New Tax on Excess Nonprofit Executive CompensationJuly 13, 2018
We’ve been addressing nonprofit compensation quite often on this blog in recent months. Between today’s low unemployment rates and tightened funding environment, Boards need to be more creative and strategic than ever when putting together compensation packages, especially for senior roles like Executive Director or Chief Executive Officer.
And now, nonprofit boards also need to be mindful of IRS Section 4960 – a provision in the 2017 Tax Cuts and Jobs Act federal tax reform bill. It is a new excise tax on excessive compensation at nonprofit organizations.
What is the IRS Code 4960 All About?
IRS Tax Code 4960 is officially known as the “Tax on Excess Tax Exempt Organization Executive Compensation.” It applies to compensation that many nonprofit experts view as neither excessive nor necessarily paid only to executives.
The intention of this provision is to “level the playing field” by ensuring that tax-exempt organizations will not enjoy a tax advantage for hiring highly compensated employees who might otherwise be hired by publicly traded companies. The new tax attempts to accomplish this by imposing a corporate-level tax on exempt organization executive compensation packages – those that exceed $1 million – as well as certain “excess” parachute payments. The new tax code imposes a 21% excise tax on tax-exempt organizations that pay their senior executives $1 million or more per year in compensation.
Which Nonprofit Organizations are Subject to the 4960 Tax?
- Any organization exempt from taxation under IRS Code Section 501(a). This includes tax- exempt organizations under Code Sections 501(c) and 501(d), as well as Code Section 401(a).
- Political organizations described in Code Section 527(e)(1).
- Farmers’ cooperative organizations under Code Section 521(b)(1).
- Governmental entities with income excluded under Code Section 115(1).
Which Employees are Impacted by the 4960 Tax?
The IRS characterizes people potentially subject to the 4960 tax as “covered employees” who are defined as:
- A current or former employee who is one of the five highest-compensated employees in a nonprofit organization for the current tax year, or any prior tax year starting after December 31, 2016.
- Unlike IRS Code 162(m), which limits the definition of “covered employees” to corporate officers, 4960 applies to any employee that fits the compensation criteria.
- Once an employee is categorized as a “covered employee” they will hold that classification for the duration of their employment. This means that an organization can have more than five covered employees if they hire additional highly compensated executives.
Who Is Responsible for Paying the 4960 Tax?
- The nonprofit employer of the “covered employee” is responsible for paying the 4960 tax.
- Any compensation which is not tax-deductible by Code Section 162(m) will not be considered when calculating the 4960 tax liability. For example, if an employee is paid $1.4 million, the nonprofit employer would be liable for 4960 tax on $400,000 – the amount that exceeds $1.0 million.
- If an individual is paid by more than one nonprofit organization, the liability for the excise tax will be divided proportionately among the employers.
What About Excess Parachute Payments?
A 4960 tax liability will also be applied to “excess parachute payments” that include the following:
- A 4960 payment made when an employee leaves a nonprofit employer.
- The aggregate present value of the payments – to be paid to/for the benefit of an employee – when they equal or exceed an amount that is three times the base compensation.
- An employee does not need to be an officer of the nonprofit organization for the parachute payment tax to apply.
- Unlike the “golden parachute” rules that apply in the for-profit business sector, a change in control of the employer is not required; an employee need only terminate employment to trigger the excess parachute payment.
What Actions Should Nonprofit Boards Take Now?
- Organizations potentially subject to the new 4960 tax should identify their five highest compensated individuals based on tax year 2017 and undertake the same exercise for tax year 2018.
- Work with your tax advisor to review compensation agreements that may trigger potential 4960 tax liability. The compensation assessment should go beyond base salary to include short-term and long-term incentive compensation agreements, deferred compensation plans and severance agreements.
- Also, be sure to look back at recently terminated executives to determine if there are any potential 4960 tax liabilities for former employees.
It Pays to Get Expert Advice
If this all sounds very complicated for nonprofit board members trying to determine potential 4960 tax liabilities – it certainly can be. That’s why it pays to get expert advice to sort out exactly who is a “covered employee” and what 4960 tax liabilities will need to be planned for moving forward.
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