A Primer on the New Excise Tax on Nonprofit Compensation
As a result of the Tax Cuts and Jobs Act, passed at the end of 2017, many nonprofits found themselves facing a significant tax on both the compensation of certain employees and any separation payments, often called “parachute payments,” paid to highly-compensated employees, under IRC Section 4960. We covered this new tax in detail
on the blog in July 2018, but the IRS recently released additional guidance to help clarify grey areas and offer additional details.
While nonprofits’ board members may not be charged with managing tax issues, this represents a significant change that could pose a serious challenge for organizations. As many organizations are now doing their first set of returns that take this change into account, now is the time to make sure board members understand how it impacts their nonprofit. For any nonprofit stakeholders, it’s critical to understand the importance of this tax and how it may impact the organizations you serve. In the primer below, we’ve answered key questions on the tax, its application, and compliance matters to keep top-of-mind.
Who owes the tax?
The excise tax applies to what the IRS describes as “applicable tax-exempt organizations (ATEO)” and related entities. This includes all nonprofits and many governmental units. But they are not the only impacted organizations. Interestingly, for-profit employers related to the ATEO could also owe the excise tax. This could include, for example, for-profit entities within a tax-exempt hospital or a university’s controlled group. It could even apply to for-profit companies that have a tax-exempt foundation.
When is the tax owed?
Compensation paid “for the taxable year” by any ATEO or related entity (regardless of whether the entity is taxable or non-profit) is counted under this provision. The recent IRS guidance clarifies that the tax is determined based on remuneration paid in the calendar year ending with or within the employer’s taxable year, aligning with Form W-2 and Form 990 reporting. It also gives an initial, first-year advantage to ATEOs and related organizations that use non-calendar year fiscal years, since those entities will only owe the tax for the portion of their fiscal year which begins during calendar year 2018 (for example, if the fiscal year begins July 1, 2018, compensation paid from January 1 to June 30, 2018 escapes the tax).
Which employees are covered?
Covered employees include any current or former employee of an ATEO who is either:
- One of its five highest compensated employees for a calendar year; or
- Was the ATEO’s (or a predecessor’s) covered employee for any preceding calendar year beginning after 2016.
To track covered employees, organizations should undertake a two-step process:
1. Create a cumulative list
. Once an employee is on the covered employee list, he or she will remain on the list forever, even after termination of employment (including death). So ATEOs need to make a cumulative list of covered employees for 2017, 2018, and each subsequent year. Even though this provision took effect January 1, 2018, ATEOs need to make a covered employees list starting in 2017, because remuneration paid to those individuals in 2018 or later could trigger the tax. Since the definition of “covered employee” is cumulative, the list will likely include more than five individuals over time.
2. Rank the five highest compensated employees
. Each year, ATEOs must rank-order their most highly compensated employees to identify the top five for that year, based on remuneration paid by the ATEO and any related entity for services as an employee during the calendar year ending with or within the ATEO’s or related entity’s taxable year. However, certain amounts are excluded, such as remuneration paid for medical services (which are discussed in detail in the recent IRS guidance) and amounts paid to independent contractors (like board members). Also, if an ATEO pays less than 10 percent of an employee’s total remuneration, he or she may escape being in the ATEO’s top five. There is no minimum level of compensation to be included on the annual top five list, so the highest-paid employees should be included even if they were not paid over $1 million for that year and did not receive an excess parachute payment for that year. Note that each ATEO must separately determine whether an individual is one of its five highest compensated employees, so there isn’t one list for the entire group of related entities.
What pay counts?
Starting in 2018, ATEOs and related entities may owe a 21 percent excise tax on (1) annual remuneration paid to covered employees in excess of $1 million and (2) any excess parachute payments (amounts that exceed three times the employee’s five-year average wages and are contingent on involuntary termination).
An excess parachute payment is the aggregate amount treated as paid by an ATEO or related entity to a covered employee that is contingent on the employee’s involuntary separation from service (generally defined as including “good reason” terminations and failure to renew an employment agreement), if the present value equals or exceeds three times the employee’s five-year average compensation. Note that amounts paid due to a voluntary termination (such as a planned retirement) are not subject to the new tax.
Certain payments are included or excluded when calculating parachute payments, as follows:
- Contributions to and benefits from certain retirement plans and payments for certain medical services
- Deferred compensation payments and retiree medical benefits provided after an involuntary separation are excluded if the benefits vested before the separation, since the separation affected only the timing of the payments, not the employee’s right to the payments.
What pitfalls exist?
- Payments conditioned on a release of claims
- Damages for employment agreement breaches
- Window program payments (i.e., special separation pay for certain employees who terminate employment during the window period, which must be less than 12 months)
- Payments for noncompete (or nondisclosure or other similar agreements)
- Value due to the acceleration of vesting upon separation from service
Many organizations may focus their attention on compensation over $1 million, believing if they do not have any employees paid at that level there is no cause for concern. However, the separation payment provision may impact employees making much less than $1 million. Failure to understand this could add additional stress to employee departures. Recent IRS guidance clarifies that even if an employer never pays an employee more than $1 million per year, it could still owe the tax on excess parachute payments. However, employers who do not pay anyone over $125,000 for a year may not ever face this tax liability. Nevertheless, employers of all sizes must track “covered employees.”
Additionally, there is often confusion on how to calculate the tax when applied to separation payments. The employer is subject to a 21 percent excise 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 (also called the Base Amount). Organizations frequently misinterpreted this, assuming the tax is applied to three times the Base Amount. If an organization is off by just $1 in its calculations, it could trigger significant exposure.
There’s also significant potential liability for nonprofits that fail to pay these taxes appropriately. IRC Section 6684 imposes a 100 percent penalty on tax-exempt organizations that fail to pay excise taxes owed under Chapter 42 of the IRC — which includes Section 4960 — unless such failure was due to reasonable cause. For organizations with limited resources or funding, facing this liability could be crippling to long term financial health.
Despite much publicity about highly-paid public university athletic coaches being subject to this tax, some of those schools may avoid paying it unless Congress enacts a technical correction. However, one unexpected target could actually be for-profit companies. If, for example, an employee of a large, for-profit company also maintains a role at related nonprofit, it’s possible the IRS could consider them a statutory employee of the nonprofit organization, meaning their for-profit employer may end up owing the 21 percent tax on the employee’s compensation. The IRS is currently taking comments on this issue, but it may require a legal fix from Congress.
What should stakeholders do to help manage this change?
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- Talk with the nonprofit management team about this change, and the organization’s approach to managing it, particularly in advance of impending tax filing deadlines.
- Ensure that steps are being taken to identify covered employees each year, and work with a trained professional to make sure taxes are remitted as appropriate.
- Be sure to consider any for-profit organizations the nonprofit may be associated with to determine if it will be subject to the excise tax.
- Keep abreast of additional guidance and regulations, as well as any further developments from Capitol Hill.