Summary
Deferred compensation arrangements maintained by tax-exempt organizations must already comply with certain provisions of the Internal Revenue Code of 1986, as amended (“Code”), including the deferred compensation rules under both Code Sections 409A and 457(f). Now, the Tax Cuts and Jobs Act of 2017 has added new rules likely to have a significant impact on certain (generally larger) tax-exempt organization’s compensation expense for both current remuneration as well as deferred compensation and separation arrangements.1
The new provision (Code Section 4960) is already in effect and will require a tax-exempt employer to pay a 21% excise tax on certain payments. While existing Code restrictions have generally applied only to officers and highly-compensated employees of tax-exempt organizations, this new provision applies to an organization’s five (5) highest paid employees, determined on a controlled group basis – called “covered employees.” The term “covered employees” may include both executives, as well as individuals serving in certain high-paid positions (such as coaches, deans, department chairs, etc.). Once an employee is a covered employee, the employee remains a covered employee for future years, including after termination of employment. This means that the covered employee group will likely expand beyond five (5) over time, affecting payments in years after employment termination.
Beginning in 2018, if the payment (or taxation, if earlier) of remuneration to any covered employee exceeds $1 million in a calendar year, the employer will incur an excise tax of 21% on the excess. The 21% excise tax also will apply to excess parachute payments provided to covered employees upon separation from service who also qualify as highly compensated employees under the Code. An excess parachute payment can exist if the present value of compensation paid upon employment termination exceeds three (3) times the highly compensated employee’s base compensation (average of five (5) full years preceding the year of separation). If the payment is an excess parachute payment, the tax-exempt organization will be subject to the 21% excise tax on the amount that exceeds one (1) times the highly compensated employee’s base compensation.
It may be difficult to avoid these excise taxes. For example, assume that compensation is scheduled to be paid in installments after separation from service. The installment payments are all vested upon separation from service, and, therefore, treated as taxable income at that time. Depending on the term of the installment payments and applicable discount factors, the present value of future installment payments could substantially exceed three (3) times base compensation, resulting in an excess parachute payment. Double excise tax consequences may be avoided since the amount of any excess parachute payment is excluded from the remuneration taken into account with respect to any excise tax on calendar year income exceeding $1 million.
Payments to medical professionals for medical care-related services are excepted from the excise taxes. Compensation to medical professionals for work that does not involved medical care are not exempt.
There does not appear to be any transition rule for agreements already in place. Guidance on the application of these new excise taxes may be necessary since, while analogous to the current rules applicable to public companies and golden parachute provisions applicable to for-profit corporations, there are differences. The excise tax can apply even if the compensation has been deemed to be fair and reasonable compensation or the presumption of reasonableness has been established under the intermediate sanctions rule.
Applicable tax-exempt organization should take the new 4960 excise tax into consideration in designing new compensation arrangements. All existing compensation arrangements should be reviewed to determine whether the excise tax may apply now or in the future. Modifying existing deferred compensation arrangements may not be possible, even with the covered employee’s consent, without violating other applicable Code restrictions. If the excise tax will apply either to current remuneration or deferred compensation, this additional cost should be considered for compensation expense budgeting.
1. We previously discussed this excise tax along with a number of other provisions of the Tax Act that impact tax-exempt organizations: See: http://bit.ly/2C1mjRy
