After working to reconcile differences between the two Tax Cuts and Jobs Act bills, the Senate and House Conference Committee reached a tentative agreement on Wednesday, December 13. Although there is not yet a published version of the Conference Committee’s bill, both the Senate and House had proposed adding a new Section 4960 to the Internal Revenue Code (Code) which would, effective for taxable years beginning after December 31, 2017, impose an excise tax of 20% on certain compensation paid to a covered employee by a tax-exempt organization in excess of $1,000,000 and for certain excess parachute payments. The excise tax would be payable by the tax-exempt organization. This post summarizes key provisions of the proposed excise tax provision.
General Rule: Tax-exempt organizations will be required to pay a 20% excise tax equal to 20% of the sum of (i) remuneration paid in excess of $1,000,000 during a taxable year to a covered employee and (ii) any excess parachute payment paid to the employee by such organization during such year. The proposed statutory text notes, though, in relevant part that any such amounts shall be considered “paid” for this purpose when there is no substantial risk of forfeiture.
Tax-Exempt Organization: Tax-exempt organization is defined to include any organization that is exempt from tax under Section 501(a) of the Code, is a farmers’ cooperative described in Section 521(b)(1) of the Code, has income excluded from taxation under Section 115(1) of the Code or is a political organization described in Section 527(e)(1) of the Code.
Covered Employee: Covered employee is defined to include any employee or former employee who is one of the five highest compensated employees of the organization for the year and anyone who was a covered employee for any preceding tax year beginning after December 31, 2016. Similar to the new proposed definition of covered employee for Section 162(m) of the Code, this provision would make the designation of covered employee permanent.
Excess Parachute Payment: The excess parachute provisions are designed similarly to the Section 280G excess parachute concept but based on payments made contingent on a separation from employment rather than a change in control. To trigger this provision, a covered employee would need to receive payments that are contingent on a separation from employment and that equal or exceed three times the employee’s base amount (which is intended to be defined similarly to Section 280G). Payments under Code Section 401(a), 403(b) and 457(b) plans are not included.
It is not clear how payments would be valued for these purposes. For example, if a covered employee would be entitled to a $1,000,000 payment pursuant to a Section 457(f) plan on the earlier of a termination without cause or June 1, 2020 and such person was terminated on May 1, 2020 and received such payment. It would seem that the value of such payment for purposes of the excise tax should equal at most the value of the one-month acceleration and one month of the performance of services rather than the full $1,000,000, but this is not clear.
Deferred Compensation: As noted above, for purposes of the excise tax, amounts shall be treated as paid when there is no substantial risk of forfeiture of the rights to such payment. Consider a senior executive who is a long-service covered employee of an applicable tax-exempt organization and who participates in an “eligible” 457(b) plan and an “ineligible”457(f) plan. Assume that such employee is required to perform substantial services for the organization through September 30, 2020 in order to become vested in his 457(f) plan account equal to $1,000,000 and that he has been vested in his 457(b) benefits since commencing participation in such plan pursuant to the plan’s terms. Further assume the following facts: (i) the employee retires on December 31, 2020 having performed substantial services and received a regular salary of $425,000 in the 2020 calendar year; (ii) the employee receives a distribution in 2020 of $600,000 from the 457(b) plan; and (iii) the employee will receive a distribution of his entire 457(f) plan account balance on March 15, 2021, which totals $1,000,000. Based on the foregoing facts, the employee would receive $1,025,000 in compensation in 2020 and $1,000,000 in 2021. Would the excise tax apply to the organization for the 2020 taxable year and if so, on what amount? The answer appears to be “yes” because both the salary paid in 2020 and the 457(f) amount that became vested in 2020 (even though not paid until 2021) would count for a total of $1,425,000, while the Section 457(b) distribution of $600,000 would not count because such amount became vested in prior tax years. The excise tax payable for 2020 would equal 20% of $425,000.
For tax-exempt organizations currently working on compensation arrangements, the proposed terms of Section 4960 at least need to be considered to mitigate risk of potential excise taxes to such organizations.