The bill known as the Tax Cut and Jobs Act of 2017 (the “Act”) in Internal Revenue Code (IRC) Section 4960 (specifically Sec. 13602) imposes a 21 percent excise tax on employers for any remuneration in either or both of two specific situations: amounts in excess of $1 million paid to a covered employee by an applicable tax-exempt organization for a taxable year, and/or any separation or “parachute” payments made to a highly-compensated employee (defined by the IRS as greater than $120,000 for 2018) terminating employment that is equal to or greater than three times the average W-2 earnings of that individual for the five years prior to the year of termination.
This new regulation should not be confused with the excise tax levied on executives and the organization for excess benefit transactions under the IRS Intermediate Sanctions (IRC 4958) which continue to be in effect. The focus here is on compensation in excess of certain amounts specified in the new regulations. An organization’s ongoing adherence to guidance for the Rebuttable Presumption of Reasonableness found in IRC 4958 is still very important, but will not invalidate the provisions of the new regulations.
Many organizations may focus on the $1 million compensation amount, and thus quickly dismiss any concern over it. However, they may be surprised that the separation payment provision may impact a large group of employees making much less than $1 million, resulting in an excise tax on the organization for all highly-compensated employees. Failure to recognize this may result in a rude awakening when those employees depart.
Let’s start with some basic information:
All tax-exempt organizations (including governmental entities and farming cooperatives) are subject to these rules for tax years beginning after Dec. 31, 2017.
- The five most highly-paid employees earning in excess of $1 million in the current year or in any prior year beginning after Dec. 31, 2016. Once an individual is a covered employee they will always remain a covered employee. The only exception is for licensed physicians, nurses or veterinarians (or that portion of compensation paid to an individual for providing these specific services).
- Any highly-compensated employee (per IRC definition – at or above $120,000 annual compensation for 2018) receiving a separation from service payment equal to or greater than three times the employee’s five-year average compensation.
- All forms of direct remuneration reportable on an employee’s W-2 are included in the determination of the $1 million amount except qualifying contributions to a Roth IRA (or payments for the licensed professionals described above). See Laura Kalick’s article on page 1 for more details.
- The present value of separation or parachute payments made to a highly-compensated employee that are contingent upon a separation from employment, with certain amounts being excluded including qualified retirement/retirement savings plans (i.e. 401(k), 403(b), Simplified Employer Pension Plan), and 457(b) plan amounts).
Application of Excise Tax:
- Compensation in excess of $1 million – the employer is subject to a 21 percent excise tax on any includable compensation in excess of $1 million.
- Separation/parachute payments – if the payment is equal to or greater than three times the employee’s “Base Amount”, the employer is subject to a 21 percent excise tax on any amount in excess of a highly-compensated employee’s Base Amount:
- Base Amount – the average of the employee’s earnings for the five years ending prior to the separation of service
- Tax – the employer is subject to a 21 percent excise on the difference between the present value of the separation payment and the Base Amount (not three times the base amount). This provision mirrors one used by the IRS in for-profit organizations (280(g)). It is frequently misinterpreted to mean up to three times current compensation with painful consequences. Being off by just $1 can trigger exposure to the full amount over the Base Amount.
- It is possible that compensation plus the present value of a parachute payment could trigger the 21 percent excise tax on both compensation in excess of $1 million, as well as the applicable portion of a separation payment.
All tax-exempt organizations would be well-advised to undertake a thorough examination of compensation arrangements for all highly-compensated employees. This should include even those making less than $1 million who might be impacted under a parachute payment scenario. This examination should include:
- A review of all includable compensation amounts to identify employees, if any, that may be a covered employee over the $1 million threshold amount in current pay for tax years beginning after Dec. 31, 2017. Any compensation paid to these individuals in excess of $1 million annually will be subject to the 21 percent excise tax going forward.
- An examination of all compensation arrangements now in effect for all highly-compensated employees. This should focus on all employment agreements, non-qualified retirement arrangements, incentive plans, severance arrangements, and retention plans. Actual or potential payments that might arise under a variety of foreseeable scenarios should be plotted out on a year-by-year basis and studied to identify potential instances where an excise tax scenario may arise.The complexity of these IRS and ERISA regulations greatly restrict the actions that might be taken to eliminate or minimize potential excise tax exposure identified in the review of present compensation levels or potential parachute payment scenarios. There may be changes that could address issues that are discovered, but they must be carefully explored.
Most formal compensation arrangements and plans used by tax-exempt organizations are subject to the Employee Retirement Income Security Act (ERISA), IRC 457 and 409A regulations. As a matter of good practice, all of these arrangements should be reviewed by legal counsel to ensure compliance with applicable provisions of these and any other requirements. Errors contained in these documents or administering them may have adverse tax consequences to employees as well as the organization. If not done so recently, now is a crucial time to check all documents.
There is not sufficient space in this article to adequately cover the issues involved in changes to any existing arrangements. Qualified legal counsel is essential to ensure that any changes considered do not violate these regulations. Similarly, any new compensation arrangements or plans for highly-compensated employees must also be examined and structured to ensure compliance and minimize unnecessary exposure to the excise taxes on excess compensation.
By BDO USA, LLP Nonprofit Practice Leaders; This article originally appeared in BDO USA, LLP’s “Nonprofit Standard Newsletter” (April, 2018). Copyright © 2018 BDO USA, LLP. All rights reserved. www.bdo.com. Warren Averett is an independent member of the BDO Alliance USA. This article was borrowed with permission from BDO USA, LLP