United States: Executive Compensation Changes Under The Tax Cuts And Jobs Act Of 2017

The U.S. House of Representatives and Senate fulfilled one of President Trump's principal campaign promises on December 19 and 20, passing the Tax Cuts and Jobs Act of 2017 (the Act). President Trump signed the Act into law on December 22, 2017.

The Act, and the various iterations of the bills that led to the final Act, received significant press coverage, garnishing either high praise or high criticism depending on one's political leanings. According to the score assigned the Act by the Congressional Budget Office (CBO), the Act can be expected to increase the federal deficit by $1.5 trillion over the next decade. Whether or not that will ultimately be offset by increased economic activity will only be answered over time, but both the House and Senate recognized the need to raise revenue to offset the tax cuts and found numerous little known provisions, as well as created several new tax provisions, to do just that. One such provision was the creation of a new excise tax that will impact hospital systems nationwide. That provision is intended to place tax-exempt organizations on similar footing with for-profit corporations with respect to executive compensation.

For-profit corporations have been subject to tax rules intended to limit the compensation paid to selected executives. Under such provisions, publicly-held corporations are not entitled to deduct the cost of covered executives' annual compensation in excess of $1 million,1 and both publicly and privately-held corporations are not entitled to deduct excess parachute payments (so called "Golden Parachutes" under Code Section 280G) following a change-in-control of the entity. However, other than the "intermediate sanction" rules that required executive compensation to be "reasonable,"2 no similar provisions limiting the compensation that could be paid to selected executives of tax-exempt not-for-profit organizations existed. To rectify this disparity between taxable corporations and tax-exempt entities, the Act established a new excise tax on excess executive compensation paid by tax-exempt organizations (new Code Section 4960).

Under this new excise tax regime, which goes into effect for tax years beginning after 2017, tax-exempt employers will be liable for a 21% excise tax (equal to the new corporate tax rate) on any compensation paid to a "covered employee" in excess of $1 million in any year, as well as on certain "parachute payments" made by the organization. These provisions went into effect immediately on January 1, 2018. However, unlike the modifications made to the executive compensation provisions applicable to taxable corporations, which grandfathers from the new rules all compensation which is provided pursuant to a written binding contract which was in effect on November 2, 2017, and which is not modified in any material respect on or after such date, there is no grandfather provision applicable to the new Section 4960 excise tax. 

For purposes of the new excise tax, the five highest-paid employees are considered "covered employees," and once considered a "covered employee," an individual will always be considered a "covered employee," even if his or her compensation subsequently drops below the highest five and even following separation from employment. Thus, over the course of time, an organization will accumulate more than five "covered employees," and severance payments, even if not captured by the parachute payments provisions discussed below, could trigger the excise tax if in excess of $1 million to any covered employee in any year.

Compensation for these purposes includes all amounts on which the organization is required to withhold income taxes, but does not include Roth or otherwise after-tax contributions to a 401(k) or 403(b) plan, and solely for purposes of the applying the $1 million annual compensation threshold, does not include "parachute payments" subject to the parachute payments excise tax (as discussed below). Compensation would include amounts taxed (whether or not distributed) upon vesting under a 457(f) non-qualified deferred compensation plan, but not contributions to such a plan. Compensation from all control group-related organizations, as well as "supporting" and "supported" organizations, is to be aggregated for these purposes. This will require an organization to know what compensation, if any, its covered employees are earning from such other employers. In cases where the aggregate compensation of a covered employee exceeds the $1 million limitation, each organization is liable for a ratable portion of the excise tax based on the amount of compensation it pays in relation to the compensation paid by all aggregated organizations. Thus, an organization could be partially liable for this new excise tax even if it pays compensation below the $1 million annual threshold.

Although included in neither the House nor Senate bills, the Conference Committee added a provision during the reconciliation process of particular import to hospital systems. Specifically, for purposes of the $1 million threshold on compensation, amounts paid to a licensed medical professional, including doctors, nurses, and veterinarians, attributable to the performance of medical or veterinary services are not counted as compensation. Thus, a hospital system may compensate a surgeon in excess of $1 million a year and not be liable for the excise tax. This raises interesting questions, including for example, in the context of a covered physician employee who is the hospital's Chief Medical Officer (CMO), what services of the CMO will be considered to be the performance of medical services? Will the CMO actually have to see and treat patients, or will it be enough that the CMO is a member of a peer review committee that reviews patient cases, teaches, lectures, or supervises the licensed medical staff? Until the IRS issues guidance on this question, if the CMO's compensation is partially based upon performing medical services, we can only assume that an allocation will need to be made to segregate compensation paid strictly for the treatment of patients from the compensation paid strictly for the performance of administrative services, with the rest being a judgment call.

In addition to the excise tax on annual compensation in excess of $1 million, new Code Section 4960 imposes the 21% excise tax on certain "parachute payments." This new provision is modeled after Code Section 280G, which triggers the loss of a taxable corporation's (both publicly- and privately held) tax deduction on certain parachute payments made to "disqualified individuals" following a change-in-control. For purposes of Section 4960, a payment made to a covered employee is considered a "parachute payment" if the payment is made contingent upon separation from employment and the aggregate present value of all such payments to the covered employee equals or exceeds three times the recipient's "base amount." The "base amount" with respect to a particular employee equals the annual taxable compensation of the employee averaged over the five years before the year of the separation from employment. Two points bear highlighting: (1) The excise tax is not imposed on parachute payments in excess of three times the "base amount," but rather is imposed on parachute payments in excess of the "base amount," and (2) amounts subject to this parachute payment excise tax are not taken into consideration for the excise tax on annual compensation in excess of $1 million.

Parachute payments do not include payments made under a tax-qualified retirement plan, a 403(b) plan or a 457(b) plan. Further, the same exemption applies for compensation paid to licensed medical professionals attributable to the performance of medical services, as well as an exemption for payments to all non-highly compensated employees as defined for purposes of tax-qualified retirement plans.3 Severance arrangements in hospital systems generally will not exceed three times annual compensation,4 so severance payments made to a departing covered employee should generally not be treated as "parachute payments" for purposes of this excise tax, but caution will need to be taken if related/affiliated organizations are required to be aggregated for these purposes. As drafted, it would seem that only members of a controlled group or affiliated service group would be required to aggregate severance payments (and not necessarily "supporting" or "supported" organizations). Nevertheless, it is important to keep in mind that the payment of severance in excess of $1 million a year to a covered employee (or even less if the covered employee receives payments from other "related/affiliated" organizations as discussed above) could trigger the excise tax even without being considered a parachute payment.5

Several questions regarding the excess parachute payment rules will require the IRS to issue guidance. For example, what is a separation from employment that could trigger the excess parachute payment tax? Will the standards established under Code Section 409A for "separations from service" apply? Another question that the IRS should address is the treatment of Section 457(f) deferred compensation that vests upon the lapse of a post-employment restrictive covenant (e.g., a non-compete period).6 As drafted, such payments would appear to be compensation for purposes of the excise tax imposed on compensation in excess of $1 million, but will it also be considered to be compensation triggered by a separation from employment? Although these and other questions remain, and keeping in mind that the new excise tax applies without any grandfathering provision for existing written and binding contracts and arrangements, it is important for all hospital systems to immediately review and assess the application and impact of this new excise tax on their 2018 compensation budgets.

Originally published in Confero Magazine

Footnotes

1  Internal Revenue Code Section 162(m)(Code). Previously, the deduction limitation under Code Section 162(m) did not apply to "performance-based" compensation, providing significant leeway for taxable entities to avoid the loss of the tax deduction. However, the performance-based compensation exception to the $1 million rule has been eliminated by the Act, effective for tax years after 2017.

2  Code Section 4958, enacted in 1996, imposes an excise tax on "disqualified persons" of applicable tax -exempt organizations that engage in "excess benefit transactions." Similar to the performance -based compensation exception to the Section 162(m) requirement, under the Section 4958 rule, a tax-exempt entity would not trigger the excess benefit transaction excise tax if compensation paid to a disqualified person was considered "reasonable" in the context of the compensation paid by like enterprises under like circumstances.

A rebuttable presumption that compensation was reasonable applied if the compensation was approved in advance by an authorized body of the organization (e.g., the Board or a Board Committee), the authorized body obtained and relied upon compensation comparability data, and the basis for the decision was adequately documented. These provisions have not changed under the Act.

3 In 2018, employees earning below $120,000 generally are considered non-highly compensated.

4 Severance payments generally are limited to twice annual compensation in order to avoid treatment as a pension plan under the Employee Retirement Income Security Act and to qualify for exemption from Code Sections 409A and 457(f) as a "(bona fide) severance pay plan."

5 Any incentive on the part of an employee to agree to reduce the amount of a payment to avoid being considered a parachute payment that exists in the taxable corporation setting (in addition to the loss of the deduction on excess parachute payments, under Code Section 280G, the employee also is subject to an excise tax) will not exist with respect to the excise tax under Code Section 4960 which only imposes a tax on the tax-exempt organization.

6 Proposed Treasury Regulations issued under Section 457(f) in June 2016 made it clear that a substantial risk of forfeiture can continue on the basis of a covenant not to perform services."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
Poyner Spruill LLP
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Poyner Spruill LLP
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions