This post continues our focus on the Tax Cuts and Jobs Act provisions that affect the tax-exempt sector. One such provision won’t hit most exempt organizations, but will nonetheless have a large impact on the ones it does reach. The provision applies a 21 percent excise tax on an exempt organization to the extent that any of its five highest paid employees have total compensation exceeding $1 million, and is expected to impact the way large exempt hospital organizations and universities recruit and retain top talent.
Intermediate Sanctions and the Rebuttable Presumption of Reasonableness. The intermediate sanctions rules under Section 4958 of the Internal Revenue Code were enacted in 1996, and impose an excise tax on excess benefit transactions, i.e., any transaction where a disqualified person like an officer or director receives a benefit with more value than the consideration provided to the organization. A common excess benefit transaction is paying more compensation than is reasonable. The excise tax must be paid by the disqualified person at issue, and in some cases, an additional tax can be imposed on management that approved the transaction knowing it was an excess benefit transaction.
However, under the regulations there is a rebuttable presumption of reasonableness process that assists nonprofits in not violating the excess benefit rules. The presumption of reasonableness is established if an organization’s board of directors, or other authorized body, gathers comparability data for compensation of executives in similar positions, demonstrably relies on that data in determining the compensation of the executive in question, and documents their deliberations and decision process in meeting minutes. Once this presumption is established, the burden shifts to the IRS to prove that the compensation paid to the executive was unfair or excessive.
Triggering The New Tax. The Tax Cuts and Jobs Act imposes a new excise tax independently and concurrently with the application of the excess benefit framework discussed above. In other words, if triggered, the new excise tax will apply regardless of whether the compensation at issue is found to be reasonable. And because it is separate from the excess benefit tax imposed on the executive (and sometimes management) level, if triggered it will apply to the organization even if the individual executive doesn’t owe tax on the excess compensation.
More specifically, for taxable years beginning after December 31, 2017, exempt organizations will owe a 21 percent excise tax on compensation paid to “covered employees” exceeding $1 million. Covered employees include the five highest paid employees or former employees of the organization for any taxable year. Once an employee has been in the top five in the current tax year or any year after 2016 (for the current organization or any predecessor organization), they are considered a covered employee of the organization on which the tax may apply for all subsequent years.
Total compensation counted toward the $1 million threshold includes salary as well as deferred compensation arrangements that are not subject to a substantial risk of forfeiture, whether paid by the organization or paid by a related person, entity, or government entity. Related persons or entities include those that control the exempt organization or that the exempt organization controls, those that are controlled by the same person or persons, supporting organizations under Section 509(a)(3), supported organization under Section 509(f)(3), and VEBAs.
Impact. The impact of the new excise tax is difficult to gauge. Some commentators predict it will force compensation down at exempt organizations in order to avoid triggering the tax. On the surface, this result may seem appropriate, as limiting compensation ostensibly frees up organizations to put more money toward their missions. However, this “one size fits all” approach to executive compensation ignores the fact that large exempt organizations—especially those that operate in highly regulated and complex environments such as hospital systems—require extensive expertise to achieve their missions, and that expertise can be expensive. For those organizations, the Tax Cuts and Jobs Act just made it even more so.
Click here for our last post on the new law’s changes to the UBIT landscape.