The sweeping 2017 federal tax law known as the Tax Cuts and Jobs Act added a number of nonprofit-organization-specific provisions to the tax code, including a new 21% excise tax on certain compensation paid by nonprofit organizations. While this provision is focused on nonprofit executive compensation of more than $1 million, its scope is much broader than may first appear.
Under new Section 4960 of the Internal Revenue Code of 1986, as amended (the "Code"), nonprofit organizations that pay "excess remuneration" or make "excess parachute payments" to "covered employees" will be subject to a 21% excise tax.1 On December 31, 2018, the IRS issued Notice 2019-09 (the "Notice"), its first piece of substantive guidance on Code Section 4960. The Notice clarifies that Code Section 4960 casts a wide net, and will impact many nonprofit organizations, even some that pay their executives well under $1 million in compensation.
Excess Remuneration
"Excess remuneration" is "remuneration" paid to a "covered employee" (one of the top five highest-compensated employees at the organization, as further defined below) in excess of $1 million. "Remuneration" includes wages for purposes of federal income tax withholding, such as salary and bonuses, as well as all amounts included in gross income under a nonqualified deferred compensation plan under Code Section 457(f).2 Thus, for example, if a nonprofit organization pays a covered employee remuneration of $1.5 million, the remuneration will trigger an excise tax of $105,000 (21% of the excess of $1.5 million over $1 million, or $500,000). However, even if a nonprofit organization does not pay any of its employees annual remuneration in excess of $1 million, the organization could be subject to the excise tax if it has a deferred compensation plan in which benefits are spread out over a period of years, and then vest all at once.
For example, a nonprofit organization that pays its chief executive officer an annual salary of $700,000 per year and contributes $50,000 per year to a deferred compensation plan that vests after 10 years could be liable for a tax of $42,000 in the year of vesting (21% of the excess of $1.2 million (salary of $700,000 + vested deferred compensation of $500,000) over $1 million, or $200,000). Thus, even though the nonprofit organization never paid its chief executive a salary of more than $700,000, it incurred liability for the excise tax when the chief executive's deferred compensation vested. Importantly, Code Section 4960 does not provide a "grandfather" rule that would exempt remuneration paid under a deferred compensation plan that was entered into prior to the enactment of Code Section 4960.
Excess Parachute Payments
In addition, a nonprofit organization's payment of severance to a departing employee who is a covered employee will trigger the excise tax if such payment is an "excess parachute payment" – generally, a severance payment that is more than three times the employee's average salary over the last five years. More specifically, an "excess parachute payment" is an amount equal to the excess of any "parachute payment" over the covered employee's "base amount." Code Section 4960 provides that an amount is a parachute payment if (i) the payment is contingent on the covered employee's separation from employment and (ii) the present value of the payment equals or exceeds three times the covered employee's average annual remuneration for the five most recent taxable years ending before the date of separation. For example, if a nonprofit organization that has paid its chief executive officer an average annual salary of $300,000 from 2014-2018 pays such executive severance of $905,000 in 2019, $605,000 of the severance payment constitutes an "excess parachute payment" subject to the 21% excise tax. Thus, the severance payment generates a tax burden for the organization of $121,000 (21% of $605,000). Note that the excise tax is imposed even though the executive's total remuneration never exceeded $1 million in any year.
Who Is a Covered Employee?
A "covered employee" is any individual who is one of the organization's five highest-compensated employees for the current taxable year, based on remuneration paid in the calendar year ending with or within the employer's fiscal year plus any individual who was a covered employee for any preceding taxable year beginning after December 31, 2016. The Notice states that there is no minimum dollar threshold to be a covered employee. The Notice provides the following guidance on identifying covered employees:
- Each employer within a related group of tax-exempt organizations will need to make its own separate determination of who is a covered employee in every year (even in years when the employer is not subject to the excise tax).
- Once an individual is classified as a covered employee, the individual remains a covered employee indefinitely, even if the individual is no longer one of the employer's five highest-compensated employees.
- In identifying its five-highest compensated employees, an employer must include remuneration paid to the employee by any "related" organizations.
Based on the foregoing rules, many nonprofit organizations will need to implement systems and procedures to identify their covered employees. Hospital and university systems, and other nonprofit organizations with multiple affiliates, will be most affected by the foregoing guidance, but many other organizations will also need to establish record-keeping or tracking systems to monitor remuneration paid (or deferred) in the future.
In sum, in addition to nonprofit organizations that pay remuneration in excess of $1 million, Code Section 4960 can potentially affect many other nonprofit organizations, including those organizations that use deferred compensation plans to attract and retain executives, and those that pay severance packages to departing employees. Furthermore, the $1 million threshold is not adjusted for inflation, so over time it will encompass an ever-increasing number of nonprofit organizations. In addition, the requirement to track covered employees indefinitely introduces new record keeping requirements for many nonprofit organizations.
Note that a number of groups are looking into regulatory and/or statutory relief from the effects of Section 4960. If your organization is interested in participating, please contact any one of us and we can provide additional information and connect you with other interested groups. Additionally, for more information, visit ASAE's Public Policy site.
- Although the excise tax applies to most organizations that are exempt from federal income tax, a governmental organization (such as a state college or university) is generally not subject to the Code Section 4960 excise tax, unless such organization has received a determination letter from the IRS recognizing it as exempt from tax under Code Section 501(a).
- Remuneration does not include wages paid for the performance of medical or veterinary services or designated Roth contributions.