The recently passed tax bill imposes a 21% excise tax on excess compensation and excess severance benefits of certain executives of nonprofit and governmental employers. The provision has a substantial impact on the compensation and benefits that such organizations can provide for their executives. Moreover, the determination of which employers, and which executives, are covered includes several traps for the unwary.
What employers are covered?
The new rules cover an “applicable tax-exempt organization,” which is defined as
- An organization exempt from tax under Internal Revenue Code (“IRC”) section 501(a),
- An exempt farmers’ cooperative described in 521(b),
- An instrumentality of Federal, State, or local government with income excluded from tax under section 115, or
- A political organization described in section 527(e)(1).
Note that this is a much broader group than the organizations currently subject to the “reasonable compensation” rules, as it includes governmental organizations as well as private tax-exempts. Moreover, the definition will be particularly hard to apply in the context of a governmental organization. There are actually three categories of governmental organizations:
- An integral part of government (e.g., a state legislature) is exempt from tax under Constitutional principles.
- A governmental instrumentality (e.g., a corporation formed by municipal corporations to provide recreational facilities for their residents and those of adjoining communities) is exempt under Code section 115 from tax on any income derived from any public utility or the exercise of any essential governmental function, even if it has not elected tax-exempt status under Code section 501(c)(3).
- Certain governmental instrumentalities (e.g., public hospitals) can elect to be tax-exempt under Code section 501(c)(3). This has typically been done in order to enable their employees to participate in certain retirement plans (403(b) plans) that are open only to employees of 501(c)(3) organizations and public schools.
Because integral parts of government and governmental instrumentalities have in practice both been tax-exempt so long as the income of the instrumentality is all derived from an exempt governmental function, the Internal Service has not always been careful to distinguish the two. For example, in Letter Ruling 8216088 (Jan. 22, 1982), the IRS held that a public employees’ retirement system was an integral part of the state. By contrast, in General Counsel Memorandum 34704 (Dec. 2, 1971), it held that a virtually identical retirement system was an instrumentality of the state. While a governmental instrumentality that has elected section 501(c)(3) status will clearly be subject to the new rules, many governmental organizations will face uncertainty regarding whether they are integral parts of government (exempt from the new rules) or instrumentalities (subject to them).
What employees are covered?
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 taxable year or was a covered employee of the organization (or a predecessor) for any preceding taxable year beginning after December 31, 2016.
Note that this definition means far more than five employees may be covered. For example, suppose that two tax-exempt organizations, A and B (with no overlapping employees), merge. The individuals who were the top five of each of A and B will continue to be covered employees forever, even if they are not among the top five of the merged organization. Similarly, an individual who has unusually high compensation in one year (e.g., as a result of bonuses or deferred compensation) may become a covered employee, and will then remain one even if their compensation in subsequent years is much lower.
Again, the definition may be particularly difficult to apply in the case of governmental instrumentalities. For example, suppose that there is a single board of trustees for a statewide retirement system. However, within that system, there are separate plans for teachers, police, firefighters, judges, and general employees, and each of those plans has completely separate internal staff. Assuming that a retirement plan is a governmental instrumentality (see discussion above), should all of the plans be treated as a single employer (and thus only the top five system employees would be covered), or should each plan be treated as a separate employer (and thus a total of 25 employees would be covered)?
What compensation is covered?
In general, all compensation reported on the Form W-2 is counted, both in determining whether someone is a covered employee and in determining whether the $1 million cap has been exceeded. However, there are two exceptions:
- Roth contributions
- Compensation attributable to medical services of licensed medical professionals, such as doctors, nurses, or veterinarians
Note that only compensation attributable to medical services is covered by the exemption. For example, if a doctor is acting as a hospital administrator, the compensation for administrative services is not exempt.
Section 457(b) plans of governmental employers, but not employers of private tax-exempt organizations, are excluded from remuneration.
What is excess compensation?
Excess compensation is compensation in excess of $1 million in any one year.
What are excess severance benefits?
A severance payment to a covered employee is a “parachute payment” subject to the tax if the aggregate present value of all severance 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. Exclusions similar to those on the excise tax on excess compensation apply to the definition of compensation for this purpose.
If a severance payment is found to be a parachute payment, then all amounts in excess of the base amount (not just the amounts in excess of three times the base amount) are subject to the tax. Example: A is a covered employee and has a base amount of $300,000. If A receives a severance payment of $899,999, none of it will be subject to the excise tax. However, if A receives a severance payment of $901,000, then $601,000 of it will be subject to the excise tax.
The same amount will not be counted for purposes of the excise tax on excess compensation and the excise tax on excess severance benefits. However, the same severance payment can give rise to both taxes. Suppose the facts are the same as in our prior example. A receives a severance payment of $901,000, plus $900,000 in regular compensation. The $200,000 in severance which is not subject to the excise tax on excess severance benefits will be added to the $900,000 in regular compensation to determine whether the excise tax on excess compensation applies. Accordingly, A’s compensation for the year is $1.1 million, and the excise tax on excess compensation will apply to $100,000 of it. This will be in addition to the excise tax on the $601,000 in excess severance benefits.
How do these rules differ from the comparable rules for taxable employers?
Section 162(m) of the tax code limits the amount of deductible compensation that a company can pay to certain covered employees to $1 million annually. However, it has two limitations that prevent it from applying to many employees of profit-making businesses:
- If the company has a net operating loss, and thus is not subject to tax, there are no penalties for paying over $1 million.
- The rule applies to compensation actually paid by a profit-making business. Thus, such a business can avoid it in many instances by spreading out part of the compensation, using a nonqualified deferred compensation plan. For example, if a business wants to pay an executive $2 million a year, and the executive is going to work for another five years, it could instead pay him $1 million a year for the five years he is employed, and another $1 million a year for each of the five years after he terminates employment. In the case of a nonprofit, the rule applies when the compensation becomes vested. This typically means that deferring compensation will not help, because the compensation deferred will have to be paid out while the individual is still receiving compensation as an employee (or at least a consultant) to the same organization.
The result is that nonprofits may be at a competitive disadvantage in structuring a compensation package for an executive who is considering offers from profit-making entities.
How does the excise tax on excess compensation differ from the “reasonable compensation” rules?
Employees of nonprofits are already subject to a “reasonable compensation” standard, which prevents them from receiving compensation which is not reasonable, considering factors such as the size of the organization and the degree of responsibility. However, the new excess compensation rules are separate from this. Thus, even over $1 million is reasonable for a particular executive (e.g., because the organization is competing with profit-making employers offering more than $1 million for the employee), it will nevertheless be subject to the excise tax if it goes over the $1 million figure.
This can be a particular problem when an executive has built up an organization. In many instances, an executive will initially accept a salary well below market rates, because the organization is small and not able to pay more. However, once the organization becomes much larger (often due to that executive’s own fund-raising and the like), it wants to pay the executive extra to compensate for the low salary in the early years. While such compensation may be reasonable, it may in some instances cause the executive to go over the $1 million cap.
How does the excise tax on excess compensation affect the ability to promote medical employees to other positions?
In some instances, a hospital, for example, may want to promote a doctor or nurse to become overall administrator of the hospital. Or a medical school may want to hire a doctor as a professor. In either instance, the compensation of the doctor or nurse involved is no longer exempt from being part of “remuneration” for purposes of the excise taxes.
This has two effects. First, the individual may become a covered employee as a result of the change. As indicated above, this may cause the individual to be subject to the rules for all future years, even if they go back to performing only medical services. Second, it may put the individual over the $1 million threshold for the excise tax on excess compensation.
As a result, many organizations may find that they have trouble recruiting the most qualified individuals for nonmedical positions.
How does the excise tax on excess compensation affect deferred compensation?
The statute sets up a general rule that amounts included in remuneration are those included in Form W-2 income. However, it also states that “remuneration shall be treated as paid when there is no substantial risk of forfeiture.” This presents an immediate conflict, inasmuch as although amounts defer 457(f) plans are subject to income tax when there is no substantial risk of forfeiture, they do not become subject to wage withholding (and thus includible in Form W-2 income) until actually paid. Technical Advice Memorandum 199903032 (October 2, 1998).
Moreover, to the extent deferred compensation included in remuneration when it becomes vested, that means that all amounts deferred (perhaps over many years or decades) will be included in remuneration while the individual is still receiving normal annual compensation from the employer. For example, supposed that A has put aside $15,000 a year for 30 years, and the amount is to be paid when A reaches age 65 if A is still employed at that point. At this point, the value of the deferred compensation would be about $850,000. If A has regular salary of $500,000 in that year, the $850,000 in deferred compensation plus the $500,000 in salary would together trigger the excise tax. Yet there is no way to defer inclusion of the $850,000 in remuneration until after the executive stops having other salary, because it can be deferred only so long as it is not vested (i.e., is contingent on future services).
For an executive with substantial 457(f) deferrals, consideration may be given to delaying vesting by requiring the executive to continue performing services (e.g., as a consultant) after termination of employment. To avoid having the entire 457(f) subject to the cap in one year, vesting might be spread out over a period of years as a consultant. However, for this to be effective, the amount of services to be performed as a consultant must be substantial relative to the payment. At the same time, the compensation as a consultant must not be so high that it, together with the amount taken into account under the 457(f) plan, gives rise to the excise tax.
How does the excise tax on excess compensation affect vacations, bonuses, and other amounts not included in section 457(f)?
Both income taxation under section 457(f) and inclusion in remuneration for purposes of the excise tax on excess compensation generally occur when an amount becomes vested. However, there are a number of exceptions to income taxation upon vesting under 457(f):
- Any 457(b) plan.
- Any bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay, or death benefit plan.
- Any plan (such as a bonus plan) in which amounts are paid within 2½ months after the end of the year in which they become vested.
- Any plan paying solely length of service awards to bona fide volunteers (or their beneficiaries) on account of qualified services performed by such volunteers.
It is clear that not all of these exceptions apply for purposes of the excise tax. For example, section 457(b) plans of private nonprofits are part of remuneration. “Excess parachute payments” are excluded from remuneration for purposes of the excise tax on excess compensation, but other severance payments are included. In instances in which the taxation of an amount is deferred beyond vesting for income tax purposes, it is unclear how the excise tax on excess remuneration will be applied. For example,
- Section 457(b) plans of nongovernmental employers are included in remuneration. Are they counted when vested, or when distributed?
- Are accrued vacation and the like included in remuneration when they become vested, not when actually paid?
How does the excise tax on excess compensation affect fringe benefits?
Any taxable fringe benefits an executive receives are included in remuneration for purposes of the excise taxes. For example, if an executive is provided with a company car, the taxable income to the executive for use of that car will be considered remuneration.
The tax bill creates new issues for nonprofits and governmental instrumentalities in structuring their compensation packages. Many long-time practices must be reevaluated in light of the change in law.