Under the recently enacted tax reform act (Tax Cuts and Jobs Act), tax-exempt organizations may be required to pay a 21 percent excise tax on certain compensation and certain separation pay. The new excise tax applies separately from, and in addition to, the private inurement rules applicable to tax-exempt organizations’ executive compensation arrangements. Tax exempt entities should act quickly to assess the impact on their organization and decide whether to make adjustments to minimize the impact of this potentially significant excise tax.
Which tax-exempt organizations are covered by the excise tax?
The excise tax applies to the following types of organizations:
- Organizations exempt from taxation under Section 501(a) of the tax code (including 501(c)(3) organizations),
- Organizations that have income excluded from taxation under Section 115(1) of the tax code (generally, state government-related organizations, including some government hospitals), and
- Certain farmers’ cooperatives and political organizations.
What compensation generates the 21 percent excise tax?
The organization will owe a 21 percent excise tax on any compensation paid to “covered employees” that is in excess of $1 million in a taxable year (and before you stop reading, it’s easier than you might think to reach $1 million).
Compensation for purposes of the excise tax generally includes all taxable wages other than designated Roth contributions under a company-sponsored retirement plan. Notably, any amounts of deferred compensation that are included in the employee’s income are included in compensation for this purpose. A tax-exempt organization should be careful to evaluate whether its non-qualified deferred compensation plan(s) could cause employees who are otherwise well below the $1 million threshold to jump over the threshold in the year non-qualified benefits vest.
Interestingly, compensation paid to a licensed medical professional for the performance of medical services is excluded from the $1 million threshold. For physicians who serve in both clinical and administrative roles, it appears that health systems will need to track what portion of pay relates to performing medical services and what portion relates to administrative and other services in order to determine whether the excise tax will apply.
What separation pay is subject to the excise tax?
The 21 percent excise tax will also apply to “excess parachute payments” to covered employees, even if those amounts do not exceed the $1 million threshold. “Excess parachute payments” are generally payments contingent on a covered employee’s separation from employment that exceed three times the covered employee’s average compensation for the prior five years.
Who are “covered employees” for the excise tax?
An individual is a “covered employee” if he or she is one of the organization’s five highest-paid employees for any tax year beginning after 2016. Organizations should note the following:
- An individual is a covered employee regardless of current employment status. This means, for example, that compensation paid to a “covered employee” in years after he or she terminates employment may still result in an excise tax.
- The list of covered employees is a cumulative list, meaning that once an individual becomes a covered employee, he or she will remain a covered employee for all subsequent years (even if he or she drops below the top five highest-paid employees or terminates employment).
What steps should tax-exempt organizations take in response to the new law?
The new excise tax is effective beginning in 2018, therefore affected organizations should take action quickly, including the following:
- Carefully evaluate whether (a) any employees could exceed $1 million in taxable compensation in any year, paying particular attention to years in which deferred compensation becomes taxable or (b) any employees have separation pay that could be an excess parachute payment.
- Evaluate potential cost of new excise tax.
- Evaluate options to reduce or eliminate potential excise taxes, including:
- Changing the type or timing of compensation
- Modifying vesting and payment terms
- Renegotiating separation pay to eliminate excise tax
To avoid additional pitfalls, particularly those arising from Section 409A of the tax code, organizations should always consult with counsel before changing the terms of an agreement or deferred compensation plan.