Daily Tax Report ®

INSIGHT: Interpreting the Nonprofit Fringe Benefit Tax

July 30, 2018, 1:06 PM

As a result of the 2017 tax act, nonprofits are now subject to tax on parking, transit passes, and certain other fringe benefits that they provide to their employees. The new rule is said to bring about “parity” with taxable employers, which lost their ability to deduct costs for providing those same fringe benefits to their employees. In reality, the purpose of the tax is to make up some of the lost revenue from reducing the corporate income tax rate from 35 percent to 21 percent (a benefit to taxable employers, but not to tax-exempts).

As nonprofits wrestle with the implications of the new rule, many have considered entering into employee salary reduction arrangements as an alternative to paying the tax or discontinuing the benefits. Unfortunately, salary reduction arrangements are not a prescription to cure the new tax. The Internal Revenue Service has not yet issued regulations, but it has already taken the position that salary reduction arrangements are taxable because they are equivalent to benefits provided directly by the employer. The questions are:

  • How much is the tax?
  • Is the amount of the employee’s salary reduction equal to the amount taxable to the employer?
  • Alternatively, is the taxable amount determined by reference to the employer’s expense in providing the benefit?


Congress enacted new tax code Section 512(a)(7) in 2017 as part of the 2017 tax act (Pub. L. No. 115-97). Section 512(a)(7) is applicable to tax-exempt organizations that are otherwise subject to the unrelated business income tax (UBIT), and it operates by increasing unrelated business taxable income (UBTI) by any amount paid or incurred by the organization for any qualified transportation fringe, any qualified parking facility, or any on-premises athletic facility to the extent that a deduction is not allowable for the amount by reason of Section 274.

This addition to the tax code was part of a broader change whereby Congress switched from treating employer-paid commuting expenses from an employer expense (and thus deductible to the employer and excludable from income to the employee) to personal consumption of the employee (and therefore includable in the employee’s income). Whereas employer-paid commuting expenses were previously not taxed to either the employer or the employee, Congress changed the rule to make them taxable.

Congress could have achieved the desired result by repealing the exclusion from an employee’s income for qualified transportation fringe under Section 132, but instead chose to amend Section 274 to make the provision of such benefits by an employer to an employee nondeductible to the employer, but still excludable from the employee’s income.

In order to tax nonprofit employers as well, Congress enacted Section 512(a)(7). Because tax-exempt employers do not have deductions under Section 274 that can be disallowed, Congress instead made the expense of providing a qualified transportation fringe an item of UBTI and therefore generally taxable at corporate rates.


There has been considerable confusion about the application of Section 512(a)(7) including not only what is included in UBTI by reason of Section 512(a)(7) but also the amount of the inclusion. The statutory language of Section 512(a)(7) is clear that in order to be included in UBTI, an amount must be both: (1) paid for one of the three enumerated categories (namely any qualified transportation fringe, qualified parking facility, or on-premises athletic facility); and (2) disallowed by reason of Section 274. While there is disagreement among practitioners and regulators regarding to what extent deductions amounts paid for qualified parking and on-premises athletic facilities are disallowed under Section 274, there is general consensus that amounts paid for qualified transportation fringe are now disallowed by reason of Section 274(a)(4). Thus, an amount paid for a qualified transportation fringe is includable in UBTI by reason of Section 512(a)(7).

The salary reduction arrangement is a commonly provided qualified transportation fringe whereby the employer reduces the employee’s salary and instead provides a transportation benefit. While many organizations and their advisors initially thought that Section 512(a)(7) might not apply to such arrangements, regulators at the IRS and the Treasury Department have signaled that they believe otherwise.

The initial thought was that the amount of the salary reduction should not be included in UBTI under Section 512(a)(7) because the expense should be considered an expense of the employee, not the employer—after all, it is the employee who is forgoing compensation in order to receive the benefit, making it economically equivalent to the employee purchasing the benefit with pretax dollars. The jurisprudence of Section 132 and the regulations thereunder, however, has long treated such salary reductions arrangements as a transportation benefit provided directly by the employer rather than as compensation first paid to the employee and then used by the employee to purchase transportation benefits. The IRS reaffirmed this position with respect to new Section 274 (and thereby Section 512(a)(7)) when it published Publication 15-B, which included a “tip” reminding employers that no deduction is allowed for qualified transportation fringe provided through a compensation reduction arrangement.


Setting aside the precedential value of an IRS “tip,” let’s take an example of how this works in practice.

Example 1: Assume an employee, Jane, at Company A, enters into a salary reduction arrangement in order to receive a transportation benefit. Jane previously received compensation of $1,000, all of which was deductible to Company A and taxable to Jane. Jane chooses instead to receive $900 of compensation and a $100 transit pass. Now, Jane receives $900 of taxable compensation and a $100 transit pass, the value of which is excluded from her income under Section 132. Prior to the amendment to Section 274, both the $900 in compensation and the $100 transit pass purchase were deductible to Company A; now under amended Section 274, the purchase of the $100 transit pass by Company A is nondeductible.

Example 2: Jane is employed under the same compensation arrangement for Company B, which is a tax-exempt organization. The $900 in compensation is includable in income to Jane while the $100 transit pass is excludable by reason of Section 132. The exempt employer does not take deductions and therefore there is no deduction to be disallowed under Section 274; to achieve “parity” with Company A, Section 512(a)(7) makes the $100 includable in UBTI of Company B. This is a comparable outcome to the tax result for Company A, which is denied a deduction for the $100 purchase of the transit pass while Company B has an UBTI inclusion of $100.


The above examples have led many in the exempt sector to conclude that the amount of a salary reduction arrangement is includable in UBTI of the exempt organization. However, it is not clear that this should always be the case, particularly where the qualified transportation benefit is provided by the employer rather than purchased by the employer, as often happens with qualified parking. The amount of the salary reduction may not equal the expense of the employer in providing the transportation benefit. In these cases, is it really the amount of the salary reduction that should be included in the employing organization’s UBTI?

Example 3: Company C owns a parking lot where qualified parking is provided for the employees of Company C. Employees who park in the parking lot enter into a salary reduction arrangement whereby their salary is reduced by $100 per month. Company C incurs $20 of expenses per month, per employee in maintaining the parking lot. In this case, the expense that was previously deductible under Section 274 was the $20 incurred in providing the parking, not the amount of the salary reduction. Thus, it is the $20 that is disallowed as a deduction under Section 274, and therefore, the $20 that is includable in unrelated business taxable income under Section 512(a)(7). Because the $100 salary reduction (for which there was no corresponding outlay by Company C) was never deductible under Section 274, there is no disallowed deduction, and the second prong of the Section 512(a)(7) test is not met with respect to the $100 salary reduction.


In summary, while salary reduction arrangements may well be qualified transportation benefits subject to Section 274 and Section 512(a)(7), the amount of the salary reduction may not necessarily be equal to the amount of the inclusion under Section 512(a)(7). The amount of the inclusion in these cases has to be determined by reference to the employer’s expense, because that is the amount for which a deduction is disallowed by reason of Section 274.

Morgan, Lewis & Bockius LLP partner Alexander L. Reid and associate Caroline Waldner advise tax-exempt organizations in planning, structuring, and transactional matters. Reid previously served as legislation counsel for the Joint Committee on Taxation of the U.S. Congress, where he advised members of Congress and staff regarding tax policy.

To read more articles log in. To learn more about a subscription click here.