The Tax Cut & Jobs Act of 2017 includes important provisions impacting non-profit organizations, with few exceptions.  Specifically, under Section 4960 of the Internal Revenue Code (the “Code”), a non-profit will be subject to a new 21% excise tax on (1) compensation exceeding $1 million annually and/or (2) excess parachute payments to covered employees (typically, the organization's executives).  As with any tax law, the devil is in the details.  

General Rule:

A.  Excise Tax on Remuneration/Compensation in excess of $1 million.  Any  Remuneration/Compensation earned by a covered employee in excess of $1M will be subject to an excise tax.  The tax (which the organization, not the individual, has to pay) is at a 21% rate on the amount in excess of $1M paid to the executive. 

Many of our clients were not initially concerned about the excise tax because none of their highly compensated employees earned $1M; however, there is a separate excise tax applicable to payments made upon a separation from service, which can apply regardless of how much a covered employee earns annually.  This is explained directly below.

B.  Excise Tax on Excess Parachute Payments.  An excise tax will be imposed on the non-profit for excess parachute payments (which are payments contingent upon a covered employee’s separation from employment) where the aggregate present value of the payments to or for the benefit of the employee is equal to or greater than 3x the base amount.  The base amount is the average compensation earned during the 5-year period preceding separation.  If the covered employee’s separation pay exceeds 3x the base amount, an excise tax is imposed on the excess.  Note that the 3x amount can actually be less that $1M in total, and still 

Important Terms:

The following terms are important in determining whether a non-profit or its covered employees are at risk for an excise tax:

1.  Covered Employees.  “Non-Profit’s” covered employees include the five highest compensated employees for the taxable year (2018), and any preceding taxable year beginning after December 31, 2016 (e.g., 2017).  

2.  Compensation/Remuneration for each covered employee, which includes, but may not be limited to:

  • Wages reported on Form W-2;
  • Amounts included in gross income under Code Section 457(f) because such amounts are “vested” (no longer subject to a substantial risk of forfeiture); and
  • Remuneration from related organizations.  Yes, as with most tax laws, compensation from related entities or members of the non-profit’s controlled group must be included.

** Compensation does not include compensation paid to a licensed medical professional (e.g., doctor, nurse, or veterinarian) for the performance of medical or veterinary services.

3.  Related Organizations.  If any of “Non-Profit’s” covered employees receive compensation from a related organization, that compensation must be analyzed.  Related organizations include an entity: (i) in control of or controlled by the “Non-Profit”; (ii) controlled by one or more persons in control of “Non-Profit”; or (iii) supported by “Non-Profit” or supporting “Non-Profit; or (iv) in the case of a VEBA (voluntary employees beneficiary association), establishes, maintains, or makes contributions to such VEBA.

What should non-profit organizations be doing at this time?

1. Determine whether either of the excise taxes is applicable.  Certain organizations (e.g. political organizations) are not subject to the new excise tax rules.  

2. Compile a list of the five highest compensated employees (current and former) for 2017 and 2018.

3. For 2017 and 2018 tax years, inventory the annual salary data for each of the five highest compensated executives. Certain perquisites and other benefits may need to be included. For example, the value of a company car would likely be included as compensation.

4. Review all employment agreements, 457(f) arrangements, severance, and other deferred compensation agreements to determine whether any payments thereunder are compensation under the new tax law.

5. Compile a list of all related organizations and information regarding any payments from related organizations make to a covered employee for 2017 and 2018.

6. Calculate the base amount for each covered employee, which requires an averaging of each covered employee’s previous five years’ compensation.  

It is important to note that the new excise tax rules do not affect the Intermediate Sanctions provisions of Section 4958 of the Code which apply to 501(c)(3) and 502(c)(4) organizations. These provisions provide for an excise tax on the individual and certain organization managers for compensation found to be unreasonable by the IRS.  Section 4958 includes procedures for creating a “rebuttable presumption of reasonableness” in setting compensation which makes it much harder for the IRS to make the case for unreasonable compensation.  It is important that non-profit organizations to which the Intermediate Sanctions rules apply continue to ensure only reasonable compensation is paid to affected employees, and ensure strict compliance with the new excise tax provisions under Section 4960 of the Code.

Currently, we are assisting our non-profit clients who could be impacted by the excise tax under Section 4960 by tracking covered employees and their compensation for 2017 and going forward to determine whether the risk of an excise tax exists or could potentially exist.  The tracking of all covered employees and their compensation will also provide the necessary support in the event of an IRS audit.  In addition, the new statute leaves a number of unanswered questions, which will likely be addressed in future guidance.