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New Excise Taxes Applicable to Tax-Exempt Organizations New Excise Taxes Applicable to Tax-Exempt Organizations

New Excise Taxes Applicable to Tax-Exempt Organizations

As tax filing season quickly approaches, it is important to recall certain changes made as part of the Tax Cuts and Jobs Act ("Act"), signed into law on Dec. 22, 2017. Several of the provisions relate to tax-exempt organizations, including new rules affecting the executive compensation paid by certain tax-exempt organizations. Specifically, new Internal Revenue Code ("Code") Section 4960 imposes an excise tax on applicable tax-exempt organizations that pay excess compensation to their most highly compensated employees. The new excise tax is effective for tax years beginning after Dec. 31, 2017. The following provides an overview of how the new excise tax may affect compensation plans for tax-exempt hospitals and health systems.

What is the Excise Tax?

Code Section 4960 imposes a 21% excise tax on the following items:

  1. remuneration in excess of one million dollars paid for a taxable year by an applicable tax-exempt organization with respect to the employment of a covered employee; and
  2. excess parachute payments paid by an applicable tax-exempt organization to a covered employee for the taxable year.

As a result, the excise tax applies to a covered employee who receives excess parachute payments, even if the employee is not paid over one million dollars for the taxable year. Under Code Section 162(m), certain corporations are denied a deduction for excess compensation. This new excise tax results in similar adverse tax consequences for applicable tax-exempt organizations that pay excess compensation.

What Tax-Exempt Organizations Are Subject to the New Excise Taxes?

Code Section 4960 applies to, among other entities: (i) organizations exempt from tax under Code Section 501(a), including any organization described in Code Section 501(c), such as a charitable hospitals; (ii) organizations whose income is excluded from taxation under Code Section 115(1); and (iii) religious or apostolic organizations organized for the purpose of operating a communal religious community under Code Section 501(d).  

Who Is a Covered Employee?

Only compensation paid to a covered employee triggers the excise tax under Code Section 4960.  The definition of covered employee includes the following employees and former employees:

  1. the five highest compensated employees of the applicable tax-exempt organization for the taxable year; and
  2. any employee who was a covered employee of the applicable tax-exempt organization for an earlier taxable year beginning on or after Jan. 1, 2017.

To clarify, once an employee becomes a covered employee, he or she will remain a covered employee for all future years, even after termination of employment. As a result, an applicable tax-exempt organization may have more than five covered employees for a taxable year.

What Counts as Remuneration for Purposes of the Excise Tax?

Remuneration means "wages" that are subject to federal income tax withholding at the source under Code Section 3401(a). This includes all compensation for services performed by a covered employee for the applicable tax-exempt organization, such as:

  • salaries, tips, fees, bonuses, commissions;
  • taxable fringe benefits;
  • severance pay;
  • deferred compensation payments;
  • taxable medical benefits; and
  • the cash value of remuneration paid in a form other than cash.

Remuneration also includes amounts required to be included in gross income under Code Section 457(f). Code Section 457(f) applies to ineligible deferred compensation paid by a state or local government or a tax-exempt employer. Deferred compensation subject to Code Section 457(f) is included in gross income in the first year in which the legal right to such compensation is no longer subject to a substantial risk of forfeiture (i.e. when the employee's interest becomes vested), even if not paid or payable until a later date.

Remuneration does not include:

  • the taxable cost of group term life insurance;
  • employer or employee pre-tax contributions or Roth after-tax contributions to a 403(b), 401(k), or 457(b) plan; or
  • any amount paid to a licensed medical professional, including a veterinarian, which is for the performance of medical or veterinarian services by such professional.

Importantly, the last exemption to the definition of remuneration is obviously good news for hospitals that are applicable tax-exempt organizations. Note, however, that if a licensed medical professional performs services in addition to medical or veterinarian services, such as administrative or teaching services, compensation for such services would likely constitute "remuneration" for purposes of Code Section 4960.

A covered employee's remuneration by an applicable tax-exempt organization includes remuneration paid with respect to the employment of the covered employee by any related person or governmental entity. A person or governmental entity is treated as "related to" an applicable tax-exempt organization if the person or entity:

  • controls, or is controlled by, the applicable tax-exempt organization;
  • is controlled by one or more persons, which control the applicable tax-exempt organization (a brother-sister relationship); and
  • is a 501(c)(3) supported organization under Code Section 509(f)(3) with respect to the applicable tax-exempt organization (a supported organization is a public charity that relies on another exempt organization for support. For example, this may include a hospital that is supported by a related foundation).

What is an Excess Parachute Payment?

An excess parachute payment is the amount by which a parachute payment exceeds the portion of the base amount allocable to such payment. A parachute payment is any payment in the nature of compensation to (or for the benefit of) a covered employee if:

  • it is contingent on the employee's separation from employment, and
  • the aggregate present value of the payment(s) equals or exceeds three times the base amount.

The base amount means the average annual compensation, which was includible in the covered employee's gross income for the most recent five taxable years ending before the date of the employee's separation from employment. Parachute payments may be payable pursuant to an employment agreement, a change of control agreement, or a severance plan or agreement. They also may be payable pursuant to a deferred compensation arrangement, such as an arrangement subject to Code Section 457(f) that pays deferred compensation at a specified date if the employee continues to work until that date, but pays the deferred compensation earlier if the employee is terminated from employment without cause.

A parachute payment does not include:

  • payments made to or from a 401(a) plan, 403(b) plan, 457(b) plan, simplified employee pension plan, or simple retirement account;
  • amounts paid to a licensed medical professional, including a veterinarian, to the extent the payment is for the performance of medical or veterinary services by such professional; or
  • compensation to an individual who is not highly compensated employee under Code Section 414(q).

A highly compensated employee for 2018 is an employee who earned more than $120,000 in 2017.

Who Pays the Excise Tax?

The applicable tax-exempt organization generally pays the excise tax. However, if more than one employer pays the remuneration taken into account under new Code Section 4960 for purposes of the one million dollar excise tax, each employer is liable for a pro rata portion of the excise tax, even if the employer is not an applicable tax-exempt organization.

What Should Tax-Exempt Organizations Do Now?

Tax-exempt organizations should determine whether they are an applicable tax-exempt organization within the meaning of Code Section 4960 and, if so, identify their covered employees who are making more than one million dollars a year or who may be entitled to receive parachute payments following termination of employment. Organizations should determine their potential exposure to the new excise tax. They should also determine ways in which they may be able to structure compensation arrangements to minimize or avoid the tax. Most tax-exempt organizations are prohibited under the anti-private inurement rules from paying certain persons more than reasonable compensation. Additionally, with respect to tax-exempt organizations under Code Sections 501(c)(3) and (4), the Internal Revenue Service may impose excise taxes on the persons receiving the excess compensation, as well as the persons approving the excess compensation, under Code Section 4958's intermediate sanction rules. The fact that such an organization owes an excise tax under Code Section 4960 does not mean the compensation is unreasonable under the intermediate sanction rules. However, it will be particularly important for these tax-exempt organizations to ensure they have taken appropriate steps to create a rebuttable presumption of reasonableness with respect to officer compensation.

For more information, contact Matt Ehinger or Tara Sciscoe, or another member of the Ice Miller Employee Benefits or Tax-Exempt Practice.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader’s specific circumstances.

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