Effective January 1, 2018, the Tax Cuts and Jobs Act, otherwise known as the Tax Reform bill, imposes a new 21% excise tax on nonprofits that pay compensation of $1 million or more to any of their five highest-paid employees. There will also be a tax on certain employee benefits.
As usual, check with a lawyer with expertise in nonprofits for the details, but the basics of the changes follow:
Tax is paid by the exempt organization and applies to all remuneration of a covered employee (including non-cash benefits), except tax-qualified retirement plans, amounts that are excludible from the covered employee’s gross income.
Any portion of compensation paid to a licensed medical professional (e.g., doctor, nurse, or veterinarian) which is for the performance of medical or veterinary services by the professional is excluded.
Payments from related organizations and governmental entities are also included – those entities pay their pro rata share of the tax.
If an employee qualifies as a covered employee for any year, the excise tax applies to compensation in excess of $1 million and certain parachute payments paid to the person by the organization in any future year.
Nonprofits were unable to plan ahead for the impact of this change – the period to qualify as a covered employee began in tax years beginning in 2017, so the tax on compensation over one million dollars will be due in 2018 for tax-exempt organizations.
Why This Change?
This approach is actually portrayed as an attempt to provide parity with the deductibility of executive compensation for publicly-traded for-profit companies.
Prior to tax reform, such corporations could only deduct salaries up to $1 million dollars for their five highest paid officers as expenses. But performance-based pay, like bonuses and stock options paid according to a transparent formula and disclosed to shareholders, was exempt from the calculation. Compensation packages in businesses then tended to shift to pay based on reaching revenue or stock price goals, away from guaranteed base salaries. The tax reform bill removed the exemption for performance-based earnings. Now all income (effective for amounts paid or incurred after December 31, 2017) for publicly-traded private company executives over $1 million will no longer be deductible as expenses. The Joint Tax Committee expects the new provision to raise $9.2 billion over 10 years.
In applying this excise tax to nonprofit executives, the Ways and Means Committee Majority Tax Staff also raised the idea in its summary that highly paid nonprofit executives actually divert resources from exempt purposes. It states that exemption from federal income tax is a significant benefit for tax-exempt organizations, making the case for discouraging excess compensation paid out to such organizations’ executives perhaps even stronger than it is for publicly traded companies.
In fact, an analysis of Forms 990 for approximately 100,000 organizations filing the annual report to the IRS in 2014 published recently by the Wall Street Journal found 2,700 nonprofit officials were paid more than $1 million. Although most were administrators at hospitals and universities, there were also many football coaches and executives at endowments like the Harvard Management Company. Nonprofit organizations respond that they are trying to attract the best candidates and are merely adopting compensation practices similar to those in the private sector.
Taxing Fringe Benefit Expenses and Termination Pay
The Tax Reform Bill subjects tax-exempt organizations to Unrelated Business Income Tax (UBIT) on the value of certain employee fringe benefits, including transportation, parking facilities and on-premises athletic facilities. This is again attempting to treat nonprofit executives the same as those in taxable corporations. Moreover, the provisions go into effect immediately – for all amounts paid or incurred after December 31, 2017.
A nonprofit organizations is also liable for the excise tax if payments made in connection with a termination of employment to any of its top five most highly compensated executives equal or exceed three times the executive's average earnings over the preceding five years.
The Impact – Still to Be Determined
In the world of large public companies, wages has not been limited to a million dollars just because the deductibility of the expense was not available.
But this will be a significant change for the nonprofit sector, not only because it adds an unexpected expense to nonprofit payrolls, but also because it modifies the procedures that have regulated excessive salary levels for the past two decades.
While nonprofits will now face the same limit on compensation as for-profit corporations, there will clearly be some initial problems. Most of the executives receiving more than $1 million have employment contracts, and the organizations will be bound by contract to pay them. However, an additional 21% to be paid in taxes was not provided in the budget, so that will have to be covered somehow for 2018. In the longer term, either nonprofits will pay less and risk losing executives to for-profit competitors who can pay more, or they will maintain the income levels and incorporate the excise tax into their budgets.
Under the existing rules for compensation, executive compensation had to represent the reasonable value that would ordinarily be paid for like services by like enterprises (whether taxable or tax-exempt) under like circumstances. The excise tax, if deemed “unreasonable,” was imposed on the person receiving the excessive payment.
While the tax reform bill doesn’t change this process, it certainly does suggest that any executive salaries above $1 million is unreasonable, as it is subject to the excise tax. As the IRS makes the necessary changes in its regulations and forms to implement the new law, ERI will continue to track its impact on the levels of nonprofit executive compensation and the process of setting them. (Also see ERI's Guide to Setting Nonprofit Executive Compensation. For further information, ERI has an upcoming webinar for Nonprofit Comparables Assessor training).