Severance Agreements for Executives at Tax-Exempt Organizations: Beware Unintended Consequences of Excise Taxes, Early Inclusion, and Intermediate Sanctions
When it’s time for tax-exempt organizations such as colleges/universities, museums, and hospital systems to part ways with their senior executives, these institutions are most often considering how to best transition these executives off into the sunset rather than a morass of special tax rules (I will mention Internal Revenue Code citations just once for reference) under the unholy quartet of IRC Sections 409A, 457(f), 4958, and new(ish) Section 4960.
While one could write a dissertation on each of these beauties, I will introduce just enough high-level concepts as to make anyone circumspect in negotiating new or modified severance agreements with key executives at tax-exempt organizations. Notably, these rules apply to new and continuing employment agreements, but I am focusing on severance agreements (and the severance provisions in employment agreements) since this is where I have most consistently seen potential risk of adverse tax consequences, imposition of penalties, and other sanctions.
First, it is important to carefully draft severance arrangements for employees of tax-exempt organizations to avoid early inclusion of income and imposing a 20% excise tax and interest on executives, taking into account special rules about vested deferred compensation and the timing and manner of payment. This is especially true where, as is commonly the case, the organization is modifying existing arrangements.
Second, I will call your attention to so-called “intermediate sanctions” imposed on excess compensation and benefits paid to key executives of tax-exempt organizations—i.e., to preserve the tax-exempt status of an organization if the IRS finds an excess benefit transaction, the executive found to be receiving unreasonable compensation must disgorge the excess amount and pay a 25% and potentially a 200% second-tier excise tax on such amount. Additionally, an organizational manager such as an officer, director, or trustee who participated in the excess benefit will be personally liable for a 10% excise tax up to $10,000 for each year of over-payment. The institution itself can be tagged as well for a penalty for failure to report the excess benefit transaction on Schedule J of its 990(s). Happily, if a proper process is followed, the parties can establish a rebuttable presumption that the compensation and benefits are reasonable. If not, the IRS will review the circumstances on a de novo basis.
Finally, I call your attention to a new 21% excise tax on certain “excess compensation” paid to executives of tax-exempt organizations and public institutions—i.e., on compensation over $1,000,000 and certain excess parachute payments. These are tricky rules, especially taking into special timing rules that apply to deferred compensation, particularly for fiscal year entities. Our earlier article elaborates on this issue.
Employer Takeaway: Although executive transitions from tax-exempt organizations can be fraught with numerous non-tax considerations, it pays to properly consider the design and implementation of any executive severance arrangement to avoid some surprising adverse ramifications.