The Tax Cut and Jobs Act includes a surprising new tax on wealthier tax-exempt organizations. The Act adds section 4960 to the Internal Revenue Code (the “Code”) to impose a 21% excise tax on “excessive” compensation paid to executives, or “covered employees.” This new tax targets tax-exempt hospital systems and other wealthy non-profits, including universities.
The most surprising twist is that there is no meaningful “grandfather” provision. As written, the tax will apply to payments and to vesting of benefits made in 2018 and later under binding written agreements that were in place when the law was enacted.
Excessive Compensation. The tax is measured by compensation paid to a “covered employee” and includes vesting of deferred compensation under section 457(f) of the Code. The tax is triggered when a covered employee earns:
- Annual pay over $1 million
- “Excess parachute payments” – meaning payments contingent on separation from employment that are 300% or more of average annual compensation
Amounts paid under certain retirement plans (e.g., 401(k), 403(b), 457(b)) are exempt. It appears, unfortunately, that supplemental retirement amounts accrued under a “457(f) plan” are not exempt.
Covered Employees. The tax applies to compensation paid to those who are among the top five employees of the organization for the year, ranked by compensation. Two groups of employees are excluded – those who earn less than $120,000 (subject to cost of living adjustments) and those who are paid to provide medical services as licensed medical professionals (including veterinarians). This applies to anyone who is or was a covered employee in any year beginning in 2017. In other words, once a “covered employee,” compensation paid to that person will always be potentially subject to section 4960.
Calculation of the 21% Tax. For covered employees who earn more than $1 million in a year, the tax applies to the amount in excess of $1 million. For example, if an executive earns $1.4 million, the employer will have an excise tax of $84,000 ($400,000 x 21%). This rule is similar to the tax treatment of for-profits under section 162(m) Code.
For excess parachute payments, the rule borrows from the golden parachute tax under section 280G of the Code. The excise tax does not apply if pay contingent on separation is less than 300% of average annual compensation (i.e., average earnings over the prior five calendar years). If this limit is exceeded, however, the tax applies to earnings that exceed average annual compensation. For example, for an executive who has average earnings of $500,000 and receives severance of $1,500,000, the employer will owe an excise tax of $210,000 ($1,500,000 - $500,000 x 21%). If the severance is $1,499,999 or less, the excise tax is $0.
The tax is coordinated so that the dollars paid in excess of $1 million that are also excess parachute payments are not taxed twice.
Who is Subject to the Tax? The tax applies to the entities listed below. The employee has no liability for the tax.
- All entities that are tax-exempt under section 501(a) of the Code – practically, this will affect non-profit hospital systems and wealthier charities
- Farmers’ cooperatives under section 521(b)(1)
- Governmental entities receiving income exempt under section 115(1) – this seems to include county and municipal hospital districts
- Congress intended that the section 115(1) reference would pull public universities into the tax (think college football powerhouses with multi-million dollar coaches) but some argue that it does not
- Political organizations under section 527(e)(1)
We are concerned that many subject to this tax have pre-existing obligations in place today that could trigger the 21% excise tax, even in organizations that pay far less than $1 million to executives. Potentially, many tax-exempts have binding obligations to pay severance and supplemental retirement that will pay out more than 300% of annual wages. Many or perhaps nearly all of these programs are supplemental retirement savings that have been in place for many years. In the for-profit sector, there is no comparable tax on supplemental retirement programs.
We recommend the following:
- Identify non-qualified deferred compensation and other severance arrangements that could potentially pay out more than 300% or more of average compensation
- This will involve calculating compensation for covered employees for the prior five years and projecting the value of future payments under these agreements
- For an executive who has been recently promoted, the five-year average may be much lower than current pay
- Consult with counsel to determine alternative strategies for maintaining pre-existing compensation and severance commitments while minimizing the effect of excise tax on the employer. IRS regulations impose significant restrictions on modifying deferred compensation payments.
- Prospectively, design compensation arrangements to avoid excessive severance:
- Maximize tax-qualified plan benefits, including “cross-testing” design, and rely less on section 457(f) arrangements
- Design vesting under 457(f) to occur at a designated age or event that is not related to separation from employment
- Consider a contractual cap on severance arrangements to stay below the excess parachute limit. This is a common practice in for-profit corporations.
We are monitoring section 4960 and are hopeful that there will be relief in Congress from the retroactive impact of the tax.
For additional information, please contact James B. Bristol or any member of Waller’s Tax practice.
The opinions expressed in this bulletin are intended for general guidance only. They are not intended as recommendations for specific situations. As always, readers should consult a qualified attorney for specific legal guidance.