Two New Excise Taxes That Could Impact Higher Ed
This is the second in a series of blog posts contributed by John Graham, vice president and regional director of compliance research at Sibson Consulting.
Since the new tax bill was passed, we’ve received a number of questions as to how the legislation affects higher education and its employees. To help answer these questions, we’ve partnered with CUPA-HR Mary Ann Wersch Premier Partner Sibson Consulting to publish a series of blog posts. These posts will be based on the information we currently have and will be updated as any guidance is issued. The content is for general information purposes only and should not be considered tax or legal advice.
This post by will answer some of the questions surrounding the new excise tax on excess compensation and excess parachute payments that applies to tax-exempt (and public) colleges and universities.
Effective for taxable years beginning after December 31, 2017, the new tax law creates a 21 percent excise tax on tax-exempt institutions to the extent they pay “excess remuneration” to “covered employees.” This new excise tax will apply to: (1) any remuneration in excess of $1 million paid to a covered employee and (2) any excess parachute payment paid to such employees. The use of the 21 percent rate for the excise tax on tax-exempt organizations is meant to be comparable to the inability of a corporation with outstanding publicly-traded securities to deduct excess compensation. (The corporate tax rate is now 21 percent).
The excise tax on “excess remuneration” applies to any amount the institution pays to a covered employee which exceeds $1 million. So, if a covered employee has remuneration of $1.5 million, the excise tax on the institution will be $105,000 (the $500,000 excess X 0.21).
For purposes of the tax, a covered employee is one of the five most highly compensated employees for the current year and any other individual who was a covered employee for any preceding taxable year beginning after December 31, 2016. Once an individual is a covered employee, the individual will always be a covered employee.
The new law generally defines “remuneration” as compensation subject to wage withholding under Internal Revenue Code (IRC) Section 3401. Remuneration is considered paid when it is no longer subject to a substantial risk of forfeiture. Amounts paid by certain related organizations (including organizations controlled by or that control the institution and certain supporting organizations) must be aggregated with amounts paid by the institution for purposes of determining excess remuneration.
Remuneration does not include amounts paid to a licensed medical professional (including a veterinarian) for the performance of medical or veterinary services. Pre-tax contributions (including Roth contributions) to qualified plans, as well as distributions from such plans, are not included in remuneration for this purpose. A similar exception applies for 457(b) plans for public institutions. However, the law appears to include amounts in Section 457(b) plans for private institutions when they are subject to withholding (which is, generally, when paid) and amounts in both private and public school 457(f) plans are included when the amounts vest.
Excess Parachute Payments
The new excise tax also applies to “excess parachute payments” to covered employees. A parachute payment is a payment of compensation to (or for the benefit of) a covered employee (as defined above) that is contingent on the employee’s separation from service. A payment is considered an excess parachute payment if it exceeds three times the employee’s “base amount” allocated to such payment. Generally, the base amount will be determined using the employee’s average annual compensation from the employer over the prior five-year period.
For example, if an executive received average annual compensation of $200,000 over the five-year period prior to termination and received a payment of $850,000 in the year of termination that was contingent on that termination of employment, the excess parachute payment subject to the 21 percent excise tax would be $250,000 ($850,000 – (3 X $200,000)).
The law specifically excludes payments from qualified plans (including 403(b) plans) and 457(b) plans from being included in the definition of a parachute payment. Additionally, as with the excess remuneration excise tax, amounts paid to a licensed medical professional or veterinarian will not be included. Finally, the excise tax will not apply to a covered employee who is not a highly compensated employee (note that an employee is considered highly compensated for 2018 if the employee’s compensation exceeded $120,000 for 2017).
The new excise tax is intended to apply to both private and public institutions. The language of the law states that the 21 percent excise tax applies to, among other organizations, any organization exempt for tax under IRC Section 501(a), which would cover private institutions, and any organization which has income excluded under IRC Section 115(1). The latter section would appear to cover public institutions; however, it is possible that some public institutions don’t rely on Section 115(1) for the exclusion of their income from taxation. Those institutions should consult their attorneys.
For most institutions, the thresholds are high enough that the excise tax will clearly not apply and no action would be necessary at this time. However, institutions that pay compensation high enough so that the excise tax may apply should review existing compensation practices and employment contracts to determine how the excise tax could potentially impact them. Then the institution could determine if the arrangements could be restructured to avoid part or all of the excise tax.
Let us know what challenges you’re facing due to these tax changes, or share examples as to how you’ve addressed these changes. Email firstname.lastname@example.org.
Visit our tax reform web page for more on the new tax law.