The world of nonprofit is ever-changing. New rules and new laws keep things fresh and organizations on their toes. New regulations influence executive compensation.
Impacting all tax years after 2017, the Tax Cuts and Jobs Act, P.L. 115-97, added new Sec. 4960, which imposes an excise tax on nonprofit organizations that pay high-levels of compensation to certain employees.
Following these new regulations, the IRS is vetting compensation your organization pays to specific employees as excessive if (1) The person’s total compensation exceeds $1 million during the tax year, and (2) the combined current values of that individual’s separation payments and benefits is equal to or exceeds 3X his or her five-year average pay (includes if amount was less than $1 million). Under either of these circumstances, the government imposes an excise tax on the organization.
The IRS determines these excise taxes in the following ways:
Organizations subject to Sec. 4960 include tax-exempt organizations under Sec 501(a), farmers’ cooperatives, certain political organizations, certain state or local government organizations, and other organizations connected to these organizations.
The excise tax impacts current or former employees who rank among the five highest-compensated employees for the tax year or was an employee of the organization for any preceding tax year after 2016.
To decide the five highest-compensated employees, total all salaries your organization paid to the employee, including income under Sec. 457(f). Exclude any amounts your organization paid to a Roth savings plan Sec. 401(k), and any compensation paid for providing medical or veterinary as well as any compensation for the performance of medical or veterinary assistance paid to a certified/licensed practitioner.
$1 Million Ceiling
When an employee reaches compensation of $1 million, the IRS imposes an excise tax equal to 21% of the compensation that exceeds $1 million paid to the employee during the year. The IRS does not consider any excessive pay for “parachute” provisions.
Excess Parachute Payments
For-profit organizations have long provided “golden parachute” benefits. Now, regulations impacting these parachutes have floated over to nonprofit organizations. These golden parachute rules influence situations where a change in leadership or control alters payments to specific persons.
The IRS analyzes four components of a parachute situation -- base amount, threshold test, parachute payments, and excess parachute payments.
The base amount is the average annual compensation your organization pays an employee over a five-year period that ended before the employee left the organization.
If the total current value of the payments and benefits that are contingent on the covered employee's exit package equal or exceed three times the base amount, the situation fails the threshold test. These contingent payments become parachute payments. The IRS will impose a 21% excise tax on the amount of the excess parachute payment over the base amount.
Example:
An organization pays a one-time payment of $800,000 on the day of termination with a base salary of $250,000. The separation pay is a parachute payment because it is more than the base of $750,000. The total of the amount of the payment minus the base amount is the excess parachute payment ($550,000). The IRS would impose an excise tax of $115,500 or 21% of $800,000 - $250,000.
When determining whether the separation amount exceeds the threshold test, you do not count monies from a retirement plan such as a Sec. 403(b) annuity, or a Sec. 457(b) plan. The IRS excludes from the threshold test all severance payments to employees who are not highly compensated employees (HCEs) under Sec. 414(q).
Tax Planning
Your organization may wish to implement vesting schedules that extend payments over many years. This way no one year exceeds $1 million in pay to an employee.
If an employee’s bonus plus his base salary and other perks would push his pay beyond the $1 million yearly limit, your organization can also move some of an employee’s bonus to the involuntary separation category.
Another way to decrease excise tax is to reduce an employee’s pay or move separation pay to active services. This action must comply with IRS tax rules under Secs. 457(f) and 409A. These sections address nonqualified deferred compensation.
This reclassifying of monies establishes a rewards procedure that offers employees less in bonuses while employed. This can bring his total under $1 million for the year. This also provides him more involuntary separation pay. This is an alternative to deferring compensation.
A plan to defer compensation that would push the annual limit may not be cost-effective for your organization. According to IRS Sec. 457(f), its proposed Sec. 457(f) would mandate exempt organizations to match 25% of the amount deferred. This 25% match is more than the 21% for excise tax. You would pay the 25% match to the employee and the 21% excise tax to the IRS.
When it comes to dealing with amounts that could exceed the annual limits for involuntary separations, think about the methods below that may impact parachute payments.
Rework Parachute Agreements:
Reduce the parachute payments to decrease excise tax. Limit the value of the separation payments to less than 3 times the employee’s base pay. Even with this provision, the IRS may still impose the excise tax if the total compensation for the year exceeds $1 million.
Tie Certain Requirements to Severance Pay:
Having an exiting employee sign a “non compete” agreement is common. There are also other conditions that restrain former employees from providing certain services. In some instances, parachute payments may not include these exclusions.
If your organization can provide undeniable proof that the agreement keeps an individual from performing services and that there is a reasonable chance your organization will enforce the agreement against the person, the IRS may consider separation pay as reasonable and add it to the $1 million limit.
Expected Separation:
When your organization anticipates the severance for several weeks/months, you may raise the employee’s base pay by moving large amounts of taxable compensation to one or two years prior to the separation. Keep in mind the $1 million annual limit.
Boost Contributions to Retirement Plans:
Increase employer contributions to retirement plans, IRS Sec. 457(b). The IRS counts distributions from a Sec. 457(b) as wages counted toward the $1 million limit.
Establish a Phased Retirement Procedure:
This approach may eliminate parachute payments. The IRS does not consider separation payments and benefits to individuals who are not HCEs as parachute payments. Use the testing period for the prior year to determine HCEs whose compensation from the earlier year exceeds $120,000. Identifying a phased retirement program beginning in the earlier year before the separation could reduce the employee’s responsibilities. These factors can change whether the employee is HCE in the years the IRS is evaluating. This action could remove all parachute payments, even if the employee’s exit pay is more than three times his base pay. If your organization decides to use this approach, also consider how this change will impact the employee’s services and benefits.
Make a Payment Based on other Factors:
Consider making a substantial payment based on an employee’s age/birthday, or on another event -- not on separation from the organization. This action needs to occur within one year before and less than one year after the end of employment. The payment must not appear to relate to separation from the organization.
Keep Your Eye on the Excise Tax
Keep on-top of the circumstances of terminating an employee. Identify those employees and monitor their annual income and how their income and separation agreements may incur excise taxes. Set into motion a plan to handle negative situations. Implement a tax-saving plan and put your procedure into action. Stay one step ahead of the IRS Sec. 4960.
When you have questions about executive compensation and the new tax rules, contact TBFoster Nonprofit Accounting to get your answers. We have solutions to help your Organization get over this hurdle. Contact our not-for-profit team leader at trent@tbfosteraccounting.com and please join our Facebook group the “Nonprofit Accounting Spot”.
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