Tag Archives: nonprofits

UBI Activity Loophole for Schools

schools

Schools often rent their facilities to a third party when they’re not in use or have excess space. They usually do this as a community service; for instance, renting the facility to a daycare provider or a summer school, or to produce additional income. School business managers and CFOs should know that this type of activity typically has to be treated as Unrelated Business Income (UBI), and may be subject to tax. However, it warrants a closer look, as the rules are not “typical” and many exceptions exist.

Schools are not taxed on income generated from their mission or programs. However, the same rules do not apply when schools use their facilities for unrelated activities. The tax code contains numerous rules that designate what an unrelated income stream is and assist in determining if it is taxable. Unrelated activities are those that fit a three-pronged definition: the school is conducting a trade or business for the production of income from selling goods or services; the trade or business is regularly carried on; and, the activity is not substantially related to the organization’s exempt purpose. When schools lease or share space, and collect rental income, they should make sure that their accounting team is aware of the intricacies in the tax code as the facts and circumstances warrant.

In the event that a school rents out any part of a debt-financed property, the rules should be evaluated to determine if it is a taxable activity. There are exceptions to the acquisition indebtedness portion of the definition of a taxable activity for certain qualified organizations. A school described in section 170(b)(1)(a)(ii) is a qualified organization under one of the exception rules, which negates the acquisition indebtedness portion of the general rule. If applied properly, a school is not subject to unrelated business tax on such income.

Generally, when UBI rules are applied, revenue can easily be categorized as such. However, when all the exceptions are carefully considered, there are often rules that exist to negate certain revenues from being considered UBI – the trick is finding it. A nonprofit school, if organized under the correct section of the tax law, qualifies for this exception under the definition of acquisition indebtedness so that rental income on a debt-financed property is actually not subject to the UBI rules.

For more information or questions, please contact Aronson’s Kathy Cuddapah at 301.231.6200.

Potential Changes Ahead for the Johnson Amendment

repeal

The new administration has made mention of repealing the so-called Johnson Amendment. What would a repeal mean? In 1954, Lyndon Johnson (later the 36th President of the United States) was the Democratic Senate Minority Leader running for reelection. On the road to reelection, Johnson faced a conservative nonprofit group calling for the election of his opponent.

Johnson, known as a Senate legislator without equal, responded to his opposition by introducing an amendment to Section 501(c)(3) of the Internal Revenue Code, which applies to organizations organized and operated exclusively for religious, charitable, and scientific purposes. In the amendment, tax-exempt status organizations cannot participate or intervene in, which includes the publishing or distributing of statements, any political campaign on behalf of or in opposition to any candidate for public office. In effect, to be exempt from paying taxes one cannot participate in partisan elective politics.

Today, religious groups and charities alike believe the amendment restricts free speech from the pulpit and that the amendment should be repealed. The Alliance Defending Freedom is a major force behind repealing the amendment. The group argues that from the founding of the Country until 1954, Pastors were free to speak boldly from the pulpit about the most crucial social and political issues of the day. Without fear of the IRS restricting or revoking their tax exemption. A commission to study the topic convened by the Evangelical Council of Financial Accountability (ECFA) recommended amending the Johnson Amendment to allow the following.

  • Speech that would be no added cost or a very minimal cost to the organization (such as a sermon, not an expensive advertising campaign).
  • If the speech of the organization would cost more than the minimal amount, then the Johnson Amendment would only prohibit speech that clearly identifies candidates and directly calls for those candidates’ election or defeat.

Defenders of the current law believe partisan politics should not be part of their mission – that they should exist to feed the homeless, provide education, do scientific research, or carryout their mission without political influence or thought. Currently, churches and charities can receive tax-deductible contributions whereas contributions to candidates or political parties are not tax deductible. If tax-deductible contributions were made to churches who promoted or opposed specific candidates, how would such contributions be treated? Furthermore, the equivalent of a Federal Election Commission (FEC) does not exist, which could create pockets of dark money. Are Political Action Committees (PACs) subject to FEC reporting the answer to oversight?

As with healthcare reform, travel restrictions, and Supreme Court nominations, if the Johnson Amendment comes up for legislative change it will no doubt be hotly contested from all sides. Additional information can be found here.

Executive Compensation Trends Upward for Nonprofit Organizations

compensation

According to a recent Wall Street Journal article by Andrea Fuller, nonprofits are becoming increasingly generous in their executive compensation. A searchable IRS database containing 2014 data, showed more than 2,700 executives received over $1 million in total compensation for that year.

The highest total compensation shown was over $17 million. Most of the top earners were a combination of doctors in various nonprofit hospital systems, and collegiate athletic coaches at private universities such as Duke and Baylor; or, coaches at public universities paid out of a separate auxiliary nonprofit such as Florida. The amounts included both base compensation and total compensation. It’s important to note, that the data could be misleading in a year where an executive retired or took a large deferred compensation payment during that one-year period.

In any regard, pay for executives at both nonprofit charities such as 501(c)(3)s, which was the subject of the article and associations largely 501(c)(6) organizations, is clearly trending upward for top level employees. Many of these organizations are large complex entities and pay must be competitive to attract the talent necessary to operate them. Whether the IRS or contributing public would regard the amounts as excessive is an open question. Any organization would be wise to establish safeguards around CEO pay such as using compensation consultants, comparing their packages against peer organizations, CEO review by independent Board members, and specific performance evaluation criteria for CEOs.

For more information or questions, please contact Craig Stevens at 301.231.6200.

Tax Planning Tool: Charitable Lead Trusts

compensation

This article was co-authored by Richard Lee.

Many donors make multi-year commitments to a charity of their choosing. For example, an agreement to contribute $50,000 per year for 5 years to a new building campaign. Some donors are happy to make the pledge payment each year from their annual income, which makes them eligible to take an income tax charitable deduction annually. However, what about the donor that wants to fund their pledge payment out of existing wealth and garner a large upfront income tax deduction? There may be a way to accommodate this type of donor with a Charitable Lead Trust (CLT).

Conventional wisdom is that CLTs are actually estate-planning tools for the very wealthy. While this is true, there are estate and gift planners, such as Lani Starkey of Fifty Rock Consulting, who believe there are income tax planning uses for CLTs as well, particularly to generate an upfront income tax charitable deduction, in a year in which the donor has unusually high income.

A CLT involves making a charitable gift to an irrevocable trust. A CLT in some respects is the mirror-image of its trust cousin Charitable Remainder Trust (CRT). A CRT is tax-exempt and provides a regular income stream to the donor or named beneficiary for the donor’s lifetime(s) or term of years, with the remainder thereafter going to the charity. Conversely, a CLT is not tax-exempt, with periodic payments going to charity for a specified term, and the remainder either reverting to the donor or passing to some other person chosen by the donor.

Please note there are two different types of lead trusts: grantor trusts and non-grantor trusts. The income tax benefits discussed here stem from using a grantor charitable lead trust.

With a grantor trust, the trust will annually file a fiduciary income tax return for income tax purposes, the trust’s income, gain or loss, will flow through the trust and be reportable on the donor’s personal income tax return (Form 1040).

The upfront income tax charitable deduction is equal to the present value of the charitable income stream, which is determined by using an IRS-prescribed interest rate known as the “Section 7520” rate. The lower the Section 7520 rate, the higher the discounted present value of the charitable income stream, and the higher the upfront income tax charitable deduction. Currently the Section 7520 rate is very low, thus producing higher income tax charitable deductions for gifts to CLTs.

As an example, assume a donor makes a pledge to a charity for $25,000 per year for 10 years and has accumulated assets of $500,000. The donor could donate to a charitable lead annuity trust and they could use a large charitable deduction in the current year to offset a large bonus they received. If you assume a 5% payout rate and a 6% investment rate of return on trust assets over the 10 years, the transaction would yield the following:

  1. An immediate charitable deduction of approximately $229,000, which could offset other income by up to 20% of the donor’s adjusted gross income, or 30% if the contribution were made in cash (compared to a $25,000 deduction per year over 10 years). The deduction is so close to the $250,000 to be paid to the charity because of the low Section 7520 rate. This rate will presumably go up given other rate increases making the deduction less.
  2. $25,000 per year to go to the charity for 10 years, same as the pledge.
  3. Approximately $566,000 to revert back to the donor or their assignee at the end of the 10-year period.
  4. An amount greater than the $500,000 contributed as the rate of return on trust assets at 6% exceeded the 5% payout.

This might be a very attractive result for a prospective donor. The catch is that they would have to have sufficient wealth to completely fund the trust in the first year. A donor that pays their yearly contribution out of their annual income could not do that.

Additional benefits:

  1. The charity has more security that the pledge will be fulfilled as the trust is funded.
  2. If the trust is funded with securities, the donor gets an immediate income tax charitable deduction applied against ordinary income whereas subsequent sales of stock to fund the payments could trigger more favorable long-term capital gains.
  3. If the pledge is paid immediately, the donor gets the full $250,000 deduction but the money is gone. With this arrangement, unspent corpus is returned to the donor.

A CLT can be structured to fit a donor’s objectives and financial situation. The donor can select the trust’s start date, the trustee (e.g., a bank, individual, or the charity), the trust term, the lead interest charitable recipient, the payout percentage and formula (annuity or unitrust), the payout frequency (e.g., quarterly or annually), the contributed assets, and the remainder beneficiaries (e.g., the donor themself, or their children).

As mentioned before, a CLT is taxable, unlike its tax-exempt CRT cousin. Therefore, contributing low basis assets and selling them once inside the trust would result in the grantor having to recognize capital gain on the sale, thus offsetting the income tax benefit of the upfront charitable deduction. Thus, higher basis assets would generally be better assets to contribute to a CLT.

Note: Although the initial contribution of assets to the trust will generate an immediate income tax charitable deduction, over the trust’s term the initial income tax benefit is at least partially offset by the donor’s reporting of the trust’s income. And, if the donor dies during the trust term, the donor is required to report as income a portion of the up-front charitable deduction.

Keep in mind too that any income tax charitable deduction allowed is limited to 20% of a donor’s adjusted gross income, or 30% of adjusted gross income in the case of contributions of cash rather than capital gain assets, even if the lead interest goes to an otherwise 50% public charity.

These arrangements might work very well in the right situation for the right donor. If you would like additional information, please contact our office at 301.231.6200. .

 

Bridging the Divide Between the Nonprofit and Startup Communities

The value of reciprocal relationships between entrepreneurs and nonprofits or associations may not be obvious, but they can bring myriad benefits.  And the divide between the nonprofit and for-profit communities is smaller than you might think.  As a managing director at 1776, a startup incubator in Washington, DC, I work each day with companies that sincerely want to drive change and have a positive impact on the world. Sound familiar?

Mission Overlap

Many nonprofit leaders I speak to don’t realize how aligned their interests are with entrepreneurs who are addressing global problems. Last year, 1776 hosted its first Challenge Cup, a global startup competition taking place in 16 cities across 11 countries to identify the most promising startups solving the biggest challenges in education, energy, health, and cities. Winners included:

  • CancerIQ, a company that provides oncologists with information they need to correctly diagnose and identify high risk patience.
  • PlugSurfing, a Berlin-based startup, is facilitating the world’s largest charging point for electric cards, e-bikes and electric scooters.
  • EduCanon, an interactive video platform that helps teachers transform and evaluate the efficacy of video learning.
  • The global winner, HandUp, which provides a technology platform for charitable giving to the homeless community and allows donors to track their donations.

Each of these startups could provide partnership opportunities for particular associations and nonprofits.  For associations, there is an opportunity to play matchmaker—connecting entrepreneurs to members who would value their innovative product, but would not otherwise know about it.  Think about a teacher association that could publicize eduCanon to members as a free tool they can use to improve their lessons.  Meanwhile, nonprofits can serve as “early adopters” of new tools that can improve your services.  For example, a nonprofit that serves the homeless could work with HandUp to provide clients with services like dental work or interview clothes that they could not otherwise offer.

DC Metro Area Opportunities

The Washington metropolitan region has a particularly active startup scene that provides ample opportunity for nonprofit and association leaders to connect with it.  The area is home to a growing number of startups due to its favorable economic outlook, well-educated and young labor pool, and vibrant neighborhoods.  Pair that with one of the strongest nonprofit communities in the country and you have a recipe for success.  You can engage with for-profit innovators in a number of ways:

  1. Attend DC Tech Meetup to see what local companies are doing to move the world forward.
  2. Sign up for specialized meetups, like DC Ed Tech or the Health Technology Forum to see what’s happening in your organization’s focus area.
  3. Monitor local tech developments through social media channels, such as the DC Tech Facebook page or the #DCTech hashtag on Twitter.
  4. Attend the 1776 Challenge Cup festival.

In addition to 1776, there are many established organizations throughout the region that are working to connect nonprofits and associations with relevant startups. The Alexandria Chamber of Commerce invited me to speak at their recent Nonprofit & Association Leadership Academy event, and they have some great programs scheduled this fall to address the changing exempt landscape.  Aronson LLC, a metro area-based accounting and consulting firm, is partnering with both 1776 and local chambers to connect organizations with the resources, products and services provided by local innovators.

Perhaps the most important takeaway is to embrace innovation and be open to forging new relationships with the startup community. Great ideas deserve to be shared!

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