Effective for tax years beginning after 2017, the law known as the Tax Cuts and Jobs Act, P.L. 115-97, added new Sec. 4960, which imposes an excise tax on tax-exempt organizations that pay excessive compensation to certain employees.
Under Sec. 4960, compensation paid by an organization to a covered employee is considered excessive in two circumstances: (1) The individual's total compensation exceeds $1 million during the tax year; and (2) the aggregate present values of the individual's separation payments and benefits equals or exceeds three times his or her five-year average pay (even if less than $1 million). In either or both instances, an excise tax will be imposed on the organization, as described below.
Entities subject to Sec. 4960 include all organizations exempt from taxation under Sec. 501(a), farmers' cooperative organizations, certain state or local government entities, certain political organizations, and any organization related to such entities.
A covered employee includes a current or former employee who is among the five highest-compensated employees of the organization for the tax year or was a covered employee of the organization (or any predecessor) for any preceding tax year beginning after 2016. For purposes of determining the five highest-compensated employees, all wages paid by the organization (and any related entity) are counted, including income under Sec. 457(f). However, Roth contributions to a Sec. 401(k) plan, as well as any compensation for the performance of medical or veterinary services paid to a licensed professional, are excluded from this count.
$1 million limit
An excise tax equal to 21% of the compensation exceeding $1 million paid to a covered employee during the year will be imposed on the organization. However, excess parachute payments are not counted toward the $1 million limit.
Excess parachute payments
These provisions introduce to exempt organizations the "golden parachute" rules that for-profit corporations can encounter under Sec. 280G when mergers and acquisitions trigger change-of-control payments to certain individuals. Four key terms are involved: "base amount," "threshold test," "parachute payments," and "excess parachute payments."
In general, the base amount is a covered employee's average annual compensation received from the organization over the five calendar years ending before the date of separation. If the aggregate present values of the payments and benefits that are contingent on the covered employee's separation from employment equal or exceed three times the base amount, then the threshold test is failed and such contingent payments are characterized as parachute payments. The organization will be subject to an excise tax equal to 21% of the excess parachute payment, which is the excess of the parachute payment over the base amount.
Example: A lump-sum payment of $800,000 is made on the separation date with a base amount of $250,000. The separation pay is a parachute payment since it exceeds three times the base amount, $750,000. The excess parachute payment is the amount of the payment less the base amount ($800,000 - $250,000), or $550,000. The excise tax on the excess parachute payment is 21% of $550,000, or $115,500.
When determining whether payments in connection with a separation from employment exceed the threshold test, distributions from a qualified retirement plan, a Sec. 403(b) annuity, or a Sec. 457(b) plan are not counted. Moreover, all separation payments to employees who are not highly compensated employees (HCEs) under Sec. 414(q) are excluded from the threshold test.
Tax planning considerations
Exempt organizations may consider implementing longer vesting schedules that spread payments over multiple years so that no single year exceeds $1 million in compensation to a covered employee.
Organizations may also consider shifting the portion of a covered employee's bonus, which could exceed the $1 million annual limit when combined with base salary and other pay, to involuntary separation pay (or shifting separation pay that could exceed the threshold test to pay for active services). If both buckets are already at capacity, the organization may consider reducing the pay or modeling shifts between active and separation pay to minimize the aggregate excise tax. This strategy must comply with the tax rules under Secs. 457(f) and 409A governing nonqualified deferred compensation for employees of tax-exempt entities.
To clarify, the "shifting" strategy entails adopting a total rewards strategy that pays less in bonuses to covered employees during their active employment, so as not to exceed the $1 million limit for any one year, in exchange for greater involuntary separation pay (or vice versa), which is distinguished from electing to defer compensation. A strategy of deferring compensation that exceeds the annual limit may not be cost-effective for the organization since the proposed Sec. 457(f) regulations effectively require tax-exempt entities to match 25% of the amount deferred. The 25% match on deferred compensation would exceed the 21% excise tax on this amount in absence of the deferral — although the match would be paid to the covered employee, whereas the excise tax would be paid to the IRS. Upon making amounts that could exceed the annual limit contingent upon an involuntary separation, organizations should consider the techniques below to address potential parachute payments.
First, the most direct method of eliminating the excise tax on separation pay is to reduce the parachute payments by imposing a "cutback" provision within separation agreements that automatically limits the present values of separation payments to an amount that does not exceed 2.99 times the covered employee's base amount. Although the separation payments will be less than three times the base amount, an excise tax may still be imposed to the extent such payments, together with other compensation for the year, exceed $1 million.
Second, severance payments conditioned upon the individual's refraining from performing services (such as a covenant not to compete) may avoid being treated as parachute payments. The organization must demonstrate by clear and convincing evidence that the agreement substantially constrains the individual's ability to perform services and that there is a reasonable likelihood that the agreement will be enforced against the individual. Guidance from the IRS is welcome on the application of this strategy, which is widely used by public corporations to mitigate the adverse tax consequences of Sec. 280G. Notably, however, the separation pay would be characterized as reasonable compensation that is counted toward the $1 million limit.
Third, if the separation from employment is known sufficiently in advance, the organization may be able to boost the covered employee's base amount by accelerating significant amounts of taxable compensation within one or more years preceding the separation. Again, the $1 million annual limit must be taken into account.
Fourth, organizations may maximize employer contributions under nonqualified Sec. 457(b) retirement plans. Although distributions under qualified retirement plans (e.g., 401(k) and 403(b) plans) also escape parachute-payment treatment, such plans may provide less effective means of reducing the excise tax since (1) the nondiscrimination rules applicable to these plans either limit the employer contributions to covered employees or significantly increase costs by requiring the employer to make comparable contributions to all other active participants; and (2) employee deferrals are not within the organization's control and reduce the base amounts for the covered employees. As a trade-off, however, distributions from a Sec. 457(b) plan are wages counted toward the $1 million limit, while distributions from qualified retirement plans are not.
Fifth, a phased retirement program may eliminate parachute payments altogether. Recall that separation payments and benefits to individuals who are not HCEs cannot be parachute payments. The testing period for determining HCEs is the prior year, in which HCEs are those employees whose compensation for the lookback year exceeds $120,000, as indexed. A bona fide phased retirement program commencing in the year prior to the covered employee's separation from employment could reduce the employee's duties or work hours and compensation, such that the employee is not an HCE in the year of separation. This technique would eliminate all parachute payments, even if the employee's separation pay is more than three times the base amount. However, other factors should be considered, such as the need for the employee's full-time services and how the reduction in hours will impact eligibility for benefits.
A sixth strategy involves making payments based on age or an event other than separation from employment. If the upcoming regulations adopt the same principles as those set forth in the existing Sec. 280G regulations, this strategy may not be effective if the payment occurs within one year before or after the separation date because it creates a rebuttable presumption that the payment is materially related to the separation from employment.
To mitigate excise taxes under the new Sec. 4960, organizations should identify the covered employees and monitor the extent to which their annual compensation and separation packages may trigger excise taxes, quantify the exposure, and formulate an approach to address the adverse tax consequences. Future IRS guidance is anticipated to clarify the application of Sec. 4960 and determine the viability of the tax planning strategies proposed here.
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.