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Tax Cuts and Jobs Act—Executive Compensation Provisions

Tax Cuts and Jobs Act—Executive Compensation Provisions

The Tax Cuts and Jobs Act (TCJA) ended up with only two provisions directly affecting tax-exempt employer executive compensation. All other tax-exempt executive compensation proposals were eliminated from the final bill.

The two provisions that passed are the excise tax on compensation in excess of $1 million, and the excise tax on parachute payments. Both excise taxes are paid by the employer, and both are at a regular corporate tax rate from time to time in effect. Under TCJA, the current corporate tax rate is 21%, resulting in a current excise tax rate of 21%.

Key elements of the excise tax on compensation in excess of $1 million are:

  • The tax applies to the top 5 highest-compensated employees.

  • More than 5 may be included in the top-5 group. The top-5 group 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.

  • Compensation is generally compensation as defined for income tax withholding purposes.2  This is primarily box 1 compensation reported on the W-2. In this regard:

    • 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.

    • 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 changed 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.

  • Compensation paid a licensed medical professional (e.g., a doctor or a nurse) for medical services rendered is excluded from the calculation.

  • There is a reasonable argument that compensation for medical services counts for determining who is in the top-5 group, but excluded in calculating the excise tax. This could push executives out of the top-5 group, replaced by physicians whose compensation may avoid the taxes. This seems an unintended result that Congress might address in technical corrections.

  • 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).

 Key elements of the excise tax on parachute payments are:

  • The excise tax applies with respect to any employee who is highlycompensated under the IRS qualified plan definition (i.e., $120,000 in 2018). Covered employees are limited to the top five highly compensated group.

  • The golden parachute rules that apply to taxable employers only apply to severance received in connection with a change of control. The new excise tax for tax-exempt employers applies to all payments that are contingent on separation from service whether or not there has been a change of control.

  • Unlike the golden parachute rules, no penalties are imposed on the employee who receives the parachute 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, and is to be calculated on “rules similar to” the golden parachute rules.

  • 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.

  • 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 golden parachute provisions for taxable employers include in the calculation the value of any accelerated vesting of deferred compensation. A default value is 1% for each month that vesting is accelerated. (For example, if a benefit is to vest in 5 years and the vesting is accelerated for a participant who is terminated, 60% of the benefit would count as a severance payment.) It remains to be seen whether a similar provision will be added to the new excise tax for tax-exempt employers.

 Please let us know if you have any questions about these new provisions.

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