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Section 4960 of the Tax Cuts and Jobs Act of 2017 enacted a 21 percent excise tax on excessive employee compensation for tax-exempt organizations. Section 4960 is effective for years beginning after Dec. 31, 2017. The excise tax must be paid by the 15th day of the fifth month following the year end of the organization’s taxable year end. For tax-exempt organizations that have a calendar year end, the excise tax would be due on May 15.

What is taxed?

The excise tax is imposed on “excess compensation” (total annual compensation exceeding $1,000,000) and “parachute payments” (severance in excess of three times the base salary for a covered employee).

Who is a covered employee? 

The tax applies to the five highest paid employees each year. However, once an employee is considered a covered employee, they will always be a covered employee in all future years. As a result, a tax exempt organization could have more than five covered employees after the first year of notice.

What about related for-profit entities?

Executives of for-profit organizations may also be subject to the excise tax if they also serve as an officer or hold a key role at a related tax-exempt organization and the total compensation for the two entities exceeds $1,000,000. An excise tax liability can also occur if the tax-exempt organization does not compensate the individual but both entities meet the related party test and the individual is considered an employee of both entities. 

How is excess compensation defined?

The $1,000,000 compensation limit applies to remuneration paid by a tax exempt organization for the applicable tax year. The following are types of compensation subject to the excise tax:

• All W-2 income for an employee less Roth IRA contributions

• Compensation for medical services provided

• Deferred compensation on 457(b) plans for the year a distribution is made

• Deferred compensation on 457(f) plans for the year an employee becomes vested

• Taxable fringe benefits

How are excess parachute payments defined?

Parachute payments are defined as any compensation, contingent upon the employee’s separation from employment with the employer. The notice expands on the definition as any compensation that would not have been made or vested, unless involuntary separation from employment accelerates a right to payment. If, the present value of all parachute payments exceeds three times a covered employee’s base amount, an excise tax liability exists. The base amount is considered to be the prior five year average of W 2, Box 1 wages. The tax liability for excess parachute payments is calculated at 21 percent of compensation on the present value of all parachute payments less the base amount.

Example excise tax liability calculation resulting from a parachute payment after an involuntary separation between an employee and an employer occurs:

Step 1: Calculate the base amount:

Year

W-2 Box 1 Wages

2014

$450,000

2015

$475,000

2016

$500,000

2017

$525,000

2018

$550,000

 

The average base amount is $500,000 Three times the average base amount is $1,500,000

Step 2: Determine the total parachute payment:

 

Parachute Payment

Amount

Salary severance

$1,000,000

Bonus severance

$350,000

Prorated bonus

$200,000

Health care benefits

$25,000

 

The total parachute payment is $1,575,000

Step 3: Does the total parachute payment equal or exceed three times the base amount?

Yes: $1,575,000 > $1,500,000 

Step 4: Calculate the amount of excess parachute payment:

Total parachute payment $1,575,000

Less: Base amount ($500,000)

Prorated bonus $1,075,000

Step 5: Calculate excise tax liability:

Excess parachute payment 

$1,075,000

Excise tax rate 21 percent

Excise tax liability $225,750

How can you prevent an excise tax liability?

• If performance bonuses fluctuate from year to year, consider compensation smoothing to stay below the $1,000,000 threshold for excessive executive compensation.

• Review severance agreements 

for rates and amounts applied to employees upon separation from the tax exempt organization.

• Consider increasing compensation amounts in the last five years of an employee’s service to increase the base amount for parachute payments (keeping in mind the $1,000,000 threshold for excessive compensation).

• Consider adjusting employee’s compensation to prevent having more than five covered employees after the first year the tax is considered.