Federal Tax Law, Nonprofits, and the Action in the States, so far

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In January, Tim Delaney and I predicted in a Chronicle of Philanthropy article that the federal tax law enacted in December would unleash a tsunami pounding nonprofits and foundations with operational issues and policy activities. Specifically, we said, “The law that Congress passed and the president signed in the waning days of 2017 has created the most dangerous policy environment across the state, local, and federal levels that we’ve ever seen in the decades we’ve spent focusing on how governments and nonprofits interact.”

Overstating the challenge, bordering on hyperbole? A few said so at the time. Accurate? Let’s look at developments over the past half year. How’d we do in predicting the impact of the major change in federal tax policy on nonprofits, state and local laws, and legislative actions? Six months is perhaps too soon to tell – four state legislatures weren’t even in session this year and many more were in “short” sessions and couldn’t adjust their agendas to take up comprehensive tax reform. But, there was plenty of action, so we ask ourselves, was it good or bad action? The short answer is – both.

As we anticipated, the federal law has had reverberations throughout the public policy world. At the federal level, there is talk of a “Tax Cuts 2.0” bill to make permanent lower individual tax rates, fix technical mistakes, and, lately, repeal of the new taxes on tax-exempt organizations – although none is expected to pass this year. The federal law also generated a great deal of action at the state level and on down to local levels as policymakers consider the impact on state tax receipts and budgets. Through all of this, nonprofits have been trying to figure out how their operations are affected and engage where appropriate to improve policies. Here’s a review of what’s happened so far:

  • Charitable Giving Incentives: The federal tax law doubled the standard deduction, thereby reducing the number of people who will itemize and receive a tax deduction for giving to the work of nonprofits. We, among many others, expressed concern. Some accused us of buying into the doom and gloom of the DC nonprofit pack mentality. We shouldn’t create a self-fulfilling prophesy, they exhorted. The truth is that no one will know for sure whether charitable giving takes a major hit due to the tax bill –until a year or two of people giving through a complete tax cycle. A study by scholars at the conservative American Enterprise Institute recently agreed with pre-passage predictions that the federal changes will reduce the amount that will be given to the work of charitable nonprofits (by $17.2 billion or 4.0 percent in 2018).

    But what happened in the states this first half-year in response to the federal tax law and the challenge it allegedly imposed on charitable giving? Did states, unlike Congress, acknowledge the potential problem and take action?

    Most recently, Vermont did the inexplicable – it took the worries about reduced giving and made them worse by repealing the state’s itemized deduction for charitable giving. To be fair, they did create a new charitable giving tax credit of five-percent for all taxpayers. But the credit is capped at $1,000 per taxpayer, meaning that donors who previously benefitted from an itemized deduction valued at their state tax rate (6.8% to 8.95%) will now see higher tax bills and no incentive for giving more than the new cap. Regardless of the impact of the federal tax law, this guarantees that giving based on tax policy in Vermont will decline. Inexplicable.

    Vermont showed all what not to do when trying to undo the damage of federal tax policy, but there are positive efforts to celebrate. Both Colorado and Minnesota currently provide a charitable deduction for taxpayers who don’t itemize, and in 2018 legislators both states tried to enhance the incentive by removing thresholds and limits. Neither bill prevailed this year, but more tax reforms next year keep these reasonable proposals on the agenda. New Jersey, which currently doesn’t have a state tax incentive to promote charitable giving, has two pending bills that enjoy bipartisan support … and that state’s legislature is still in session.

    One more point is needed here in acknowledgment of concerns about the impact of advocacy on fundraising outcomes. Sound public policies on charitable giving are important, but they aren’t substitutes for the actual work of generating donations. Regardless of tax policies, it is incumbent on nonprofits to get out there and make personal connections with donors, demonstrate impact, and tell their stories. We’ve said it before, and will again and again: Develop a fundraising strategy, work it, revise it, work it some more. Every day.
  • SALT Workarounds: The federal tax law took a direct shot at so-called “high-tax states” by capping the itemized deduction for state and local taxes (SALT) at $10,000. As predicted, state legislatures took action to revise their laws to limit the adverse impact of the federal changes on their taxpayers. To date, three states – Connecticut, New Jersey, and New York – have established “SALT workarounds,” i.e., laws that allow state taxpayers to get around the federal cap by paying their state and/or local taxes through government-run charities, enabling them to take an uncapped federal charitable deduction (assuming they itemize) for those payments while receiving a credit against some or all of their state or local tax liabilities. Another SALT workaround bill is still working its way through the California Legislature.

    Many nonprofits have expressed reservations about the SALT workarounds because of concern that the laws could reduce giving to true charitable organizations, anxiety about public and donor confusion, and questions about governance and transparency. Those may become moot when the IRS and Treasury addresses the legality of the SALT workaround laws. The IRS announced it will soon be writing regulations on SALT workaround efforts, warning taxpayers that “federal law controls the proper characterization of payments for federal income purposes.” Scholars have noted, however, that 32 states have been providing tax credits in exchange for charitable donations for many years, including other types of workaround schemes in more than half the states. Even if the IRS and Treasury were to issue proposed regulations, it may take years to resolve as litigation is certain, such as a lawsuit filed in July by four states (Connecticut, Maryland, New Jersey, and New York).

    Bottom line here: The states haven’t taken the federal law as the last word, a reality that was at the core of our Chronicle article in January.
  • Decoupling from Federal Taxes on Tax Exempts: Perhaps the biggest surprises in the federal tax law were two new taxes on tax-exempt organizations known as unrelated business income taxes (UBIT). One provision imposes an income tax on transportation expenses of employers and employees. Another forces nonprofits to reallocate all of their income and costs in unrelated business activities into “separate” “trades or businesses,” whatever those undefined terms mean. Accountants, lawyers, nonprofits, and many others are baffled by the terms and are demanding delay and clarification. We have a separate blog posting that explains the challenges of those new taxes. In addition to not knowing what their federal liabilities will be, nonprofits also have to worry about how the federal law interacts with state tax laws.

    The problem is that several states impose their own tax on top of the federal UBIT. The Minnesota Council of Nonprofits was the first to raise the issue and nearly succeeded in including language in the state’s tax reform package that would have “decoupled” state UBIT from the federal taxes. Alas, the Governor vetoed the bill for other reasons and tax reform will return to the agenda early next year.

    This spring, at the urging of the North Carolina Center for Nonprofits, the North Carolina Legislature enacted a budget and spending bill that decoupled state UBIT on nonprofit parking from the new federal tax law. The provision ensures that tax exempt organizations will not be taxed an additional three-percent state UBIT or have to file state tax forms for their employees’ parking expenses. Similarly, the New York State Senate and Assembly approved a bill to decouple state tax law from the new federal tax on nonprofit and employee expenses for transportation benefits. State law imposes UBIT whenever federal law does so. As a result, New York would have automatically followed the new federal statute, imposing a nine-percent state tax retroactive to January 1, 2018 in addition to the 21 percent federal tax. The Nonprofit Coordinating Committee of New York, the New York Council of Nonprofits, and other organizations advocated for the legislative fix. It is unclear whether Governor Cuomo will sign the bill.
  • Dealing with Tax Windfalls: We forecast in January, the new federal tax law would result in increased tax revenues in some states because they use federal definitions of income and follow federal law on things like personal exemptions. Increased revenue projections led, or are leading, a number of states to consider reopening their tax codes. During their brief legislative sessions this year, some states cut state taxes or provided other tax benefits to avoid higher tax bills on residents. Three states (GeorgiaIdahoIowa) passed laws cutting income tax rates, among other provisions. North Carolina legislators passed a bill that will place a constitutional amendment on the ballot in November to lower the constitutional cap on the state income rate from ten percent to seven percent. As discussed above, Vermont sought to enact tax reform that eliminated the charitable deduction while lowering tax rates.

    Earlier this year, Kentucky created a flat five-percent personal income tax, which eliminated its five tax brackets and decreased the tax rate for all income over $8,000. At the same time, however, the legislation expanded sales tax to services and labor, including imposing new tax liabilities on nonprofits in the commonwealth. Lawmakers in Kansas were encouraged to cut taxes by $80 million due to the federal tax windfall, but ultimately rejected the siren song, citing ongoing economic recovery after the failed tax-cut experiment from a few years ago. Other states (such as Michigan and Nebraska) looked to adjust personal exemptions and other provisions of their tax codes to provide tax relief to individuals.

    A few states actually passed legislation to increase revenues immediately without waiting for any federal tax windfall. Delaware increased tax rates, and Oklahoma’s revenue bill capped itemized deductions, but excluded charitable donations from under the cap.

The foregoing review tells us at least two things. First, changes to federal tax law are not the end, but the beginning of the story. There is a ripple effect, perhaps even a tsunami, depending on how state revenues are structured and the economy of the different regions. Second, states do not take dictation from Congress when it comes to taxing their citizens. As with business lobbyists and financial planners, state policymakers are creative and aggressive in envisioning and implementing loopholes, workarounds, and alternative funding mechanisms when it is in their perceived best interests. To re-emphasize and update our conclusion in the January Chronicle article, “If we learn nothing else from [the past six months], it should be the urgent need for nonprofits and foundations to take active steps to advocate for smarter public policies.”

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