The Tax Cuts and Jobs Act (TCJA) that was passed by Congress late in 2017 has two provisions that will affect compensation programs in tax-exempt organizations. The two provisions are the excise tax on compensation in excess of $1 million and the excise tax on parachute payments. Both of these taxes are paid by the employer and both are tied to the corporate tax rate in effect. Under TCJA, the current corporate tax rate is 21%, resulting in an excise tax rate of 21%.
Excise Tax on Compensation in Excess of $1 Million
- The tax rate applies to the 5 highest-compensated employees earning over $1 million. In subsequent years, more than 5 employees may be included in top-5 group as it will include current employees plus anyone that has been on the top-5 list in prior years. The determination will begin with 2017 compensation (even though the excise tax only applies to compensation in 2018 or later).
- Compensation is generally defined as compensation subject to income tax withholding purposes. This is primarily box 1 compensation on the W-2.
- Deferred compensation will count in this calculation as soon as it is no longer subject to a substantial risk of forfeiture (as defined under Section 457(f)). Accounts that might accumulate over a period of years will all be counted in the year in which they vest.
- Under the Section 457(f) short-term deferral rule, some deferred compensation that vests late in the year may be paid and taxed in the following year. Unless changed by regulations, that compensation will still count towards the $1 million excise tax in the year it vests (and not in the year it is taxed and paid).
- Earnings on previously vested and taxed deferred compensation will count towards the $1 million threshold each year as they accrue (even though they are not taxed until paid).
- Compensation paid to a licensed medical professional (i.e., a doctor or a nurse) for medical services rendered is excluded from the calculation. There is an argument for including medical compensation when determining the top 5 list but then excluding it for purposes of the excise tax. That approach could potentially push executives from the top 5 list because they are replaced by physicians with higher pay but are ultimately not subject to the excise tax. We expect Congress might address this situation in technical corrections.
- Compensation paid by all related organizations is aggregated and the excise tax is allocated among the organizations by the percentage of compensation provided.
Excise Tax on Parachute Payments
- The excise tax applies to any employee who is highly-compensated under the IRS’ qualified plan definition ($120,000 in 2018). Covered employees are limited to the top five highly compensated group.
- This excise tax for tax-exempt employers will apply to all severance payments that are contingent on separation from service, whether or not there has been a change in control.
- To be subject to the tax, total severance payments must equal or exceed three times the employee’s 5-year average W-2 taxable income. The 5-year average is called the Base Amount. Expressly excluded from the calculation are benefis under qualified plans, tax-sheltered annuities, simplified employee pension plans, 457(b) plans, and payments for medical services by a licensed professional.
- If total severance payments equal or exceed 3 times the Base Amount, the severance payments in excess of 1 times the Base Amount are parachute payments that are subject to the excise tax.
The potential excise taxes mean that tax-exempt organizations will need to review their compensation programs to determine if components can be restructured to avoid these taxes or if it will become necessary to budget for a 21% excise tax. For example, organizations maintaining supplemental retirement plans that vest benefits at a single age near retirement may wish to consider a periodic vesting approach instead. Gallagher Integrated consultants are available to discuss your specific situation and answer any follow-up questions that you might have.
Additional information from our outside counsel (Sherman & Patterson) can be viewed here.
If you have any questions, please contact us at 1.612.339.0919.