By R. Michael Sorrells, CPA
The recently passed tax reform package added new Internal Revenue Code Section 4960 to the tax laws. This code section imposes an excise tax on organizations who pay certain executives compensation in excess of $1 million dollars annually. The tax (which is paid by the organization, not the individual) is at a 21% rate on the amount in excess of $1M paid to the executive. The provision is applicable for tax years beginning after December 31, 2017.
The tax is applicable to virtually all nonprofit organizations except for political organizations and specifically includes Section 115 governmental entities. Covered employees include any employee that is one of the five highest paid employees for any prior taxable year beginning after December 31, 2016. The only excluded class of employees are certain medical professionals (including veterinarians) for performance of services. Related groups of organizations have to be looked at as a whole; the tax cannot be avoided by splitting up the compensation among related organizations. The definition for related organizations is about the same as for related organizations being reported on Form 990, Schedule R and includes supporting and supported organizations.
Although the drafters apparently intended the provision to cover both public and private universities and colleges, public universities appear to be excluded from this tax unless the statute is corrected. Organizations (like public universities exempt under Section 115) can only be taxed when Congress is explicit in overriding the tax immunity afforded by this code section. An example of this is Code Section 511(a)(2)(B) which explicitly includes public colleges and universities in unrelated business income taxation. Thus, state universities such as the University of Alabama, which pays its football coach many millions of dollars per year are exempt from the tax while private schools such as Notre Dame will bear the brunt of this tax.
Compensation for purposes of this provision is wages as defined in Section 3401(a) including amounts required to be included under Section 457(f) but not including any designated Roth contributions. The amount in excess of $1M is going to be taxable at 21%. Deferred revenue is excluded until it is paid or there is no substantial risk of forfeiture. “Excess parachute payments” are also taxable under this provision. These are payments contingent upon the employee’s separation from employment which exceeds three times the “base amount.” The base amount is the average annualized compensation included in the employee’s gross income for the five years preceding the employee’s separation.
This legislation does not change the Intermediate Sanctions provisions of Section 4958 which are only applicable to 501(c)(3) and 502(c)(4) organizations. These provisions provide for an excise tax on the individual and certain organization managers (not the organization) for compensation found to be unreasonable by the IRS. So it is possible for such an organization to pay the 21% excise tax on compensation over $1M and for individuals to pay an excise tax personally on the amount of excess compensation in excess of “reasonable.” 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. Organizations should clearly continue to follow these procedures.
The legislation leaves a few open questions:
- For a fiscal year filer (such as a June 30 year end), is the compensation based upon the W-2 for the individual for the calendar year that ends within the fiscal year? That is how executive compensation is reported on Form 990 currently. For example, on a June 30, 2017 Form 990, compensation reported for officers and directors, etc. is from the December 31, 2016 form W-2.
- Or does a fiscal year filer have to calculate the amounts applicable from its actual fiscal year (which will not tie into the individual’s W-2)?
- How is the tax paid? We do not know if the tax will be paid through a new line on Form 990-T (as proxy tax currently is handled) or will a separate excise tax form be required to be filed.
Thus, some guidance is clearly required from the IRS, probably in the form of regulations.
Organizations which regularly pay executives greater than $1M should take a close look at this provision and make budgetary allowances for this tax for the 2018 tax year. Other organizations which anticipate vesting in deferred compensation plans should also plan on this tax if the extra amount of compensation will take the executive over the $1M threshold for a particular year. And organizations which make parachute payments upon separation should also be aware that this tax may affect them.
This is an area to watch closely as we do believe that guidance will be forthcoming.
Mike Sorrells, CPA is a tax principal with Tate & Tryon and may be reached [email protected]