New Excise Tax On Excess Compensation Paid By Tax-Exempt Employers

by Fox Rothschild LLP
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The 2017 Tax Cut and Jobs Act, signed into law on December 22, 2017, added Internal Revenue Code section 4960, which imposes a 21% excise tax on annual compensation in excess of $1 million paid by an “applicable tax-exempt organization” to a “covered employee.” In addition, the excise tax applies to “excess parachute payments.” The excise tax is payable by the tax-exempt organization.
 

Effective Date. The new excise tax is effective for tax years beginning after 2017. There is no grandfather or transition rule for existing arrangements, such as Section 457(f) retirement arrangements.

Applicable Tax-Exempt Organization. An “applicable tax-exempt organization” includes any entity that is exempt under Code section 501(a), a farmers’ cooperative under Code section 521(b)(1), and a governmental entity whose income is exempt under Code section 115(l). It is not clear that a public university would be included, because its exemption relies on the doctrine of intergovernmental immunity, not Code section 115(l).

Covered Employee. Under this new excise tax provision, a “covered employee” is each of the five highest paid employees for the year, and any person (including a former employee) who was a covered employee for any tax year after December 31, 2016. Thus, a tax-exempt employer must determine its covered employees for their 2017 tax year, which is one year prior to the effective date of the new excise tax. Once an employee is a covered employee, that person is a covered in employee in all subsequent tax years.

Compensation Counted Towards the Limit. Compensation subject to the excise tax generally includes all taxable wages subject to tax withholding, other than Roth contributions to a qualified plan. This includes any amounts that become taxable under a Code section 457(f) retirement arrangement. In addition, a tax-exempt employer must include compensation paid to the covered employee by any “related entity.” A person or government entity is considered to be related to the tax-exempt organization if the person or entity:

  • controls, or is controlled by, the applicable tax-exempt organization;
  • is controlled by a person, or persons, that control the organization;
  • is a supported organization under Code section 509(f)(3);
  • is a supporting organization under Code section 509(a)(3); or
  • if the organization is a VEBA under Code section 509(c)(9), establishes, maintains, or makes contributions to that VEBA.

Compensation subject to the excise tax does not include wages paid to a licensed medical professional (including a veterinarian) for medical or veterinary services performed by the professional.

Excess Parachute Payments. The new 21% excise tax is also imposed on “excess parachute payments.” An excess parachute payment arises if an employee’s severance payments exceed three times the employee’s “base amount.” An employee’s base amount is the average annual taxable compensation from the employer for the employee’s prior five calendar years (or shorter period of employment). If the severance payments exceed three times the base amount, then everything in excess of one times the base amount is an excess parachute payment subject to the 21% excise tax.

IRS’ Anti-Abuse Authority. New Code section 4960(d) gives the IRS authority to issue regulations “as may be necessary to prevent avoidance of the tax under this section, including regulations to prevent avoidance of such tax through the performance of services other than as an employee or by providing compensation through a pass-through or other entity to avoid such tax.”

Next Steps. While we anticipate further guidance from the IRS in the coming months, and will update you accordingly, tax-exempt employers with employees who may receive more than $1 million of compensation during a tax year, including upon the vesting of any 457(f) arrangement, or who have a robust severance package, should determine whether they might be subject to the excise tax. One key consideration for tax-exempt employers is the impact of significant accumulated savings under a section 457(f) retirement arrangement. A modestly paid executive, who was one of the top five paid employees in any year after 2016, could easily accumulate over $1 million in a section 457(f) arrangement, and subsequently trigger the excise tax when the right to those benefits vest.

Impacted tax-exempt employers will need to identify and maintain a list of their “covered employees,” and identify the compensation that might be subject to the excise tax. A tax-exempt employer should review, and if necessary, restructure its compensation and retirement programs to minimize the potential impact of the excise tax. As with any compensation and retirement plan changes, a tax-exempt employer must consider the requirements imposed by Code sections 457(f) and 409A.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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