New Tax on 'Excess' Executive Compensation Poses Challenge for Tax-Exempt Organizations

The ability to attract and retain high-quality executives is an important component in the success of any tax-exempt organization and the fulfillment of its mission. A new provision of the Internal Revenue Code added by the Tax Cuts and Jobs Act of 2017 will have a "sea change" impact on the cost of compensating such individuals. Under the provision, "excessive compensation" paid to executives by a tax-exempt organization will subject the organization to a substantial excise tax liability. The penalty may be viewed as an attempt to level the playing field, inasmuch as the tax consequences associated with the payment of "excessive compensation" paid by for-profit employers, in particular by for-profit public companies, to their senior executives can result in the loss of a tax deduction for excessive compensation payments.

What Is the New Excise Tax?

Effective as of January 1, 2018, "applicable tax-exempt organizations" are subject to a 21 percent excise tax on the sum of (i) compensation paid by the tax-exempt organization (and certain entities related to the tax-exempt organization) for a taxable year to a "covered employee" that exceeds $1 million, and (ii) any "excess parachute payment" paid by the tax-exempt organization to a covered employee.

Which Tax-Exempt Organizations Are Subject to the Tax?

Any organization that is exempt from federal income tax under Internal Revenue Code section 501(a), such as public charities (e.g., United Way), exempt farmers' cooperative organizations, certain state or local governmental entities, and certain political organizations, are subject to the tax.

What Is a "Covered Employee"?

A "covered employee" for purposes of the new excise tax is an employee (or former employee) of a tax-exempt organization that (i) is one of the five highest paid employees of the organization in a taxable year, or (ii) was considered a covered employee under clause (i) for any preceding year after 2016. Once an employee (or former employee) is considered a "covered employee" for a taxable year, he or she will be treated as a covered employee for all subsequent taxable years. Therefore, over time, a tax-exempt organization's covered employees may well exceed its current top five highest-paid employees.

What Kind of Compensation Is Subject to the Tax?

For purposes of the new tax, compensation includes wages that are subject to federal income tax withholding, as well as certain non-qualified deferred compensation at the time it is included in income (e.g., when such amounts become vested). Interestingly, compensation paid to a licensed medical professional (e.g., doctor, nurse, or veterinarian) for the performance of such medical services (but not for any administrative/executive services performed by such persons) is excluded from the $1 million compensation limit under the legislation.

What Is an "Excess Parachute Payment"?

Under the new tax, an "excess parachute payment" is the amount by which a "parachute payment" exceeds the covered employee's "base amount." A parachute payment is one or more payments of compensation to a covered employee that is contingent on the employee’s separation from employment and where the present value of such amounts equals or exceeds three times the employee's base amount. An employee's base amount is the employee's average taxable compensation over the five taxable years (or lesser employment period if applicable) immediately preceding the taxable year of the termination of employment. In calculating an employee's parachute payments, amounts paid (i) from a qualified retirement plan (e.g., 401(k) plan, 403(b) tax-deferred annuity plan, or 457(b) eligible deferred compensation plan), (ii) to a licensed medical professional (as described above), and (iii) to an employee that is not a "highly compensated employee" (as defined for purposes of qualified plan requirements), are excluded.

What Steps Should a Tax-Exempt Organization Take?

A tax-exempt organization subject to the new excise tax should be proactive in taking the following steps:

• Identify all "covered employees" for 2017 and 2018 (remember, once an employee, or former employee, is determined to be a covered employee, he or she will thereafter be treated as a covered employee regardless of their later years' compensation level).
• Review all compensation arrangements with covered employees.
• Determine the organization's potential tax liability under the tax.
• Consider whether any current compensation arrangements with covered employees can be revised, if necessary, to avoid or reduce excise tax exposure.
• Be mindful of the new tax rules when negotiating new compensation arrangements with executives or others who are currently covered employees or may be expected to become covered employees in the future.

Conclusion

The new excise tax is a major change with respect to the landscape in which tax-exempt organizations compensate their executives. Failure to understand and properly apply these new rules can result in significant tax liability for the tax-exempt organization. Accordingly, it is strongly recommended that all tax-exempt organizations subject to the new excise tax take the above action steps now so that they may appropriately mitigate or eliminate any potential excise tax liability.

Bruce L. Wolff ([email protected]) is counsel in the Labor and Employment Practice at Brach Eichler LLC, a law firm located in Roseland, New Jersey.