As the end of the year approaches, individuals responsible for the management of tax-exempt organizations need to review the operations of those organizations to prepare annual information reporting for this year, to plan potential excise tax payments, and in some cases prevent unnecessary excise taxes and penalties on organizations and individuals.
There are numerous categories of federally tax-exempt organizations recognized by the IRS. Below are a few of the most significant excise taxes that may become payable by certain exempt organizations, and even individuals associated with these organizations as a result of one or more common mistakes in managing or operating an exempt organization.
New Excise Tax on Executive Compensation
As a result of the Tax Cuts and Jobs Act (TCJA) passed in December 2017, effective for tax years beginning in 2018, an excise tax of 21% is imposed on the annual compensation of covered employees of tax-exempt organizations that exceeds $1 million. To be considered a “covered employee” for purposes of this excise tax, an individual must be 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 addition, the TCJA added a 21% excise tax to certain “excess parachute” severance payments made by tax-exempt organizations, similar to the rules that have already applied to for-profit entities. This excise tax applies to payments— contingent on a covered employee’s separation from service—that equal or exceed three times the covered employee’s average compensation over the last five years. The tax is also limited to employees who meet the IRS-adjusted definition of “highly compensated employee” in Section 414(q) of the Internal Revenue Code. For 2018, this amount is $120,000. Significantly, this “excess parachute” excise tax becomes payable by the employer-organization as soon as the compensation is not subject to a “substantial risk of forfeiture” (i.e., becomes guaranteed to the covered employee).
5% Payout Rule for Private Foundations
Tax-exempt charitable organizations that are classified as private foundations are required to annually spend a minimum amount of their assets for their charitable purposes, including grants to other charitable organizations. This annual spending minimum, called the “distributable amount,” is generally 5% of the tax-exempt organization’s assets (with certain adjustments), which must be distributed by the end of the organization’s following tax year. A private foundation that fails to pay out the distributable amount in a timely manner is subject to a 30% excise tax on the undistributed income. According to the IRS, the tax is charged for each year (or partial year) that the deficiency remains uncorrected.
Excise Tax on Private Foundation’s Investment Income
Most tax-exempt private foundations must pay a 2% excise tax on their net investment income. In some cases when a private foundation makes sufficient distributions for its charitable purposes and has not recently (as defined by law) incurred any excise taxes, this excise tax is reduced to 1%. The tax is reported on a private foundation’s annual Form 990-PF.
Excise Tax on Excess Benefits Paid to Disqualified Persons of Certain Organizations
“Disqualified persons” who have a defined relationship with a Section 501(c)(3) public charity, or Section 501(c)(4) social welfare organization, incur a personal tax liability of 25% of the value of any “excess benefit” the disqualified person receives from the exempt organization. “Disqualified persons” include any person who was in a position to exercise substantial influence over the affairs of the organization at any time during the five years prior to the transaction, including family members of a disqualified person. An “excess benefit” is generally a subjective determination that the value of the economic benefit provided to the disqualified person exceeds the value received by the organization. Some absolute prohibitions apply relating to donors. This tax is also called the “Initial Tax” or “First Tier Tax.”
In addition, a 10% excise tax is imposed on organization managers who participate in these transactions knowing that they are excess benefit transactions.
Correct an Excess Benefit Yourself, or Risk Paying More
If the excess benefit transaction is not corrected before the IRS assesses the excise tax or issues a notice of deficiency, an additional excise tax equal to 200% of the excess benefit (also called the “Additional Tax” or the “Second Tier Tax”) is imposed on the transaction. This Additional Tax is also payable by the disqualified person who received an excess benefit on which the 25% tax was imposed.