Under the Tax Cuts and Jobs Act (TCJA), tax-exempt entities are subject to two new taxes on executive compensation paid to covered employees. In a nutshell, The TCJA imposes on tax-exempt organizations a 21% tax on certain payments to covered employees that are contingent upon the covered employee’s termination of employment (the Parachute Tax). In addition, tax-exempt entities are subject to a 21% tax on remuneration paid in a tax year to any covered employees that exceeds $1 million (the Excess Compensation Tax). The taxes are coordinated, so that the Excess Compensation Tax does not apply to an amount to which the Parachute Tax applies. Tax-exempt entities need to pay close attention to these provisions of the TCJA because:
- Even a relatively small tax-exempt entity can be subject to the Parachute Tax.
- Many common retirement and severance arrangements (that have been created to accommodate the special timing rules applicable to compensation paid by tax-exempt entities) are likely to cause those entities to be subject to the Excess Compensation Tax.
We have provided our initial answers to some frequently asked questions, below, in order to help our clients assess the impact of the new law. Please note, however, that each situation must be independently reviewed and that the Internal Revenue Service (IRS) is likely to publish additional guidance and regulations that could clarify or change some of the answers to these frequently asked questions.
To which tax-exempt entities do the new taxes apply?
The new taxes are imposed under Section 4960 of the Internal Revenue Code (the Code) which applies to the following types of entities:
- Entities exempt from tax under Code section 501(c), Code section 501(d), and Code section 401(a). These sections include most tax-exempt charities and organizations.
- Any farmers’ cooperative organization described in Code section 521(b)(1).
- Entities that have income excluded from taxation under Code section 115(1). Code Section 115(1) provides that gross income does not include income derived from the exercise of any essential governmental function and accruing to a state or political subdivision.
- Any political organization described in Code section 527(e)(1).
Although this list appears to be relatively straight-forward, it is unclear whether the reference to Code section 115(l) is intended to refer to public universities and similar organizations that may or may not derive their tax exemption from Code section 115(l). Any entities that may fall into this category should discuss the application of the statute in detail with their counsel.
Who is a covered employee?
The term “covered employee” means the five highest compensated employees (including former employees) of the organization for the taxable year. Tax-exempt organizations need to make this determination for each taxable year beginning after December 31, 2016 (although the new taxes are effective only for taxable years beginning after December 31, 2017). The statute also includes a once-a-covered-employee, always-a-covered-employee rule. As a result, tax-exempt entities will need to continue to track anyone who was ever considered a covered employee (starting with the determination based upon the 2017 tax year).
What is an “Excess Parachute Payment” for purposes of the Parachute Tax?
Determining how much, if any, compensation is subject to the Parachute Tax will require complicated calculations and may require detailed interpretations of the new statute. In simple terms, there is a compensation threshold (equal to three times the “base amount” – described below) to determine whether the Parachute Tax is triggered. If the Parachute Tax is triggered, the amount of the tax is calculated on the parachute payments in excess of the covered employee’s base amount. The covered employee’s base amount is generally the average of the last five years of the covered employee’s Form W-2 compensation. If the total present value of all payments contingent on the employee’s separation from employment exceeds the threshold, then the tax is triggered. If the tax is triggered, it applies to the payments contingent on the covered employee’s separation from employment in excess of the base amount (not three times the base amount) – these are the Excess Parachute Payments.
For example, if a covered employee’s base amount is $130,000, then that covered employee’s threshold is $390,000. If that same covered employee receives payments contingent on the covered employee’s separation from employment with a total present value of $400,000, the Parachute Tax is triggered. The amount of the Parachute Tax is then determined on the contingent payments in excess of the base amount, which in this example would be $270,000 (this is the Excess Parachute Payment) – resulting in a tax to the tax-exempt organization of $56,700 (21% of $270,000). Please note that the calculation is more complicated than is portrayed by the example.
What payments are considered contingent on the employee’s separation from employment for purposes of the Parachute Tax?
The statute applies to payments in the nature of compensation that are contingent on the covered employee’s separation from employment with the employer. There are not any details regarding what it means for a payment to be “contingent” for purposes of the Parachute Tax. Presumably this concept would include any severance agreements and promises. It is less clear as to whether this concept will capture nonqualified deferred compensation that is intended to be for retirement purposes.
The closest analogy to the “contingent” concept is the rules under Code section 280G that apply to payments that are considered contingent upon a change in control. Under the detailed Code section 280G regulations, “…a payment is treated as contingent on a change in ownership or control if the payment would not, in fact, have been made had no change in ownership or control occurred, even if the payment is also conditioned on the occurrence of another event.” The Code section 280G regulations broaden this concept even further, capturing many payments that would not obviously be contingent upon a change in control. Applying the Code section 280G concept by analogy would result in a fairly broad rule that would likely capture many retirement oriented arrangements. We recommend that tax-exempt organizations work closely with legal counsel to look at all compensation arrangements, not just severance arrangements, in evaluating the Parachute Tax.
Is any compensation excluded from the definition of Parachute Payment for purpose of the Parachute Tax?
Yes. The following payments are not considered Parachute Payments.
- Amounts paid to or from qualified retirements plans (such as Code section 401(k) plans).
- Amounts paid to or under an annuity contract described in Code section 403(b).
- Amounts paid to or from a plan described in Code section 457(b),
- Amounts paid to a licensed medical professional (including a veterinarian) to the extent that such payment is for the performance of medical or veterinary services by such professional.
- Amounts paid to an individual who is not a highly compensated employee (HCE) as defined in section 414(q). For 2018 the threshold for determining HCE status is $120,000 (this number is indexed annually).
These exclusions effectively exempt non-HCEs and medical professionals (providing medical services) from the Parachute Tax, but it will be important to track the details and timing for such determinations when the IRS issues more detailed guidance.
What is “Remuneration” for purposes of the Excess Compensation Tax?
The term “Remuneration” means wages other than designated Roth contributions. Remuneration is treated as paid when there is first no longer a substantial risk of forfeiture as defined under the Code section 457(f) rules. Under those rules, there is no longer a substantial risk of forfeiture when there is no further requirement to provide substantial future services. Remuneration also includes any remuneration paid with respect to employment of such employee by any related person or governmental entity. If remuneration from multiple employers is taken into account, each employer is proportionately liable for the tax. Remuneration does not include amounts to a licensed medical professional (including a veterinarian) which is for the performance of medical or veterinary services by such professional.
Do the Excess Compensation Tax and the Parachute Tax apply to individuals providing services through another entity, a partnership, or in a capacity other than that of an employee?
Probably. The statute instructs the Secretary of the Treasury to issue regulations “as may be necessary to prevent avoidance of the tax under this section, including regulations to prevent avoidance of such tax through the performance of services other than as an employee or by providing compensation through a pass-through or other entity to avoid such tax.” The reference in this language to “other entity” could arguably extend to joint ventures and contractual arrangements with taxable entities that would not normally be subject to these taxes. Tax-exempt entities may want to address this potential liability in contracts with third party vendors that provide services to the tax-exempt entity.
Does this replace the intermediate sanctions (excess benefit transaction) rules under Code section 4958?
No. Certain tax-exempt entities are subject to rules requiring that the compensation paid to higher level employees be reasonable. If certain governance procedures are followed when a compensation arrangement is entered into, then the compensation is presumed to be reasonable. The IRS can rebut the presumption, but to do so they must develop sufficient contrary evidence to rebut the comparability data that was reviewed by the board (which is very difficult in practice). However, if the Board did not follow procedures in evaluating the comparability of such compensation with similar organizations, and if compensation payable to a “disqualified person” was determined to be unreasonable, the disqualified person is subject to an excise tax of 25% of the excess compensation and the organizational decision-makers who approved the compensation are subject to an excise tax of 10% of the excess compensation (up to $20,000). Finally, the IRS can impose an excise tax of 200% of the excess benefit if the compensation transaction is not corrected within a specified time period. Since these rules remain in effect, we recommend that tax-exempt entities subject to these rules continue to follow the rules and governance procedures provided for under existing regulations.
What should tax-exempt entities be doing at this time, and what, if any, planning opportunities are there to address these new taxes?
Tax-exempt entities subject to these new taxes should determine which employees are covered employees and evaluate their existing compensation arrangements.
It appears that the Excess Compensation Tax can be managed by ensuring that deferred and incentive compensation becomes vested over multiple years (as opposed to a large lump sum becoming vested in a single tax year).
For existing deferred compensation, retirement, severance, and incentive arrangements, this is difficult, but not necessarily impossible. Strict rules under Code sections 457(f) and 409A make it difficult to extend the vesting period (the substantial risk of forfeiture) of an existing contractual arrangement, but it can be done if sufficient additional compensation is offered as part of such an extension. Those extensions could be used, for example, to take a single large payment and have it vest over multiple future years (which might eliminate the Excess Compensation Tax). In particular, tax-exempt organizations with respect to which large amounts of compensation will become vested at the end of 2018 and early in 2019 must need to act quickly in order to apply such an extension strategy. The details and risks associated with such extensions are beyond the scope of this alert, but it is important to be aware that any regulations with respect to the new 4960 taxes might foreclose or limit such approaches.