Tax-Exempt Organizations Face New Executive Compensation Rules Under Tax Reform
Tax-exempt organizations will need to add an extra layer of compensation planning after the newly enacted Tax Cuts and Jobs Act’s addition of a 21% excise tax on certain “excessive” employee compensation. The newly added Section 4960 of the Internal Revenue Code imposes a 21% employer-paid excise tax on two types of compensationany amount over $1 million paid to an employee in a year, or certain large “parachute payments” triggered by the employee’s severance-paid to a prescribed group of highly compensated current and former employees. Unpacking each of those items, however, leads to a more complex set of determinations that all tax-exempt employers must begin tracking.
When Do the New Rules Apply
The new excise taxes apply for taxable years beginning after December 31, 2017. This means any tax-exempt organization operating on a calendar-year basis is already subject to the new limitations. For those operating on a non-calendar fiscal year, these new rules will apply with their new fiscal year. While the Act itself contains no exception for existing arrangements, the IRS will issue regulations that will hopefully contain a transition rule.
Which Organizations Are Covered
Virtually all tax-exempt and governmental entities are covered, including all organizations exempt from federal income tax under Code Section 501(c) – private sector charities, hospitals, churches, schools, universities, labor unions, credit unions, social clubs, chambers of commerce, trade associations, etc. – as well as all state and local governments and other public bodies or instrumentalities – state agencies, public universities, hospital and airport authorities, commissions, etc.
Notably, the employer pays any excise tax due under the new rules.
Which Employees Are Covered
The excise tax only applies to employees (including former employees) of a tax-exempt organization who are the five highest compensated employees of the organization in a given year. They are called “covered employees.” While this may seem to be a simple enough exercise, the list of covered employees also includes anyone who was a covered employee (i.e., one of the top five highest compensated employees) for any preceding year starting in 2017, even if they are not one of top five highest compensated employees in the current year.
There is no threshold earnings requirement before becoming a covered employee.
This effectively creates a “once-on, always-on” list of current and former employees that must be maintained on a rolling basis. For example, if a hospital system’s CEO is its highest paid employee during 2018 (even if she never earns more than $1 million in a year during her employment), then she retires and receives no payments for five years, then receives a lump-sum payout of $1.5 million from her SERP account in 2023, she would still be a “covered employee” and the excise tax would apply.
What Pay Is Counted for the $1 Million Excise Tax
After determining that the organization is covered and compensation is paid to a covered employee, the final step is calculating the amount of compensation the covered employee received. Broadly speaking, this amount includes all compensation reported on an employee’s W-2.
More specifically, the new rules count all wages, including base salary, bonuses, commissions, taxable fringe benefits, etc. They also includes amounts required to be included in income under Section 457(f). This covers the vast majority of nonqualified deferred compensation plans, requiring the present value of their benefits to be included as soon as they vest, regardless of whether they are actually paid. The law also appears to apply to distributions from 457(b) plans maintained by non-governmental tax-exempt organizations. This would be more expansive than the amounts included as parachute payments discussed below.
Certain types of pay are also excluded from this calculation, including an employee’s Roth elective deferrals as well as distributions from a 401(k) plan, 403(b) plan, and governmental 457(b) plan. These types of pay aren’t counted when determining whether a covered employee receives more than $1 million in a given year or in calculating the excise tax if the covered employee does receive more than $1 million in a year.
A late revision to the Act also excludes amounts paid to a licensed medical professional for the performance of medical services. This exclusion applies only to the extent that the compensation is paid for the provision of medical services, so any employee who both performs medical services and performs administrative services may need to have their activities tracked more closely.
What Is an Excess Parachute Payment
The excise tax applies not only to pay exceeding $1 million in a given year, but also to any “excess parachute payment.” The excess parachute payment excise tax applies to the same types of organizations and to the same list of “covered employees” discussed above.
An “excess parachute payment” is any payment contingent on the employee’s separation from employment where the separation payments exceed three times the employee’s average pay over the preceding five years. Excess parachute payments do not have to reach $1 million before becoming subject to the excise tax – this portion is separate from the $1 million excise tax. Also of note, if a separation payment exceeds three times the employee’s preceding five-year average, the excise tax will apply to everything over one times the employee’s five-year average.
For example, a university president’s average total compensation for the five years preceding his termination has been $200,000; upon his termination he is given a lump sum severance payment of $750,000. Because the $750,000 severance payment exceeds three times his average pay for the preceding five years (3 x $200,000 = $600,000), then $550,000 ($750,000 minus one times his average pay of $200,000) of his severance will be subject to the excise tax, resulting in a 21% employer-paid tax of $115,500. This outcome applies even though his total compensation for the year is under $1 million.
Like the $1 million excise tax, there are some exclusions from the calculation of an excess parachute payment, including distributions from 401(k) plans, 403(b) plans, and both governmental and non-governmental 457(b) plans. This appears to represent a distinction between the $1 million excise tax and the parachute payment excise tax in that a distribution from a non-governmental 457(b) plan would not be considered a parachute payment, but could nonetheless be subject to an excise tax if the distribution combined with other compensation paid during the year exceeds $1 million.
A parachute payment similarly does not include any payment to a licensed medical professional to the extent that such payment is for the performance of medical services.
Finally, the statute effectively limits the excess parachute payment excise tax to employees who are highly compensated employees under the qualified plan rules (currently those earning over $120,000 in a year). For instance, an employee who has consistently earned $75,000 per year would not be subject to the excise tax even if they received a severance payment of more than $225,000 (three times their five-year average).
Although the new year has just begun, and the IRS will almost certainly clarify some of these concepts in forthcoming regulations, tax-exempt and governmental employers should immediately determine who was a “covered employee” for 2017, and who is likely to be in 2018, and whether any existing or pending pay arrangements could trigger one of the new excise taxes. Affected employers should also begin compiling a running list of individuals who are covered employees for reference in future years.
Finally, although existing compensation arrangements might be eligible under a grandfathering rule, newly entered arrangement almost certainly will not be, so employers must begin factoring in these new rules in negotiating new employment agreements or deferred compensation plans.
The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2020.