457(f) Landmine Lurks for All Tax-exempt Organizations…Even the Small Ones!
“Maybe not today. Maybe not tomorrow, but someday” … you are likely to have a golden parachute problem.
It’s not often that Casablanca and tax law intersect, but the above warning is apropos for any tax exempt organization that has a 457(f) plan. Plans of that kind are typically structured to avoid immediate income taxation for executives by deferring benefit payments until their termination of employment. No one would think this could trigger golden parachute penalties for the organization. In the wake of IRS Notice 2019-09, however, tax-exempt organizations should think again.
Today’s challenge for 457(f) plans has its genesis in Code Section 4960, which was enacted as part of the Tax Cuts and Jobs Act of 2017. This new Code section imported Code Section 280G’s golden parachute rule into the world of tax-exempt organizations. There is, however, one huge twist in Code Section 4960: the three times pay (3x) limit found in Code Section 280G only applies to amounts paid in connection with changes in corporate control. By contrast, Section 4960’s 3x limit applies to most forms of severance pay that tax-exempt organizations provide to exiting executives, not just payments relating to changes in corporate control.
1. Here are a few sobering observations drawn from Notice 2019-09:
A tax-exempt organization with an employee earning more than $125,000 in 2019 (indexed for future years) could become subject to Section 4960’s golden parachute excise tax.
- From a technical perspective, tax-exempt organizations must identify any individual within the organization who, for any year after 2016, is deemed a “highly compensated employee” (“HCE”) under the rules that retirement plans follow under Code Section 414(q).
- This means that tax-exempt organization will perpetually need to track all employees who are HCEs, in order to test their severance pay – at the time their employment terminates -- to be sure it does not exceed Section 4960’s three times pay limit (described further below).
3. Section 4960’s 3x limit is exceeded if an HCE receives “contingent payments” exceeding three times the HCE’s average W-2 income for the five calendar years ending before the year in which employment terminates. This five-year average establishes what is called “Base Amount” for Section 4960 purposes.
- Amounts that vest or are paid only because of the HCE’s involuntary termination of employment, generally count as contingent payments.
- Retirement plan benefits generally do not count as parachute payments, unless they are paid pursuant to a 457(f) plan of the kind described above.
- Nor would 457(f) benefits that vest upon death (rather than an involuntary termination) seem to count as contingent payments.
4. Section 4960 is structured in a manner that can trigger shockingly high excise taxes.
- Consider the following example. At the time an HCE is involuntarily terminated from employment, her Base Amount is $200,000. If she collects $100,000 of severance pay and $600,000 of 457(f) plan benefits (which vest due to her involuntary termination), then she will have exceeded the 3x limit by $100,000. That is, however, not the amount for which the organization must pay a 21% excise tax under Code Section 4960. Instead, the excise tax is based on the excess of her $700,000 of parachute payments over her $200,000 Base Amount. The excise tax will accordingly be $105,000 . . . which is $5,000 more than the excess over the limit!
5. There is not yet any grandfathering for amounts already accrued under existing 457(f) plans.
- Consequently, tax-exempt organizations should immediately consider their exposure to Section 4960 penalties under existing structures, in order to consider changes by which to avoid or mitigate the imposition of future excise taxes.
- Notice 2019-09 provides that “amounts includible in gross income under section 457(f)(1)(A) and any vested earnings that accrued before the effective date of section 4960 are not subject to the excise tax under section 4960.” However, many 457(f) plans are designed to avoid current income for active HCEs until they terminate employment – meaning those amounts are unlikely to qualify for the foregoing exclusion from 4960 limits.
- Note that future IRS or Treasury Department action, such as through temporary or proposed rules, could provide grandfathering relief.
6. Rolling risks of forfeiture have long been an effective tax planning device under Section 457(f) plans. Now, however, their use could “roll-up” parachute payments to levels that trigger Section 4960 problems.
- Before being allowed on a broad-based or individualized basis, rolling risks of forfeiture should be modeled for their Section 409A and 4960 implications - as should 457(f) plans generally!
Although there is no need for tax exempt organizations to panic in response to what is described generally above, there are a few responses that are worthy of consideration. First, make an immediate Section 4960 risk assessment -- because Section 4960 excise taxes could be imposed on your organization as soon as this year (2019). Second, consider design changes that mitigate any Section 4960 risks. Third, bear in mind that IRS Notice 2019-09 is likely to be refined and superseded by future regulations. Overall, the smart move involves positioning now to control your organization’s risk of today, or someday, becoming liable for Section 4960 excise taxes.
The above is intended merely to alert you, in generalized terms, to one of many planning issues that the directors of tax exempt organizations should consider. It is critical for them to make executive compensation decisions that carefully navigate the intersection of Code Sections 457, 4958, and 4960.