The Impact of the Tax Cuts and Jobs Act on Nonprofit Salaries

December 31, 2017; National Law Review

NPQ has been reporting on attempts to monitor or penalize what are considered to be overly generous compensation packages over the past few weeks, and here’s yet another attempt to do something about payments to nonprofit executives some see as excessive. The Tax Cuts and Jobs Act recently signed by President Trump will bring many changes to nonprofits. Among them is a slightly confusing provision with an impact on nonprofit compensation packages in excess of $1 million. As Michael Wyland discussed back in March, there are about 2,700 executives working at 501c3 organizations who reach that threshold, which isn’t many.

At this point, it might be most helpful to explain in plain English the impact of the new tax law on executive compensation. (This is based on a very comprehensive assessment of the new law in the National Law Review.) There has always been a clause in the tax code against excessive compensation of nonprofit executives. Section 4958 of the code has “intermediate sanctions” that impose penalties on payments to people at a charitable organization who have significant impact on the decisions made by that organization. These people are called “disqualified persons” or “insiders.” No one in a nonprofit is supposed to receive unreasonable or unfair financial benefit from the income of a nonprofit; the sanctions are intended to prevent insiders from making decisions that would line their own pockets.

The sanctions in the current laws can actually be quite severe. If it is determined that a payment has been unfair or excessive, the person who received the money could see an excise tax of 25 percent of the amount deemed excessive. That money must also be returned to the organization, and an additional repayment made to bring the nonprofit back to where it would have been had the excessive payment never been made. If this is not done, the insider receiving the payment would be liable for an additional tax of 200 percent of the value of the excessive payment. In addition, any other managers, board directors, or trustees who were knowingly involved in the excessive transaction could see a penalty of 10 percent of the excessive amount, up to $20,000.

Of course, there are ways to avoid these penalties by establishing what is called a “rebuttable presumption of reasonableness.” The nonprofit should do things like ensure decisions about compensation and other payments are made by an authorized body made up of people with no conflicts of interest, base the decision on research of similar transactions at other organizations, and document the deliberations and the actual decision in meeting minutes. If they do so, then the burden of proof suddenly shifts to the IRS.

The new Tax Cuts and Jobs did not remove this presumption of reasonableness, as many people had feared. But it does for the first time impose an excise tax on compensation of insiders. If the insider receives compensation of more than $1 million, the nonprofit organization would be liable for an excise tax of 21 percent of the amount above that threshold. This is in effect for any of the employees who are or would have been among the five highest paid employees at the nonprofit in the current tax year or in any tax year from 2016 onwards.

This excise tax is not only for salary, but also for “parachute payments.” Parachute payments are a way of deferring a salary, involving payment to the employee after they have left the organization. If the net payment in the parachute payment is more than three times the employee’s average salary of the previous five years, it is considered excessive and liable for a 21 percent excise tax.

There are other clauses in the new law that impact nonprofits’ compensation of employees, of course. One involves raising the amount a nonprofit pays in unrelated business taxable income for reimbursement of some transportation expenses and on-site athletic facilities. There are also issues of how to report the compensation on the IRS Form 990.

Still, what seems to stand out here is that the new law labels any compensation of more than $1 million as “excessive” instead of basing reasonableness on what peer organizations offer. It also shifts the tax burden from the person receiving the payment to the nonprofit making the payment. Nonprofit boards and other decision-makers are encouraged to carefully consider the impact of this new regulation as it relates to their compensation policies and to seek counsel on how to best address it.—Rob Meiksins