While the 2017 tax legislation did not produce all of the changes some had predicted, new rules governing excessive compensation for tax-exempt entities will substantially alter the landscape of executive compensation. Deferred compensation and other executive compensation arrangements for tax-exempt entities differ from those established for taxable for-profit entities. Tax consequences account for some of this difference as for-profit entities cannot deduct a compensation expense until the benefit is paid. Alternatively, the compensation deduction is of little consideration to a tax-exempt entity so it can incentivize the use of deferred compensation arrangements in certain circumstances. Generally, tax-exempt entities were not subject to compensation limitations, but were limited under the private inurement doctrine and section 4598 if compensation was excessive.
Nevertheless, tax-exempt entities must adhere to deferred compensation rules, reasonable compensation rules, and the private inurement doctrine. Tax-exempt entities must be mindful of deferred compensation requirements under The Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code when designing executive compensation plans. Previously, tax-exempt entities were not subject to excise taxes on executive compensation arrangements. After the 2017 tax legislation, however, tax-exempt entities are subject to a golden parachute and excise tax regime similar to those in sections 280G and 162(m) (irrespective of any organizational change in control), which prohibit deductions for excess parachute payments by public companies.
II. Private Inurement Doctrine
Private inurement is prohibited under the Code and regulations. To maintain its tax-exempt status, tax-exempt entities must be organized and operated exclusively for charitable purposes. “An organization is not operated exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the benefit of private shareholders or individuals.”1 Accordingly, a tax-exempt entity is not organized and operated exclusively for charitable purposes if the exempt entity’s net earnings inure to the benefit of any private shareholder or individual.2
A private shareholder or individual means a person who has a personal and private interest in the activities of the entity.3 A person includes an individual, trust, estate, partnership, association, company, or corporation.4 Thus, excessive compensation violates the prohibition on private inurement. However, the prohibition on private inurement only applies to transactions involving individuals receiving a benefit as a result of their position of control or influence over the tax-exempt entity, such as shareholders, directors, officers or major contributors.5
Nevertheless, if the tax-exempt entity is receiving fair market value for the goods, services or other consideration in the transaction, then the prohibition against inurement does not apply. Further, there is no safe harbor for de minimis inurement. While a small amount of inurement can jeopardize a tax-exempt entity’s status, a compensation arrangement with a person who has a private interest will not constitute private inurement if the compensation is reasonable relative to the services provided to the tax-exempt entity.
III. Reasonable Compensation Rules
The compensation provided by a tax-exempt entity is not considered “excessive” if it is “reasonable.” Reasonable compensation is the value that would ordinarily be paid for like services by like entities under similar circumstances. Reasonable compensation rules apply to the aggregate of all compensation received by the executive.
In 1996, Congress enacted the Taxpayer Bill of Rights 2, which included Section 4958. That section imposes intermediate sanctions on prohibited private inurement by establishing a series of excise taxes, commonly referred to as intermediate sanctions penalties, on disqualified persons who enter into excess benefit transactions with tax-exempt entities. A disqualified person is generally a person, at any time during the five-year period ending on the date of the transaction, in a position to exercise substantial influence over the affairs of the applicable tax-exempt entity.6 Additionally, adisqualified person includes certain family members of a disqualified person, and 35% controlled entities of a disqualified person.7
An excess benefit is the amount by which the value of the economic benefit provided by an applicable tax-exempt entity, directly or indirectly, to or for the use of any disqualified person exceeds the value of the consideration (including the performance of services) received for providing such benefit.8
Pursuant to section 4958, an excess benefit transaction will trigger: (1) a tax of 25% of the excess benefit on each disqualified person who receives an excess benefit; (2) a tax equal to 10 % of the excess benefit (up to $20,000 per person) on those involved in approving the excess benefit; and (3) a tax of 200% on the recipient if the excess benefit transaction is not corrected by a certain date.9
Under section4958, an exempt entity may establish a rebuttable presumption of reasonableness for compensation or that a transfer of property or the right to use property is presumed to be at fair market value with respect to the specific transaction. Once the rebuttable presumption is established, the burden of establishing that the transaction results in an excess benefit shifts to the Service. The rebuttable presumption may be established if pursuant to regulations the tax-exempt entity has an informed independent body approve compensation arrangements and contemporaneously documents decisions.10 Nevertheless, a compensation arrangement that qualifies for the presumption of reasonableness under section 4958 continues to be subject to excise tax under section 4960.
In addition to the tax penalties, the Service may revoke a tax-exempt entity’s exemption status for an excess benefit transaction. There are correction rules, however, which require undoing the excess benefit transaction (to the extent possible) by making a payment in cash or cash equivalents equal to the correction amount to the applicable tax-exempt entity.
IV. Deferred Compensation Rules
Deferred compensation arrangements of tax-exempt entities must account for ERISA as well as Code sections 409A and 457. Deferred compensation structured as a top hat plan avoids ERISA funding and other requirements. Generally, ERISA requires that pension benefit plans, which include many deferred compensation arrangements, be funded.11 However, funding a plan that only covers a small number of individuals can have unfavorable tax consequences under section 402(b). One solution to this problem is to structure the arrangement as a top hat plan. Top hat plans are also exempt from ERISA’s participation, vesting, and fiduciary responsibility requirements.12 Additionally, top hat plans are exempt from Form 5500 reporting and ERISA disclosure requirements as long as the sponsor files a one-time notice with the Department of Labor.13
Further, deferred compensation arrangements of tax-exempt entities must account for sections 457 and 409A. Section 457 governs the tax treatment of the deferred compensation paid by state and local governmental employers as well as tax-exempt entities. It does not apply to tax-favored plans under sections 401(a), 403, the portion of plans that consist of a transfer of property under section 83, the portion of plans that consist of a section 402(b) trust, qualified governmental excess benefit arrangements, and applicable employment retention plans. The tax treatment under section 457 is dependent on whether an arrangement qualifies as a 457(b) plan or a 457(f) plan.
Generally, 457(b) plans are eligible deferred compensation plans that are designed as defined contribution arrangements due to nature of the requirements. 457(f) plans encompass all other deferred compensation arrangements of governmental and tax-exempt employers that do not meet the requirements under section 457(b). As such, 457(f) plans are referred to as ineligible deferred compensation plans. Section 457(f) imposes income taxes on all nonqualified deferred compensation when amounts are no longer subject to a substantialrisk offorfeiture, with the exception of amounts disbursed under a 457(b) plan.
Eligible plans under section 457(b) are not subject to the requirements of section 409A.14 However, section 409A applies to 457(f) plans, in addition to section 457(f), to the extent any plan provides for the deferral of compensation within the meaning of section 409A.15 Amounts included as income under either section 457(b) or section 457(f) are counted as remuneration in determining whether the excise tax on excess compensation applies.
Section 409A covers nonqualified deferred compensation arrangements that permit an employee to defer income recognition and income taxation on amounts earned, but paid in a subsequent year. It does not apply, however, to tax-qualified retirement plans such as 401(k) plans, 403(b) plans, 457(b) plans or similar tax-favored plans, although these plans similarly delay taxation on compensation.16 Under section 409A, a nonqualified deferred compensation arrangement must meet (1) distribution, (2) acceleration, and (3) election requirements both in form and in operation unless an exception applies. Failure to comply with the requirements of the provision causes the compensation at issue to be immediately included as income, even if not yet payable under the deferred compensation arrangement, and subjects the compensation to an additional 20% tax, plus an additional excise tax imposed, equal to the IRS underpayment rate plus 1%.17 It is important to note that while both sections 457 and 409A impose taxes on nonqualified deferred compensation arrangements when there is no longer a substantial risk of forfeiture, the definition of the phrase differs in the two sections.
V. Tax Reform
The 2017 tax legislation added section 4960 (the “Tax on Excess Tax-Exempt Organization Executive Compensation”).18 This section imposes a new excise tax on “excessive” compensation paid by tax-exempt entities for taxable years beginning after December 31, 2017.19 It applies to:
(i) farmers’ cooperatives under section 521(b)(1);
(ii) political organizations under section 527;
(iii) governmental entities under section 115(1) and organizations under section 501(a);
(iv) and organizations under section 401(a).20
Note the tax is imposed on the entity, not the employee.
Under this new provision, tax-exempt entities are subject to a 21% excise tax (the new corporate tax rate) on any remuneration paid to covered employees in excess of $1 million.21 This excise tax equals 21% of the sum of:
(i) compensation paid by the entity to any covered employee in excess of $1 million;
(ii) all forms of deferred compensation; and
(iii) excess parachute payments to covered employees triggered by separation from employment, to the extent that the total parachute payments exceed three times the five-year average total compensation.22
A covered employee is any current or former employee who is one of the five highest-compensated employees for the current year or any prior tax year beginning after December 31, 2016.23 Section 4960 applies to any such employee, even if the employee is not an officer. Once an employee is a covered employee, the employee will always be a covered employee.
An exception is provided for remuneration attributable to medical services of certain qualified medical professionals.24 Remuneration means wages under section 3401(a). Remuneration paid to a licensed medical professional which directly relates to the performance of medical or veterinary services are not taken into account. Thus, qualified medical professionals such as doctors, nurses, and veterinarians are not considered covered employees.
Remuneration is treated as paid when there is not a substantial risk of forfeiture of the right to payment.25 Payments from a 457(f) plan are included in the year vested.26 Designated Roth contributions are excluded.27 Remuneration includes not only remuneration by the tax-exempt entity itself, but also by related persons, which includes persons or governmental entities that:
(i) control or are controlled by the organization;
(ii) are controlled by one or more persons that control the organization; or
(iii) are supporting organizations or supported organizations for the taxable year with respect to the organization.
However, if the related organization is subject to the section 162(m) limit on deductible compensation and the remuneration is not deductible under that section, then the deduction is also disallowed under section 4960. Further, a related entity is liable for its proportion of the excise tax from the remuneration paid to the covered employee.
This section also defines an excess parachute payment as an amount equal to the excess of any parachute payment over the employee’s base amount.28 The base amount is equal to the employee’s trailing five-year average W-2 compensation before the date of the employee’s separation from employment. An amount would be a parachute payment if it is contingent on the employee’s separation from employment and the present value of the compensation equals or exceeds three times the employee’s base amount.29 The excess parachute payments under section 4960 operate in a manner similar to the golden parachute rules under section 280G, although the golden parachute rules are not tied to a change in control and also do not apply to employees who are not highly compensated employees. However, parachute payments do not include payments under a qualified retirement plan, a simplified employee pension plan, a simple retirement account, a tax-deferred annuity, or an eligible deferred compensation plan of a state or local government or tax-exempt entity.30
Entities subject to section 4960 should identify their five highest compensated employees starting with the first year beginning after December 31, 2016, and maintain a cumulative list of all such employees for each year thereafter. Additionally, entities should track the total amount of remuneration being paid. After December 31, 2017, these employees—as well as the five highest compensated employees in 2018—will be the covered employees for the first tax year in which the excise tax applies.
Entities should review covered employees’ compensation arrangements to determine whether the excise tax may apply. The review should consider annual base salary, long-term incentive programs, taxable benefits, employment agreements, deferred compensation plans, severance arrangements, and change in control agreements. Following the assessment, entities may need to amend existing employment and other agreements to address the impact of the excise tax. Entities will also need to assess the impact of the excise tax on recently terminated covered employees to determine the impact on payments to such covered employees.
Future planning techniques may include accelerating amounts of taxable compensation within one or more years prior to separation from service from the tax-exempt entity to boost the base amount. Another planning strategy for tax-exempt entities involves using restrictive covenants, such as covenants not to compete, as conditions of severance payments. If permitted under state law, a valid and enforceable covenant not to compete could prohibit the classification of the severance payment as a parachute payment. This strategy is regularly used to mitigate the adverse tax consequences of section 280G. Note, however, any severance payment would be characterized as reasonable compensation and counted toward the $1 million limit.
From a tax policy perspective, the excise tax creates tax equity between tax-exempt entities and taxable entities because the section 4960 provisions parallel the golden parachute and excise tax regime provisions under sections 280G and 162(m). Tax-exempt entities must account for the new excise tax and consider the tax and fiscal ramifications. Additionally, this process can be onerous for larger tax-exempt entities with multiple entities as the section applies on an entity-by-entity basis.
Tax-exempt entities will need to be creative in attracting quality candidates because section 4960 substantially impacts executive compensation practices in this sector. Historically, tax-exempt entities have competed with for-profit entities for talent. Section 4960 may be a disadvantage to tax-exempt entities as these entities may now face new challenges and increased costs in designing competitive executive compensation packages. Tax-exempt entities may be forced to choose between incurring the excise tax liability for offering competitive compensation packages or risk being unable to attract and retain quality talent with reduced compensation packages for executives.
Tax-exempt entities may have to juggle additional payroll expenses and simultaneously navigate new procedures as this new provision modifies regulations that have governed this sector for nearly two decades. While tax-exempt entities need to offer competitive compensation, the distinction between reasonable compensation and excessive compensation can be difficult to discern. Until the Service promulgates regulations and other guidance under the new law, the impact on executive compensation for tax-exempt entities will remain uncertain.
Further, since sections 4958 and 4960 operate independently, tax-exempt entities must account for both regimes: a compensation arrangement can trigger the excise tax on excess benefit transfer under section 4958 and the excise tax on excessive executive compensation under section 4960. We will likely see regulations clarifying ambiguities of section 4960 and interpreting provisions applicable to public universities, credit unions, medical/veterinarian professionals, and 457(f) plans. ■
1 Prop. Treas. Reg. § 1.501(c)(3)-1(c)(2).
2 I.R.C. § 501(c)(3).
3 Prop. Treas. Reg. § 1.501(a)-1(c)
4 I.R.C. § 7701.
6 I.R.C. § 4958(f)(1)(A)-(F).
8 I.R.C. § 4958(c)(1)(A)-(B).
9 I.R.C. § 4958(a)-(b).
10 Treas. Reg. § 53.4958-6(a).
11 ERISA §§ 302 through 308 govern funding of defined benefit pension plans. (Also see 26 U.S.C. § 412, §430, §431, and §432.) Funding requirements for single-employer plans were amended by §§101 to 116 of the Pension Protection Act of 2006. Funding requirements for multiemployer DB plans were amended by §§ 201 to 221 of the Pension Protection Act of 2006.
12 ERISA §§ 201(2), 301(a)(3), 401(a)(1) (29 U.S.C. §§ 1051(2), 1081(a)(3), 1101(a)(1)).
13 29 C.F.R. § 2520.104-23.
14 I.R.C. § 409A (d)(2)(B); Reg. §1.409A-1(a)(2)(vii). See Notice 2005-58 (until further guidance is issued, federal credit unions may treat nonqualified deferred compensation plans as eligible §457(b) plans).
15 I.R.S. Notice 07-62, 2007-2 C.B. 331.
16 Treas. Reg. § 1.409A-1(b)(9).
17 Treas. Reg. § 1.409A-1(b)(1).
18 Pub. L. No. 115-97.
19 Pub. L. No. 115-97.
20 I.R.C. § 4960(c)(1).
21 I.R.C. § 4960(a).
22 I.R.C. § 4960(a)(1)-(2).
23 I.R.C. § 4960(c)(2)(A)-(B).
24 I.R.C. § 4960(c)(3)(B).
25 I.R.C. § 4960(a)(2).
27 I.R.C. § 4960(a)(1), I.R.C. § 4960(c)(2).
28 I.R.C. § 4960(c)(5)(A).
29 I.R.C. § 4960(c)(5)(B)(ii).
30 I.R.C. § 4960(c)(5)(C)(i)-(iv).