“Millionaire” Employment Tax: Could This Be Your Nonprofit?

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How much is too much compensation for nonprofit executives? Many nonprofits face the opposite challenge, with below-market pay provided to key leaders who are willing to make financial sacrifices.  A new tax law nonetheless aims to curb abuses of Section 501(c)(3) organizations offering either very high salaries or too generous severance pay upon departure. The penalty?  A 21% excise tax on the amount deemed to be excessive compensation. Nonprofits thus may continue with such compensation largesse, but only if they pay Uncle Sam too. 

Then and Now – Excess Compensation Tax

The new law affecting executive compensation, Section 4960 of the Tax Cut and Jobs Act, passed in December 2017 and effective January 1, 2018, applies to all Section 501(c)(3) organizations with the 21% tax imposed on employers (not the employees).[1]  First, Section 4960 imposes this employer tax for any employees earning a salary above $1,000,000, who are also one of the five highest paid employees of the organization (known as “covered employees”), with some notable exclusions as addressed below. Second, Section 4960 imposes the tax on “parachute payments” – that is, severance compensation paid when an employee leaves employment – that equals or exceeds triple the employee’s “base amount” of compensation with the nonprofit.[2]  This new tax may certainly cause organizations to weigh such compensation amounts carefully, given the overall cost ultimately borne by the nonprofit employer.

Legal constraints on nonprofit compensation are nothing new under basic tax principles.  To qualify for Section 501(c)(3) tax exemption, a nonprofit must be “exclusively” organized and operated for charitable, religious, educational, or other qualified purposes.  Under Section 4958 of the Tax Code, a nonprofit “insider” who receives compensation deemed to be “excessive” (i.e., too much in relation to the person’s work duties, qualifications, experience, skills, and organizational aspects) is subject to an excess benefit tax of 25% to 200% on such amount.  This assessment is punitive in nature, based on underlying tax principles for Section 501(c)(3) organizations.  On this basis, insiders who improperly benefit must pay an excise tax as well as return the “excess benefit” to the organization, plus interest. 

Implications of Section 4960

Million-dollar salaries and triple-salary severance admittedly seems like quite an economic stretch.  While most nonprofits do not compensate their employees so lavishly, Section 4960’s tax bite may reach further than one may initially think.  

For example, the new law contains no built-in adjustment for inflation, so what constitutes $1,000,000 today could be quite different in future years. Additionally, it is possible that exiting parachute payments or other deferred compensation plans (when vested), could exceed $1,000,000 – especially given future inflation.  Notably, Section 4960 does not provide for grandfathering of existing compensation plans in effect prior to its passage, so no option exists to ease into this new constraint for compensation paid this year. 

Also significant is Section 4960’s definition of “covered employee” as one of the organization’s five highest compensated employees in the current tax year or in any prior tax year beginning after December 31, 2016.  Consequently, once an employee qualifies as a “covered employee,” he or she will remain a covered employee for all future tax years.  Over time, an organization thus may have more than five covered employees, compounding Section 4960’s financial impact. 

Section 4960 is apparently aimed at leveling the playing field for high-level executive compensation for tax exempt organizations and publicly traded business.  In the latter, the Tax Code limits the deductibility of certain top executive compensation beyond $1,000,000.  Since Section 501(c)(3) organizations generally do not take business deductions, given their tax-exempt status, the Act addresses such matter through its affirmative 21% excise tax on the nonprofit employers. Yet all is not so smooth.  Businesses may still reward employees through stock options and other ownership incentives, which nonprofits may not.  Further, creative tax professionals serving nonprofit organizations have already worked out “split dollar plans” as an executive retirement vehicle falling outside of Section 4960’s reach.

Should a Nonprofit Provide Such Generous Pay?

Some commentators have indicated that nonprofits covered by Section 4960 may wish to proceed with high-level salaries and parachute severance payments, complying with the new 21% excise tax as an operational cost.  Is such high compensation appropriate within the nonprofit context?

Generally speaking, tax-exempt nonprofits are legally constrained to pay only reasonable compensation.  What is reasonable?  For severance pay, the appropriate considerations may include the employee’s length of service, reason(s) for termination, avoidance of a potential lawsuit or other adverse action, the extent to which the employee’s post-termination cooperation is needed, and available funds. The answer for executive salaries typically depends on a due diligence evaluation of many favors including the employee’s experience, skills, and education, as well as the specific work to be performed, the geographic location for such work, and the nature of the nonprofit organizations.  For example, soup kitchens pay far less than large hospitals, neighborhood youth centers pay far less than metropolitan museums, etc. 

All such matters, whether for salaries or severance, necessarily involve business judgment decisions for the nonprofit board or its other high-level decision makers.  Part of salary due diligence evaluation may well involve consulting outside resources for comparable pay, such as IRS Form 990s containing pay data for similarly situated employers and positions.  It may be quite helpful, and important for any potential later inquiry, to document well the basis for high compensation packages, such as through a detailed written report and/or board resolution reflecting the reasonableness of such compensation decision.

With respect to high-level salaries, it may be helpful too to include a provision in the executive’s employment contract reserving the nonprofit employer’s right to unilaterally reduce the employee’s compensation.  Such provision could allow later avoidance of the employer’s Section 4960 tax, by reducing compensation below the one-million-dollar threshold.  It also would protect against punitive tax implications for the employee, if Section 4958 “excess benefit” issues were to later arise.

Is a nonprofit executive worth a million bucks or a really big financial parachute?  In practical terms, this question may be rare for many nonprofits.  Perhaps the bigger question for all nonprofits is one of stewardship.  How do we recruit (and retain) talented and capable leaders, while neither breaking our budget nor exceeding “reasonable” compensation parameters and while continuing to carry out the mission with excellence?  Now that is a great question to ponder!

 


[1]  New Section 4960 also applies to government entities exempt under Code Section 115(1) (to include state and local governments, public universities, state agencies, commissions, and other public bodies), farmers’ cooperatives exempt under Section 521(b), and political organizations under Section 527(e)(1).  Section 4960 does not apply, however, to licensed medical professionals employed to provide medical services, including veterinarians.

[2] The base amount is the average annualized compensation includible in gross income for the five taxable years ending before the date of the employee’s separation.