Each year, Congress adopts a concurrent budget resolution setting net spending, revenue, and debt limits on legislation emerging from each committee during the current session. This year, the path to tax reform began on October 5 when the House passed its budget resolution, followed by the Senate passing its Fiscal 2018 Budget (“FY18”) on October 19. On October 26, the House adopted the Senate’s version of the plan, allowing tax reform to increase our deficit by a maximum of $1.5 trillion over a 10-year budget period.
The House passed H.R. 1, the “Tax Cuts and Jobs Act” (“the Bill”) on November 16, and the Senate Finance Committee (“SFC”) approved its version on the same day. The Joint Committee on Taxation (“JCT”) estimated the Bill would cost approximately $1.414 trillion over the 10-year period.
The Bill contains reconciliation instructions which allow it to pass the Senate with a simple majority. However, any senator may challenge proposed amendments if the instructions are not met. For example, an amendment made in reconciliation must be limited to provisions having more than an incidental effect on revenue spending, and may not increase projected deficits in fiscal years beyond those covered in the measure. This is the feature that is behind the 8-year sunset in the SFC’s version. We suspect the reconciliation instructions will shape current tax proposals.
Below, ACGA snapshots specific SFC provisions impacting charitable giving, House counterparts, and estimated costs. Keep in mind a large portion of SFC’s provisions will not apply after 2025, when these changes will revert to pre-2018 law. We will conclude with the possible next steps in the legislative playbook, and some charitable planning observations.
Executive Summary: The Impact of Tax Reform on Charitable Giving
The most important item in each bill is the absence of language eliminating the charitable income tax deduction, limiting the deduction to a percentage (i.e., 28% effective rate as in President Obama’s proposals), or limiting the deduction to tax basis (rather than fair market value). These are huge considerations in reviewing this proposed legislation, and should not be overlooked.
Unfortunately, the overall tax restructuring of the House and Senate bills produces an unfavorable result for the charitable world, whereby charitable giving may be significantly reduced, as set forth below.
Tax Reform Snapshot
Many exemptions, deductions, and credits have been eliminated, curtailed, or adjusted. For example:
- The personal exemption is repealed.
- The mortgage interest deduction is significantly curtailed and is now limited to the principal residence alone. The mortgage deduction on new acquisition indebtedness is limited to $500,000 (effective November 2, 2017).
- State and local income tax (or sales tax) deductions are eliminated, except for a deduction up to $10,000 for real property taxes.
- The AGI limitation for charitable contributions of cash made by individuals to public charities is increased to 60% (from the current 50%).
- The 3% limitation on itemized deductions (including the charitable deduction) – known as the “Pease Limitations” – are repealed.
- Personal casualty losses are eliminated.
- Wagering losses are limited.
- Tax preparation deductions are eliminated.
- Medical expense deductions are eliminated.
- Alimony deductions are eliminated.
- Moving expense deductions are eliminated.
- Medical Savings Account deductions and exclusions are eliminated.
- Employee trade or business expense deductions are eliminated.
- The alternate minimum tax is repealed.
The SFC version of the Bill has similar limitations, reductions, or elimination of deductions, all of which must be resolved in one bill, probably during a Conference Committee (discussed below).
For example, the SFC retains the current 7 tax brackets, lowering several rates, while the House’s version reduces the tax brackets to 4. Both versions double the standard deduction, while eliminating personal exemption deductions and most itemized deductions. The JCT estimates repealing the personal exemption deductions will increase the budget revenue by approximately $1.2 trillion, and repealing itemized deductions will add another approximately $978 billion over 10 years.
In early November 2017, the Joint Committee on Taxation released a memorandum, which reflected the impact of these changes on the charitable income tax deduction:
“For tax year 2018 [under current law], we estimate that 40.7 million taxpayers who itemize will deduct charitable contributions totaling $241.1 billion. Under H.R. 1, we estimate that approximately 9.4 million taxpayers who itemize will deduct charitable contributions totaling $146.3 billion in 2018.”
The memo confirms a study released earlier this year by Indiana University’s Lilly School of Philanthropy: a doubling of the standard deduction alone will reduce charitable giving by $11 billion; and the increase of the standard deduction, along with other provisions in the House bill, will cause the claimed charitable deductions to fall by $95 billion, or 40%. This does not mean charitable giving will fall by $95 billion, but the amount claimed as a charitable deduction will fall by $95 billion.
Both versions of tax reform permanently reduce the corporate tax rate to 20% (from the current 35%). However, the House version is effective in 2018, while the SFC version is effective in 2019. Both versions alter passthrough business income (“PBI”): the SFC bill allows a 17.4% rate deduction, while the House version caps the PBI tax rate at a flat 25% rate with the rebuttable presumption that 70% is wage income (taxed at regular rates) and 30% is PBI; service providers are taxed on 100% of PBI.
Both versions modify rules for expensing capital investments. The SFC bill increases Section 179 expensing to $1 million (from the current $500,000), with a phaseout range beginning at $2.5 million (from the current $2 million), and expands the definition of qualified property. The House bill increases Section 179 expensing to $5 million, with a phaseout range beginning at $20 million.
Both versions of the Bill double the estate, GST, and gift tax exclusion amounts to $10 million, adjusted for inflation. The JCT estimates this provision would decrease revenues by approximately $83 billion over 10 years. The House bill completely repeals the estate tax after 2024. The Tax Policy Center estimates completely repealing the estate tax alone would reduce giving by $4 billion in the long run, while altering behavior of lifetime giving by reducing charitable bequests by approximately 27%.
SFC’s Permanent Provisions for Exempt Organizations
Exempt organizations will be affected by the reduced 20% corporate income rates, changes to the various fringe benefits, and tax-exempt bond reform. SFC’s bill proposes additional permanent changes to exempt organizations which include, in part:
- A 20% excise tax will be imposed on employees who receive more than $1 million in compensation or “excess parachute payments” (producing $3.6 billion of additional revenue over 10 years; similar provision in House version).
- charitable deduction will no longer be allowed for amounts paid in exchange for college athletic event seating rights (producing $1.9 billion of additional revenue over 10 years; similar provision in House version).
- donee organizations will no longer be allowed to provide a contemporaneous written acknowledgement (“CWA”) by issuing statements for all donors on a report to the government; instead a donor making a gift exceeding $250 will need to rely on a separate or individual CWA (this has negligible revenue effects; similar provision in House version).
- A 1.4% excise tax will be imposed on net investment income earned by private colleges and universities with at least 500 students and non-exempt use assets with last year’s value of $250,000 per full time student (producing $2.5 billion of additional revenue over 10 years; similar provision in House version).
- Name and logo royalties will be treated as unrelated business taxable income (producing $2 billion of additional revenue over 10 years; no House corollary provision).
- Losses from one unrelated trade will not be allowed to offset income from another unrelated trade, thus unrelated business taxable income must be separately allotted for each trade or business activity (producing $3.2 billion of additional revenue over 10 years; no House corollary provision).
House Provisions for Charities (not part of SFC bill)
- A flat excise tax rate of 1.4% will be imposed on investment income of private foundations (rather than the 2% or possible 1% tax rates).
- Charitable organizations sponsoring donor advised funds (“DAFs”) must disclose their policies with respect to inactive DAFs and average amounts of grants.
- All charities (that is, Section 501(c)(3) organizations) will be allowed to engage in “de minimis” political activity (this is a change in the so-called “Johnson Amendment”).
Next Steps in the Legislative Playbook
The Senate is expected to debate the SFC bill, potentially stripping, replacing, or incorporating various House provisions during the week of November 27. Following approval by the Senate, both chambers must resolve differences between the two versions of the bills before submitting one final bill to the White House, to be signed by President Trump. The proposed deadline is 12/31/17.
Given the uncertainty in the horizon, donors who wish to make their charitable contributions must donate this calendar year (2017) to take advantage of current charitable giving tax benefits. Those unsure about how to allocate gifts in 2017 may nonetheless secure current benefits by using charitable giving vehicles. Donors should print out this article and consult with their advisers to explore their options.
Charitable Planning Observations
- Many exclusions from income, exemptions, deductions, and credits have been eliminated under the Bill. For a vast majority of all Americans, the Bill simplifies the income tax laws.
- Given the elimination or reduction of many deductions, exemptions, and credits, a person with a home and a $400,000 – $500,000 mortgage may well have deductions which exceed the new standard deduction of $24,000. If this is the case, the only remaining income tax planning option is charitable giving. Charities should be alert to this opportunity, and should promote outright and planned gifts during life with itemizers.
- With the anticipated reduction in charitable income tax deductions due to the increased standard deduction, charities should be aware of the danger of reduced funding, and should enhance communicating their missions to donors who take the standard deduction.
- Under current law, taxpayers have tried to avoid treating business activities as “passive,” preferring them to be “active,” so that losses from one business activity can be offset against income earned as compensation. This trend may see a 180-degree turn.
- Almost all serious proposals in the past decade for repeal of estate and generation-skipping taxes have included a corollary: the imposition of carry-over basis at death, rather than a step-up in basis to fair market value at death. The Joint Committee on Taxation has scored the repeal of death taxes, in conjunction with a carry-over basis regime as a revenue enhancer. This “omission” may be remedied in the final version of the Bill, and if this occurs, split-interest gifts will receive a significant boost.
- The world of Mergers and Acquisitions (“M&A”) will be changed radically. Sellers will want to sell assets because the corporate tax rate will be significantly reduced (35% down to 20%). Buyers will want to buy assets since the expensing of acquisition costs will be significantly increased. Charitable planners aware of this potential trend will be able to offer donors/clients the opportunity to avoid two levels of taxation, by suggesting charitable split-interest vehicles such as a gift annuity, pooled income fund, and charitable remainder trust. In this manner, a person selling his or her business may find they are only paying a 20% tax and are able to benefit the charity of their choice!
As we were getting ready to “go to press,” new events developed in Washington. On November 28th, the Senate Budget Committee approved the SFC’s version of the TCJA, paving the way for Senate approval, based upon a majority vote on the floor. This vote (51-49) took place in the early hours of Saturday morning, December 2nd. The bill the Senate approved was an “amendment” of the earlier bill approved by the Senate Finance Committee.
This amended bill did not directly impact charitable giving, but it made changes regarding individual and corporate AMT; a $10,000 state and local property tax deduction (similar to the House version of the TCJA); rates of 14.5% and 7.5% for repatriation of cash and noncash earnings, respectively; an increase in the pass-through deduction from 17.4% to 23%; a medical expense deduction for amounts in excess of 7.5% of AGI (not the current 10%); a catch-up for contributions to retirement accounts for church, charity, school, and public employees; and the use of college savings plans to include elementary and secondary school expenses.
The House and the Senate will go to conference committee this week to resolve the differences between the Senate and House bills. It is still unclear which provisions will survive this process. Provisions that must be reconciled include individual tax cuts, income tax rates, income tax brackets, pass-through treatment, and sunset provisions.