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Tax-Exempt Organizations, Excise Taxes and Executive Compensation – A Year End Reminder and 2019 Planning Opportunity

As 2018 draws to a close, the trustees, directors, and senior management of tax-exempt organizations should review the compensation structure of some of its executives in light of the Tax Cuts and Jobs Act (TCJA), which was enacted earlier this year. Under the applicable provisions of the TCJA, certain compensation arrangements could result in the imposition of excise taxes and penalties on the organization, beginning in 2018. In light of these changes in the federal tax law, tax-exempt organizations will also want to carefully structure their compensation arrangements for 2019 and beyond.

Under the TCJA, an excise tax of 21% is imposed on all annual compensation in excess of $1 million of each “covered employee” of an “applicable tax-exempt organization.”  Generally, an “applicable tax-exempt organization” is any organization that has been recognized by the federal government as exempt from federal income taxes in accordance with the provisions of Section 501(a) of the Internal Revenue Code.

A “covered employee,” for purposes of this excise tax, is any individual who is one of the five highest-paid employees of the organization for the applicable tax year, or for any prior tax year beginning after December 31, 2016. In 2018, tax-exempt organizations will need to look to the 2017 tax year to determine whether any executive is a “covered employee.”  Also, note that once an executive is characterized as a covered employee, the executive is a covered employee for all future tax years.

Generally all amounts paid or payable to an executive by the employing organization during the tax year are included in determining whether an executive’s compensation exceeds the $1 million threshold (including deferred compensation that becomes taxable during the tax year). In addition, compensation paid or payable to the executive by a related organization (such as a supporting or controlling organization) counts toward the $1 million limit.

In addition to the above excise tax, the TCJA imposes a 21% excise tax on certain “excess parachute” severance payments made by a tax-exempt organization. Similar to the long-standing rules applicable to certain for-profit entities, this excise tax applies to amounts paid upon an executive’s separation from service that equal or exceed three times the executive’s average compensation over the last five years, provided that the executive is a “highly compensated employee” as determined under the Internal Revenue Code (i.e., an executive whose annual compensation is $120,000 or more in 2018). This “excess parachute” excise tax is assessed upon the organization when the severance payments are no longer subject to a substantial risk of forfeiture.

These newly-enacted excise taxes under the TCJA pose a potential liability for unsuspecting tax-exempt organizations, and could significantly increase the costs of both compensating certain key executives, and the overall financial impact of the departure of such executives.

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