Tax Reform Tosses Nonprofits $1M Quandary
The recent reform of the U.S. tax code has been lauded in many circles, but it has left some nonprofits reeling and facing potentially large excise taxes.
For tax years beginning on or after Jan. 1, tax-exempt organizations face a 21 percent excise tax on executive compensation that is above $1 million, prompting intense chatter among some nonprofits worried about hefty tax bills.
While nonprofit organizations have had to contend with the excess benefit transaction rules, there was no hard limit on how much they could pay top executives without tax consequences. By contrast, publicly held companies have long paid additional taxes (by result of the disallowance of a deduction) on certain executive pay over $1 million.
The new law imposing the 21 percent excise tax on compensation over $1 million is equal to the corporate tax rate and is owed by the employer, not the employee. Further, it applies only to the amount paid above $1 million. There is also a 21 percent excise tax on “excess parachute payments,” which generally includes amounts paid as the result of separation (e.g. severance pay) in excess of three times the executive’s five-year average pay.
The change requires that all tax-exempt organizations identify employees who meet the $1 million threshold. If an organization has many employees earning more than $1 million, the tax will only be levied on the five highest paid among them.
Workers likely to be impacted include top executives running hospital systems, nonprofit insurance companies, large charities and foundations, university presidents and executives running political organizations. The change will hit colleges with high-paid athletic coaches especially hard. For example, the $7 million annual pay for Duke University basketball coach Mike Krzyzewski would incur an excise tax bill of $1.26 million (21 percent of $6 million). Likewise, the $11 million paycheck for University of Alabama football coach Nick Saban would cost the school an extra $2.1 million each year (21 percent of $10 million).
The law exempts compensation for medical services, including pay to licensed medical professionals, such as veterinarians, doctors and nurses. So, a nonprofit hospital system with several surgeons earning more than $1 million will not need to pay excise tax on those earnings.
The excise tax change has left chief financial officers at affected organizations seeking creative approaches to mitigate the impact. There are two principal actions that organizations should consider in an effort to avoid paying the excise tax:
1. Restructuring bonus payout terms. For executives with pay hovering near the $1 million level—perhaps rising above it some years and below for others as a result of performance-based payments—employers can look at the structure of remuneration to gauge if modifications could minimize the tax impact. For example, a coach with a base pay of $500,000, who leads a team to the playoffs on average every two years and has a $1 million bonus for doing so, would trigger the excise tax on years when the team performs well.
However, weighting that bonus schedule to reflect performance goals over several years could change the coach’s pay to $1 million every year, avoiding the tax liability entirely. The goal is to structure pay so that by weighting performance goals over several years, pay remains relatively steady, avoiding fluctuating above the $1 million threshold. The same approach could be used for any executive with performance targets that can result in large swings in bonus size.
2. Defer compensation. Proposed regulations under section 457(f) of the tax code, excludes taxing compensation that is subject to “substantial risk of forfeiture.” That opens up the possibility to using deferred compensation to prolong the risk of forfeiture and postpone the tax liability. A nonprofit entity and the affected executive could, for example, contractually agree to extend the vesting period of a yet-to-be-earned bonus, pushing the tax liability into future years.
Organizations can also use non-compete agreements for former employees to extend their risk of forfeiture for up to five years. Another option is putting off vesting until after retirement. So, an executive earning $1.1 million could have $100,000 of that amount placed into a deferred compensation plan, dated to vest one year after retirement. Then, in the first year of retirement, assuming that the deferred compensation doesn’t exceed $1 million, the executive would collect that amount, avoiding the excise tax liability.
Organizations can also look to make some smaller changes that can help. If employers are not maxing out their retirement plan contributions, they can do so to put some compensation there. However, contributions generally max out at $55,000, so that change won’t make a significant difference.
Nonprofits could also add non-taxable fringe benefits, such as retiree medical coverage, although that may end up costing more than reducing excise taxes because increased benefits would also apply to others.
Additionally, employers with severance or other agreements that put them at risk of a tax on excess parachute payments can look for ways to build up an employee’s compensation while employed to mitigate the excise tax impact.
With the new tax laws having just passed, it will remain unclear exactly how all this will play out until the IRS writes new regulations to codify the latest tax regime. Those regulations may even result in the agency nixing its proposed section 457(f) regulation, making it harder to avoid taxes using the substantial risk of forfeiture approaches outlined above.