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Expert Q&A: New Excise Tax on Excessive Compensation at Tax-Exempt Organizations
Practical Law Article w-013-8295 (Approx. 5 pages)
Expert Q&A: New Excise Tax on Excessive Compensation at Tax-Exempt Organizations
by Practical Law Employee Benefits & Executive Compensation
| Law stated as of 14 May 2018 • USA (National/Federal) |
An Expert Q&A with Michael Sirkin of Proskauer Rose LLP on the new excise tax on excessive compensation paid by tax-exempt organizations. The new excise tax was added to the Internal Revenue Code by the Tax Cuts and Jobs Act, which was enacted in December 2017.
The Tax Cuts and Jobs Act (the Act), enacted on December 22, 2017, added Section 4960 to the Internal Revenue Code (Code). Code Section 4960 imposes a 21% excise tax on excessive executive compensation and excessive separation payments paid by certain tax-exempt organizations to their covered employees (26 U.S.C. § 4960). This new excise tax is intended to put tax-exempt organizations in parity with for-profit organizations, which are subject to Code Sections:
- 162(m), which prohibits publicly held corporations from deducting more than $1 million per year in compensation paid to each of certain covered employees (26 U.S.C. § 162(m); see Practice Note, Section 162(m): Limit on Compensation). Before the Act was enacted, qualified performance-based compensation was excluded from Code Section 162(m)'s deduction limitation. The Act eliminated the qualified performance-based compensation exception to the deduction limitation, with a transition rule for certain compensation payable pursuant to a written binding contract that was in effect on November 2, 2017 and is not materially modified thereafter (see Practice Note, Section 162(m): Limit on Compensation: Transition Rule).
- 280G and 4999, which create the following adverse tax consequences for a corporation paying excess compensation in connection with a change in control and the individual receiving the compensation:
- Section 280G prohibits a corporation from deducting certain excess payments made in connection with a change in control (26 U.S.C. § 280G); and
- Section 4999 imposes a 20% excise tax (in addition to ordinary income tax) on the individual receiving the excess payments (26 U.S.C. § 4999; see Practice Note, Sections 280G and 4999: Golden Parachute Payments).
We asked Michael Sirkin, partner at Proskauer Rose LLP, to answer a few questions about the new Code Section 4960.
What is the new excise tax on excess tax-exempt organization executive compensation?
The Act imposes, effective with regard to taxable years starting after December 31, 2017, a 21% excise tax on:
- Compensation that exceeds $1 million paid to each of a tax-exempt organization's covered employees.
- Certain excessive separation payments made to the organization's covered employees.
The excise tax is payable by the organization, not the employee receiving the compensation.
Who are an organization's covered employees?
Covered employees are employees (and former employees) of the tax-exempt organization that were either:
- One of the five highest compensated employees of the organization for the taxable year.
- A covered employee of the organization, or a predecessor of the organization, for any preceding taxable year beginning after December 31, 2016. This means that once an individual is a covered employee of a tax-exempt organization, the individual is a covered employee of that organization for all future years, even after the individual's employment terminates.
When and on what compensation is the new excise tax imposed?
The excise tax is imposed on compensation in excess of $1 million paid to a covered employee in a year, with compensation including:
- Wages, as defined in Code Section 3401(a) (26 U.S.C. § 3401(a)), other than designated Roth contributions (as defined in Code Section 402A(c) (26 U.S.C. § 402A(c))).
- Deferred amounts required to be included in gross income under Code Section 457(f) (26 U.S.C. § 457(f)).
The definition of compensation for purposes of the excise tax excludes certain compensation for medical services paid to medical professionals.
The excise tax is also imposed on severance that exceeds the golden parachute limit that for-profit entities and their executives are subject to on a change in control under Code Sections 280G and 4999 (for more on Code Sections 280G and 4999, see Practice Note, Sections 280G and 4999: Golden Parachute Payments).
How does this new excise tax compare to Section 4999 excise taxes and Section 280G and Section 162(m) limits on deductibility of excessive compensation at for-profit organizations?
The Code Section 4960 excise tax on excess severance paid by tax-exempt organizations applies whether or not there is a change in control, while Code Section 4999's excise tax on excess amounts paid by for-profit entities applies only in connection with a change in control. Additionally, the Code Section 4960 excise tax is imposed on the entity as opposed to the individual receiving the payments, unlike the Code 4999 excise tax. For-profit entities lose a corresponding deduction on excess parachute payments in connection with a change in control under Code Section 280G.
Code Section 162(m) deals with a loss of deductibility on compensation in excess of $1 million. The excise tax is supposed to be the equivalent for tax-exempt organizations since they are not concerned with deductibility.
Does the new excise tax place tax-exempt organizations at a competitive disadvantage to private companies that are not tax-exempt?
Tax-exempt organizations are always at a competitive disadvantage because of the lack of equity availability as part of the compensation package. This new excise tax does not place them at a competitive disadvantage because it is imposed on the organization. What it does is raise the cost to the organization of hiring top executives.
While it is too early to determine the actual impact, the new excise tax is not expected to have a significant impact on pay packages because those are driven by the competitive market and the need for executives. It is likely to place budget pressure on organizations and require money to be redirected from mission purposes to administrative purposes. It may also cause some organizations to delve deeper into the quality of person needed for certain positions and the other items that can be covered by the budget.
Are there any planning opportunities for tax-exempt organizations to reduce the impact of the new excise tax? If so, what are some of those opportunities?
The use of deferred compensation and the design of it can impact the excise tax. For example, supplemental executive retirement plans (SERPs) are common for senior executives. SERP benefits usually vest at one date and are, therefore, taxed at that date because there is then no substantial risk of forfeiture. It may be possible to avoid the $1 million limit in any year by spreading the vesting over several years. Of course, this may negate some of the retentive effect of the SERP.
Do you have any predictions on how this new excise tax may change executive compensation at tax-exempt organizations?
It is likely to bring more focus on whether deferred compensation or current compensation is more logical on a situation by situation basis, with perhaps more current compensation so there is not the large one-time lump sum pushing compensation over $1 million in a year. Initially, as in the for-profit world when Code Section 162(m) was adopted, it is likely to push compensation around the $1 million mark down. However, in the long run, organizations must pay what is necessary to attract the people they need and want and it just becomes an additional budget cost.