Mitigating your excise tax liability risk: Excessive executive compensation for non-profit organizations
The Tax Cuts and Jobs Act of 2017 added Section 4960 to the Internal Revenue Code, which imposes a 21 percent excise tax on certain “applicable tax-exempt organizations” (ATEO) that employ “covered employees” who have either: “excess compensation” (total annual compensation in excess of $1,000,000) or “excess parachute payment” (severance in excess of three times a base amount as defined below).
Sec. 4960 is effective for the ATEO’s first taxable year beginning after Dec. 31, 2017. The IRS provided detailed interim guidance in Notice 2019-09 while regulations are being drafted, including almost 40 Q&As, illustrating the application of Sec. 4960.
What can you do to prevent the imposition of the excise tax?
There are several ways to prevent or mitigate the impact of Sec. 4960 and Notice 2019-09. For example, you can:
- Review compensation paid to covered employees and determine if “smoothing” can help stay below the $1 million annual threshold (e.g., if compensation fluctuates from year to year based on performance).
- Evaluate deferred compensation plans, including potential for accelerated vesting, to limit remuneration for years that exceed $1 million.
- Review parachute payments periodically to identify and mitigate any excess.
- Consider limitations on parachute payments in employment or severance agreements (e.g., three times base amount, less $1).
- Consider increasing W-2 in the five years prior to the employment termination (in order to increase the base amount), keeping in mind the $1,000,000 excess remuneration limitation.
- Consider a split-dollar life insurance arrangement.
The first step? Identify how the four defined terms below apply to your organization and assess the potential risk.
Evaluate deferred compensation plans, including potential for accelerated vesting, to limit remuneration for years that exceed $1 million.
What is an “applicable tax-exempt organization?”
An ATEO is considered:
- An organization exempt from tax under IRC Section 501(a) (e.g. Schools, nonprofit hospitals, other public charities, foundations).
- An exempt farmers’ cooperative described in IRC Section 521(b).
- An instrumentality of federal, state, or local government with income excluded from tax under IRC Section 115.
- A political organization described in IRC Section 527(e)(1).
Under Notice 2019-09, there’s no aggregation of related tax-exempt organizations permitted to reduce the number of covered employees. For example, in the case of a parent organization that has two subsidiaries, there will be one analysis required for each entity (i.e. three in total). The Notice also provides rules for allocating liability for the excise tax among the related organizations.
Who is a “covered employee”?
A covered employee of an ATEO is either one of the top five highest paid employees for the taxable year, or was at any time one of the top five highest paid employees in a previous taxable year beginning after Dec. 31, 2016. This means, once an individual is classified as a covered employee after Dec. 31, 2016, then they’ll always be classified as a covered employee. Thus, ATEO will be required to determine their top five highest paid employees each taxable year. Further, there’s no minimum dollar threshold for an employee to be a covered employee.
Only an ATEO’s common law employees (including officers) can be one of an ATEO’s five highest compensated employees. To identify your five highest compensated employees, you must include remuneration paid for the taxable year by any related organization, including remuneration paid by a related for-profit organization or governmental entity, for services performed as an employee of such related organization.
How is “excess compensation” determined?
The $1,000,000 limit applies to “remuneration” paid by an ATEO for the relevant taxable year. The following compensation in excess of $1,000,000 will be subject to the aforementioned 21 percent excise tax:
- All components of the employee’s W-2 income, except:
- Roth contributions.
- Compensation for the direct performance of medical services (i.e. not administration, teaching, or research) by licensed medical professionals.
- Taxable fringe benefits.
- Certain types of deferred compensation. For 457(b) plans, amounts are included in the year of distribution. For 457(f) plans, amounts are included in the year of vesting.
Remuneration paid by a separate organization on behalf of the ATEO, whether related to the ATEO or not, for services performed as an employee of the ATEO is treated as remuneration paid by the ATEO for purposes of Sec. 4960.
How is an “excess parachute payment” determined?
A “parachute payment” is any payment in the nature of compensation to a covered employee, which is contingent on the employee’s separation from employment with the employer. The Notice clarifies that a payment is contingent on a separation from employment if the payment wouldn’t have been made or vested absent an involuntary separation of employment.
If, the aggregate present value of all parachute payments equals or exceeds three times the covered employee’s base amount, then an excise tax is due on the total of all parachute payments, less one times the base amount. The employee’s base amount is generally the employee’s average compensation (Box 1 of Form W-2) for the preceding five years (or shorter period of service).
However, if the aggregate present value of all parachute payments doesn’t equal or exceed three times the covered employee’s base amount, then no excise tax is due.
Base amount calculation
|YEAR||W-2 Box 1|
|Base amount (average)||$900,000|
|3x base amount||$2,700,000|
Parachute payment determination
Assumption: The following payments are contingent on the employee's separation of employment with the employer.
|Health & welfare||$36,000|
Excise tax calculation
Step 1: Does the present value of the total parachute payments exceed the 3x base amount?
Yes: $2,811,000 > $2,700,000
Step 2: Determine amount of excess parachute payment.
|Total parachute payments||$2,811,000|
|1x base amount||($900,000)|
|Excess parachute payments||$1,911,000|
Step 3: Calculate excise tax due.
|Excess parachute payments||$1,911,000|
|Excise tax||21 percent|
|Excise tax on excess parachute payments||$401,310|
Is your nonprofit organization unsure where to start to address Sec. 4960 and the Notice? Give us a call. We can help you identify your risks and develop clear, actionable results.