The Tax Cuts and Jobs Act (the Act), which was signed into law on December 22, 2017, makes numerous changes to the Internal Revenue Code (the Code), some of which affect the tax-exempt sector. Among those changes is the addition of a new excise tax on certain tax-exempt organizations in connection with the compensation paid to their highest compensated employees. This excise tax applies to the following:
- “Remuneration” other than “Excess Parachute Payments” paid to a “Covered Employee” in excess of $1 million in the tax year; and
- any Excess Parachute Payment that is paid by the tax-exempt organization to a Covered Employee.
This new excise tax is intended to place tax-exempt organizations on equal footing with publicly held corporations, which generally are not permitted to deduct compensation expenses in excess of $1 million for each covered employee or the value of Excess Parachute Payments.
The new excise tax is effective for tax years beginning after December 31, 2017, and the Act does not contain a transitional provision that would protect any compensation arrangements that existed before the Act. Therefore, tax-exempt organizations should analyze their compensation arrangements to determine whether and to what extent those arrangements may subject them to the excise tax.
I. Which Tax-Exempt Organizations are Subject to the Excise Tax?
The new excise tax applies to most tax-exempt organizations, including organizations exempt from taxation under Section 501(a) of the Code, certain governmental entities, and certain political organizations. Persons or governmental entities related to these tax-exempt organizations (each, a Related Organization) also may be subject to the tax under circumstances described in Section III below.
II. Who is a Covered Employee?
For purposes of the new excise tax, a Covered Employee is any current or former employee who (a) is one of the five highest compensated employees of the organization (each, a Highest Compensated Employee) for the tax year; or (b) was a Covered Employee for any preceding tax year beginning after December 31, 2016. Accordingly, once a person becomes a Covered Employee, he or she will remain a Covered Employee for all subsequent tax years, even if he or she no longer qualifies as a Highest Compensated Employee during those tax years.
III. What is Remuneration?
Remuneration includes wages, other than designated Roth contributions, and any amounts that are required to be included in gross income under Section 457(f) of the Code (e.g., vested benefits under certain deferred compensation plans, even if not yet received). Additionally, Remuneration also includes any Remuneration paid by a Related Organization in connection with the employment of a Covered Employee. For these purposes, a Related Organization is any person or governmental entity that (a) controls, or is controlled by, the organization; (b) is controlled by one or more persons that control the organization; (c) is a supported organization with respect to the organization; (d) is a supporting organization with respect to the organization; or (e) with respect to an organization that is a voluntary employees’ beneficiary association (a VEBA), establishes, maintains, or makes contributions to the VEBA.
Remuneration does not include amounts that are not deductible by reason of the $1 million limit that applies to publicly held corporations. It also does not include amounts paid to licensed medical professionals, such as doctors, nurses, or veterinarians, for their performance of medical or veterinary services. Amounts paid to a medical professional in any other capacity, however, do constitute Remuneration. If, for example, a surgeon were paid $600,000 for the performance of medical services and $500,000 for service as the Chief Executive Officer of a hospital system, only $500,000 would be considered Remuneration for purposes of the new excise tax analysis.
IV. What is an Excess Parachute Payment?
A parachute payment generally is a payment that is made to or for the benefit of a Covered Employee and is contingent upon his or her separation from employment with the organization. A parachute payment is considered an Excess Parachute Payment if the aggregate present value of all parachute payments made to the Covered Employee equals or exceeds three times his or her average compensation from the five years preceding his or her separation from employment. The Act includes certain exceptions to the definition of Excess Parachute Payment, including exceptions for payments under certain deferred compensation plans and for payments to medical professionals for their performance of medical services.
V. Who is Responsible for the Excise Tax Liability?
The new excise tax is assessed on the employer at the corporate federal income tax rate, which presently is 21 percent. Where the tax is imposed on Remuneration paid by the tax-exempt organization and one or more Related Organizations, each employer is liable for its proportionate share of the tax liability based upon the amount of Remuneration it paid to the Covered Employee.
VI. Q&B Comment
Certain aspects of the new excise tax regime will require clarification. For example, although the Act expressly provides that amounts paid to a medical professional for the performance of medical services are excluded from the computation of his or her Remuneration and any Excess Parachute Payments, it is silent as to whether those amounts similarly are excluded for any other purposes. Accordingly, it is unclear whether those amounts would be excluded for purposes of determining whether the medical professional is a Covered Employee. The Conference Agreement, as summarized in the Conference Report, appears to indicate that those amounts would in fact be excluded in determining whether the medical professional is a Covered Employee. Specifically, it states, “For purposes of determining a covered employee, remuneration paid to a licensed medical professional which is directly related to the performance of medical or veterinary services by such professional is not taken into account . . . .” Because this statement was not included in the Act itself, however, uncertainty remains. Similarly, the Conference Report provides, “A medical professional for this purpose includes a doctor, nurse, or veterinarian”, but the Act does not include this statement or otherwise define “medical professional.” Accordingly, guidance is needed to clarify who qualifies as a medical professional for purposes of the new excise tax.
Additionally, the Act does not define Highest Compensated Employee, which adds even more ambiguity to the Covered Employee analysis. It also is not clear why Congress chose to define Covered Employee to include the five highest compensated employees regardless of the tax-exempt organization’s size or number of paid employees, other than some notion of parity with publicly held corporations. It appears, however, that there may be some interesting planning opportunities in light of this rigid threshold.
The IRS’s Priority Guidance Plan for 2017-2018 recently was updated to include guidance on certain issues relating to the new excise tax on excess compensation paid by tax-exempt organizations. We suspect that the outstanding questions described above may be addressed in that guidance, but it is unlikely that the guidance will be issued in the near future given the complexities associated with employee compensation matters and the numerous other provisions of the Act that the IRS likely will need to clarify.