With all the national press coverage about tax savings, tax cuts and company bonus payments associated with the Tax Cuts and Jobs Act of 2017 (the “Tax Act”), it is easy to miss the changes in federal tax laws that impose substantial negative tax consequences on employers that pay certain executives an amount of compensation that Congress has deemed “excessive.” In this particular area, the changes brought about by the Tax Act do not cut taxes. Rather, for many for-profit and non-profit corporations, the Tax Act creates new taxes.
For example, the Tax Act provides for a new Section 4960 of the Internal Revenue Code. This statutory provision creates an excise tax that will be imposed upon certain tax exempt organizations that pay their covered employees remuneration in excess of $1 million annually or that make an excess parachute payment to a covered employee. This new excise tax impacts 501(a) tax exempt entities (i.e., charitable organizations); farmers’ cooperative organizations; states, political subdivisions and public utilities with income excluded from taxation under Code section 115; and political organizations as defined by Code § 527(e)(1). “Covered employees” are the five highest compensated employees of the organization for the tax year, or a person who was a covered employee for any preceding tax year beginning after December 31, 2016.
The Code § 4960 excise tax payment may be triggered by an excess parachute payment. The term “excess parachute payment” is a payment, triggered by a covered employee’s separation from employment, that is equal to or greater than the base amount determined under the golden parachute rules of Code § 280G(d)(3). Tax exempt organizations may also be surprised to find that they can become liable for excise tax under Code § 4960 because the $1 million compensation threshold is exceeded due to the vesting (rather than payment) of ineligible deferred compensation under Code § 457(f). Thus, a covered employee need not actually receive payment of compensation for a tax exempt organization to incur excise tax liability under the new law.
The excise tax under Code § 4960 is 21% of the sum of the remuneration received by the covered employee in excess of $1 million, plus any excess parachute payment paid to a covered employee.
For-profit corporations may be surprised by the Tax Act’s additions to Code § 162(m), which broaden both the application of the excessive employee remuneration rules in terms of what type of entity is subject to Section 162(m) and in terms of who is a “covered employee under” that statutory provision.
Code § 162(m)(1) provides that a publicly held corporation may not take a deduction for any applicable employee remuneration with respect to any covered employee that receives such remuneration in excess of $1 million annually. The Tax Act expands the scope of the terms “publicly held corporation” beyond those entities that issue classes of common equity securities that must be registered under Section 12 of the Securities Exchange Act of 1934 (the “Exchange Act”). Code § 162(m) now also applies to corporations that are issuers as defined in Section 3 of the Exchange Act, and are required to file reports under Section 15(d) of the Exchange Act. Consequently, any company that is an “issuer” required to file a registration statement for debt or equity securities is subject to Code § 162(m), whether or not they are listed on an exchange. As a result, the $1 million deduction limit on remuneration paid to covered employees now applies to foreign companies that are publicly traded through American depository receipts as well as all domestic publicly traded companies. Certain large private corporations may also fall within Code § 162(m).
The term “covered employee” has also been expanded under Code § 162(m) beyond the CEO or the four most highly paid officers of the company. Under the Tax Act, Code § 162(m) applies to the CEO, the CFO and the three other highest compensated company officers for the tax year.
The Tax Act’s provisions do not apply to remuneration paid pursuant to a written binding agreement in effect on November 2, 2017, and which has not been substantially modified in any material respect on or after that date. Contracts that are subject to cancellation by either party, or which expire on or before November 2, 2017, and are renewed on or after that date, will likely be treated as a new agreement subject to the amended Code § 162(m), according to the Committee Reports commentary under the Tax Act.
Given the new and broadening regulation of excess compensation under the Tax Act, non-profit organizations and large corporations are encouraged to review their executives’ compensation packages with their tax advisors to determine the impact on income received by the executives due to vesting and forfeiture provisions in deferred compensation plans, payments made under severance agreements and compensation packages described in employment agreements.