New Excise Tax Cuts Into Tax-Exempt Executive Compensation

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On December 22, 2017, President Trump signed into law a congressional revenue act originally introduced in Congress as the Tax Cuts and Jobs Act (TCJA). A major element of TCJA was reducing the maximum for-profit corporate income tax rate from 35 percent to 21 percent. The corporate tax cut will benefit some areas of the healthcare industry, particularly pharmaceutical and health insurance companies. However, only 21 percent of the nation’s 4,840 community hospitals are owned by for-profit entities that might enjoy the large corporate income tax cut. A majority (59 percent) of the nation’s community hospitals are owned by nongovernment not-for-profit hospitals and the remainder (20 percent) are owned by state and local governments. TCJA also included a new 21 percent excise tax on excess tax-exempt organization executive compensation that may impact those not-for-profit hospitals that claim exemption from federal income taxes under Internal Revenue Code (IRC) Section 501.

Background – Limits on Publicly Held, For-Profit Executive Compensation

Taxable employers and other service recipients generally may deduct reasonable compensation expenses. However, in some cases compensation in excess of specific levels is not deductible. A publicly held corporation generally cannot deduct more than $1 million of compensation in a taxable year for each “covered employee.” For this purpose, prior to TCJA a covered employee was the corporation’s principal executive officer (or an individual acting in such capacity) defined in reference to the Securities Exchange Act of 1934 (Exchange Act) as of the close of the taxable year, or any employee whose total compensation is required to be reported to shareholders under the Exchange Act by reason of being among the corporation’s three most highly compensated officers for the taxable year (other than the principal executive officer or principal financial officer). TCJA added the principal financial officer to the definition of “covered employee” for publicly held corporations.

In addition to the limited deductions for compensation paid to the most highly compensated officers of publicly traded corporations, all for-profit corporations are subject to limits on deducting certain change in control payments, commonly known as “parachute payments.” A for-profit corporation generally cannot deduct that portion of the aggregate present value of a “parachute payment” which equals or exceeds three times the “base amount” of certain service providers. The nondeductible excess is an “excess parachute payment.” A parachute payment is generally a payment of compensation that is contingent on a change in corporate ownership or control made to certain officers, shareholders, and highly compensated individuals. An individual’s base amount is the average annualized compensation includible in the individual’s gross income for the five taxable years ending before the date on which the change in ownership or control occurs. Certain amounts are not considered parachute payments, including payments under a qualified retirement plan, a simplified employee pension plan, or a simple retirement account.

Reasons for the Change for Tax-Exempt Organizations

The limits on for-profit corporations deducting compensation of more than $1 million and excess parachute payments previously did not affect tax-exempt organizations. The House Ways and Means Committee believes that tax-exempt organizations enjoy a tax subsidy from the federal government because contributions to such organizations are generally deductible and such organizations are generally not subject to tax (except on unrelated business income). As a result, such organizations are subject to the requirement that they use their resources for specific purposes, and the Committee believes that excessive compensation (including excessive severance packages) paid to senior executives of such organizations diverts resources from those particular purposes. The Committee further believes that alignment of the tax treatment of excessive executive compensation (as top executives may inappropriately divert organizational resources into excessive compensation) between for-profit and tax-exempt employers furthers the Committee’s larger tax reform effort of making the system fairer for all businesses. The American Hospital Association lobbied against the excise tax provision to no avail.

TCJA adds new Section 4960 to the IRC to impose an excise tax equal to 21 percent (the current corporate income tax rate) of the sum of (1) any remuneration paid (other than an excess parachute payment) by an applicable tax-exempt organization for a taxable year with respect to employment of any covered employee in excess of $1 million, plus (2) any excess parachute payment paid by such organization to any covered employee. Accordingly, the excise tax applies as a result of an excess parachute payment, even if the covered employee’s remuneration does not exceed $1 million.

The term “covered employee” means any employee (including any former employee) of an applicable tax-exempt organization if the employee is one of the five highest compensated employees of the organization for the taxable year or was a covered employee of the organization (or a predecessor) for any preceding taxable year beginning after December 31, 2016. An “applicable tax-exempt organization” is an organization exempt from tax under IRC section 501(a), an exempt farmers’ cooperative, a federal, state or local governmental entity with excludable income, or a political organization.

Remuneration means wages as defined for income tax withholding purposes, but does not include any designated Roth contribution. Remuneration shall be treated as paid when there is no substantial risk of forfeiture of the rights to such remuneration, even if it has not yet been received. Remuneration includes any remuneration paid with respect to employment of a covered employee by any related person or governmental entity.

Section 4960 contains a new definition of parachute payment that relates solely to separation pay, in contrast to a broader change in control notion for taxable corporations. A parachute payment under Section 4960 is a payment in the nature of compensation to (or for the benefit of) a covered employee if the payment is contingent on the employee’s separation from employment and the aggregate present value of all such payments equals or exceeds three times the base amount. The base amount is the average annualized compensation includible in the covered employee’s gross income for the five taxable years ending before the date of the employee’s separation from employment. An excess parachute payment subject to Section 4960 is the amount by which any parachute payment exceeds the portion of the base amount allocated to the payment. Parachute payments do not include payments under a qualified retirement plan, a simplified employee pension plan, a simple retirement account, a tax-deferred annuity, or an eligible deferred compensation plan of a state or local government employer.

The employer of a covered employee is liable for the excise tax. If remuneration of a covered employee from more than one employer is taken into account in determining the excise tax, each employer is liable for the tax in an amount that bears the same ratio to the total tax as the remuneration paid by that employer bears to the remuneration paid by all employers to the covered employee.

Section 4960 is effective for taxable years beginning after December 31, 2017. The Joint Committee on Taxation estimates that the new 21 percent excise tax on tax-exempt executive compensation will raise $1.2 billion over ten years (2018-2027).

Important Exceptions for Licensed Medical Professionals

The conference agreement to TCJA added important exceptions for the portion of any compensation attributable to medical services of licensed medical professionals from the definitions of remuneration and parachute payment. A licensed medical professional for this purpose includes a veterinarian. These exceptions allow tax-exempt hospitals to pay specialized physicians over $1 million per year and parachute payments for medical services without incurring the 21 percent excise tax. However, licensed medical professionals who are performing administrative duties and not medical services are not covered by the exceptions and could be subject to the 21 percent excise tax. If a licensed medical professional is performing both medical services and administrative duties, hospitals will need to make proportional calculations to remove compensation for medical services, and then analyze whether the remaining compensation for administrative duties is subject to the 21 percent excise tax.

Example of How the 21 percent Excise Tax Will Apply to Tax-Exempt Hospitals

The new 21 percent excise tax will likely mainly impact the larger tax-exempt hospital systems that commonly pay executive compensation in excess of $1 million per year. For example, Ascension Health Alliance is the nation’s largest non-profit health system, with 141 hospitals and 2,500 sites of care in 22 states and the District of Columbia. Using information on the five highest compensated employees from Ascension’s tax-exempt return on Form 990 filed with the Internal Revenue Service for the fiscal year ended June 30, 2016, one can estimate the impact of the 21 percent excise tax assuming executive compensation in 2018 is comparable to the most recently reported information:

Conclusion

The new 21 percent excise tax better aligns the tax treatment of excessive executive compensation for publicly traded for-profit corporations and tax-exempt organizations. The excise tax will cost some non-profit hospital organizations millions of dollars in new federal taxes. The new tax should cause tax-exempt governing boards to rethink whether excessive executive compensation and severance packages are consistent with the tax-exempt purposes of the organizations.

Please click here for the full article as published in American Bar Association.