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

New Excise Taxes Applicable to Tax-Exempt Organizations

In addition to changing the tax rates and rules applicable to individuals and corporations, the Tax Cuts and Jobs Act ("Act"), signed into law on Dec. 22, 2017, added 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, and, therefore, is already in effect.

This article is the first of a series by Ice Miller discussing how the Act affects employee benefits and compensation.

What is the New Excise Tax?

New Code Section 4960 imposes a 21% excise tax on:

  1. remuneration (not including excess parachute payments) 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.
Comment: 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.
 
Comment: 21% is the new corporate income tax rate under the Act. 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 applicable tax-exempt organizations, which are defined to include the following:

  • Organizations exempt from tax under Code Section 501(a), including:
    • Any organization described in Code Section 501(c), such as a charitable organization, social welfare organization, trade association, labor organization, social club, fraternal society, voluntary employee benefit association (VEBA), or veterans organization. 
Comment: Some governmental universities and hospitals are dual-qualified, i.e. have secured a determination letter under Code Section 501(c)(3) in addition to being tax-exempt due to their governmental status. Further guidance is needed as to the applicability of the excise tax to organizations that have more than one basis for their tax-exemption.

  • A religious or apostolic organization organized for the purpose of operating a communal religious community under Code Section 501(d).
  • A qualified trust forming part of a pension or profit sharing plan of an employer under Code Section 401(a).
Comment: A custodial account or annuity contract is treated as a qualified trust under Code Section 401(a) if it satisfies certain requirements. 
 
  • A trust under a governmental 457(b) plan, a 403(b)(9) retirement income account, or a 403(b) custodial account.
Comment: Governmental retirement systems and denominational church plans are, therefore, subject to the new excise tax.

  • Farmers' cooperative organizations exempt from tax under Code Section 521(b)(1).
  • Organizations whose income is excluded from taxation under Code Section 115(1). Code Section 115 exempts from tax the income of entities that are separate and distinct from states and political subdivisions but that serve an essential governmental function and whose income accrues to a state or political subdivision. Entities that rely on the Code Section 115(1) exemption may include hospitals, libraries, port authorities, fire associations, soil and water conservation districts, health plans, pooled liability funds, and economic development corporations.
Comment: The IRS has concluded that states and political subdivisions—and the integral parts of states and political subdivisions—are exempt from federal income tax under the doctrine of intergovernmental immunity. Political subdivisions of a state include counties, cities, towns, and school districts.  Significantly, public colleges and universities frequently qualify as either political subdivisions or as integral parts of states or political subdivisions. To the extent an organization of this type does not rely on Code Section 115(1) for exemption from tax, it appears not to be an applicable tax-exempt organization unless, potentially, it has obtained a determination letter under Code Section 501(c)(3), as discussed above.

  • Political organizations, such as political action committees ("PACs"), described in Code Section 527(e)(1).
Note: The definition of "applicable tax-exempt organization" under Code Section 4960 is much broader than the tax-exempt organizations subject to the intermediate sanction rules under Code Section 4958, which apply only to organizations exempt from tax under Code Section 501(a) and described in Code Sections 501(c)(3) (charitable organizations), (c)(4) (social welfare organizations), and (c)(29) (coop health insurance issuers). The intermediate sanction rules enforce the anti-private inurement rules that apply to most tax-exempt organizations by imposing an excise tax on certain persons who receive excess benefits and on those who approve such transactions.
 
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:

  • the five highest compensated employees of the applicable tax-exempt organization for the taxable year; and
  • 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. 
Comment: 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
  • 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.
Comment: The last exemption listed above is 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 (a parent-child relationship);
  • is controlled by one or more persons, which control the applicable tax-exempt organization (a brother-sister relationship);
Comment: While Code Section 4960 does not refer to the existing controlled group rules under Code Sections 414(b), (c), (m), and (o) and Treasury Regulation Section 1.414(c)-5, it is likely that the "control" rules under Code Section 4960 will be interpreted in a consistent manner. 
 
  • is a 501(c)(3) supported organization under Code Section 509(f)(3) with respect to the applicable tax-exempt organization;
Comment: 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 philanthropic entity.

  • is a 501(3) supporting organization under Code Section 509(a)(3) with respect to the applicable tax-exempt organization; or
Comment: A supporting organization is a public charity whose exempt purpose is to support another exempt organization. For example, this may include a foundation that supports a university. If the foundation pays a portion of the salary for the university's president, for example, that amount will count toward the president's remuneration for purposes of the excise tax.

  • in the case of an applicable tax-exempt organization that is a VEBA, establishes, maintains, or makes contributions to the VEBA.
Comment: The aggregation rules are intended to preclude employers from avoiding the new excise tax by splitting payments among related entities. 

Remuneration does not include amounts with respect to which a deduction under Code Section 162(m) is not allowed.

Comment: Code Section 162(m) disallows a deduction for any publicly held corporation for covered employee remuneration in excess of one million dollars. Since a publicly held corporation could be aggregated with an applicable tax-exempt organization under these rules, this provision ensures the same remuneration will not be taken into account under both Code Sections 4960 and 162(m).

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. 

Comment: 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). 
Comment: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.

Do Anti-Abuse Rules Apply?

The Secretary of the Treasury is directed to issue regulations as necessary to prevent the avoidance of tax under Code Section 4960, such as through the performance of services in a capacity other than as an employee (i.e., as an independent contractor) or by providing compensation through a pass-through or other type of entity in order to avoid the tax.

What Is the Effective Date of Code Section 4960?

The excise tax applies for tax years beginning after Dec. 31, 2017. There is no grandfathering rule for existing employment agreements or other contracts. Accordingly, it applies to remuneration and parachute payments paid in 2018.

Comment: In determining who is a covered employee, an applicable tax-exempt organization must look back to the 2017 taxable year to determine the five highest compensated employees for that year. Any covered employee in 2017 will remain a covered employee in 2018 and thereafter, even if he or she is no longer one of the five highest compensated employees and even if he or she is no longer employed.
 
Comment: Any 457(f) plan benefits that vested and were taxed in 2017 would not be subject to Code Section 4960, even if paid in 2018.
 
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. Note that parachute payments may be provided for by employment agreements, change of control agreements, deferred compensation programs, or a severance plan or arrangement.

Organizations should determine their potential exposure to the new excise tax. They should also determine ways in which they can structure compensation arrangements to minimize or avoid the tax. By way of example, an organization may be able to reduce potential excise taxes by shifting compensation to qualified and tax-advantaged retirement plans or by providing for payments that come within the short-term deferral rule under the proposed Treasury Regulations under Code Section 457(f). In making any such changes, however, organizations must be sure to comply with the rules under Code Sections 457 and 409A as well as the anti-abuse provisions of Code Section 4960.

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, Audra Ferguson-AllenRob GaussGina Giacone, Lisa HarrisonMarc SciscoeTara SciscoeChris Sears, Marilee Springer, or the Ice Miller Employee Benefits or Tax-Exempt Practice attorney with whom you work.

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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