21% Excise Tax on Nonprofit Compensation

Nonprofit organizations are generally exempt from income tax. However, there are certain instances where a non-profit may have to pay income or other taxes on activities not related to their tax-exempt purpose. For instance, business income inside a charity can trigger a tax on income unrelated to the business, often called “Unrelated Business Income Tax” or “UBIT.” There is a special form these nonprofits use to report business income (Form 990-T).

An exempt organization may also have to pay an excise tax for compensating its executive employees. An excise tax is usually a special tax on specific goods, services, and activities, and it is usually imposed per unit. Examples of a federal excise tax include a tax imposed on the sale of things like fuel, airline tickets, heavy trucks and highway tractors, indoor tanning, tires, tobacco and other goods and services. The specific excise tax for executive compensation in nonprofits was created in 2018 and has a flat tax rate of 21%.

Triggering the Tax

Nonprofits must have several key qualities before they are required to pay the excise tax. Most importantly, the tax only applies when an employee’s compensation exceeds $1 million. In some ways, the excise tax functions similarly to a payroll tax in that it is an additional tax based on the income of the employee paid by the corporation. However, unlike a traditional payroll tax, there is no employee portion.

The rule only applies to “covered employees,” which are defined as “one of the 5 highest compensated employees of the organization for the taxable year.” Generally, this will be officers or executives of the nonprofits. Total compensation is taken into consideration, not just wages. Certain taxable fringe benefits, such as bonuses, group term life insurance, and more are taken into consideration. Non-taxable fringe benefits, like health insurance or educational assistance are not considered.

Technical Details

Under section 4960, the excise tax rate is equal to the corporate rate. This means the excise tax rate has the potential to increase if corporate taxes increase. Since the amount is tied directly to the tax under Section 11 of the IRC, the new 15% minimum tax will not factor in. The tax went into effect in January of 2018. When the tax applies, it is calculated on Schedule N of IRS Form 4720.

The 21% excise tax impacts most tax exempt organizations/institutions, including religious organizations, pension and profit-sharing plans, farmers’ cooperatives, and political organizations. There are a few organizations/institutions the excise tax may not reach, like public universities or certain government entities.

The law applies to compensation agreements that were already in place when it went into effect – organizations were not “grandfathered” out of the new law. This means that for organizations that have agreements to pay executives deferred compensation, the law may trigger the excise tax for those former employees if they are receiving compensation above the $1 million threshold.

Related organization rules can come into play in doing the math. Many tax-exempt organizations have multiple “arms” – for instance, a 501(c)(3) will often have a 501(c)(4) or 501(c)(6) branch for lobbying or educational purposes. In these cases, if an employee is employed by both organizations, their total compensation will be considered to determine if their compensation is over $1 million.

The tax only applies when the compensation is paid to a statutory employee of the organization. If the individual is receiving payment as an independent contractor, the excise tax will not be triggered even if they are receiving over $1 million in compensation. Additionally, certain corporate directors or executives supplying limited services to foundation or charitable arms of the organization will not trigger the tax.

There are special rules for medical services. When a doctor or veterinarian supplies medical services for payments, these payments generally do not count. However, if the doctor or veterinarian also supplies administrative services, the payments may not be allocated, and the payments allocated to administrative services will count towards the total compensation amount.

Consider a Review Project

The 21% excise tax on executive compensation won’t affect most groups. However, when they apply, the rules become complicated rather quickly.  

Many nonprofits should review whether this new excise tax will reach their organization and consider compensation planning alternatives for avoiding the new excise tax.