2018 Tax Reform Series: New Excise Tax on “Excess” Executive Compensation Paid by Tax-Exempt Employers
This is the fifth article in our series covering the various employee benefits-related changes contained in the Tax Cuts and Jobs Act signed by the President on December 22, 2017.
Some of the most fundamental changes under the Act in the employee benefits and executive compensation arena impact executive compensation paid by tax-exempt employers and may result in the imposition of significant new excise taxes on such employers. These changes are summarized below.
Excise Tax on “Excess” Compensation and “Excess Parachute Payments” Paid by Tax-Exempt Employers
Under the Act, starting in 2018, tax-exempt organizations are subject to a 21% excise tax on
(i) remuneration exceeding $1 million paid to a “covered employee” in a tax year, and
(ii) any “excess parachute payment” paid to a covered employee.
“Covered employee” includes any active or former employee who is one of the 5 highest compensated employees of the organization for the current tax year, or was a covered employee in any prior year beginning in 2017 (so that the “covered employee” status persists into subsequent years, meaning that a tax-exempt employer may eventually accumulate more than 5 covered employees).
“Excess parachute payments” generally refers to compensatory “parachute payments” that are contingent on a covered employee’s separation from employment and exceed the employee’s 5-year average annual compensation (the “Base Amount”), provided that the aggregate parachute payments exceed 3 times the Base Amount. This definition is subject to some exceptions, including exceptions for payments made to individuals who are not “highly compensated employees” under Code Section 414(q) and payments for services performed by a licensed medical professional.
Remuneration is considered to be paid when the covered employee’s right to such remuneration is not subject to a substantial risk of forfeiture, so deferred compensation may fall within the scope of these rules before it is actually paid to the covered employee.
This excise tax, if applicable, is payable by the tax-exempt employer and not by the covered employee. The Act does not provide for any grandfathering of existing compensation arrangements, or any transition period.
Employer Action Items
Tax-exempt employers must (i) identify their “covered employees” for 2018 and 2017 (because, as noted above, the “covered employee” status persists into subsequent years), and (ii) review their existing executive compensation and severance arrangements (including any deferred compensation plans) to determine whether payments to any covered employee in 2018 or future years could result in the imposition of the 21% excise tax. If so, then the employer should consider potential modifications to such arrangements, or other strategies to avoid or mitigate the impact of the excise tax.
Tax-exempt employers and their counsel will also need to consider the new rules when structuring new compensation arrangements for executives. For example, an employer may consider including protective language in any new executive compensation arrangements that would allow it to unilaterally modify or reduce compensation to the extent needed to avoid the excise tax (similar clauses are already used by some taxable corporations for excise taxes under Code Section 280G, but as this new excise tax is imposed on the employer rather than the executive, it may be more difficult to negotiate a cutback where the excise tax applies).
Although the new rules are already in effect, they raise a number of compliance questions that will need to be resolved by the IRS in future guidance. Until guidance is issued, employers and their counsel will need to put forth their best efforts to interpret the Act.