Excess Employee Remuneration for Tax-Exempt Organizations
Today, President Trump signed the tax bill (formerly known as "The Tax Cuts and Jobs Act") into law. The tax bill had to be renamed as the not-too-catchy "Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018" (the "Act") after the Senate parliamentarian objected to the original name. The tax bill was passed by both Chambers on December 20, 2017. Our overview of the tax bill can be read here.
Although it could have been worse based upon the Senate proposals for tax reform, tax-exempt institutions took two major hits under the Act. The first is the 1.4% excise tax on the endowment funds of certain private colleges and universities - a controversial measure, but one that by its very nature affects a limited number of entities.
The second is a more wide-ranging provision: the new section 4960 to the Internal Revenue Code (the "Code"), Tax on Excess Tax-Exempt Organization Executive Compensation. (Colleges and universities will also be adversely affected by section 4960, particularly with respect to their highly paid football ($75 million over 10 years for a recent highly publicized hire) and basketball coaches.
The overall purpose of new section 4960 is to subject tax-exempt entities such as section 501(c)(3) organizations to the same types of constraints that publicly traded corporations are subject to under 162(m) of the Code with respect to compensation paid to officers and highly compensated individuals and 280G with respect to golden parachute payments. (Note, however, that certain large privately held corporations may be subject to the limitations of section 162(m), but not to those of section 280G. Neither the Act nor the Conference Committee Report provides details of the expansion of section 162(m) to certain large privately held corporations.)
Prior to the passage of the Act, there were reasonableness constraints under section 4958 of the Code and a prohibition against private inurement with respect to executive compensation. However, no excise tax was imposed in connection to the amount of compensation paid. Under section 4960, the tax exempt employer is liable for a 21% excise tax (identical to the new corporate tax rate, and increased from a 20% in the initial proposals) on the sum of (i) any remuneration (other than an excess parachute payments) in excess of $1 million paid to a covered employee by an applicable tax-exempt organization for a taxable year, and (ii) any excess parachute payment that relates solely to separation pay to a covered employee. The excise tax on the excess parachute payment applies even if the covered employee's remuneration does not exceed $1 million. Remuneration is treated as paid when the rights to the remuneration are no longer subject to a substantial risk of forfeiture, which is based on the definition of "substantial risk of forfeiture" under section 457(f). Under section 457(f), an individual's rights to compensation is subject to a substantial risk of forfeiture if his or her rights are conditioned on the future performance of substantial services by the individual.
A covered employee is an employee (including any former employee) of the organization if the employee is one of the five highest compensated employees for the taxable year or was a covered employee of the organization for any preceding taxable year beginning after December 31, 2016.
However, there is an important carve-out in section 4960 for compensation attributable to medical services of certain qualified medical professionals. For purposes of determining whether an individual is a covered employee, remuneration paid to a licensed medical professional (including doctors, nurses and veterinarians) which is directly related to the performance of medical or veterinary services by such professional is not taken into account. Note that remuneration paid to a professional in any other capacity is taken into account. However, it is unclear how remuneration should be allocated in the case of a licensed medical professional performing multiple services for an organization, for example, a doctor performing medical services, teaching, attending medical conferences, performing medical staff peer review in the credentialing and privileging of physicians, publishing research results and new ideas in the medical literature and performing administrative work for a hospital.
Remuneration is an important term for understanding how section 4960 works. It means wages as defined for income tax withholding purposes, other than designated Roth contributions and elective deferrals to a 401(k) plan that an employee designates as not excludible from income. Remuneration includes not only remuneration by the 501(c)(3) organization itself, but also by related persons, which includes persons or governmental entities that (i) control, or are controlled by the organization; (ii) are controlled by one or more persons that control the organization, (iii) are supporting organizations or supported organizations for the taxable year with respect to the organization, as defined under section 509 (the section of the Code defining private foundations). However, if the related organization is subject to the section 162(m) limit on deductible compensation, remuneration that is not deductible under section 162(m) is not treated as remuneration under section 4960.
The excess parachute payments under section 4960 of the Code operate in a manner very similar to the golden parachute rules under section 280G, although the golden parachute rules are not tied to a change in control of the 501(c)(3) organization and also do not apply to licensed medical professionals or employees who are not highly compensated employees, defined in the same manner as under a tax qualified plan such as a 401(k) plan (compensation of $120,000 or less in 2017). An excess parachute payment is the amount by which any parachute payment exceeds the portion of the base amount allocated to the payment. A parachute payment is a payment in the nature of compensation to or for the benefit of a covered employee if the payment is contingent upon the employee's separation from employment and the aggregate present value of all such payments equals or exceeds three times the base amount. The base amount is the average annualized compensation included in the covered employee's gross income for the five taxable years ending before the date of the employee's separation from employment. Parachute payments do not include payments under a tax qualified retirement plan, a simplified employee pension ("SEP") plan, a SIMPLE IRA, a tax deferred annuity under section 403(b), or an eligible deferred compensation plan of a state or local government employer.
If more than one employer is liable for the excise tax, because the employee is employed by multiple organizations, the entities are liable for the excise tax in the ratio that their compensation paid to the covered employee bears to the total compensation. For example, if tax exempt entity A paid covered employee Smith $1,600,000 and tax-exempt entity B paid Smith $400,000, of the total excise equal to $210,000 tax-exempt entity A would be liable for $168,000 of the $210,000 excise tax, while tax-exempt entity B would be subject to an excise tax of $42,000.
Finally, as is true of several other provisions of the Act, as an anti-abuse measure, the Internal Revenue Service ("IRS") is authorized to issue regulations necessary to prevent avoidance of the tax including avoidance by performing services other than as an employee or by providing compensation through a pass-through entity.
Even if the receipt of the payments does not trigger an analysis of excess benefit transactions under section 4958 of the Code, Boards of tax-exempt organizations making payments to covered employees that are subject to the excise tax will need to consider a few issues.
First, consider how the total cost to the entity bears upon the reasonableness of the compensation, and the benefit to the section 501(c)(3) tax exempt entity. With respect to severance agreements that could result in an excess parachute payment, the 501(c)(3) organization may wish to consider, although it would require the consent of the covered employee, the possibility of reducing compensation, if a payment to a covered employee would otherwise become an excess parachute payment.
Second, with respect to the possible excise taxes that might be imposed upon the tax-exempt entity because of payments in excess of $1 million and excess parachute payments, the organization will need to identify the information that needs to be provided to potential donors to the organization.
Third, to the extent that a portion of the compensation a covered employee is scheduled to receive is nonqualified deferred compensation that is nonvested, it may be possible to accelerate the vesting of the amounts due under the agreement, so that they are treated as income before the start of the organization's next taxable year. However, the 501(c)(3) organization will not be able to implement any such amendment unilaterally, and the participant may not agree to such change, because he or she may not want to accelerate income into 2017. If the participant does agree to accelerated vesting, unless there is also a commensurate accelerated distribution of the participant's benefit under the plan (which is not permissible under current Code section 409A regulations and may not be permissible under the proposed Code section 409A and 457(f) regulations), the affected covered employee will be subject to tax on phantom income. The current 409A regulations permit an accelerated distribution of funds to pay the tax on the phantom income, but there will be a cost to the tax-exempt entity in so doing.
Section 4960 of the Code is effective for taxable years beginning after December 31, 2017. This date is fast approaching. If we can assist your organization in any way, please let us know.