We’ve previously posted on the new excise tax on executive compensation enacted as part of the Tax Cuts and Jobs Act in December of last year. As a recap, this applies a 21 percent excise tax on an exempt organization to the extent that any of its five highest paid employees have total compensation exceeding $1 million for tax years beginning after December 31, 2017. This new tax is expected to have the biggest impact on how large exempt hospital organizations and universities recruit and retain top talent. However, the excise tax may present a trap for the unwary because based on the vesting provisions of Section 457(f) plans, even executives from smaller organizations could be pushed over the $1 million threshold and trigger the tax.
Background on Section 457(f) Plans. Section 457(f) plans are nonqualified deferred compensation arrangements that allow exempt organizations to supplement the retirement income of their executives. Generally, this works by having a plan in place where the organization (and sometimes the executive as well) contributes funds to the plan on behalf of the executive, and the plan pays out benefits in retirement or earlier if the executive becomes disabled or dies.
The plan contains conditions that must be met in order for the executive to have the right to the benefits under the plan, usually a length of service requirement. The condition for providing future services is why these are sometimes referred to as “golden handcuff” plans. If the conditions are not met, the executive has no right to the funds contributed to the plan on their behalf. When the conditions are met the executive is said to have “vested” or earned the right to the benefit. Prior to vesting, the benefits are said to be subject to a “substantial risk of forfeiture.”
For income and employment tax purposes, the executive includes in income amounts contributed to the plan as the funds “vest,” even if they are not payable under the plan until the executive retires.
How Section 4960 Works. The 21 percent excise tax on compensation under Section 4060 is applicable to “covered employees” who receive compensation exceeding $1 million. Covered employees include the five highest paid employees or former employees of the organization for any taxable year. Once an employee has been in the top five in the current tax year or any year after 2016 (for the current organization or any predecessor organization), they are considered a covered employee of the organization on which the tax may apply for all subsequent years.
Total compensation counted toward the $1 million threshold includes salary as well as deferred compensation arrangements that are not subject to a substantial risk of forfeiture, whether paid by the organization or paid by a related person, entity, or government entity. Related persons or entities include those that control the exempt organization or that the exempt organization controls, those that are controlled by the same person or persons, supporting organizations under Section 509(a)(3), supported organization under Section 509(f)(3), and VEBAs.
Section 457(f) Plan Vesting Triggering Executive Compensation Tax. The new excise tax specifically includes long-term incentive compensation and contributions to a Section 457(f) plan in the calculation of compensation in the year in which the executive’s rights under the plan vest (the time at which they are included in income for income and employment tax purposes). Because the time at which the right to funds under the plan vests is based on the terms of the plan, it could be that the organization is surprised by the vesting putting an executive over the $1 million threshold.
For example, a moderate-sized exempt organization’s top compensated executive director has the following compensation:
- a salary of $150,000/year
- health, dental, and vision benefits for their family valued at $50,000/year
- the use of facilities and cars as well as other fringe benefits valued at $50,000/year
This totals $250,000/year, which is nowhere near the $1 million threshold for triggering the 21% tax. Thus, the organization having done a Section 4960 analysis and finding themselves comfortably below the threshold for triggering the tax on their highest paid employee, puts the issue to rest.
However, several years later when the executive reaches 60 years of age, the conditions of the organization’s 457(f) plan that required services until the executive’s 60th birthday in order to vest in the entire balance in their 457(f) plan all at once, called “cliff” vesting. Thus, an account valued at $1,500,000 is now included in the executive’s compensation. The executive has now been paid a total of $1,750,000 in that year for the purposes of Section 4960, triggering the 21% tax on $750,000 (the excess of compensation over $1 million threshold) and the organization now is subject to a $157,500 excise tax. Ouch. With a little planning, this tax can be avoided simply by having the vesting spread out over a number of years.