The Tax Cuts and Jobs Act (the “Act”), which was agreed upon by the House/Senate Conference Committee last week, includes a provision that imposes an excise tax equal to the corporate tax rate—which is 21 percent under the Act—on certain compensation paid to employees of tax-exempt entities, including not only 501(c)(3) organizations, but also 501(c)(4) and 501(c)(6) organizations, as well as governmental employers and political organizations.
Under the Act, an employer subject to the new rules would be required to pay the excise tax with respect to compensation paid to any of its five most highly compensated employees (referred to under the Act as “Covered Employees”) in two separate instances.
- First, the excise tax is imposed on annual compensation paid to a Covered Employee in excess of $1 million; and
- Second, the tax applies to compensation payable to a Covered Employee, which is contingent on a termination of employment, if the value of the compensation exceeds three times the employee’s average annual compensation in the five preceding years. The Act somewhat confusingly refers to compensation payable to a Covered Employee upon a termination of employment as a “parachute payment.” In the case of for-profit businesses, under other provisions of the tax law that have been in place for a number of years, parachute payments are limited to compensation payable in connection with a change of control of the business.
Under the Act, parachute payments are defined as any “payment that is contingent on a [Covered Employee’s] separation from employment from the employer,” which means that parachute payments do not appear to be limited to severance payments. The Act does, however, provide that benefits payable from tax-qualified retirement plans such as a 401(k) plan, a 403(b) plan or a 457(b) eligible deferred compensation plan, are not parachute payments.
A significant complexity, which was added by the Conference Committee, treats compensation as being paid when it vests. As an example, if a trade association executive who is a Covered Employee has a combined annual base salary and bonus of $750,000 and is granted a vested non-qualified deferred compensation benefit with a present value of $500,000, the executive would be treated as having been paid $1,250,000, and as a result, the trade association would owe a tax of 21 percent on $250,000.
Another change made by the Conference Committee, which will be helpful to tax-exempt hospitals, is an exception from the excise tax for compensation payable to a Covered Employee who is a licensed medical professional for the performance of medical services. The exception does not apply to compensation paid to a licensed medical professional for services in any other capacity, such as for services as an officer.
Given the nature of this new excise tax, we expect that it may impact, for example, the compensation of football and basketball coaches at a number of universities across the country.
The changes take effect January 1, 2018. The Act does not provide for the grandfathering of existing agreements. In light of the Act’s inclusion of compensation at the time of vesting, we anticipate some sort of transition rules or clarification will be needed from the Internal Revenue Service for deferred compensation that has already vested.