The 2017 Tax Act includes a new 21% excise tax on compensation in excess of $1 million and payments upon separation from service that exceed a specified threshold paid by an applicable tax-exempt organization (an “ATEO”) to a covered employee. If subject to the excise tax, the tax-exempt organization (and/or a related organization) will be responsible for paying the tax.
The purpose of new excise tax is to place tax-exempt and for-profit organizations on relatively equal footing as it relates to executive compensation. The disparate treatment of tax-exempt and for-profit organizations is particularly pronounced in the context of tax-exempt hospitals, where executives frequently receive compensation on par with their for-profit counterparts. To remedy the disparity, the new legislation imposes limitations similar to those under Code Sections 162(m), relating to excess employee compensation, and Code Section 280G, relating to certain payments upon a change in control, on tax-exempt organizations. These changes will create significant new compliance hurdles for tax-exempt organizations. For example, in order to determine whether compensation exceeds the $1 million threshold, compensation payments between the tax-exempt and related organizations will need to be consolidated.
In general, an ATEO is any organization that is exempt from taxation under Code Section 501(a) (e.g., public charity or private foundation), or an organization for which income is excluded from taxation under Code Section 115(1) (e.g., certain political subdivisions). The Department of Treasury recently published a notice which clarified, among numerous other items, that governmental units, including many state colleges or universities, are not considered ATEOs, unless they have also received federal tax-exempt status.
A covered employee includes any employee (including any former employee) who is one of the 5 highest compensated employees of the ATEO for the current year, or was a covered employee in any prior year, beginning in 2017. Based on the foregoing, covered employee status will persist once triggered. As a result, an ATEO may accumulate and be required to pay excise tax, if applicable, with respect more than the 5 highest compensated employees in any given year.
For purposes of this provision, compensation is defined as wages, excluding certain payments to or from a qualified retirement plan, but including certain deferred compensation payments. In addition, compensation includes wages paid by certain related organizations. An organization, including a for-profit entity, or governmental entity is related to an ATEO if, among other things, the organization or governmental entity (i) controls, or is controlled by, the ATEO, or (ii) is controlled by one or more persons that control the ATEO.
Example: A family foundation compensates an employee $10,000. A related family office compensates the same employee $1,500,000. Based on the foregoing, total compensation paid is $1,510,000. If this employee is in the 5 highest compensated employees of the family foundation, then the family foundation and family office will be subject to the excise tax on the excess compensation paid over $1 million (i.e., $107,100 = $510,000 x 21%). This liability is allocated between the family foundation and family office based on the amount of compensation paid by each relative to overall compensation. In this example, the family office would have 99% of the excise tax allocated to it (i.e., $506,622), while the family foundation would have 1% of the excise tax allocated to it (i.e., $3,378).
Ultimately, the new excise tax will present tax-exempt organizations with significant compliance burdens, including determining whether an individual is (i) a common law employee, (ii) in the 5 highest compensated employees (and continuously tracking them thereafter), and (iii) receiving compensation from related organizations. While these are only a handful of the potential considerations necessary, they demonstrate the challenging landscape presented by this law.