Most Americans are now aware that new tax reform legislation, titled the 2017 Tax Cuts and Jobs Act, was signed into law late last year. There has been significant news coverage of the provisions of the law that relate to individual taxpayers and corporations, but little about the law’s effect on tax-exempt organizations. One provision in the new law will impact those tax-exempt organizations that pay any employee wages in excess of $1 million. This article will summarize what we know about this provision and the questions that have yet to be answered by official guidance.
New Excise Tax on Excess Compensation
Internal Revenue Code (IRC) section 162(m) has long disallowed a deduction for corporate taxpayers that compensate certain employees in excess of $1 million per year. However, this law had no effect on tax-exempt organizations that were not subject to tax on related income; therefore, there was no excess-compensation-related economic impact for tax-exempt organizations.
The 2017 Tax Cuts and Jobs Act, with the addition of Section 4960 to the IRC, now stipulates that tax-exempt organizations are subject to excise tax for compensation paid to covered employees that exceeds $1 million per individual. This new tax is in effect for tax years beginning after December 31, 2017. Though the Internal Revenue Service (IRS) and the Department of the Treasury likely are working to provide further guidance for Section 4960, we currently know the following:
- The excise tax rate is 21%– the same as the corporate income tax rate.
- As defined in Section 4960, a tax-exempt organization includes entities exempt from tax under Section 501(a) and political organizations exempt under Section 527(e)(1).
- “Compensation” is defined as wages (excluding designated Roth contributions) that include income (reportable in the employee’s Form W-2 because there is not a substantial risk of forfeiture) from nonqualified deferred compensation plans under Section 457(f).
- Wages paid to a licensed medical professional for services performed while providing medical care are not included in the calculation of the amount subject to excise tax.
- Compensation paid by related organizations is aggregated when determining if an individual is remunerated in excess of $1 million per annum. The liability for the excise tax will be pro rata across the organizations, and it is possible that an organization that pays less than $1 million to the covered employee will be subject to a portion of the excise tax.
The Need for Further Guidance
Though policy makers have released the above guidance, there are many questions for which tax-exempt organizations and tax practitioners will continue to seek clarity. The following are some areas requiring further consideration:
- A “covered employee,” according to Section 4560, is an individual who “is one of the [five] highest compensated employees of the organization for the taxable year”. At present, there is no guidance specifying if licensed medical professionals working in direct patient care are excluded as one of the five highest compensated employees. The IRC simply states that wages paid for medical services are not subject to excise tax, but provides no further clarification.
- Also of note, the definition of a covered employee includes language referring to the taxable year, not the calendar year. Historically, compensation for reportable employees of tax-exempt organizations has been reported on the calendar year. If excise tax is to be calculated based on taxable year compensation, then compensation amounts will not align to either the individual’s Form W-2 or Form 990 reporting for fiscal year filers.
- If a tax-exempt organization has a taxable corporation as a related organization, how is the pro-rata share of the excise tax calculated? Will the taxable corporation be subject to excise tax and be required to file an excise tax return, in addition to the income tax return?
What Should Tax-Exempt Organizations Be Doing Now?
Clearly, there is a need for more guidance and clarification, and tax-exempt organizations are advised to keep a close eye on the matter. In addition, it is recommended that tax-exempt organizations perform an internal review of compensation policies sooner, rather than later, as the law applies starting with calendar year 2018. Keep in mind that the law does not prohibit compensating an employee in excess of $1 million and should not be used as the final determinant of a compensation package. Organizations should begin planning for the excise tax, being aware of upcoming deferred compensation payouts or other unusual payouts to its highest compensated employees.
If you have any questions about the new tax reform law, or would like more information about how it will affect tax-exempt organizations and employee compensation or would like to request a speaker on this topic for your organization or event, contact one of our executives below at (800) 270-9629.
Access additional tax reform insights here.
