How can a tax-exempt employer manage the new excise tax on executive compensation?
The executive compensation provisions of the Tax Cut and Jobs Act have been widely reported, and public companies and tax-exempt employers are now thinking about how to adjust to the new statutory changes. Tax-exempt employers face the startling new reality of a 21% excise tax on "remuneration" exceeding $1,000,000 paid to a "covered employee" in a tax year and on severance pay in excess of certain limits paid to a covered employee in connection with a separation from service. We are all just beginning to fully process the new changes and, thus far, there has been no administrative guidance from the Treasury Department. But based on preliminary analysis, tax-exempt employers may be able to mitigate (or at least manage) the sting of the new excise tax through a combination of traditional supplemental executive retirement plans and long-term incentive plans, and (where possible) well-designed non-competes that comply with the proposed regulations under Code Section 457(f) published last year. In ideal circumstances, a tax-exempt employer may even be able to avoid the excise tax entirely.
Excise tax on excessive "remuneration" and "excess parachute payments"
Beginning this year, tax-exempt employers will have to pay a 21% excise tax on: (1) "remuneration" in excess of $1,000,000 paid to a "covered employee" in any tax year; and (2) any "excess parachute payment" paid to a covered employee. Any current or former employee who is among the five highest paid employees of the organization for the current tax year will be considered a "covered employee." And, importantly, an individual who is considered a covered employee for any prior taxable year (including2017) will continue to be considered a covered employee while she remains employed by the organization. So once a covered employee, always a covered employee.
The term "remuneration" includes all wages payable to a covered employee that are subject to withholding and are not subject to a substantial risk of forfeiture. So regular compensation and bonuses paid during the year count toward the $1,000,000 limit, but the non-vested benefit under a supplemental executive retirement plan would not count. Importantly, the final legislation clarified that the term "substantial risk of forfeiture" has the meaning given in Code Section 457(f)(3)(B). (Spoiler alert: The "not subject to a substantial risk of forfeiture" qualification creates the planning opportunities discussed below.)
The term "excess parachute payment" means compensation paid in connection with the covered employee's separation from service that exceeds three times the covered employee's "base amount" (which is essentially the employee's average annual compensation determined over the prior five years). Although this concept is borrowed from the rules governing "change in control" payments under Code Section 280G, the excise will apply to any severance pay that exceeds three times the covered employee's base amount – even if the separation does not relate to a change in control. Note that excess parachute payments do not count toward the $1,000,000 threshold on annual remuneration and the excise can apply to an excess parachute payment even if the covered employee's remuneration for the year did not exceed $1,000,000.
Finally, compensation paid to two classes of employees within tax-exempt organizations can be ignored when determining the applicability of the excise tax. First, the tax does not apply to compensation paid to licensed medical professionals for the provision of professional medical services. (So the tax will not apply to compensation for professional services rendered by a physician employed by a tax exempt hospital.) Second, compensation paid to individuals who are not considered "highly compensated employees" under the definition provided under Code Section 414(q) – the definition used in the nondiscrimination rules that apply to tax-qualified retirement plans and 403(b) plans – is also exempt from the tax.
SERPs and LTIPs
Compensation that is subject to a substantial risk of forfeiture – as defined for purposes of Code Section 457(f) – will not be considered "remuneration" subject to the 21% excise tax under the new statutory changes. This means that any compensation that can be made subject to a service-related vesting requirement will not count toward the $1,000,000 threshold until it vests. This may expand the utility of Supplemental Executive Retirement Plans (SERPs) and long-term term incentive plans (LTIPs) for "covered employees" who might otherwise be near or above the threshold. Most large tax-exempt employers already have these types of programs for executives, but they may have even greater utility now. At a minimum, an exempt organization may be able to plan for the payment of the excise tax and consider change to existing SERP and LTIP arrangements to keep payments to a minimum in any given year.
Non-competes and elective deferrals under the 457(f) regulations
The proposed regulations under Code Section 457(f) published in 2016 created many planning opportunities for tax-exempt employers and their executives. (You can read our blog post about the proposed regulations here.) Three opportunities in particular come to mind: non-competes and elective deferrals.
Non-competes. The 2016 proposed regulations under Code Section 457(f) provide that a bona fide non-compete can impose a substantial risk of forfeiture within the context of a compensation arrangement established by a tax-exempt entity. (As those who follow these issues know, this is diametrically opposed to the final regulations under Code Section 409A, which expressly reject the use of non-competes to create a substantial risk of forfeiture.) Specifically, a non-compete imposed by a tax-exempt employer can create a valid substantial risk of forfeiture under Code Section 457(f) if: (1) the executive's right to compensation is specifically conditioned in writing upon compliance with the non-compete; (2) the non-compete is enforceable under applicable state law; (3) the tax-exempt employer can demonstrate that it has a bona fide interest in ensuring that the executive complies with the non-compete; (4) the tax-exempt employer makes reasonable efforts to verify the executive's compliance with the non-compete; and (5) the executive has the ability to provide services to a competitor.
That fact that former employees can still be considered "covered employees" may make non-competes much more appealing for tax-exempt employers as way to keep annual payments to a former executive below the $1,000,000 threshold (assuming, of course, that the subject executive is willing to agree).
Elective deferrals. The 2016 regulations allow elective deferrals to be made under a Section 457(f) arrangement so long as: (1) the deferral election is made in writing before the beginning of the calendar year in which the compensated services will be performed; (2) the executive provides substantial services for at least two additional years; and (3) the compensation payable when the risk of forfeiture lapses will be more than 25% of the compensation that otherwise would have been paid. This approach – which obviously requires the active participation of the executive – could work in the context of negotiating a new compensation program or perhaps a new retention bonus or incentive bonus arrangement. It also makes sense to build elective deferrals into a new or existing 457(f) plan simply to make the option available. (Many will recall that the 2016 regulations also breathe new life into the use of "rolling vesting" provisions. While a welcome opportunity for executives, we don't view that as a meaningful planning tool for an employer.)
Much more thinking will be required before sound strategies for managing the new excise tax can be developed. And one hopes that the Treasury Department will provide transition guidance about which strategies – if any – can work during 2018. For now, however, the field remains open to cautious exploration albeit without many options to explore.
