How the Tax Cuts and Jobs Act Affects Nonprofit Executive Compensation
The Tax Cuts and Jobs Act created Section 4960 of the Internal Revenue Code that imposes a new 21% excise tax on certain tax-exempt entities (including any organization exempt under Section 501(c), (d), 401(a) or 115) on (i) the annual compensation (including benefits and deferred compensation) paid to its five (or more) highest-paid employees in excess of $1,000,000 and (ii) excess parachute payments paid to the same class of employees.
The 21% excise tax (the “Excise Tax”) is imposed on the amount of “remuneration” over $1,000,000 paid to a “covered employee” during the applicable taxable year. An individual is a “covered employee” if he or she is an employee (or former employee) who is one of the five highest compensated employees of the organization for the taxable year or was such an employee of the organization for any preceding taxable year beginning after December 31, 2016.
Remuneration, for purposes of Section 4960, means all amounts treated as wages for federal income tax withholding purposes paid to an employee for services, including the cash value of all benefits. Generally, this means that the taxable amount for determining the Excise Tax includes:
- (i) salaries, fees, bonuses, and commissions;
- (ii) the value of fringe benefits;
- (iii) amounts vested, even if not yet received, and taxable under § 457(f), related to deferred compensation; and
- (iv) amounts paid with respect to the covered employee paid by any related organization of the applicable tax-exempt organization (in which case, the excise tax is prorated among the various employers).
“Remuneration” does not include, among other exclusions from wages, (i) parachute payments (discussed below), (ii) Roth contributions, (iii) Section 457(b) governmental plan contributions, or (iv) compensation for medical services provided by medical professionals, including doctors, nurses and veterinarians.
The Excise Tax imposed on “excess parachute payments” applies to “parachute payments,” which are payments contingent upon the separation from service of the covered employee. The present value of all parachute payments does not need to be in excess of $1,000,000 to apply. Rather, a payment is considered an “excess parachute payment” if the total present value of all parachute payments exceeds three times the covered employee's average W-2 compensation over the preceding five years; the so-called, “base amount.” The excise tax applies to parachute payments to a covered employee in excess of the base amount.
Although there is both an excise tax on compensation over $1,000,000 and parachute payments, those two taxes operate independently, such that one may apply even if the other does not.
Traps for the Unwary
There are certain aspects of Section 4960 that may not be obvious at first glance:
- When an employee becomes a top-five earner, they retain that designation for life. Mergers, for example, could increase the number of executives to whom the Excise Tax applies with respect to a given organization. In other words, the excise tax could apply to the compensation of far more than five employees as Section 4960 may initially suggest.
- Although the Excise Tax only applies for tax years beginning after December 31, 2017, the measuring period for whether a person is one of the top five most highly compensated employees of a tax exempt organization begins for any taxable year beginning after December 31, 2016.
- The exception for wages paid to medical professionals is limited to the extent that those professionals provide medical services. For example, wages paid to a doctor who takes on hospital administration duties or teaching would not be exempt.
At this time, it is unclear how the IRS intends to require nonprofits to report and pay the excise tax. Nonetheless, organizations should review their compensation arrangements to determine whether there will be an impact for taxable years beginning after December 31, 2017.
Organizations must identify their “covered employees” for 2018 and 2017 and review existing executive compensation and severance arrangements to determine whether payments to any covered employees in 2018 or future years could result in the imposition of the Excise Tax, whether on remuneration or excess parachute payments. Then, to the extent possible, the organization should consider modifying such arrangements to avoid triggering the tax.