The Tax Cuts and Jobs Act of 2017 added a 21 percent excise tax on tax-exempt organizations, including associations, that pay what the law defines as “excess tax-exempt organization executive compensation” through the addition of IRC Section 4960. While most people are aware that this is a 21% excise tax on compensation in excess of $1M, it is actually more complicated. While the TCJA may sound like old news, the final regulations on excess tax-exempt organization executive compensation were released at the start of 2021 and are effective for tax years starting after December 31, 2021 so the 2022 tax year is the first one for which these final regulations are applicable.
Before we get too far in to this discussion it is important that we understand the technical definitions of some common terms that we will be using.
- For purposes of Section 4960 wages means all remuneration for services performed by an employee for his employer, including the cash value of all remuneration (including benefits) paid in any medium other than cash.
- It does not include the following:
- Designated Roth contribution
- Payments to a licensed medical professional for the performance of medical services by such professional
- Any employee of an applicable tax-exempt organization if the employee-
- Is one of the 5 highest compensated employees of the organization for the taxable year, or
- Was a covered employee of the organization for any preceding taxable year beginning after December 31, 2016. This means that even if a person is no longer one of the 5 highest compensated employees the fact that they had been before causes them to retain the covered employee status.
Applicable Tax-Exempt Organization (ATEO)
- Any organization that is exempt from taxation under 501(a)
Two Distinct Rules under IRC Section 4960
Under IRC Section 4960 excise tax is paid on excess tax-exempt organization executive compensation under two distinct rules. The first is for remuneration paid in excess of $1M to any covered employee and the second is for excess parachute payments.
Remuneration in Excess of $1M
Let’s discuss what we must consider when we are trying to determination if remuneration paid was in excess of $1M. While there are many items such as salary, employer 403(b) contributions, etc. that are very straightforward, many deferred compensation arrangements need closer examination. Deferred compensation is included in remuneration for the year in which it becomes vested under Section 457(f), i.e. when it is no longer subject to a substantial risk of forfeiture.
Example #1 : An executive director has a five-year employment agree that provides for salary and benefits equal to $800,000 annually and for $150,000 of deferred comp per year to be paid out only if the full five-year term is served.
- Since the deferred comp carries with it a substantial risk of forfeiture it is not included in his remuneration calculation in years 1-4. As such, no excise tax would be paid for those years. At the end of year 5, the substantial risk of forfeiture is gone. In year 5 she would have earned the $800,000 annual salary/benefits plus $750,000 of deferred comp, for a total of $1,550,000. The organization would owe excise tax at 21% of the $550,000, which is the excess compensation over $1M, which comes out to $115,500.
Example #2: Same as above but the executive director is paid the $150,000 as a bonus every December.
- Since the bonus is not subject to a risk of forfeiture, it would be included in the annual calculation. Each year in years 1-5 the executive director would have $950,000 of remuneration. The organization would not owe any excise tax to the IRS.
As you can see in the two examples, the executive director is receiving the same amount of compensation under each agreement. However, the first agreement is costing the organization an extra $115,500 in excise tax. Obviously there are business reason for structuring deferred comp plans so while example two removes any excise tax it might not be the right solution for every situation. However it is important that organizations understand the impact of their deferred compensation plans on their future tax liabilities.
Another consideration is that ATEOs must aggregate compensation with Related Organizations. The Final Regulations require that remuneration for each covered employee must include not only remuneration from the ATEO but also remuneration from all “related organizations.” The threshold for relatedness is 50%. Organizations can be related on the basis of different factors, including voting rights or rights to value of a corporation, profits or capital interests in a partnership, beneficial interests in a trust, or control over the organization’s board or similar governing body. In finalizing the regulations, the Treasury and IRS rejected requests to count only remuneration paid by an ATEO for services provided to the ATEO. Treasury and the IRS concluded that loosening the aggregation rule could increase the potential for abuse.
Even if a covered employee does not exceed $1M is remuneration, separate payments to that person could trigger the parachute payment tax. Separation pay includes any amount that becomes payable as a result of a covered employee’s involuntary separation from employment with an employer. The general rule is the parachute tax is triggered if separation pay equals or exceeds 3 times a covered employee’s “base amount.” The base amount is not the current salary but the individual’s average taxable wages as reported on Box 1 of Form W-2 over a five year period. For parachute payments even nontaxable compensation is taken in to account so the value of health insurance and life insurance would be included as parachute payments. Additionally, vesting bonuses, equity and other deferred comp paid out at involuntary termination are included in the parachute calculation.
While the threshold for triggering the excise tax is 3 times the base amount, the actual excise tax is applied to the separation payment in excess of 1 times the base amount. For example, assume a base amount of $200,000. The excise tax would be triggered if the separation pay is $600,000 or more. If the individual’s separation pay is $599,999 the excise tax would not be triggered. If the individual’s separation pay is $600,000 the excise tax about be $84,000 (21% of the excess of $400,000 over the $200,000 base). The one dollar pay difference equated to a difference of $84,000 in tax.
The Bottom Line
If there is compensation related excise tax due, it is reported and paid by filing Form 4720. The Form 4720 has the same due date as the organization’s 990 and is automatically extended if the 990 extended. The tax due must be paid by the due date without extension. A note for fiscal year entities, the Final Regulations provide that the applicable tax year is the calendar year ending with or within the ATEO’s tax year. For amounts paid in calendar year 2021, the excise tax would have to be reported and paid by the Form 990 filing deadline. The IRS is increasing scrutiny over failure to file the Form 4720 and less likely to waive penalties associated with failure to file the form.