Authored by Christine Faris and Stephen Sutten
Under pre-Tax Cuts and Jobs Act (TCJA) law, tax-exempt entities had to comply with reasonableness requirements and a prohibition against private inurement with respect to executive compensation. Following the enactment of the TCJA, in addition to these existing requirements, “applicable tax-exempt organizations” will be subject to a 21 percent excise tax on payments of executive compensation deemed to be excessive under the provisions of the new law.
This new law is intended to place tax-exempt organizations in the same position as publicly held companies already subject to limits on the deductibility of high compensation amounts to certain executives in accordance with Internal Revenue Code sections 162(m) and 280G. However, in reality, the new law will place applicable tax-exempt organizations at a significant disadvantage with respect to for-profit companies that are not publicly traded, as tax-exempts will have to pay a 21 percent excise tax to pay comparable salaries for comparable positions. Specifically, complex, diversified tax-exempt organizations will face increased pressure to defend their charitable status given the totality of their overall operations. They will also find it more costly to attract and retain top talent.
Under the law existing prior to the TCJA, a publicly held corporation generally cannot deduct more than $1 million of compensation in a taxable year for each CEO and the next four highest-paid executives. And, unless an exception applies, generally a corporation cannot deduct that portion of a “parachute payment” — a payment in the nature of compensation contingent on change in corporate ownership or control that is not specifically exempted from the definition — which equals or exceeds three times the “base amount” of certain service providers. The nondeductible excess is an “excess parachute payment.”
Tax Cuts and Jobs Act
The TCJA extends the notion of penalties for payments of excess compensation to tax-exempt organizations. Under the TCJA, a tax-exempt employer is liable for an excise tax equal to 21 percent of the sum of (1) any remuneration (other than an excess parachute payment) in excess of $1 million paid to a covered employee by an applicable tax-exempt organization for a taxable year, and (2) any excess parachute payment (under a special definition that relates solely to “separation pay”) paid by the applicable tax-exempt organization to a covered employee. In the event the covered employee’s remuneration does not exceed $1 million, the excise tax may apply as a result of an excess parachute payment upon separation from employment.
A “covered employee” is an employee (including any former employee) of an applicable tax-exempt organization if the employee is one of the five highest-compensated employees of the organization for the tax year or was a covered employee of the organization (or a predecessor) for any preceding tax year beginning after Dec. 31, 2016. Therefore, the covered-employee category is calculated anew for each tax year after 2017. Remuneration is treated as paid when there is no substantial risk of forfeiture of the rights to such remuneration. Remuneration means wages as defined for income tax withholding purposes, but does not include any designated Roth contribution.
Remuneration also includes any remuneration paid to a covered employee with respect to employment of the covered employee by any tax-exempt entity or governmental entity related to the applicable tax-exempt organization. Under the provision, a tax-exempt entity or governmental entity is treated as related to an applicable tax-exempt organization if the person or governmental entity controls or is controlled by the organization; is controlled by one or more persons that controls the organization; is a supported organization under section 509(f)(3) during the taxable year with respect to the organization; or in the case of a voluntary employees’ beneficiary association (VEBA), establishes, maintains or makes contributions to the VEBA.
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 on 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 includible 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 qualified retirement plan, a simplified employee pension plan, a simple retirement account, a tax-deferred annuity or an eligible deferred compensation plan of a state or local government employer. The employer of a covered employee is liable for the excise tax. If remuneration of a covered employee from more than one employer is taken into account in determining the excise tax, each employer is liable for the tax in an amount that bears the same ratio to the total tax as the remuneration paid by that employer bears to the remuneration paid by all employers to the covered employee.
This provision is effective for taxable years beginning after Dec. 31, 2017.
Observations and suggestions
Action steps: Tax-exempt organizations should review their compensation practices to determine whether the organization will be subject to the new tax, and if so:
- Which entity is liable for the tax
- Which employees are covered employees
- How compensation paid to covered employees is determined
- What constitutes an excess parachute payment
Efforts should then be made to implement tax planning strategies to avoid the excise tax in the future by considering each covered employee’s work history, compensation arrangement and future role with the organization.
- To provide $2 million of reasonable compensation to a covered employee in 2018, for example, an exempt organization will owe $210,000 in tax.
- For multicorporate tax-exempt systems like large hospitals and universities, the excise tax will apply on an entity-by-entity basis. Accordingly, if two tax-exempt entities within the controlled system each have five persons earning in excess of $1 million, all 10 such employees will trigger the excise tax. Careful planning and structuring of its top executives may be required to lower the excise taxes otherwise due.
- The covered-employee category consists not only of the five highest-paid current or former employees for that year, but also former employees who were previously among the “high five” in any year after 2016 and are still being paid any form of post-termination compensation subject to withholding that exceeds $1 million in the current year. Therefore, the number of covered employees is not actually limited to five per year.
- The excise tax applies to current compensation and all forms of deferred compensation unless specifically exempted (e.g., qualified plans). And, in many cases, the deferred compensation will impact when it becomes vested, whether or not paid. Further, the excise tax will affect excess parachute payments to any high-five employee triggered by separation from employment to the extent the total parachute payments exceed three times the five-year average total compensation.
- This excise tax does not apply to payments made to licensed medical professionals (physicians, nurses and veterinarians), but only to the extent compensation payments relate directly to performance of medical services. Therefore, the portion of the payment attributable to administrative and executive services will count for purposes of the excise tax. This may present challenges for health systems that will now need to track (and categorize as clinical pay or nonclinical pay) compensation paid to physician-executives who perform multiple roles within the system.
The TCJA does not address a number of issues, including the application of these rules to large tax-exempt organizations with multiple entities, allocation of compensation between a tax-exempt organization and its related taxable entity when an executive provides services to both, and determination of the executive’s compensation on a tax-exempt entity’s fiscal year or calendar year. Guidance on these topics should be forthcoming from the IRS and the Treasury.
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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.