Tax Services • Published 2/21/2018 New Excise Tax on Executive Compensation for Tax Exempt Organizations

The Tax Cuts and Job Act of 2017 adds a section that imposes a 21 percent excise tax on executive compensation in excess of $1 million and on severance pay in excess of certain limits paid to “covered employees.”  While administrative guidance has yet to be issued on this provision, tax-exempt employers should start to consider how this new excise tax will impact their organization and plan accordingly.

Who Does This Apply to?

The excise tax applies to compensation paid by an “applicable tax-exempt organization” including the following:

1. Any organization exempt from tax under Section 501(a)
2. A farmer’s cooperative exempt from taxation
3. A political organization described in Section 527(e)(1)
4. An instrumentality of any branch of government (Federal, State, or local government) with income excluded from tax under Section 115

While the first three organizations are readily identifiable, a governmental instrumentality can be hard to identify. Because the Internal Revenue Service (IRS) has not distinguished the operations integral to government from governmental instrumentalities, it will leave many governmental organizations to face the uncertainty whether they are integral parts of government (exempt from this provision) or instrumentalities (subject to this provision).

Who is a Covered Employee?

A “covered employee” is any current or former employee among the five highest compensated employees of the organization during the current tax year or any preceding tax year beginning after December 31, 2016. In future years, even if an employee is no longer one of the “top” five highest paid, they will still be considered a covered employee. So once a covered employee, always a covered employee. Therefore, an organization may have more than five covered employees in one tax year.

Deferred Compensation Agreements

Through the use of nonqualified deferred compensation plans in conjunction with non-compete agreements that comply with the proposed regulations under Code Section 457(f) it may be possible for tax-exempt employers to minimize their risk of this new excise tax. Code Section 457(f) applies to nonqualified deferred compensation plans of tax-exempt organizations and governmental employers.

Remuneration Over $1 Million

Beginning in 2018, tax-exempt employers will have to pay a 21 percent excise tax on: (i) “remuneration” in excess of $1 million paid to a “covered employee” in any tax year; and, (ii) any “excess parachute payment” paid to a covered employee.

The term “remuneration” includes all compensation paid to a covered employee and subject to income tax withholding. Any compensation that is subject to a risk of forfeiture, is not subject to income tax withholding, and therefore is not includable in determining remuneration for a tax year. While regular compensation and bonuses will count towards the $1 million limit, non-vested benefits under a nonqualified deferred compensation plan will not count towards limit. Furthermore, this provision references the risk of forfeiture provisions under 457(f), which includes non-compete agreements.

The term remuneration does not include compensation paid to a licensed medical professional for providing medical services. So the excise tax will not apply to a physician rendering medical services to a tax-exempt hospital. However, the excise tax will apply to a physician in an administrative position. The law is not clear on whether the excise tax will continue to apply to the physician in the event that they return to providing medical services. The law does also not apply to those that are not considered to be “highly compensated employees” under the definition for qualified plans.

Excess Parachute Payments

“Excess parachute payments” means the compensation paid to a covered employee upon that employee’s separation from service, in an amount that exceeds three times the covered employee’ s base amount. The base amount is an average of the employee’s compensation over the over the prior five years. If you have ever worked with golden parachutes you will note the similarities, but this excise tax applies to all parachute payments not just those as a result of a change in control. The excise tax is applied separately to excess remuneration and excess parachute payments. Excess parachute payments are not added in determining remuneration and excess parachute payments that do not exceed $1 million but exceed three times the base amount are subject to the excise tax.

Non-Compete Agreements

How can nonqualified deferred compensation plans help the situation? The proposed 457(f) regulations allow non-compete agreements to create a substantial risk of forfeiture within the context of a nonqualified deferred compensation plan established by the tax-exempt entity. Those familiar with 409A, will note that this is diametrically opposed to allowing non-compete agreements to create a substantial risk of forfeiture in the for-profit world. A non-compete agreement imposed by a tax-exempt entity will create a substantial risk of forfeiture if the following factors are present:

• The executive’s compensation is specifically conditioned, in writing, upon compliance with the non-compete agreement
• The agreement is enforceable under state law
• The tax-exempt employer can demonstrate that it has a bona fide interest in enforcing the agreement
• The tax-exempt employer makes reasonable efforts to ensure compliance
• The employee does not have the right to provide services to a competitor

Therefore, a nonqualified deferred compensation plan coupled with a non-compete agreement that terminates after a separation from service may be used keep current remuneration under the $1 million limit by paying out at a future date.

This arrangement can even be used with elective deferrals, with a slight modification. The proposed regulations allow elective deferrals to be made to a 457(f) plan so long as: (i) theater for election is made in writing before the calendar year in which the compensated services will be performed, (ii) the executive is required to perform services for at least two additional years, and (iii) the compensation to be paid when the risk of forfeiture lapses is at least 25 percent more than the compensation that would’ve otherwise been paid. This approach, which requires the executive’s participation, could be used when negotiating a new compensation package.

Begin Preparing

Tax-exempt organization should begin reviewing their compensation agreements and consider the impact of this new excise tax for tax years beginning after December 31, 2017. Tax-exempt organizations will want to identify their covered employees and how they will continue to track these employees going forward.  

If you have any questions on the new excise tax on executive compensation and how you can begin preparing your organization for the changes, please contact us.