By Dennis Dollar
In an ironic twist to the just-enacted “Tax Cuts and Jobs Act,” many tax-exempt organizations - including credit unions - will be subject to a substantial new tax that could potentially limit their ability to recruit, compensate and retain leadership talent.
While penalizing employers for providing certain levels of otherwise reasonable compensation is not a new concept for publicly-traded companies, it is unprecedented in tax-exempt organizations like credit unions and will require some adjustment of strategy as it relates to executive deferred compensation plans.
For many years, publicly-traded companies have been limited in their ability to deduct certain types of compensation for their chief executive officer and the four other most highly compensated executives.
For the first time the new tax law has applied such a restriction on not-for-profit entities that are exempt from federal income tax by imposing a similar, but differently structured tax on the tax-exempt employer.
How New Provision Reads
Since tax-exempt employers don’t use tax deductions, new IRC section 4960 imposes an excise tax on compensation in excess of $1 million. The excise tax rate is the corporate tax rate then in effect, which under the new law is 21%. The new provision reads that there is “hereby imposed a tax equal to product of the [corporate tax rate] and . . . so much of the remuneration paid . . . by an applicable tax-exempt organization for the taxable year with respect to employment of any covered employee in excess of $1,000,000 . . . The employer shall be liable for the tax imposed…”
The 4960 excise tax applies to the tax-exempt organization’s five highest compensated employees (or former employees) for the year, plus anyone who was in the five-highest group for any preceding year (2017 or later).
Even though a covered employee’s aggregate annual salary and incentive payments may be less than $1 million, 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. This is because “remuneration” includes deferred compensation not as it accrues each year, but in a lump sum in the year it vests (i.e., is no longer subject to a “substantial risk of forfeiture”).
Under many plans, deferred compensation accrues over 10 or more years so that the vesting amounts can represent many multiples of current salary and bonus. Nevertheless, the full amount of vesting deferred compensation is added to current compensation, significantly increasing the risks that the total for the year will exceed $1 million, resulting in the 21% excise tax on the excess.
What Is Crucial to Recognize
Most credit unions have not had the opportunity to carefully study every aspect of the new tax law. Normally, new tax law provisions have minimal, if any, impact on tax exempt not-for-profit organizations. However, it is crucial that credit unions recognize that this time there are provisions that could affect them.
Credit unions should study the new law’s potential impact on its presently structured deferred compensation plans, as well as those who are currently considering implementing such plans in the future. Early indicators are that there are some alternatives through innovative split dollar plans and other options that might mitigate the impact of this new tax law provision.
The competitive nature of recruiting, hiring and retaining the best and the brightest has always been a challenge for the not-for-profit sector when compared to its for-profit brethren. This new tax change will make that challenge even greater, but not impossible. Credit unions should become aware of this new provision and seek the advice of qualified counsel, accountant or knowledgeable consultant regarding the options available for addressing this potential tax liability.
Dennis Dollar is a former NCUA Chairman and Board Member. He currently is a principal partner in Birmingham, AL-based Dollar Associates LLC, a full-service credit union consulting firm. He can be reached at ddollar@dollarassociates.com or 205-991-1525.