The passage of the Tax Cuts and Jobs Act (TCJA) in late 2017 brought several unwelcome developments for nonprofits, including a new excise tax on certain executive compensation. To answer the many questions about the tax, the IRS has issued interim guidance that is largely unfavorable for organizations with highly paid executives or so-called “excess parachute payments.” These nonprofits must take the guidance in Notice 2019-09 into account when making decisions about executive compensation, severance payments and settlements.
The tax summed up
The TCJA created Internal Revenue Code provision Section 4960. It generally imposes an excise tax at the corporate tax rate (currently 21%) on any compensation of more than $1 million, paid by a nonprofit, to a covered employee in a tax year. Compensation includes most, but not all, benefits. The tax also applies to excess parachute payments made to a covered employee when he or she leaves the organization.
A payment generally is considered a “parachute” if:
1. It’s contingent on the employee’s involuntary “separation from employment” (termination), and
2. The total present value of all such payments to the employee equals or exceeds three times his or her average annual compensation for the preceding five years.
The excise tax applies to the excess of the parachute payment over the average annual compensation. It’s imposed on the nonprofit that employs the covered employee and related organizations that also employ that same covered employee.
Who’s a “covered employee”?
The new excise tax (see main article) applies only to payments made to “covered employees.” But you may be surprised by who qualifies as covered and how many covered employees you have.
For starters, no minimum dollar threshold applies to the determination of who’s covered. Rather, a covered employee is defined as any employee who’s one of the five highest-compensated employees for the current tax year or was a covered employee in any tax year dating back to 2017. That means you could have more than five covered employees for this tax year and going forward.
The determination is based on remuneration paid by you — and by related organizations — in the calendar year ending with or within your taxable year. And the determination is made separately for each organization in a group of related organizations.
Even if you have no excise tax liability for a year, you should determine the five highest compensated employees for that year. They could trigger future liability.
Related organizations may include taxable, tax exempt and governmental entities that satisfy certain tests about the extent of the relationship between the organizations. A tax-exempt hospital, for example, might have a related for-profit testing lab that would employ one of the hospital’s covered employees. The lab would then be subject to these excise tax considerations.
Some nonprofits won’t be affected by Section 4960 because they don’t pay excess remuneration or excess parachute payments. That doesn’t mean, though, that such organizations can simply ignore the guidance. (See “Who’s a ‘covered employee’?” at left.)
The guidance covers a range of issues, including:
Deferred compensation. Compensation generally counts toward the $1 million threshold when it vests, not when it’s paid. Deferred compensation vests, at present value, when it’s no longer subject to a substantial risk of forfeiture. For example, compensation hasn’t vested if it’s conditioned on the future performance of substantial work or an occurrence related to the purpose of the employee’s work, such as completion of an organizational goal.
Covered parachute payments. The guidance provides that a parachute payment is contingent on an “involuntary” separation from employment. Examples include termination without cause or failure to renew an employee’s contract. Payments that the nonprofit must pay when an executive resigns or otherwise voluntarily terminates employment wouldn’t be treated as parachute payments. The right to a severance payment that vests on an involuntary separation would result in the payment being considered a parachute payment.
Calculation of the tax for multiple related organizations. When a nonprofit computes its excise tax liability for a covered employee, it must include remuneration paid by both it and any related organization that employs the employee. The liability is then allocated among each of the employers based on the percentage of the compensation paid by each. The guidance provides limited relief so a nonprofit won’t get double-charged — for its own covered employee and additionally as a related organization — for the same employee.
Reporting excise tax liability. You’ll report your excise tax on Form 4720, “Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code.” Each employer liable for the tax, whether a nonprofit or a related organization, must separately report and pay its share of the tax. Payment is due on the 15th day of the fifth month after the end of the taxable year — May 15 for calendar-year employers.
Follow the guidance
Nonprofits can rely on the interim guidance until the IRS issues further guidance. The IRS has indicated that payment of the Section 4960 excise tax will be enforced for tax years starting after December 31, 2017.