In the final hours of 2018, the IRS issued interim guidance on the new excise tax for excess compensation paid to executives of nonprofit organizations. The new guidance was released on Dec. 31, 2018, while most of the federal government was in the midst of a shutdown.
Previously, tax-exempt organizations were only bound by a “reasonableness” standard for executive compensation on the federal level, although a handful of states have enacted stricter requirements. However, under a provision in the Tax Cuts and Jobs Act (TCJA) that has largely flown under the radar, a 21% excise tax is imposed on compensation above $1 million, as well as excess severance payments. The TCJA provision takes effect for tax years beginning in 2018.
The idea was to put nonprofits on the same basic footing as for-profit entities. The tax law already imposed restraints on excess compensation and “golden parachutes” paid to executives of public companies. Now the new guidance clarifies the TCJA changes for nonprofits and defines some of the key terms. It also explains how nonprofits should report and pay the excise tax on excess compensation.
Generally, the new excise tax applies to “covered employees” of the following tax-exempt organizations:
- Entities that are exempt under Section 501(a) of the tax code (including 501(c)(3) and 501(d) organizations);
- State and local governmental entities with tax-exempt income;
- Tax-exempt political organizations; and
- Tax-exempt farmers’ cooperatives.
For these purposes, a “covered employee” is defined as an employee from one of these organizations who is among the five highest-paid employees in any year after 2016. The tax applies to any “remuneration” paid to a covered employee that is subject to federal income tax withholding.
Similarly, the rules regarding excess severance pay provisions for nonprofits are generally intended to mirror the “golden parachute “payment provisions that apply to for-profit entities. Deductions aren’t allowed for those payments. Notably, parachute payments do not include payments under a qualified retirement plan, such as a 401(k) plan or a 403(b) plan for certain nonprofits.
The excise tax for nonprofits only applies if the covered employee’s total severance equals or exceeds three times the employee’s base amount. However, if the employee’s severance exceeds this threshold, the tax is imposed on the excess.
Note that there is no transition period for the TCJA provision. Nonprofits may rely on the new interim guidance for compensation paid in 2018 until final regulations are issued. Consult with your professional tax advisor concerning your situation.
For more information on the IRS Nonprofit Executive Compensation Guidance contact your MarksNelson professional at 816-743-7700.