The Tax Cut and Jobs Act (the “Act”), signed into law by President Trump on December 22, 2017, received considerable attention for the changes it implemented to tax rates and other income tax provisions. Receiving far less publicity and discussion was the addition of Internal Revenue Code (“IRC”) section 4960, imposing a new excise tax on “excess compensation” paid to certain employees of applicable tax-exempt organizations. In this article we will look at this provision and at how it might affect your organization.
What is the New Excise Tax?
The Act imposes a 21% excise tax on an “applicable tax-exempt organization” on the amount of “remuneration” it pays a “covered employee” in excess of $1,000,000 and on any “excess parachute payment” paid to the employee in a taxable year. (We’ll define all these terms below). The excise tax rate is the same as the corporate tax rate under the Act and presumably would change if the corporate tax rate changes in the future. The tax is levied on the employer, and not on the employee.
What is an Applicable Tax-Exempt Organization?
There are a number of types of tax-exempt organizations that are subject to this tax. There are two that are most relevant for readers of this newsletter:
Organizations that are exempt from taxation under IRC section 501(a). This covers organizations that are tax-exempt under IRC section 501(c)(3).
Organizations that have income excluded from taxation under IRC section 115(1). An organization that is subject to the income exclusion of IRC section 115(1) generally includes governmental organizations that are not an “integral part” of a state or political subdivision of a state (e.g., a city or a county) but are performing an integral governmental function. This definition can include, for example, a state university.
What Employees are Covered by this Rule?
A “covered employee” is any employee, including a former employee, who is one of the five highest compensated employees for the taxable year or who was a covered employee for any preceding taxable year after December 31, 2016. This means that you may have more than five covered employees in any given year.
How is Remuneration Defined?
Remuneration is generally defined as wages under IRC section 3401(a), which is similar although not quite identical to wages entered onto the W-2 form. Remuneration also includes any amounts required to be included in gross income under a non-governmental section 457(b) and 457(f) plans but does not include amounts that are designated Roth contributions. It also includes amounts paid to the employee by any related organization. This basically includes organizations that have control over the applicable tax-exempt organization. For more information on controlled groups, see FAQ-Rules-for-Identifying-Controlled-Groups-of-Tax-Exempt-Organizations
What is an Excess Parachute Payment?
First, let’s define a parachute payment, which is any compensation paid to an employee that is contingent on the employee separating from service and the present value of such payment is equal to or exceeds three times the “base amount.” The base amount is generally the average annual compensation paid to the employee during the most recent five taxable years before the severance (or fewer years if the employee has fewer years of service). Finally, an excess parachute payment is the excess of any parachute payment over the base amount. The excise tax is levied on the excess parachute payment.
This is best described in an example. Assume that a covered employee is terminating in 2020 and receiving a severance payment plus a distribution from a 457(f) plan of $800,000. The employee’s base amount (the average compensation over the last five years) is $250,000. The payment is a parachute payment because it is contingent on the employee separating from service and it exceeds three times the base amount ($750,000). The excess parachute payment amount is the parachute payment ($800,000) over the base amount ($250,000) or $550,000. The excise tax is 21% of $550,000.
Note that a number of types of payments are not included in determining whether the amount being paid is a parachute payment. These include distributions from qualified plans, 403(b) plans, and 457(b) plans, and payments to a non-highly compensated employee.
What do I do Now?
If you have employees who are earning in excess of $1 million, you might be able to defer some of the employee’s compensation by using qualified and non-qualified plans to the fullest extent.
If you have employees whose severance pay plus compensation from a 457(f) plan might result in an excess parachute payment in the future, you can look at your severance and deferred compensation arrangements and see if you can restructure any of them. For example, you may be able to more fully utilize a plan that is exempt from the parachute payment calculation, such as a 457(b) plan. Or you might consider using a feature available under 457(f) plan that allows you to delay a taxable event under a plan to a date post termination. And, finally, you can review your severance plans and consider whether they can be restructured to keep you under the excise tax threshold.
If you would like further information about this issue, please contact Evan Giller or any of the other attorneys at Boutwell Fay, LLP.
© Boutwell Fay LLP 2018, All Rights Reserved. This handout is for information purposes only, and may constitute attorney advertising. It should not be construed as legal advice and does not create an attorney-client relationship. If you have questions or would like our advice with respect to any of this information, please contact us. The information contained in this article is effective as of March 2, 2018.