All entities, including governmental entities, are now potentially liable for penalties[1] due to overpaying employees. For-profit companies have been at risk for losing their tax deduction for excessive salaries, with publicly-traded companies subject to a specific $1 million limit that the Tax Cuts & Jobs Act (Act) just made easier to exceed,[2] and certain nonprofit organizations have been at risk for “intermediate sanctions,”[3] but the Act also created a new Internal Revenue Code (Code) section that places tax-exempt organizations[4] and governmental entities at risk for a 21 percent excise tax for excessive compensation.[5]
Avoiding the Excise Tax. Amounts contributed to a retirement plan avoid or delay the application of these rules. Specifically, amounts contributed to and distributed from retirement plans subject to Code ss. 401(a), 401(k), 403(b), and 457(b) are not included in “compensation” that can trigger the penalty; and amounts contributed to retirement plans subject to Code ss. 409A or 457(f) (often called “nonqualified deferred compensation plans”) are not included in the assessment until those amounts are distributed or no longer subject to a substantial risk of forfeiture.
Following are some ways employers can “convert” potentially excess compensation into retirement plan contributions to avoid penalties. For a more detailed explanation, see the “How Retirement Plans Can Help” section of my more focused article available here.
-
Increase current salary deferrals to a retirement plan that allows it (like a 401(k), 403(b), or 457(b) plan);
-
A tax-exempt or governmental entity with only a 401(k) plan or 403(b) plan can establish a 457(b) plan to allow an additional set of salary deferrals;
-
Convert “bonus payments” to “bonus retirement plan contributions”;
-
Renegotiate for lower salaries with a corresponding retirement plan employer contribution;
-
Establish a second plan under a different Code section, for example adopting a 457(b) or 403(b) plan to go alongside a profit-sharing plan, within which to make additional contributions;
-
Use the above concepts to redirect funds into nonqualified deferred compensation plans that have no contribution limits or nondiscrimination requirements. These amounts will be included in the calculation for a later year.
Although severance pay is not the focus of this article, it is included in the assessment of whether these penalties apply, so using the above options to “convert” severance pay to retirement plan contributions may be useful, but employers should be careful because there are restrictions on how retirement plans treat and accept severance pay. Entities sponsoring 403(b) plans may have an amazing solution in their retirement plan, as 403(b) plans can accept employer contributions for up to five years following a termination of employment, although the nondiscrimination rules applicable to nongovernmental entities will make this less useful.
Assessing the Risk. The table below highlights key considerations of which employers should be aware to assess whether they are at risk. Readers focused on governmental and tax-exempt entities may want to read my more focused article, available here.
|
Factor |
Publicly-held |
Governmental & Tax-exempt |
|
Employees Who Can Trigger the Penalty |
The CEO, CFO, the 3 other highest-paid employees, and anyone who ever fell into one of these categories since 2017. This is a change from the prior rules that only looked at the CEO and the other 4 highest-paid employees. |
Tax-exempt and governmental entities and can ignore the titles and roles of their employees, as the excise tax can be triggered by any of the 5 highest compensated employees of an organization, or anyone who has ever been one of the 5 highest compensated employees since 2017. |
|
What Is At Risk |
Loss of the business deduction on the excess compensation paid to the CEO, CFO, the 3 other highest-paid employees, and any employee who ever fell within this category since 2017. |
Excise tax on the amount in excess of $1 million. The excise tax rate is applied based on the corporate income tax rate, which is currently 21%. The tax is due from the employer. |
|
What Compensation Is Considered |
All compensation, including salary, per diem allowances, bonuses, and any other amounts that the employee normally includes in income and for which the employer receives the benefit of a deduction. |
All compensation that is includable in income and generally reported on an IRS form W-2.
Doctors who also serve in administration can exclude the portion of their compensation that is paid for medical or veterinary services.
|
[1] Tax exempt and governmental entities are at risk for an excise tax. Other entities risk the loss of a tax deduction. When referring to both of these items, we refer simply to “penalties.”
[2]See Code s. 162(m).
[3]See Code s. 4958.
[4] Specifically, organizations that are exempt from taxation under Code ss. 501(c), (d), 521(b)(1), and quasi-tax-exempt political organizations described in Code s. 527(e)(1).
[5]See Code s. 4960 (“Tax on Excess Tax-Exempt Organization Executive Compensation”).
