New Excise Tax on Excess Executive Remuneration Paid by Tax Exempt Organizations
The Tax Cuts and Jobs Act that was enacted into law on December 22, 2017, introduced a new excise tax on excess compensation (or excess parachute payments) that is paid to “covered employees” by tax-exempt organizations, including government entities with exempt income, beginning with taxable years beginning after December 31, 2017.
The new excise tax (IRC § 4960) that will be assessed to the tax-exempt employer will be equal to 21 percent of:
(1) “remuneration” (other than an excess parachute payment) in excess of $1 million that is paid to a “covered employee” in a taxable year, and
(2) any “excess parachute payment” to a “covered employee,” even though the employee’s remuneration may otherwise be less than $1 million.
Covered Employees. A “covered employee” is defined as an employee (including a former employee) who is one of the five highest compensated employees for the year, or was a “covered employee” for any preceding year beginning after December 31, 2017. In other words, once a “covered employee,” always a “covered employee.” Therefore, the number of covered employees can exceed five in a particular year.
Remuneration Subject to the Excise Tax. The “remuneration” subject to the new tax is generally all wages for income tax withholding purposes (other than designated Roth contributions), and will include deferred compensation benefits that are includible in income, whether or not paid. However, compensation paid to a licensed medical professional for the performance of medical or veterinary services is excluded from “remuneration” and will not be subject to the new excise tax. For example, the salary and deferred compensation that is paid to a physician-employee of a tax-exempt hospital for the performance of medical services may exceed $1 million in a taxable year without subjecting the hospital to the excise tax for excessive remuneration. But compensation that is paid to a licensed medical professional for any services other than professional medical services would be counted as “remuneration” for purposes of the new excise tax.
Although not clear under the statute, the Conference Committee Report indicates that compensation paid to a licensed medical professional will not be treated as “remuneration” for purposes of determining whether the professional is one of the five highest compensated employees of the organization (i.e., a “covered employee”). In the case of hospitals and health care organizations, this should have the effect of restricting “covered employees” to only the executive employees of the organization.
Related Systems and Entities. For multi-corporate tax-exempt systems, the excise tax applies on an entity-by-entity basis. However, when determining “remuneration” of an employee, “remuneration” paid by “related entities” (generally defined as those entities that are in control of, or controlled by the tax-exempt employer, or which are supporting organizations) is included as “remuneration” paid to the covered employee.
Excess Parachute Payments. The new excise tax also applies to “excess parachute payments” which are defined as compensation paid by the tax exempt organization to a “covered employee” that is contingent on the employee’s separation from service if the present value of such payments exceeds three times a “base amount.” This “base amount” is the average annualized compensation includable in the employee’s gross income for the five years ending before the employee’s date of separation. Again, compensation paid to a licensed medical professional will not be included as a parachute payment for purposes of the excise tax. This excise tax on excess parachute payments can apply even if a covered employee’s compensation does not exceed $1 million.
The excise tax for “excess parachute payments” is clearly directed to capture large severance benefits (relative to average compensation) that are paid to a covered employee. However, it is not apparent from the new statute how certain deferred compensation that may be paid or triggered upon a termination of employment will be classified – as a parachute payment or as “remuneration” that must exceed $1 million to be subject to the excise tax. Further guidance from the IRS on how to classify such deferred compensation for purposes of the new excise tax will be needed.
Current Compensation Arrangements. Tax-exempt organizations should first examine current compensation arrangements with their highest-paid executive employees to determine whether there will be excess remuneration that could subject the organization to the new excise tax in 2018 or future years. In making this assessment, it must be noted that the $1 million threshold used to identify excess remuneration is not indexed or adjusted in future years for increases in the cost of living.
Deferred Compensation Arrangements. Existing deferred compensation arrangements should be examined to determine whether future vesting/payment of deferred compensation benefits with respect to an executive may expose the tax-exempt employer to the new excise tax. Deferred compensation arrangements can present special concerns since, in many cases, the benefit that has accrued under the arrangement is included in income and paid in a single taxable year when there is no longer a substantial risk of forfeiture of the accrued benefit. The new law specifically provides that “remuneration” for purposes of the new excise tax includes amounts required to be includable in gross income under IRC § 457(f), and there is no transition relief or carve-out in the new statutes for deferred compensation benefits that may have accrued in years before January 1, 2018. As a result, there will be many instances in which deferred compensation benefits that have accrued over a number years will expose the tax-exempt entity to the new excise tax when the accrued benefit is actually paid and includable in the income of the covered employee in a future taxable year. Depending on the exposure to the new tax under existing arrangements, certain remedial or preventative actions may be considered, including the freeze of future benefit accruals (in favor of current compensation) or accelerating the vesting (and taxation) of the deferred compensation to the extent possible under the existing agreements and the applicable rules of IRC §457(f) and § 457(f).
Severance Benefit Agreements. Finally, tax-exempt organizations should consider whether amounts that could be paid under severance agreements could result in an “excess parachute payment” in future years with respect to the executive employee. In appropriate cases, severance benefit agreements could be revised to either reduce the amount of severance benefits or spread the severance payments over more than a single year to reduce the present value of the benefit in measuring whether it will be an excess parachute payment.
Gary N. Clatterbuck
Labor, Employment and Employee Benefits Section