rule—§530 of the Revenue Act of 1978—permits a service recipient to treat a worker as an independent contractor for employment tax purposes, even though the worker may be an employee, if certain other requirements are met. Under the Camp proposal, a worker qualifying for the safe harbor would not be treated as an employee and the service recipient would not be treated as employer for any federal tax purpose. The safe harbor also would apply to three-party arrangements. Workers would have to satisfy certain sales or service criteria and the worker and service recipient would be required to have a written agreement. The service recipient would withhold tax on the first $10,000 of payments made to worker in a year at a rate of 5%. Withheld amounts would be creditable by the worker against quarterly estimated tax. If the IRS determines that the requirements of the safe harbor were not met, the IRS generally would be limited to reclassification of the worker and service recipient, prospectively.

Intermediate Sanctions:Currently, if certain tax-exempt organizations provide excess benefits to certain individuals who can exercise substantial influence over the affairs of the organization (“disqualified persons”), then the IRS can impose penalties on the individuals receiving these excess benefits. IRS can also impose penalties on organization managers who knowingly approve such excess benefits. These penalties, known as “intermediate sanctions,” currently only apply to Section 501(c)(3) and 501(c)(4) organizations.

Proposed changes to the intermediate sanctions provisions include the following:

• Expanding the scope of these provisions to apply to Section 501(c)(5) and 501(c)(6) organizations;
• Adding a new 10% excess-benefits excise tax on the organization, if certain minimum standards of due diligence or other procedures were not followed to ensure that a transaction is not excessive;
• Eliminating the current “rebuttable presumption of reasonableness,” that conveys a presumption that a transaction is not excessive if certain steps are followed and documented;
• Eliminating the “professional advice” safe harbor, for organization managers who approve a transaction after relying on professional advice; and
• Expanding the definition of disqualified persons to include athletic coaches and investment advisors.

Deferred Compensation:Under this provision, any compensation deferred under a nonqualified deferred compensation plan is includible in gross income by the service provider, when there is no substantial risk of forfeiture of the service provider’s rights to such compensation. For this purpose, the rights of a service provider to compensation are treated as subject to a substantial risk of forfeiture only if the rights are conditioned on the future performance of substantial services by any individual. The provision would apply to both Section 457(b) and 457(f) plans.

This provision would have a significant impact on the taxation of income from Section 457(b) plans. Currently, participants in these plans are taxed when they withdraw from their plan accounts, as opposed when the substantial risk of forfeiture lapses.

Income from Section 457(f) plans is already taxed based on the substantial risk of forfeiture standard. However, the bill re-defines “substantial risk of forfeiture” to mean conditioned solely on the performance of substantial future services. Should this provision ever become law, it would become important to revisit the language in such plans, to ensure that the defined “substantial risks” would still qualify for deferred tax treatment.

Present law rules for Section 457(b) and 457(f) plans would no longer apply with respect to deferrals attributable to services performed after December 31, 2014. For amounts related to services performed prior to that date, present law rules would remain in effect through December 31, 2022.

Tax-Exempt Organizations

Taxes and Penalties: The proposal would amend the unrelated business income tax, modify the intermediate sanctions rules to, among other things, expand application to §501(c)(5) and (6) organizations, and change various private foundation excise tax provisions, including the taxes relating to self-dealing and investment income. The proposal would add a new 1% excise tax on certain investment income earned by private colleges and universities that own assets above a certain amount. Certain exempt organization penalties, such as those relating to information returns and the unrelated business income tax, would increase under the proposal.

Tax Exempt Bonds:Hospitals and private colleges and universities (and other private institutions that use tax exempt financing) could be impacted, as the Draft aims to eliminate future tax-exempt Private Activity Bonds (PABs) under the rationale that the federal government should not subsidize the borrowing costs of private institutions.

Repeal of Tax Exemption for Professional Sports Leagues and Certain Insurance Entities: The proposal would eliminate the ability of professional sports leagues to qualify for §501(c)(6) tax-exempt status. Amateur sports leagues would retain eligibility to qualify as tax-exempt entities. The proposal would also make the following insurance entities ineligible for tax-exempt status: (a) property and casualty insurance companies, regardless of gross receipts and premium amounts; and (b) qualified nonprofit health insurance issuers that, under the Affordable Care Act, have received loans or grants under the CO-OP program.

Elimination of Type II and Type III Supporting Organizations: Under the proposal, only Type I supporting organizations (that is, those tax-exempt support organizations that are operated, supervised or controlled by publicly supported organizations) would retain the ability to qualify for public charity status. The proposal would repeal Type II and Type III supporting organizations. This change would mean that tax-exempt support organizations supervised or controlled in connection with a publicly supported organization (Type II) or operated in connection with a publicly supported organization (Type III) could be classified only as private foundations.

Special Rules for Social Welfare Organizations: The proposal would add several provisions addressing §501(c)(4) social welfare organizations, including streamlined notification requirements and donation reporting restrictions.

The Joint Committee on Taxation has “scored” the provisions indicating whether the provision would raise money (and how much) or lose money, or whether it is revenue neutral. There are various provisions that impose greater penalties for not properly reporting and disclosing returns, applications for exemption, transactions, etc., changes to private foundation rules, and the reduction of the excise tax on the net investment income of private foundations to a uniform one percent.

While it is still early in the process, and we have no way to accurately predict whether any of these provisions will become law, the fact that 2014 is an election year could render many of these provisions difficult to move forward. Regardless, organizations should begin to familiarize themselves with the pending legislation now and should think about contingency plans should any of these provisions go into effect.