Beginning in 2018, new Internal Revenue Code ("Code") Section 4960 imposes an excise tax on certain types of tax-exempt organizations (referred to as “Applicable Tax-Exempt Organizations”) if they make excessive compensation payments to certain highly compensated employees (referred to as “covered employees”). The excise tax rate is equal to the corporate tax rate (currently 21%). Although compensation payments in excess of $1,000,000 may trigger an excise tax, this article focuses on the excise tax triggered by a separation from employment.
Applicable Tax-Exempt Organizations Applicable Tax-Exempt Organizations include a broad range of tax-exempt entities such as the following:
(1) organizations exempt from tax under Code Section 501(a); (2) governmental entities exempt from tax under Code Section 115; and (3) political organizations described in Code Section 527.
Therefore, entities such as charities, private foundations, social welfare organizations, churches, and hospitals could be impacted.
Covered Employee An employee is a covered employee if the employee is one of the five highest compensated employees of the Applicable Tax-Exempt Organization for the current year or a prior year beginning after 2016. Once an employee is classified as a covered employee, the employee remains a covered employee even if the employee is no longer one of the five highest compensated employees. Therefore, an Applicable Tax-Exempt Organization can have more than five covered employees.
The excise tax does not apply to payments made to employees who are not considered highly compensated employees under Code Section 414(q) (annual pay is less than $120,000 for 2018). Also, the excise tax does not apply to payments made to licensed medical professionals for the performance of medical services.
Application of the Excise Tax In general, a parachute payment is compensation paid to the covered employee that is contingent on his or her separation from service that is equal to or in excess of three times a “base amount”. The base amount is the covered employee’s average compensation for the five years prior to the year of separation from service. Compensation includes “W-2 wages” such as salary, taxable fringe benefits, and nonqualified deferred compensation which has vested.
To the extent a parachute payment exceeds three times the covered employee’s base amount, the excise tax is triggered. It is important to note that if the payment is equal to or in excess of three times the base amount, the excise tax applies to all amounts over the base amount, as illustrated in the following example.
Example: Assume a covered employee has a base amount (average compensation) of $200,000 and receives a severance payment of $800,000. Because the severance payment is contingent upon the covered employee’s separation from service and is greater than three times the base amount, it is a parachute payment. The excess parachute payment is $600,000 ($800,000 – $200,000) and the excise tax is $126,000 (21% x $600,000).
Considerations Applicable Tax-Exempt Organizations need to identify their covered employees and evaluate their potential exposure to the excise tax. It is imperative to act quickly to consider options to minimize or avoid the tax. For example, agreements with covered employees (including employment agreements, deferred compensation plans, incentive plans, and severance arrangements) should be reviewed to determine if they can be restructured in accordance with applicable rules such as Code Section 409A.
Code Sections 501(c)(3) and 501(c)(4) organizations need to keep in mind that escaping the Code Section 4960 excise tax does not mean the compensation is reasonable. If the compensation is deemed to be unreasonable, an excise tax could be imposed on the executive under the rules of Code Section 4958. To reduce the risk of triggering the excess benefit excise tax, these organizations also need to comply with specific IRS guidelines to establish a rebuttable presumption that the compensation is reasonable.