Tax on Excess Tax-Exempt Org. Executive Compensation

House Bill

Under the provision, an employer is liable for an excise tax equal to 20% of the sum of: 1) any remuneration (other than an excess parachute payment) in excess of $1 million paid to a covered employee by an applicable tax-exempt organization for a taxable year; and 2) any excess parachute payment (under a new definition for this purpose that relates solely to separation pay) paid by the applicable tax-exempt organization to a 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. For purposes of the provision, a covered employee is an 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 Dec. 31, 2016. An “applicable tax-exempt organization” is an organization exempt from tax under §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 of a covered employee includes any remuneration paid with respect to employment of the covered employee by any person or governmental entity related to the applicable tax-exempt organization. However, remuneration of a covered employee that is not deductible by reason of the $1 million limit on deductible compensation is not taken into account for purposes of the provision.

Under the provision, an excess parachute payment is the amount by which any parachute payment exceeds the portion of the base amount allocated to the payment. A parachute payment 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. Parachute payments do not include payments under a qualified retirement plan, a simplified employee pension plan, a simple retirement account, a tax-deferred annuity, §1034, or an eligible deferred compensation plan of a State or local government employer. §1035. 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. The provision is effective for taxable years beginning after Dec. 31, 2017.

Senate Amendment

The Senate amendment is the same as the House bill, except that remuneration is treated as paid when there is no substantial risk of forfeiture of the rights to such remuneration. Under the conference agreement, the tax rate is equal to the corporate tax rate, which is 21% under the conference agreement. In addition, for purposes of the requirement to treat remuneration as paid when the rights to the remuneration are no longer subject to a substantial risk of forfeiture, the conference agreement clarifies that “substantial risk of forfeiture” is based on the definition under Section 457(f)(3)(B), which applies to ineligible deferred compensation subject to Section 457(f). Accordingly, the tax imposed by this provision can apply to the value of remuneration that is vested (and any increases in such value or vested remuneration) under this definition, even if it is not yet received. The conference agreement exempts compensation paid to employees who are not highly compensated employees (within the meaning of Section 414(q)) from the definition of parachute payment, and also exempts compensation attributable to medical services of certain qualified medical professionals from the definitions of remuneration and parachute payment. For purposes of determining a covered employee, remuneration paid to a licensed medical professional which is directly related to the performance of medical or veterinary services by such professional is not taken into account, whereas remuneration paid to such a professional in any other capacity is taken into account. A medical professional for this purpose includes a doctor, nurse or veterinarian.

A Solution to Compliance

An announcement on June 21, 2016 by the Department of the Treasury provides further bright-line tests for benefits provided by non-profits which will cover and complies with §4960 and §162(m). REG-147196-07 provides additional guidance in the compensation arena for Tax Exempt Employers and Executives and Professionals.

The Treasury has provided the roadmap for exceptions to IRC §§457 and 457(f) risks of forfeiture and acceleration of tax upon a triggering event. Section 457(e)(11) provides that certain plans are treated as not providing for a deferral of compensation or remuneration. These plans include any bona fide vacation leave, sick leave, compensatory time, severance pay, disability pay or death benefit plan, as well as any plan paying solely length of service awards to certain bona fide volunteers (or their beneficiaries) and certain voluntary early retirement incentive plans.

Bona Fide Death Benefit Plan

The proposed regulations provide that a bona fide death benefit plan, which is treated as not providing for the deferral of compensation pursuant to §457(e)(11)(A)(i), is a plan providing for death benefits as defined in §31.3121(v)(2)-1(b)(4)(iv)(C) (relating to the application of the Federal Insurance Contributions Act to nonqualified deferred compensation). The proposed regulations further provide that benefits under a bona fide death benefit plan may be provided through insurance, and that any lifetime benefits payable under the plan that may be includible in gross income will not be treated as including the value of any term life insurance coverage provided under the plan.

In Notice 2007-62 (2007-2 CB 331 (Aug. 6, 2007)), the Treasury Department and the IRS announced the intent to issue guidance under §457, including providing definitions of a bona fide severance pay plan under §457(e)(11) and substantial risk of forfeiture under §457(f)(3)(B). In response to comments received in response to a request in Notice 2007-62 (on subjects including, but not limited to, severance pay, covenants not to compete, and the definition of substantial risk of forfeiture), the rules in these proposed regulations have been modified from the proposals announced in that notice.

Announcement 2000-1 (2000-1 CB 294 (Jan. 1, 2000)) provides transitional guidance on the reporting requirements for certain broad-based, non-elective deferred compensation plans maintained by State or local governments. The announcement states that, pending the issuance of further guidance, a State or local government should not report amounts for any year before the year in which a participant or beneficiary is in actual or constructive receipt of those amounts, if the amounts are provided under a plan that the State or local government has been treating as a bona fide severance pay plan under §457(e)(11) for years before calendar year 1999. To be eligible for this transitional relief, the plan must satisfy certain requirements described in the announcement.

The §457(e)11 Plan for Non-Profits (Plan) is an arrangement in which the employer, a 501(c) non-profit organization, agrees to pay the actuarially determined cost of the current death benefit on a permanent life insurance policy to be owned by the employee or employer. Under this arrangement, no lifetime benefit is provided by the non-profit employer, so the new rules of §§4960 and 162(m) are followed. The employer and employee enter into a written agreement that ordinarily requires the employer to make premium payments as long as the employee works for the employer. The agreement also requires the employee to execute a “co-ownership” or “restrictive endorsement” at the time the policy is purchased. The co-ownership agreement would set forth the terms of the restrictive endorsement and the basis for its evaporation. Pursuant to the statute, the employee or employer will own the death benefit. The co-ownership agreement sets forth the limitation to the policy by the employee, and the actuarial cost of the current death benefit will expensed by the employer and not taxable to the employee. The economic benefit of the death benefit coverage will be taxable to the employee. Any monies contributed by the employee or otherwise taxable to the employee will be a credit against the employee's economic benefit taxation. The non-profit executive benefit paid by the employer received by the employee is the death benefit owned, and the life insurance policy can be continued after the employee's disability or retirement. The named beneficiary may receive the life insurance proceeds income tax-free under §101(a).

The cash value of a permanent life insurance policy grows on a tax-deferred basis. Because the coverage funded by the employer's contribution will terminate upon the employee's retirement, the executive will not be in constructive receipt of any benefit, and there will be no benefits provided that are not covered by the new rules. Unlike most forms of traditional non-qualified deferred compensation, the employee receives immediate benefits under the §457(e)11 Plan, and as permitted by the new rules, the employee can immediately name the beneficiary of the death benefit. Qualified retirement plans are subject to restrictions on the amount of money that can be contributed by (or on behalf of) an employee. When distributions are taken from a qualified plan, they may be subject to certain penalties, such as the 10% penalty tax on early (prior to age 59½) withdrawals. This Plan is not a qualified plan: Once a participant is no longer in the Plan, access to the policy's cash value (by withdrawal up to basis or by loan) is not ordinarily subject to income or penalty taxes. The death benefit only plan is in compliance with the deferred compensation rules under §409A and the safe harbor under §409A(d)(1) confirms its use. Under the House and Senate initial drafts of HR1, the limitations on deferred compensation specifically exempted this program under proposed §409B(b).

The §457(e)11 Plan can play a very important role in a compensation package by combining the advantages of current death benefit protection and immediate vesting of the policy's cash value. Immediate vesting of the policy's cash value differentiates the Plan from traditional non-qualified deferred compensation plans where the employee usually receives little more than the employer's promise to pay future benefits. The legislative history of this section specifically indicated it was not to be considered compensation or deferred compensation for remuneration purposes.

One major disadvantage of qualified plans is the strict rules pertaining to participation that require an employer to make the plan available to most (or all) employees. The Plan is not a qualified plan, therefore, the employer can select which employee, or group of employees, to cover. The Plan can be tailored to fit each employee's needs and can reflect each employee's value to the non-profit employer. The use of the Plan also complies with §409A. See, Notice 2005-01 and the Final Regulations covering deferred compensation. Unlike qualified plans and some types of traditional non-qualified deferred compensation plans, once established, minimal annual reports and administration should be required. The ERISA implications of the Plan are discussed below. As long as the employee's total compensation package is “reasonable,” the employer's premium payments providing the current death benefit should constitute compensation and be a currently deductible expense. This differs from traditional non-qualified deferred compensation arrangements where benefits are not deductible to the employer until paid to the employee.

Tax Consequences of the §457(e)11 Plan for Non-Profits

Section 61 Taxation. The economic benefit of using the government tables are generally believed to be compensation to the employee under IRS §61. Therefore, subject to “reasonable compensation” limitations, the likely tax treatment should be current income for the employee equal to the economic benefit offset by any payments deemed paid by the participant.

Section 457 Taxation. Notice 2002-8 and Prop. Reg. 1.457-11, dealing with §457(f) deferred compensation, set forth the permissible benefit areas and the Plan complies with those rules. As a §457(e)11 death benefit plan, it is not required to have a risk of forfeiture contingency as required under §457(f). Additionally, when the Plan is integrated into a group carve-out arrangement, the Final Regs permit treatment under §79, and are specifically excluded from being affected by §1.61(b)(2)(ii). The IRS ruled in Technical Advice Memorandum (TAM) 121876-98 that the rules of §79 will apply to coverage provided to certain employees as covered under the DBO Plan and Department of Labor Advisory Opinion 2003-08A (June 26, 2003).

Section 409A, Taxation Notice 2005-1, and the Final Regulations gave bright-line tests for exceptions to complying with the deferred compensation rules. See, §31.3121.

Excess Benefit Transaction §4958. In order to assure non profit organizations did not provide inappropriate benefits that could exercise influence over the organization, Congress enacted sanctions on “excess benefit transactions” under Code §4958 in 1996. These rules parallel and overlap the private inurement rules and have become the primary focus on enforcement efforts. Code §4958 imposes “intermediate sanctions” (i.e., a sanction that is less penal than full loss of exemption) for insubstantial inurement.

Unlike the vague tests for inurement and private benefit, testing for excess benefit is fairly straightforward. The test requires three definitional inquiries: 1) is this organization an “applicable tax-exempt organization;” 2) is the person involved a “disqualified person;” and 3) is the transaction an “excess benefit transaction.” If the answer to all three questions is “yes,” then there has been an impermissible excess benefit.

Applicable Tax-Exempt Organizations. The first question is whether the organization is an “applicable tax-exempt organization.” Applicable tax-exempt organizations include only 501(c)(3) and (c)(4) organizations or organizations that were 501(c)(3) or (c)(4) organizations at any time within the five preceding years. For example, 501(c)(6) organizations are not subject to Code §4958.

Disqualified Person. The second question in excess benefit analysis is whether there is a “disqualified person.” Disqualified persons include:

1. Any person who was, at any time during the five-year period ending on the date of the transaction involved, in a position to exercise substantial influence over the affairs of the organization (whether such influence is formal or informal);
2. A family member of an individual in the preceding category; or
3. An entity in which individuals described in the preceding categories own more than a 35% interest.

Those who perform the functions of voting members of the governing body — presidents, chief executive officers, chief operating officers, chief financial officers and treasurers — are all disqualified persons, regardless of title. And certain persons are deemed not to be disqualified persons. These “deemed non-disqualified persons” include 501(c)(3) and (c)(4) organizations and employees receiving economic benefits of less than a specific amount.

Excess Benefit Transaction. An “excess benefit transaction” is a transaction in which an economic benefit is provided by an applicable tax-exempt organization to or for the benefit of any disqualified person, if the value of the economic benefit provided by the exempt organization exceeds the value of the consideration (including performance of services) received for providing the benefit. Reasonable compensation paid to employees of the non-profit organization is not considered an excess benefit.

The Department of Treasury and the IRS has announced that a §457(e)11 plan benefit is not deferred compensation or remuneration or compensation so the plan categorically could not be an excess benefit transaction.

Tax Shelter Issues. The Plan is not a “listed transaction” under Treas. Regs. §§1.6011-4(b)(2) and 301.611-2(b)(2), Notice 2007-83, a “tax shelter” under IRC 6111(c) and 6111d) and Treas. Reg. 301.6111-1T, Q&A 4, a “potentially abusive tax shelter” under 6112(b) and Treas. Reg. 301.6112-1(b) or a “reportable transaction” under Treas. Reg. 1.6011-4(b). Additionally, the Plan does not violate the Economic Substance Doctrine as codified in new Internal Revenue Code §7701(o). Tax Circular 230 Issues. Because the Plan is not a listed transaction, there are no conditions of confidentiality or contractual protection, the covered opinion requirements of §10.35 do not apply. Because the employer is not subject to income tax as a nonprofit employer, the principal purpose or significant purpose of tax avoidance or tax evasion.

ERISA Implications of the §457(e)11 Plan for Non-Profits

Title 1 of ERISA covers all employee benefit plans and divides them into welfare plans and pension plans. To be covered by ERISA, there must be a “plan.” If the plan is a negotiated arrangement between an employer and a single employee, there is a strong argument that there is no “plan” and ERISA does not govern the arrangement. ERISA reporting requirements for “top hat” plans are limited. The employer need only perform an e-filing two pages in length, and the name of the covered employees is not required to be disclosed.

Conclusion

For non-profit employers looking for a relatively simple way to comply with §4960 and excess benefit rules while rewarding key employees and recruit prospective employees, the §457(e)11 Plan may be an answer. The Plan offers many of the best features of a §162 bonus plan with less costs (e.g., current death benefit, current employer tax deduction, and immediate employee vesting), while serving as a “golden handcuff” that encourages key employee loyalty. In addition to providing an employee with current death benefit protection, the insurance policy's cash value may be available as a source of supplemental retirement income.

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Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP®, AEP, a member of this newsletter's Board of Editors, has served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, GASB, FASB, IASB and OPEB solutions. To learn more, visit www.mycpo.net.