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Mar 26, 2018

The Tax Cuts and Jobs Act

A Windfall for Corporate America
A New Challenge for Non-Profit Organizations


Non-profit organizations have long faced a competitive disadvantage in their efforts to attract and retain key employees and professionals. Now they face a new challenge in the form of an excise tax on “excessive executive compensation.”

What is the Nature and Purpose of the New Tax?

Under the 2017 Tax Act, a 21% excise tax is imposed on “excessive executive compensation,” which includes:

  • Amounts paid in any tax year in excess of $1.0 million plus,
  • Any “excess parachute payments.”

The tax is imposed on the entity, not on the employee. It is intended to provide a degree of equivalence with the deduction limitation for publicly held corporations under Section 162(m).

However, many wonder why this new tax is necessary. Current tax law prohibits the inurement of the income or assets of a charitable organization to the benefit of insiders, except for “reasonable compensation” paid for services rendered. Violation of this standard could lead to revocation of the organization’s tax-exempt status, or to an excise tax on the individual.

What Organizations are Affected?

The tax applies very broadly to charitable organizations and other tax-exempt entities including; hospitals, churches, public universities, state and local governmental entities, political organizations, public utilities, farm cooperatives, credit unions and other organizations exempt from tax under 501(a).

What Employees are Covered?

The definition of a “covered employee” under Section 4960 includes more than just officers. It includes any current or former employee who is (or was) among the five highest paid in a tax year beginning after December 31, 2016. Once an individual is classified as a “covered employee,” he/she will always be considered a “covered employee.” That means the excise tax could be triggered by deferred compensation payments to a former executive after retirement.

What is “Excessive Compensation?”

Compensation is deemed to be excessive if it exceeds $1 million in any tax year, or if it meets the definition of an “excess parachute payment.” Generally, all wages reported on an employee’s W-2 are taken into consideration, including:

  • Deferred compensation when taxable upon vesting under a Section 457(f) plan (regardless of when actually paid),
  • Distributions from a non-governmental Section 457(b) plan or,
  • Compensation paid by a related or supported organization, such as a hospital and a surgical center or nursing home.

Under a “surgeons’ exception,” compensation paid to a licensed medical professional for medical services is excluded. However, amounts paid to a licensed medical professional for executive / administration duties is included.

What is an “Excess Parachute Payment?”

First, a “parachute payment” is any compensation that is contingent upon the separation from service of an employee, including; severance pay, deferred compensation that vests upon termination, and/or the continuation of health care benefits. However, qualified retirement plan benefits, distributions from a Section 457(b) plan, and payments to a licensed medical professional related to medical services are excluded.

The definition of an “excess parachute payment” is based on a simple mathematical test which compares the present value of all benefits triggered by a separation from service to an amount equal to 3 times the employee’s average annual compensation for the 5 years preceding termination. For example:

  • If the present value of deferred compensation and continuing health care coverage triggered by a separation from service was $1,500,000 and,
  • The employees’ average annual compensation for the five years preceding retirement was $200,000,
  • The benefits would represent an “excess parachute payment” (as $1,500,000 exceeds 3 times $200,000),
  • And, the organization would be subject to excise tax in the amount of $273,000 (($1,500,000 - $200,000) x 21%).

Note: The excise tax applies to an “excess parachute payment,” even if less than $1.0 million.

When Does the New Excise Tax Apply, and are There Grandfathering Rules?

The excise tax under Section 4960 applies for tax years beginning after December 31, 2017; and, there is no transition rule or grandfathering of existing agreements.

For example, it would be applicable to deferred compensation benefits under a Section 457(f) plan when vested in 2018, regardless of the date of agreement.

Are There Ways to Mitigate the Excise Tax?

Yes, there are some planning opportunities based on the facts of the specific situation. One obvious approach is to try to limit compensation subject to the excise tax in exchange for some other form of benefit that is not subject to the new rules.

For example, the value of the benefit of certain split dollar life insurance arrangements is not subject to the excise tax in contrast to deferred compensation arrangements under a Section 457(f) plan, which potentially are.

What are the Next Steps in Addressing This Issue?

The first thing a non-profit organization should do is to identify the highest paid 5 employees for tax years beginning after December 31, 2016.

In the case of a non-profit health care organization, the second step is to identify the amount of compensation paid to licensed medical professionals among the highest paid 5 employees that is related to executive or administrative duties, as opposed to the provision of medical services.

And finally, all non-profit organizations should review existing employment contracts and deferred compensation arrangements for possible applicability of the new excise tax.

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Feb 23, 2018

2016 Proposed Section 457(f) Regulations - Planning Opportunities for Non-profit Organizations


In 2007 the IRS has promised future guidance under Section 457(f) for non-profit organizations with respect to compensation planning techniques that were commonly used at that time:

  • Severance pay arrangements
  • Non-compete agreements,
  • Extension of a risk of forfeiture (so-called, "Rolling Risk of Forfeiture") and,

In June 2016 (after only 9 years), the IRS issued Proposed Section 457(f) Regulations that provide helpful guidance, and even some surprisingly good news. The Regulations are effective for years beginning after the publication of the Final Regulations; however, taxpayers can rely on the Proposed Regulations now.

Severance Pay Exemption

The Proposed Regulations provide needed clarification, and indicate that a severance pay arrangement is exempt from Section 457(f) if it meets certain requirements:

  • Separation from service must generally be involuntary
  • However, a voluntary separation from service may qualify for exemption if:
    • For "good reason," as defined in the Regulations 
    • Or during a window period
  • The payments must be made by the end of the second year following termination
  • The amount must not exceed 2 times the annualized rate of pay for the prior year:
    • Note 457(f) / 409A difference: There is no limit under the Proposed Section 457(f) rules with respect to the amount of severance pay that is exempt, whereas the limit under Section 409A is 2 times the compensation limit ($550,000 for 2018).

Non-Competition Agreement as a "Substantial Risk of Forfeiture"

Under the Proposed Section 457(f) Regulations, a non-compete agreement may represent a "substantial risk of forfeiture" and defer the timing of taxation if the agreement is:

  • In writing
  • Enforceable under applicable law 
  • There is a bona fide interest for the participant and the employer to enter into the agreement
  • And there is compliance with on-going requirements for monitoring by the organization and written verification from the participant
This clarification of the rules creates an opportunity to defer the taxation of compensation beyond separation from service, and provides the employer non-compete protection.
  • Note 457(f) / 409A Difference: This is another case of inconsistency with Section 409A, which does not recognize a non-compete agreement as a "substantial risk of forfeiture." Therefore, the deferral of compensation after separation from service under Section 457(f) must be coordinated with the Section 409A distribution rules. 

Voluntary Deferral of Compensation

In 2007, the IRS's position was that it would be irrational for an employee to voluntarily defer compensation that was already earned and vested to a substantive risk of forfeiture and, therefore, it would not recognize elective deferrals.

However, the 2016 Proposed Section 457(f) Regulations provide that the voluntary deferral of compensation will be recognized if the employee has an opportunity to earn a "materially greater" amount of compensation at the end of the vesting / deferral period. More specifically;

  • The deferral election must be made before the beginning of year of service during which the compensation will be earned,
  • The minimum amount of the benefit payable at the end of the vesting / risk of forfeiture period that would meet the "materially greater" test is 125% of the amounts voluntarily deferred, on a present value basis and,
  • The minimum period of extension of the vesting / risk of forfeiture period is 2 years, during which substantive services are provided and/or an enforceable non-compete agreement is in place.

Extension of the Risk of Forfeiture

The vesting / risk of forfeiture period may be extended using the same 125% test. In addition:

  • The agreement to extend the risk of forfeiture period must be made at least 90 days before the original vesting date and,
  • The period of extension must be at least 2 years.
  • Note 457(f) / 409A difference: If the agreement to extend the risk of forfeiture period is based on a non-compete agreement, the arrangement comply with the subsequent election rules under Section 409A (12 months prior election / 5+ year extension). 

In Summary

The 2016 proposed Section 457(f) regulations provide helpful guidance and a number of planning opportunities; subject to strict compliance with the new rules.

Hypothetical Example

The following example illustrates a one possible planning concept under the Proposed Section 457(f) Regulations:

  • Problem / Issues:
    • A non-profit organization would like to encourage the CEO to:
      • Continue working for 2 years past his normal retirement date,
      • And to enter into a consulting / non-compete arrangement for 2 years after the extended retirement date.
    • The CEO needs additional retirement savings.
  • Possible solution:
    • The CEO agrees to voluntarily defer $100,000 of his $300,000 annual salary for each of the two years of extended full-time employment, and 100% of the $150,000 annual consulting fee paid for the 2-year consulting / non-compete period.
    • Amounts deferred are credited to a deferred compensation account in the name of the CEO as is interest at the 10-year Treasury Bond rate.
    • The Organization promises to credit to the CEO's account a retention bonus in the amount of $150,000 at the end of the 2-year consulting / non-compete period.
  • Result: 
    • The CEO would continue to work full-time for two more years and part-time during a 2-year consulting / non-compete period, during which he would provide substantive consulting services and assist with the transition to the new CEO.
    • The CEO will earn an above market rate of return on the compensation voluntarily deferred to compensate for the voluntarily assumed risk of forfeiture, and add significantly to his retirement savings.

Caveat: This example is intended to illustrate a possible planning concept under the Proposed Section 457(f) Regulations. Any such arrangement must also be compliant with Section 409A, and take into consideration the new Section 4960 21% excise tax on excessive compensation - a subject for a later blog.

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