Very few fully appreciate the complexity of leading a large nonprofit organization and the executive skills required to do so successfully. Even before the recent passage of Pub. L. 115-97, nonprofit organizations were at a significant disadvantage in terms of attracting and retaining senior executive talent.
Contrary to its informal name, the legislation known as the “Tax Cuts and Jobs Act” (the Act) will levy a new tax on many nonprofit organizations, limiting the ability and potentially increasing the cost to attain or retain leadership talent. Under the provisions of the Act, nonprofit organizations will also be penalized, similar to for-profit companies, for providing remuneration that exceeds “reasonable” amounts to covered employees.
Unlike for-profit companies, with which they often compete for talent, nonprofit organizations are limited in the types of incentives and compensation arrangements they can offer. As an example, nonprofits are unable to provide stock, stock options or other forms of equity that are appealing to many senior executives. The excise tax, coupled with the lack of flexibility and already increasing scrutiny on nonprofit executive compensation and benefit arrangements, has exacerbated this issue making it doubly difficult for nonprofit organizations to achieve their talent objectives.
Significant Changes For The Nonprofit Sector
In what appears to be an attempt to level the playing field between publicly traded corporations and nonprofit entities, the Act created a new section of the Internal Revenue Code (IRC): §4960. This new section would place limitations, similar to those on publicly traded companies, on “wages” paid to covered employees in nonprofit entities. IRC §3401(a) generally defines wages as payments that would be subject to income tax withholding.
Since nonprofit organizations have a tax rate of 0%, they are not concerned with the impact of deductions. Because of this distinction, §4960 would impose an excise tax of 21% (or the current corporate tax rate at the time) on the remuneration of more than $1,000,000 to covered employees of a nonprofit organization. The tax is paid by the nonprofit organization, not the employee.
We believe the act will impact a considerable portion of nonprofit organizations because of the increasing levels of executive compensation at large nonprofit organizations and also the potentially hidden effects of deferred compensation plans (and similar arrangements) with benefits commonly paid in lump sums at retirement.
While an executive may not have salary and incentive compensation that exceeds $1,000,000, the value of the deferred compensation payment when made will be additive to annual compensation and, if the total exceeds $1,000,000, it will result in excise tax due from the organization. Based on our internal research, the effect of the excise tax will be widespread and result in a significant loss of capital for nonprofit organizations.
Preparing For Impact
A surprising number of advisers to nonprofit organizations have described the excise tax as a “cost of doing business” for these organizations. While this may be the ultimate conclusion based on the organization’s facts and circumstances, nonprofits should go through a disciplined process of evaluating the full set of options before arriving at this decision.
Nonprofits should review their compensation arrangements to determine the potential to create excise tax due. While salary and incentive payments are significant components of total compensation, organizations should not ignore deferred compensation and other plans where benefits accrue over an extended period and are paid in a lump sum, either periodically or at retirement. These compensatory plans could create an unfortunate and expensive surprise if their impacts are not assessed and fully understood.
Depending on the circumstances, there could be ways to provide retirement benefits for covered employees in a manner that does not meet the definition of wages (IRC §3401(a)) under the Act. As an alternative to traditional deferred compensation arrangements, split dollar plans are not considered compensatory if appropriately structured. While these plans have been utilized for decades, with the advent of the excise tax, they are growing in popularity. In addition, there may be ways to restructure existing compensatory plans in a manner that does not trigger the excise tax. We recommend that nonprofit organizations consult with qualified counsel as well as your provider for compensation and executive benefit-related services for guidance on the best way to proceed in the new environment.
