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."
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