By: James F. Reda and Toni Dolby
Added with permission from Journal of Compensation and Benefits
Due to the passing of Tax Cuts and Jobs Act (“TCJA”) on December 22, 2017 (effective January 1, 2018), management of tax-exempt organizations’ compensation programs just got more complicated and expensive. In addition to the intermediate sanctions rules that have been in effect for decades, the TCJA imposes two new possible excise taxes of 21 percent each on compensation above $1 million and on excess parachute payments. The excess amounts of compensation can fall under both the intermediate sanctions and the excess compensation, resulting in a massive tax bill for the participant and for the exempt organization, and personal liability for the employees and directors.
The information in this article is based on the TCJA that was passed and is effective today. There is a technical corrections bill that is working its way through Congress, which if passed, will clarify and/or slightly change the provisions. In addition, the IRS must provide guidance on how to apply the tax code. Moreover, these final rules will be further clarified as they are implemented across the multitude of taxexempt organizations. This process may extend through the remainder of 2018 and beyond.
These new excise tax rules are the only two provisions directly affecting tax-exempt employer executive compensation. All other taxexempt executive compensation proposals1 were eliminated from the final legislation.
The two provisions are the excise taxes on (a) current compensation in excess of $1 million, and (b) certain excess severance payments. Both excise taxes are paid by the employer, and both are at the regular corporate tax rate in effect at the time. The current corporate tax rate is 21 percent, resulting in a current excise tax rate of 21 percent.
For those tax exempt organizations that provide compensation in excess of $1 million to a top 5 highest-compensated employee or have a severance program that may result in payments that equal or exceed three times any “highly compensated” employee’s 5-year average W-2 taxable income, remedial actions may be necessary.
These new excise tax rules are in addition to the intermediate sanctions currently in effect. Thus, compensation in in excess of $1 million if also found to be in excess of reasonable fair market value could potentially trigger both the intermediate sanctions and the excise tax amounts. However, since intermediate sanctions require that the unreasonable compensation be repaid by the employee, the repayment could allow the employer to avoid (or be entitled to a refund of) the excise tax.
It is important to note that there are certainly instances where compensation above $1 million isn’t necessarily unreasonable. These situations could include non-profit executives with pay in line with other non-profit organizations or similar positions in general industry.
This article covers the key elements of the two situations where the new TCJA excise tax rules apply:
EXCISE TAX #1. CURRENT COMPENSATION IN EXCESS OF $1 MILLION
What is the Excise Tax and Who Pays It?
- The excise tax is 21 percent of current compensation in excess of $1 million for its highly paid executives and is paid by the tax-exempt entity.
Who is Covered?
- The excise tax applies to the top 5 highestcompensated employees.
- More than 5 employees may be included in the top-5 group (“Top-5”). The Top-5 includes not only the 5 highest compensated in the current year, but also any current or former employee who was in the Top-5 in a prior year. The determination begins with 2017 compensation even though the excise tax only applies to compensation in 2018 or later. The following exclusion applies:
- Compensation paid to a licensed medical professional (e.g., a doctor or a nurse) for medical services rendered is excluded from the determination of the Top-5.
- However, there is a reasonable argument that compensation for medical service counts for determining who is in the Top-5, but excluded for purposes of calculating the excise tax. This interpretation could push executives out of the Top-5 group, replaced by medical professionals. This may be an unintended result that Congress might address in technical corrections.
How is Compensation Defined?
- Compensation is generally defined as “Box 1” compensation reported on the W-2 earnings statement for income tax withholding purposes.2 In this regard:
- Deferred Compensation counts towards the $1 million threshold when it is no longer subject to a substantial risk of forfeiture as defined under Section 457(f). For example, deferred compensation that accumulates over many years and vests in a single year is all counted as compensation in the year it vests.
- Compensation paid by all related organizations is aggregated and the excise tax allocated among the organizations by the percentage of compensation provided. Related organizations are those the employer controls or who control the employer, and supported and supporting employers under Section 509(a)(3).
How Important is Incidence of Payment and Vesting of Compensation?
- Under the Section 457(f) short-term deferral rule, some deferred compensation that vests late in the year can be paid and taxed in the following year.
- Unless clarified by regulations, that compensation still counts for purposes of the $1 million excise tax in the year it vests, not in the year it is taxed and paid. For example:
- An executive vests in $500,000 of deferred compensation in December 2018. The compensation is paid and taxed in January of 2019. The statute requires the $500,000 to be counted toward the $1 million threshold in 2018.
- Earnings on previously vested and taxed deferred compensation are not taxed until the earnings are paid. However, those earnings count toward to the $1 million threshold each year as they accrue.
EXCISE TAX #2. EXCESS SEVERANCE PAYMENTS
- Applies to all forms of severance payments. Unlike the parachute tax that applies to taxable entities, which only applies to a change in control of ownership, the tax exempt excise tax applies to all forms of severance payments.
- 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”.
- 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 (which is 21% and is payable by the employer).
- The excise tax applies with respect to any employee who is highly compensated under the IRS qualified plan definition (i.e., $120,000 in 2018). Covered employees are not limited to 5 employees, such as in the current compensation rule.
- Expressly excluded from the calculation are benefits under qualified plans, tax-sheltered annuities, simplified employee pension plans, and 457(b) plans, and payments for medical services by a licensed professional.
- The TCJA excise tax on excess severance compensation paid by taxexempt employers differs from the IRS Code Section 280G golden parachute provisions for taxable employers, as follows:
MORE ON INTERMEDIATE SANCTIONS
As mentioned earlier, the two new excise tax rules are in addition to the intermediate sanctions currently in effect.
“Intermediate sanctions” is a term used in regulations enacted by the United States Internal Revenue Service (“IRS”) that is applied to nonprofit organizations who engage in transactions that inure to the benefit of a disqualified person within the organization. These regulations allow the IRS to penalize the organization and the disqualified person receiving the benefit. Intermediate sanctions may be imposed either in addition to or instead of revocation of the exempt status of the organization.
These regulations allow the IRS to impose penalties when it determines that such officials have received excessive compensation from their organization. The penalties can be severe as shown in the table below:
It is therefore important for tax-exempt organizations to be aware of the regulations and, when appropriate, to take the necessary compliance steps. To determine whether or not your organization is in compliance, the IRS has issued a three-part test:
POSSIBLE REMEDIAL ACTIONS
Organizations at risk of either excise tax should consider the following possible compensation plan structures:
- Rolling Long-Term Incentive Plan Structure:
- A possible change to consider for Long- Term Incentive plans would be to move to a rolling plan structure where a cycle would end each year and a new cycle begins.
- This does not decrease compensation but would avoid large payouts at the end of a plan cycle (e.g., every 3- to 5-years) and instead result in annual payouts as each cycle ends.
- This approach could prevent an executive’s compensation from exceeding $1 million in any one year and/or minimizing the number of executives’ compensation subject to the excise tax as fewer executives would move into the “Top 5” group by making compensation more consistent year over year.
- Vesting non-qualified deferred compensation over shorter periods. Many organizations are moving to a 3- to 5-year vesting cycle as it divides the non-qualified program into smaller bites, which will not decrease the ben efit provided but will minimize the payout amount occurring in any one year.
- Initiating New Loan-Based Split Dollar Life Insurance Arrangements:
- Another way to reduce the impact of TJIA is implementing a loan-based split dollar program as a method to provide an opportunity for wealth accumulation.
- The main concept of this method of delivering compensation to a NFP executive is for the employer to make a loan to an executive which he/she uses to purchase a life insurance policy.
- As long as program is structured appropriately the executive may take loans from the life insurance policy which are not taxable and therefore do not appear on the executive’s W-2 statement. The employer recovers the loan principal plus a built-in-interest payment (minimum of the federal Applicable Federal Rate (AFR)) at a later date, typically upon the death of the executive, since the death benefit is typically a multiple of the loan, which was used to pay the insurance premium.
Boards of tax-exempt institutions will need to carefully evaluate terms and conditions for both current and deferred compensation (including severance plans and agreements) that would cause compensation to exceed the new excise tax thresholds. This review may result in significant restructuring of compensation philosophies, performance incentive plans, and nonqualified deferred compensation arrangements (including severance plans and agreements). As before, there is a concurrent need to assess the effect of the new tax rules on availing the safe harbor threshold for intermediate sanctions and accurate reporting on the Form 990.
Tax-exempt organizations should evaluate the filing of their Form 990 to ensure that compensation is correctly classified so as to, if possible, reduce the effect of the new tax law. In general, tax-exempt organizations are required to annually file Form 990, which is an informational tax return that provides an overview of the organization’s activities, governance and financial information. A big change is that under the new tax law, a tax payment may be due.
1Examples of provisions proposed but not passed include replacing 457(b) and 457(f) plan provisions with new Section 409B; deleting Section 409A; integrating the 457(b) deferral limit with 403(b) and 401(k) limits; subjecting 457(b) plans to early withdrawal penalties; imposing an employer-level tax under the intermediate sanction provisions; eliminating the rebuttable presumption of reasonableness; eliminating tax-deferred earnings on after-tax deferrals; and taxing severance pay as deferred compensation.