As part of the Tax Cuts and Jobs Act of 2017, Congress enacted new § 4960 of the Internal Revenue Code.  Section 4960 imposes an excise tax on certain executive compensation paid by tax-exempt organizations – similar to the $1 million limit on deductions for compensation paid to highly paid executives in for-profit companies under § 162(m) of the Code and to the golden parachute rules of § 280G of the Code.  The new provision could have a significant impact on some tax-exempt organizations, but it lacks important detail and leaves many questions unanswered.  The excise tax provision is in addition to other rules applicable to reasonable compensation paid to employees of tax-exempt organizations.

The statute directs the Secretary of the Treasury to prescribe regulations under § 4960 “as may be necessary to prevent avoidance of the tax under this section, including regulations to prevent avoidance of such tax through the performance of services other than as an employee or by providing compensation through a pass-through or other entity to avoid such tax.”   No regulations or other IRS guidance have been issued under § 4960 thus far.

1.  How much is the tax?

The excise tax is imposed at the corporate income tax rate, which is currently 21 percent.  The tax is imposed on a covered employee’s compensation that constitutes (a) “remuneration” in excess of $1,000,000 or (b)  an “excess parachute payment.”

2. Which employers are covered?

The provision applies to “applicable tax-exempt organizations,” which include any organization that is exempt from tax under IRC § 501(a).  Schools, nonprofit hospitals, and other public charities, foundations, trade associations, VEBAs, and other organizations exempt under section 501(a) of the Code, as well as farmers’ cooperatives, and certain governmental entities and political organizations, are covered.  So far, no express exemptions or modifications have been provided for church or governmental organizations.  It is not clear whether the IRS has the authority to grant such exemptions, even if it wished to do so.

Note that “remuneration” for purposes of the $1,000,000 limit includes amounts paid to a covered employee by an entity that is related to the tax-exempt organization – generally, entities that control, or are controlled by, the tax-exempt organization. It is not clear whether these rules also apply for purposes of the excess parachute payment provisions, which do not use the term “remuneration.”

3. Which employees are covered?

The tax is imposed on compensation paid to an organization’s “covered employees.” An organization’s “covered employees” include the five most highly compensated employees for the taxable year and each employee or former employee who was one of the five most highly compensated employees during any taxable year after 2016.  Thus, once an employee is subject to this excise tax, he or she will always be covered by it, even after termination of employment.

4. On whom is the excise tax imposed?

Liability for the excise tax falls on the employer.

5. What compensation is included for purposes of the $1,000,000 limit?

The $1,000,000 limit applies to “remuneration” paid by an applicable tax-exempt organization  for the relevant taxable year.  Remuneration for this purpose is generally the employee’s wages for purposes of federal income tax withholding plus amounts included in gross income under section 457(f) of the Code when no longer subject to a substantial risk of forfeiture.

Remuneration is taken into account for § 4960 purposes when it is “paid.”  It is treated as “paid” when it is no longer subject to a substantial risk of forfeiture. For example, a covered employee’s salary generally will be treated as “paid” when it is earned, because it is never subject to a substantial risk of forfeiture. Amounts credited under a nonqualified deferred compensation plan, including a plan subject to § 457(f) or 409A, should be taken into account when vested.

“Remuneration” for purposes of § 4960 also includes amounts paid to a covered employee by an entity that is related to the tax-exempt organization. Related organizations include entities that control, or are controlled by, the tax-exempt organization, and certain other organizations.  Accordingly, exempt organizations may need to determine whether any of their highest paid employees also receive compensation from a related entity and whether the total remuneration would trigger the excise tax.

“Remuneration” for purposes of § 4960 excludes:

• designated Roth contributions

• remuneration paid to licensed medical professionals for performance of medical or veterinary services.

• welfare and fringe benefits that are excludable from the employee’s income and are not treated as wages for purposes of federal income tax withholding (such as excludable medical, lodging, and automobile benefits)

• contributions to and distributions a plan that is tax-qualified under Code § 401(a) or a 457(b) plan

• probably contributions to and distributions from a 403(b) plan (although the statute is not clear on this point)

6. What is an excess parachute payment for § 4960 purposes?

The new excise tax also applies to an “excess parachute payment” paid by an applicable tax-exempt organization to a covered employee.

• For purposes of the new excise tax, an “excess parachute payment” is the excess of any “parachute payment” over the portion of the “base amount” allocated to such payment.

• Drawing on concepts from the golden parachute rules in § 280G, a “parachute payment” is any payment in the nature of compensation to a covered employee if (1) the payment is contingent on the employee’s separation from employment with the employer, and (2) the aggregate present value of all such contingent payments equals or exceeds three times the “base amount”.

• The employee’s “base amount” is determined under § 280G and generally is the employee’s average compensation for the preceding five years (or shorter period of service).

• Note: 280G denies a deduction to some for-profit corporations for certain payments that are contingent on a change in ownership or control of the corporation. An excise tax may also be imposed on the employee for excess payments under § 280G — see IRC § 4999 — but there is no comparable provision in § 4960.

Parachute payments do not include (i) payments to a nonhighly compensated employee, or to a licensed medical professional for medical or veterinary services, or (ii) probably distributions from a tax-qualified plan, 457(b) plan, or 403(b) arrangement, even if separation from employment triggers the distribution.

7. When are amounts “paid” for purposes of the excess parachute prong of § 4960?

It is not clear from the statute whether the payment timing rule for “remuneration” under the $1,000,000 prong discussed above – i.e., treating an amount as “paid” when it is no longer subject to a substantial risk of forfeiture – applies to the excess parachute prong of § 4960.  Treasury and IRS guidance should address this question, including the interaction of § 457(f) and the excess parachute prong of § 4960.

8. When does § 4960 become effective?

The excise tax is effective for taxable years beginning after December 31, 2017.  Because the excise tax liability falls on the employer, the effective date provision is probably referring to the employer’s taxable year. Thus, tax-exempt employers with a taxable year starting late in the calendar year may be able to escape imposition of the tax during the 2018 calendar year.