The 2017 Tax Cut and Jobs Act included many tax law changes. Tax-exempt entities were impacted in many ways including changes for taxable transportation fringe benefits like employee provided parking, reporting of net operating losses on unrelated business activities and a new excise tax on excess executive compensation.
One of the revenue raisers in the 2017 tax reform bill included limiting the amount of executive compensation a for-profit corporation could deduct. Now, all compensation paid to publicly-traded company executives over $1 million will no longer be deductible. Congress enacted code section 4960 to tax excess nonprofit compensation in an attempt to provide parity with the deductibility of executive compensation for publicly traded for-profit companies.
Compensation Paid by an ATEO
The new code section 4960 imposes an excise tax of 21% on the amount of compensation paid by an “applicable tax-exempt organization” (ATEO) with respect to the employment of any covered employee in excess of $1 million and on any excess parachute payment paid by such organization to any covered employee.
Compensation paid would include all remuneration of a covered employee, including non-cash benefits, except tax-qualified retirement plans. Amounts paid to licensed medical professionals, including veterinarians, for the performance of medical or veterinary services, are excluded from this new excise tax. Payments from related organizations and governmental entities are included, and those entities pay their pro-rata share of the excise tax.
A covered employee means any ATEO employee that is one of the organization’s five highest-compensated employees for the tax year, or was a covered employee for any preceding taxable year, starting after December 31, 2016.
Nonprofit Excess Parachute/Separation Payments
Excess parachute payments are amounts exceeding three times the employee’s five-year average wages. The employer is subject to a 21% excise tax on the difference between the present value of the separation payment and average of the employee’s last five years of compensation prior to their departure, the Base Amount. For example, a nonprofit provides a departing executive with a lump-sum payment of $800,000 on the date of separation. The executive’s base salary was $200,000, so the separation payment is more than three times the base. Only the difference between the separation payment and the base salary, $600,000, is considered excess. In this scenario, the employer would be liable for excise taxes of $126,000, or 21% of $600,000.
Nonprofits with executive salaries at or near $1 million need to be aware of the new excise tax. Nonprofits impacted by this new rule should consider adjusting employee compensation or bonuses to not exceed the $1 million annual threshold. Organizations with golden parachute agreements should consider replacing parachute payments with a phased retirement program. Rather than agreeing to one lump sum payment at retirement, consider a structured step down over a three-year period.
Exempt organizations with questions about the new rules imposing excise tax on executive compensation should reach out to PBMares’ Nonprofit team for further guidance.