Source: https://www.americanbar.org/groups/taxation/publications/abataxtimes_home/18aug/18aug-pp-howard-executive-compensation-for-tax-exempt-entities-after-tax-reform/
Timestamp: 2019-04-21 04:40:30+00:00

Document:
While the 2017 tax legislation did not produce all of the changes some had predicted, new rules governing excessive compensation for tax-exempt entities will substantially alter the landscape of executive compensation. Deferred compensation and other executive compensation arrangements for tax-exempt entities differ from those established for taxable for-profit entities. Tax consequences account for some of this difference as for-profit entities cannot deduct a compensation expense until the benefit is paid. Alternatively, the compensation deduction is of little consideration to a tax-exempt entity so it can incentivize the use of deferred compensation arrangements in certain circumstances. Generally, tax-exempt entities were not subject to compensation limitations, but were limited under the private inurement doctrine and section 4598 if compensation was excessive.
Nevertheless, tax-exempt entities must adhere to deferred compensation rules, reasonable compensation rules, and the private inurement doctrine. Tax-exempt entities must be mindful of deferred compensation requirements under The Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code when designing executive compensation plans. Previously, tax-exempt entities were not subject to excise taxes on executive compensation arrangements. After the 2017 tax legislation, however, tax-exempt entities are subject to a golden parachute and excise tax regime similar to those in sections 280G and 162(m) (irrespective of any organizational change in control), which prohibit deductions for excess parachute payments by public companies.
Nevertheless, if the tax-exempt entity is receiving fair market value for the goods, services or other consideration in the transaction, then the prohibition against inurement does not apply. Further, there is no safe harbor for de minimis inurement. While a small amount of inurement can jeopardize a tax-exempt entity’s status, a compensation arrangement with a person who has a private interest will not constitute private inurement if the compensation is reasonable relative to the services provided to the tax-exempt entity.
The compensation provided by a tax-exempt entity is not considered “excessive” if it is “reasonable.” Reasonable compensation is the value that would ordinarily be paid for like services by like entities under similar circumstances. Reasonable compensation rules apply to the aggregate of all compensation received by the executive.
Under section4958, an exempt entity may establish a rebuttable presumption of reasonableness for compensation or that a transfer of property or the right to use property is presumed to be at fair market value with respect to the specific transaction. Once the rebuttable presumption is established, the burden of establishing that the transaction results in an excess benefit shifts to the Service. The rebuttable presumption may be established if pursuant to regulations the tax-exempt entity has an informed independent body approve compensation arrangements and contemporaneously documents decisions.10 Nevertheless, a compensation arrangement that qualifies for the presumption of reasonableness under section 4958 continues to be subject to excise tax under section 4960.
In addition to the tax penalties, the Service may revoke a tax-exempt entity’s exemption status for an excess benefit transaction. There are correction rules, however, which require undoing the excess benefit transaction (to the extent possible) by making a payment in cash or cash equivalents equal to the correction amount to the applicable tax-exempt entity.
Further, deferred compensation arrangements of tax-exempt entities must account for sections 457 and 409A. Section 457 governs the tax treatment of the deferred compensation paid by state and local governmental employers as well as tax-exempt entities. It does not apply to tax-favored plans under sections 401(a), 403, the portion of plans that consist of a transfer of property under section 83, the portion of plans that consist of a section 402(b) trust, qualified governmental excess benefit arrangements, and applicable employment retention plans. The tax treatment under section 457 is dependent on whether an arrangement qualifies as a 457(b) plan or a 457(f) plan.
Generally, 457(b) plans are eligible deferred compensation plans that are designed as defined contribution arrangements due to nature of the requirements. 457(f) plans encompass all other deferred compensation arrangements of governmental and tax-exempt employers that do not meet the requirements under section 457(b). As such, 457(f) plans are referred to as ineligible deferred compensation plans. Section 457(f) imposes income taxes on all nonqualified deferred compensation when amounts are no longer subject to a substantialrisk offorfeiture, with the exception of amounts disbursed under a 457(b) plan.
Eligible plans under section 457(b) are not subject to the requirements of section 409A.14 However, section 409A applies to 457(f) plans, in addition to section 457(f), to the extent any plan provides for the deferral of compensation within the meaning of section 409A.15 Amounts included as income under either section 457(b) or section 457(f) are counted as remuneration in determining whether the excise tax on excess compensation applies.
Section 409A covers nonqualified deferred compensation arrangements that permit an employee to defer income recognition and income taxation on amounts earned, but paid in a subsequent year. It does not apply, however, to tax-qualified retirement plans such as 401(k) plans, 403(b) plans, 457(b) plans or similar tax-favored plans, although these plans similarly delay taxation on compensation.16 Under section 409A, a nonqualified deferred compensation arrangement must meet (1) distribution, (2) acceleration, and (3) election requirements both in form and in operation unless an exception applies. Failure to comply with the requirements of the provision causes the compensation at issue to be immediately included as income, even if not yet payable under the deferred compensation arrangement, and subjects the compensation to an additional 20% tax, plus an additional excise tax imposed, equal to the IRS underpayment rate plus 1%.17 It is important to note that while both sections 457 and 409A impose taxes on nonqualified deferred compensation arrangements when there is no longer a substantial risk of forfeiture, the definition of the phrase differs in the two sections.
Note the tax is imposed on the entity, not the employee.
A covered employee is any current or former employee who is one of the five highest-compensated employees for the current year or any prior tax year beginning after December 31, 2016.23 Section 4960 applies to any such employee, even if the employee is not an officer. Once an employee is a covered employee, the employee will always be a covered employee.
An exception is provided for remuneration attributable to medical services of certain qualified medical professionals.24 Remuneration means wages under section 3401(a). Remuneration paid to a licensed medical professional which directly relates to the performance of medical or veterinary services are not taken into account. Thus, qualified medical professionals such as doctors, nurses, and veterinarians are not considered covered employees.
(iii) are supporting organizations or supported organizations for the taxable year with respect to the organization.
However, if the related organization is subject to the section 162(m) limit on deductible compensation and the remuneration is not deductible under that section, then the deduction is also disallowed under section 4960. Further, a related entity is liable for its proportion of the excise tax from the remuneration paid to the covered employee.
Entities subject to section 4960 should identify their five highest compensated employees starting with the first year beginning after December 31, 2016, and maintain a cumulative list of all such employees for each year thereafter. Additionally, entities should track the total amount of remuneration being paid. After December 31, 2017, these employees—as well as the five highest compensated employees in 2018—will be the covered employees for the first tax year in which the excise tax applies.
Entities should review covered employees’ compensation arrangements to determine whether the excise tax may apply. The review should consider annual base salary, long-term incentive programs, taxable benefits, employment agreements, deferred compensation plans, severance arrangements, and change in control agreements. Following the assessment, entities may need to amend existing employment and other agreements to address the impact of the excise tax. Entities will also need to assess the impact of the excise tax on recently terminated covered employees to determine the impact on payments to such covered employees.
Future planning techniques may include accelerating amounts of taxable compensation within one or more years prior to separation from service from the tax-exempt entity to boost the base amount. Another planning strategy for tax-exempt entities involves using restrictive covenants, such as covenants not to compete, as conditions of severance payments. If permitted under state law, a valid and enforceable covenant not to compete could prohibit the classification of the severance payment as a parachute payment. This strategy is regularly used to mitigate the adverse tax consequences of section 280G. Note, however, any severance payment would be characterized as reasonable compensation and counted toward the $1 million limit.
From a tax policy perspective, the excise tax creates tax equity between tax-exempt entities and taxable entities because the section 4960 provisions parallel the golden parachute and excise tax regime provisions under sections 280G and 162(m). Tax-exempt entities must account for the new excise tax and consider the tax and fiscal ramifications. Additionally, this process can be onerous for larger tax-exempt entities with multiple entities as the section applies on an entity-by-entity basis.
Tax-exempt entities will need to be creative in attracting quality candidates because section 4960 substantially impacts executive compensation practices in this sector. Historically, tax-exempt entities have competed with for-profit entities for talent. Section 4960 may be a disadvantage to tax-exempt entities as these entities may now face new challenges and increased costs in designing competitive executive compensation packages. Tax-exempt entities may be forced to choose between incurring the excise tax liability for offering competitive compensation packages or risk being unable to attract and retain quality talent with reduced compensation packages for executives.
Tax-exempt entities may have to juggle additional payroll expenses and simultaneously navigate new procedures as this new provision modifies regulations that have governed this sector for nearly two decades. While tax-exempt entities need to offer competitive compensation, the distinction between reasonable compensation and excessive compensation can be difficult to discern. Until the Service promulgates regulations and other guidance under the new law, the impact on executive compensation for tax-exempt entities will remain uncertain.
1 Prop. Treas. Reg. § 1.501(c)(3)-1(c)(2).
10 Treas. Reg. § 53.4958-6(a).
11 ERISA §§ 302 through 308 govern funding of defined benefit pension plans. (Also see 26 U.S.C. § 412, §430, §431, and §432.) Funding requirements for single-employer plans were amended by §§101 to 116 of the Pension Protection Act of 2006. Funding requirements for multiemployer DB plans were amended by §§ 201 to 221 of the Pension Protection Act of 2006.
12 ERISA §§ 201(2), 301(a)(3), 401(a)(1) (29 U.S.C. §§ 1051(2), 1081(a)(3), 1101(a)(1)).
13 29 C.F.R. § 2520.104-23.
14 I.R.C. § 409A (d)(2)(B); Reg. §1.409A-1(a)(2)(vii). See Notice 2005-58 (until further guidance is issued, federal credit unions may treat nonqualified deferred compensation plans as eligible §457(b) plans).
15 I.R.S. Notice 07-62, 2007-2 C.B. 331.
16 Treas. Reg. § 1.409A-1(b)(9).
17 Treas. Reg. § 1.409A-1(b)(1).
18 Pub. L. No. 115-97.
19 Pub. L. No. 115-97.
27 I.R.C. § 4960(a)(1), I.R.C. § 4960(c)(2).

References: § 1
 § 53
 § 412
 §430
 §431
 §432
 § 2520
 § 409
 §1
 §457
 § 1
 § 1
 § 4960
 § 4960