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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

Introduction

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.