For the first time, large nonprofit entities will be subject to a 21% excise tax for their top executives.
Under Section 4960 of the Tax Cuts and Jobs Act, nonprofits who are tax-exempt under sections 501(c)(3) and 501(c)(6) of the IRS Code can, will have to pay this hefty tax if they:
- Pay more than $1 million in annual compensation to any of their top 5 executives, or
- Make “parachute payments” to any of these executives when they leave the nonprofit. This refers to, generally, severance packages that exceed 3 times the executive’s average annual salary from the last 5 years, even if the package totals less than $1 million.
Under this new law, even large nonprofits that don’t pay million-dollar salaries may have to pay this tax if exit plans to these executives triple their annual average pay. Importantly, when calculating compensation to determine if the tax is triggered, anything that is “not subject to a substantial risk of forfeiture” needs to be considered. Thus, certain deferred compensation plans (e.g., 409A retirement plans) may push a nonprofit over the $1 million threshold when added to an executive’s salary.
Compensation committees of these large nonprofits should, therefore, take stock of their methods of compensation to determine if they are subject to this tax. Of course, these companies—just like smaller nonprofits—should have already met to determine the reasonableness of executive pay according to their market research. But the new tax kicked in after December 31, 2017, without grandfather clause or transition period to permit nonprofits to adjust. So, swift and continued review of the new tax bill and its impact on large nonprofits would be wise. Nonprofits can determine if the structure of compensation as it relates to bonuses or other vested benefits can be modified to stay below the tax threshold. They should also consider adopting policies or including employment contract provisions reserving the right to unilaterally modify or reduce executive compensation to avoid or mitigate the impact of this tax. Nonprofits with related organizations or comprised of multiple entities need to carefully review their new tax obligations, which may be evaluated on an entity-by-entity basis, leading to greater tax liability.
Further guidance from the IRS on the subject is expected, but while we wait, nonprofits should carefully reach decisions about executive pay consistent with their governing documents, conscious of other federal and state law obligations (such as reporting requirements for the Form 990), and with the counsel of both their legal and tax advisors. For better or worse, the new tax is now in effect, and as nonprofits focus on their tax-exempt mission, they can’t lose sight of this additional responsibility.