The 21% excise tax leveraged on excess compensation as outlined in the Tax Cuts and Jobs Act (TCJA) is equal to the corporate tax rate. In an effort to provide more guidance to the applicable tax-exempt organizations (ATEOs) that are subject to this tax rate, the IRS issued guidance outlining the meaning of excess compensation and how it should be calculated for tax purposes.
Section 4960 was added to the Internal Revenue Code by the TCJA and states that “covered employees,” whose pay is greater than $1 million or who receive excess parachute payments, are covered by this tax. Understanding and calculating these excess payments is critical even for ATEOs who do not compensate anyone in excess of $1 million. It is particularly relevant for deferred compensation plans, severance payments, settlement agreements, and other parachute payments.
Who are ATEOs?
ATEOs are any tax-exempt organization organized under Section 501(a) and any related organization that is making excess payments to covered employees. This includes public charities from collages to hospitals, electric cooperatives to certain governmental entities. Related organizations would be foundations designed to support certain charitable entities, groups under substantially similar control to the ATEO, or organizations that have a board of directors made up of representatives from the ATEO.
Who are Covered Employees?
In addition to employees making over $1 million in compensation, an ATEO’s covered employees are the five highest-compensated individuals each year. This number must be based on pay collected from the ATEO as well as any related entities. Once someone has been designated as a covered employee, they continue to be considered part of the category, even if other employees fall into the five highest-paid categories in a different year. There are some exceptions in the case of employees that provide medical or veterinary services where they can exempt portions of their pay related to these services.
What is Excess Compensation?
Compensation subject to the 21% excise tax is the excess compensation about which these guidelines are concerned. This includes compensation and wages subject to income tax withholding in excess of $1 million. Distributions from certain tax-qualified retirement plans are excluded, but other vested amounts, such as those under 457(b) deferred compensation plans, may be included. Severance agreements are treated as deferred compensation, which would be included, regardless of how the payment is structured. This compensation is considered “paid” when there is only a limited risk of forfeiture, so for example, when vesting begins, then the compensation would be calculated based on the present value of future payments.
For any covered employee, a parachute payment is a payment that is contingent on the end of someone’s employment and the total compensation is greater than three times the base amount. This base amount is calculated based on the average annual compensation an employee received while working for the ATEO for the five most recent taxable years. As previously set forth above, there are some exceptions to the base amount, including payments from a qualified plan and payments for professional medical or veterinary services.
The interim guidance issued by the IRS is what companies should currently follow, but it is not the final regulation that will govern this particular issue.