By Ray Birch
BIRMINGHAM, Ala.—Credit unions that have never had to worry about the IRS will soon have to do so—and many CUs and execs who believe new rules around compensation don’t apply to them are likely in for a surprise, according to analysts.
Former NCUA chairman Dennis Dollar believes IRS 990 forms are coming to federal CUs as a result of the Tax Cuts and Jobs Act. As CUToday.info reported, the Tax Cuts and Jobs Act imposes a 21% excise tax on executive compensation that exceeds $1 million annually–and that means more than just salary.
The tax would apply to the compensation paid to the five highest-paid executives at a nonprofit organization. The tax would be paid by the credit union, not the executive, and could amount to the hundreds of thousands of dollars, sources have stated.
“Is this a camel's nose under the tent of eventual credit union taxation? That might be a stretch,” said Dollar, who is more concerned about the excise tax affecting CUs’ ability to retain top talent. “However, it is definitely a significant change in law and therefore it will bring about a change in IRS policy regarding credit unions.”
Facing Tax Man For First Time
But what this provision of the tax law may likely do, said Dollar, is have federal credit unions that have never had to face the IRS by even filing the 990 form, potentially facing the tax man for the first time in history.
While the precise number of credit union executives who are paid in excess of $1 million annually isn’t publicly known, there are numerous executives at the largest credit unions who earn in excess of that amount annually, noted Dollar. The new tax rule kicked in Jan. 1.
Dollar said that even if a CU thinks that its current CEO salary structure exempts the credit union from this tax today, unless the credit union digs into the rule and calculates how its leaders are fully compensated, it may not come to the right conclusion.
Dennis Dollar
“Admittedly most credit union executives don't today have an issue with salary and bonuses over $1 million. However, as credit unions continue to grow and compete for the best executive talent, any such impact on total compensation packages can have an effect that may be limiting over time,” said Dollar. “Even for today, the hidden problem in this new excise tax regime is deferred compensation balances at many credit unions.”
Dollar noted that deferred compensation benefits have become an important—even vital—part of the executive benefits package at most growing and progressive credit unions.
“This will only grow with time as the marketplace becomes more competitive for quality talent at the executive level,” he said. “This new tax law provision is now a consideration that credit unions will have to factor in when structuring their deferred compensation benefit programs.”
Pay Attention Here
Dollar shared an example to demonstrate that an executive doesn't have to actually earn $1 million in salary to bring this provision into play.
“Let's say a credit union executive makes $400,000 in salary per year plus a $100,000 performance bonus for a total of $500,000. However, over the past 10 years the credit union has reserved $100,000 per year into a deferred compensation plan,” explained Dollar. “Let’s say the executive just vested in the plan. The executive's total compensation that year is $400,000 (salary) plus $100,000 (bonus) plus $1 million (vested deferred compensation). The total compensation for that year, under the new rule is $1.5 million.”
In this example, Dollar said, the credit union now owes 21% on the amount exceeding $1 million under the new excise tax.
“It is important to recognize that this change in the tax law essentially means that any deferred compensation arrangement increases the likelihood of incurring the 4960 tax,” said Dollar.
Sources explained that alternatives through innovative split-dollar plans and other options are available to mitigate the impact of the new tax law provision.
Dale Edwards
“We are advising clients to focus on the hidden potential dangers of their deferred compensation arrangements, which are typically retirement benefits paid out in the future,” said Dale Edwards, principal and co-founder at benefits consulting firm Triscend. “The typical structure is the CEO gets a lump sum in the future when the program vests—and it all goes to the calculation related to the excise tax.”
Ways To Avoid Tax
Edwards addressed specific benefit structures credit unions can adopt to avoid the excise tax.
“One way is to change the vesting schedules related to deferred compensation arrangements,” said Edwards. “Rather than someone getting a $1-million lump sum after 10 years, the CU could structure more frequent payouts in smaller amounts to avoid the $1-million threshold.”
But Edwards said taking that approach might lead to some tough conversations among board members.
“Deferred compensation arrangements typically have a retention feature, giving the leader an incentive to stay for the full term,” said Edwards. “So this will be the balancing act the boards will have to wrestle with—either pay the excise tax to keep a big, lump-sum incentive in place or make more frequent payments.”
Edwards said that collateral assignment split-dollar life insurance arrangements can work best toward providing a leader with an incentive to stay, and also avoid the excise tax. The arrangements are called split-dollar because the death benefits, cash surrender values, and premium payments are split between an employer and employee. In this case the credit union is loaning substantial funds to the executives to buy life insurance policies. The arrangement generally provides that the employer will be repaid its cumulative premiums upon the death of the employee from the proceeds of the policy and any remaining proceeds will be paid to the employee’s named beneficiary.
Collateral assignment split-dollar life insurance is used by many credit unions as a more affordable means of funding an executive’s supplemental retirement benefits, sources have stated.
Alexandria Staron
Split-Dollar Options
Several versions of split-dollar programs exist, and a loan regime split-dollar arrangement, Edwards said, may be the best option to address the excise tax issue.
“A loan regime split-dollar program that is properly structured to be non-compensatory is a good option,” said Edwards.
Loan regime applies when the executive owns the policy or when the executive and the credit union jointly own the policy and the executive is the first named owner. “But it needs to be carefully crafted so that it remains non-compensatory over time. We think the devil is in the details in terms of how you craft and structure these arrangements and administer them over time. Another aspect of loan regime split dollar is that rather than it being an expense, it’s a growing asset on the balance sheet of the credit union,” said Edwards.
Just how many credit unions will be impacted by the new excise tax is difficult to estimate, said Triscend VP Alexandria Staron, simply because federal credit unions don’t file 990 tax forms.
She said it would be natural to assume that the larger credit unions, generally those over $250 million in assets, is where concerns will begin.
“Certainly, the larger credit unions have the larger compensation packages,” Staron said. “However, based on recent studies by NAFCU, two-thirds of credit unions above $75 million are providing supplemental benefits. And while split dollar is quite prevalent in this group, I’d say that any credit union of $75 million and up that has deferred comp plans is at risk because the arrangements may be structured with lump-sum payouts.”
Like Dollar, Edwards said the excise tax is unsettling for the credit union movement.
“This is historic in that it is the first time credit unions have been taxed on something, and who knows if that is a harbinger for things to come,” said Edwards. “It is certainly not a good trend.”
Look Out For 990s
Dollar restated that he believes the IRS will require 990 forms for federal credit unions. State-chartered CUs already file the forms.
“I guess it’s anyone’s guess how the IRS will get the data,” said Dollar, who emphasized that the tax agency will get the information it needs.
“Most believe, as I do, that federal credit unions will soon be required to file 990s. If not, it is certain there will be a substitute reporting form developed for not-for-profits not currently required to file Form 990,” Dollar said. “You can be assured that credit unions reporting to the IRS and the scrutiny such reporting will generate by the IRS is going to be ratcheted up now that actual tax dollars are on the line.”