The 500-plus pages of the Tax Cuts and Jobs Act contain many tax breaks and benefits for individuals and businesses, but as previously discussed on our blog, there are also several provisions focused solely on tax-exempt organizations. Most notably, tax reform created a brand-new section of tax code, Section 4960, to impose an excise tax on excessive compensation for nonprofit executives. This tax is paid by the nonprofit, not the individual employee, and is here to stay: Section 4960 will not sunset after December 31, 2025, unlike other provisions of the Tax Cuts and Jobs Act.
Mitigating the impact of this new tax will require up-front assessment and potential realignment of pay practices and ongoing monitoring of annual compensation and separation packages. Nonprofit leaders should consider the information and tactics below with their RKL advisor in the context of their unique organizational structure.
Executive compensation over $1 million affected
Internal Revenue Code Section 4960 imposes a 21 percent excise tax on annual compensation exceeding $1 million paid during a given tax year to covered employees of the organization. It is important to note that Section 4960 considers both current and former employees who are among the top five highest compensated employees for the year since 2016 as covered employees.
The $1 million limit only applies to federal withholding wages, not separation or parachute payments, which are addressed below. Keep in mind, however, that wages from a related party or organization paid to a covered employee do count toward the $1 million limit.
Other notable exclusions from the $1 million limit are Roth contributions to a 401(k) plan and compensation paid to licensed medical professionals, like doctors, nurses and veterinarians, for medical services. Compensation for non-medical services must still be figured into the excise tax calculation.
Separation payments over three times base salary taxed
In addition to annual salary, the new excise tax is also levied on certain separation pay packages, commonly referred to as “golden parachutes,” that are greater than or equal to three times the departing executive’s base salary. Three times base salary is the point at which the payment becomes taxable, but the excise tax is not levied on the excess of the base salary times three. Instead, it is levied on the difference between the base salary and the separation payment.
Here’s a quick demonstration: A nonprofit provides a departing executive with a lump-sum payment of $700,000 on the date of separation. The executive’s base salary was $225,000, so the separation payment is more than three times the base. So only the difference between the separation payment and the base salary, which equals $475,000, is considered excess. Thus, the 21 percent excise tax owed is $99,750, or 21 percent of $475,000.
Tactics to lessen excise tax impact
There are several options for nonprofits seeking to mitigate the effects of the Section 4960 excise tax on their finances. Be sure to explore the feasibility of these options with your tax advisor before implementing at your organization.
Shifting income: Nonprofits may consider moving the portion of a covered employee’s bonus that exceeds the $1 million annual threshold to involuntary separation pay. This shift can also work in the opposite direction, with separation pay over the threshold moved to annual wages. If both the wage category and separation pay category are already at or very near the $1 million threshold, organizations should reevaluate pay models to reduce the potential excise tax impact. These tactics must be conducted in compliance with Sections 457(f) and 409A regulations for nonqualified deferred compensation for employees of tax-exempt entities.
Phased approach to retirement: Replacing parachute payments with a phased retirement program eliminates the separation pay and benefits that trigger the excise tax. In this model, an employee would step down her role with the organization gradually over time in concert with reduced pay and benefits to the point where she would not be counted as one of the nonprofit’s highest-compensated employees in the year of separation. This model could avoid the excise tax on a parachute payment by distributing the amount of separation pay over the step-down years. This could have an impact on the service provided by the employee as well as eligibility for medical benefits, so vet thoroughly before implementing.
Longer vesting period: Nonprofits may also want to consider extending vesting schedules for employee compensation. This approach would spread payments over several years to prevent any single year from exceeding the $1 million threshold.
As with many components of tax reform, additional guidance from the IRS is anticipated to further clarify Section 4960. The dedicated Not-for-Profit tax team at RKL, one of the largest and most respected in the region, will continue to monitor developments and advise on best practices. Any new regulatory guidance or specific circumstances at a nonprofit may alter the applicability of the strategies described above, so contact me at firstname.lastname@example.org to customize an approach for your organization.