By Employee Benefits & Executive Compensation and Business & Taxation Practice Groups
Both closely held for-profit corporations and nonprofit organizations have long been restricted in how much they may compensate their key employees. In both situations, the compensation paid to key employees must be “reasonable.” With for-profit corporations, this rule is in place to ensure that amounts deducted by the corporation as “wages” paid to shareholders are not in actuality non-deductible dividends. With nonprofit organizations, this rule is in place to ensure that the money coming into the organization is being used in ways that further the mission for which the organization was granted tax-exempt status. When reasonable compensation rules applicable to forprofit corporations are not followed, the consequence is loss of deductions. When reasonable compensation rules applicable to nonprofits are not followed, the consequence can be significant excise taxes and even loss of tax-exempt status. The passage of the Tax Cuts and Jobs Act (the “Act”) brings the issue of nonprofit executive compensation back into the forefront because the Act included two new excise taxes specific to nonprofit organizations.
Payment of Excess Compensation to a Nonprofit’s Key Employee
Many nonprofit organizations have the difficult task of attracting and retaining top talent in key positions. Nonprofit organizations must fend off other nonprofits and for-profit organizations from poaching their key employees. The Internal Revenue Code (the “Code”) requires that a nonprofit pay its key employees no more than “reasonable compensation.” A key employee is generally one who can exercise substantial influence over the organization, such as an officer or director or the family member of an officer or director. The Code does not provide a definition or formula for determining what exactly “reasonable compensation” is. Rather, the Code’s regulations and the courts have stated that compensation will be deemed “reasonable” if the amount paid would ordinarily be paid for comparable services by a comparable enterprise (whether nonprofit or for-profit) under comparable circumstances. If compensation is deemed excessive, the key employee can be hit with a 25% excise tax on amounts deemed in excess of “reasonable.” If the excess amount is not repaid to the organization in a timely manner, then the excise tax increases to 200% of the excess amount. In some situations, those individuals who approved the excess compensation (such as the organization’s trustees, directors and/ or officers) may also be hit with an excise tax, albeit at a lower rate. As indicated above, in particularly egregious situations the nonprofit organization may also lose its tax-exempt status.
When Compensation Paid to “Covered Employees” Exceeds One Million Dollars
Even if a public for-profit corporation’s compensation paid to an executive is reasonable, the corporation may not be able to take the full amount of compensation paid as a deduction. The IRS limits deductions to business expense salaries that did not exceed $1 million for “Covered Employees,” which is generally defined as the corporations’ five highest paid officers. Because nonprofit organizations are not publicly held and do not claim deductions, this $1 million limitation was not applicable to such organizations.
Prior to the Act, bonuses, stock options and other “performance-based” pay were excluded when calculating the salaries of Covered Employees. As a result, many publicly-held corporations structured the compensation packages of Covered Employees through incentives, rather than a high base salary. Under the Act, the exclusion of performance-based pay from the $1 million limitation is eliminated for publicly-held companies.
Additionally, a new version of the $1 million limitation on compensation paid to Covered Employees was extended to nonprofit organizations. Since nonprofit organizations are not subject to income tax, the mechanism to provide the limitation is an excise tax of 21% on compensation that exceeds $1 million, which is imposed to the nonprofit organization. This excise tax is independent of the unreasonable compensation limits, meaning that a nonprofit could pay all of its executives “reasonable compensation” and still trigger this new excise tax. When calculating a Covered Employee’s compensation for purposes determining whether it exceeds $1 million, the IRS includes: (1) the employee’s total wages (with some exceptions for certain Roth contributions); and (2) any amounts that are considered vested deferred compensation (i.e., amounts not subject to a “substantial risk of forfeiture”). Notably excluded when determining an employee’s compensation are amounts paid to licensed medical professionals including surgeons, doctors, nurses, or veterinarians. However, only amounts paid in relation to the medical professional’s services are excluded. Any other amounts paid to the medical professional would be included.
Excess “Parachute Payments”
The Act also limits income tax deductions and imposes an excise tax upon “excess parachute payments” made by public, for-profit and nonprofit organizations, respectively. However, unlike the $1 million limitation, the excise tax is imposed on the recipient of the payment rather than on the nonprofit organization. A “parachute payment” is compensation that is contingent on an employee’s separation from employment with the employer. The Act defines an “excess parachute payment” as any parachute payment, the present value of which exceeds three times the executive’s “base amount.” The executive’s “base amount” is generally the average compensation paid to the executive over the previous five years. Excluded from the definition of a parachute payment are payments made from qualified retirement plans, 403(b) plans, 457(b) plans, and payments to licensed medical professionals or to employees who are not considered “highly compensated employees” under Code section 414(q). In the event that an amount is deemed to be an excess parachute payment subject to the excise tax, that excess amount is disregarded when determining whether the nonprofit has paid Covered Employees compensation in excess of $1 million. In other words, the excess amount is not taxed twice (e.g., once as compensation in excess of $1 million and again as an excess parachute payment).
The takeaway from these new nonprofit laws is the same as the old: Nonprofit executive compensation must be closely monitored to avoid significant tax penalties. Finding the right balance between offering a competitive and attractive compensation package and offering unreasonable or excess compensation can be tricky. Our attorneys in the Employee Benefits and Executive Compensation Group would be happy to assist your organization in structuring new executive compensation packages or evaluating your current agreements.