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Nonqualified retirement plan benefits could trigger excise tax for nonprofits

August 10, 2020 Article 3 min read
Michael Krucker

The treatment of certain nonqualified retirement plan benefits under new proposed guidance from the IRS could trigger an unexpected excise tax bill for nonprofits. Here’s what executives need to know. 

Close-up view of a desk at home with a laptop computer and various other office supplies.Tax-exempt organizations and certain government employers who pay any of its top five executives more than $1 million in a taxable year should be aware of newly proposed regulations issued by the Treasury regarding Internal Revenue Code (Code) Section 4960, the “tax on excess tax-exempt organization executive compensation.” This provision, added by the Tax Cuts and Jobs Act, imposes an excise tax on remuneration in excess of $1 million paid by an applicable tax-exempt organization to an individual during any taxable year. Although few organizations have executives with salaries in this range, the guidance includes an unusual treatment for certain retirement benefits that could trigger the tax if organizations don’t plan carefully.

Guidance largely follows previous IRS Q&As

The proposed regulations track closely to previous guidance that the IRS released as a series of Q&As in Notice 2019-09; we discussed the basics on the provision and the initial guidance in a previous article and webinar. There were no significant changes to the IRS’ interpretations of key terms in the law such as “applicable tax-exempt organization,” “covered employee,” “excess compensation,” and “excess parachute payment.”

Potential concern with vesting retirement benefits

While this next step in the formalization of the regulations didn’t include any significant surprises, the guidance created inconsistencies with Code Section 457 and the regulations thereunder, which applies to deferred compensation plans established by tax-exempt organizations. Most retirement benefits paid by tax-exempt organizations are considered compensation to the recipient in the taxable year that those amounts are paid. However, Code Section 457(f) requires that ineligible deferred compensation plan benefits be included in an individual’s income when they’re no longer subject to a substantial risk of forfeiture — in most cases, at the time of vesting.

The Section 457(f) regulations allow for a short-term deferral exception, which provided that if the benefits of the plan are paid out to the individual within a certain time after vesting (generally, by March 15 the year after vesting), the amounts are included in income for the employee in the year they are paid.

Unfortunately, the proposed regulations make clear that this short-term deferral exception will not be recognized for purposes of the Code Section 4960 excise tax. When calculating compensation for Section 4960 purposes, the organization has to include the ineligible deferred compensation amounts in the year of vesting. As a result, the employer can’t push the payment of deferred compensation amounts to the subsequent year to mitigate or eliminate the Section 4960 excise tax.

For example, suppose an employee has $800,000 in base salary and will receive an additional $1 million upon attaining age 65 under an ineligible deferred compensation plan. Assume the employee attains age 65 on June 30, 2020, and retires Dec. 31, 2020, and the ineligible deferred compensation plan provides for payment of the $1 million on March 15 of the year after reaching age 65 (i.e., March 15, 2021). Absent the proposed Code Section 4960 regulations’ disregard of the 457(f) short-term deferral exception for excise tax purposes, the employer wouldn’t be subject to the excise tax as the employee would have $800,000 in compensation in the year of retirement and $1 million in compensation in the year following retirement. However, with the proposed Section 4960 regulations, the employer must include the $1 million payment in the year of vesting and would be subject to the excise tax as the employee would have compensation of $1.8 million in the year of vesting.

Awareness is critical

Organizations that have executives who participate in ineligible deferred compensation plans under Code Section 457(f) need to develop and maintain an inventory of those plans that identifies vesting dates for applicable covered employees since the amounts payable under these plans may be considered for 4960 excise tax purposes in one year and individual tax (Form W-2) purposes in another. This tracking is critical given the “once a covered employee, always a covered employee” rules under Section 4960. It’s important that the people who oversee human resources, benefits, and payroll all coordinate to minimize the potential tax impact of these vesting events.

Final guidance yet to come

The IRS has acknowledged the challenges that this treatment causes for tax-exempt organizations, and it specifically mentioned this issue in its request for comments on the proposed regulations. It’s possible that comments from affected taxpayers may lead to some relief in the final regulations, but it may be some time before those are released. In the meantime, tax-exempt organizations with established Section 457 plans should take steps to make sure that all relevant parties within the organization are aware of the vesting timeline and the potential tax impact.

To learn more about how these rules may affect your organization and what you can do to plan ahead, please contact Plante Moran. 

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