Due to the Tax Cut and Jobs Act of 2017, many changes to employment taxes and income taxes were made. One of the lesser talked about, but still having a large impact is the excise tax on tax-exempt organizations for their highly compensated ‘covered employees.’
Excise Tax Basics
An excise tax of 21 percent is imposed on the remuneration (other than excess parachute payment) paid by all tax-exempt employees in the following two situations:
1. Amounts in excess of $1 million paid to a covered employee for a tax year.
2. Any separation (parachute) payment paid to a highly compensated employee that is equal to or greater than three times the 5-year average annual earnings of that employee.
The excise tax applies to all tax-exempt entities including political organizations and farmers’ cooperatives. Employees whose compensation will trigger the tax-exempt entity to have to pay the 21 percent excise tax, making them ‘covered employees’ for the purposes of the excise tax. These individuals include:
• The five most highly paid employees earning more than $1 million per year for the current year or any prior year, starting December 31, 2016. The tax-exempt entity must determine the five individuals annually, which means that the list could change or revolve each year. Additionally, once a covered employee has been named, that individual remains a covered employee.
• Any highly compensated employee (defined as receiving compensation equal to or greater than $120,000 in 2018) receiving a separation from service payment equal to or greater than three times the 5-year average final annual compensation.
Depending on the tax-exempt entity examining the excise tax, the tax-exempt employer might have a tendency to despair to dismiss the excise tax as being no applicable. It is always better to take action rather than do nothing, so let’s look at our options and opportunities.
The excise tax does not apply to:
• Remuneration paid to licensed physicians, nurses, or veterinarians, to the extent that the remuneration is for the performance of medical or veterinary services rendered by such professionals.
• Payments received from qualified retirement plans, such as 401(k), 403(b), simplified employer pension plans (SEPs) and 457(b) plans.
• Separation payments to highly-compensated employees if the payment is limited to 2.99 times their five-year average annual earnings.
Many tax-exempt entities are likely to be quick to dismiss the excise tax as not applicable to their employees because of the $1 million threshold. Those employers need to be careful that they don’t also ignore the fact that any single 457(f) payment that exceeds the threshold is subject to the tax made at the time of separation from service.
Most formal compensation arrangements and plans used by tax-exempt organizations are subject to Employee Retirement Income Security Act (ERISA), IRC 457 and 409A regulations. As a matter of good practice and to protect your organization, it is always advisable to have your arrangements reviewed by legal counsel to ensure proper compliance with applicable provisions.
There’s good news, too.
While it may seem that providing compensation to those employees who are crucial to the tax-exempt entity’s continued success is impossible without paying a hefty excise tax, that’s not necessarily the case. A knowledgeable financial and tax advisor can work with the tax-exempt entity to create a compensation plan coupled with life insurance to build a meaningful remuneration package for highly compensated employees without negative tax consequences. Before making any decisions, take the time to fully investigate your options for a solutions that will be in the best interest of your business and your employees.
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Please be advised that, based on current IRS rules and standards, any advice contained herein is not intended to be used, nor can it be used, for the avoidance of any tax penalty that the IRS may assess related to this matter. Any information contained in this article, whether viewed or subsequently printed, cannot be relied upon as qualified tax and accounting advice. Any information contained in this article does not fall under the guidelines of IRS Circular 230.