Now that the 2017 Tax Cuts and Jobs Act is into its second year, it may be a good time for colleges and universities to review the implications of these new tax rules and consider any changes they might make to reduce their tax liability.
Enacted December 22, 2017 and effective for taxable years beginning after December 31, 2017, the Tax Cuts and Jobs Act left little time for reflection and planning by affected employers before the 2018 taxable year. IRS interim guidance came out later in 2018 (IRS Notice 2018-99 on employer-provided parking issues) and at the beginning of 2019 (IRS Notice 2019-09 on the new excise taxes).
The new tax law made changes to tax rules applicable to certain employee compensation arrangements provided by tax-exempt organizations that may have a significant impact for colleges and universities. These include an excise tax on “remuneration” in excess of $1 million for a taxable year, an excise tax on “excess parachute payments” and unrelated business taxable income resulting from employer-provided parking and other qualified transportation fringe benefits (e.g., transit passes).
Excise Tax on Remuneration in Excess of $1 Million
The Tax Cuts and Jobs Act added new Section 4960 to the Internal Revenue Code, imposing an excise tax on applicable tax-exempt organizations and related organizations equal to the corporate income tax rate (currently 21%) multiplied by the amount of remuneration paid to a covered employee that exceeds $1 million for any calendar year ending in the organization’s taxable year. Amounts paid by related organizations are aggregated in determining whether the threshold is exceeded. Note that related organizations include supporting organizations, such as a foundation supporting a university or certain booster clubs.
Notice 2019-09 indicates the IRS view that public universities are applicable tax-exempt organizations subject to the excise tax if they either (i) have a determination letter recognizing exemption from taxation under Code section 501(c)(3) or (ii) exclude income under Code section 115(1) as a governmental entity that is separately organized from a state or political subdivision of a state. (However, some public colleges and universities qualify as political subdivisions or integral parts of states or political subdivisions and do not rely on Code section 115(1).)
Covered employees are the five highest compensated employees for the current taxable year and any employee who was a covered employee for an earlier taxable year beginning after December 31, 2016 (the year before the excise tax went into effect). Thus, a covered employee remains a covered employee for all future years, even after termination of employment.
Remuneration for purposes of the excise tax means all wages subject to federal income tax withholding, except it excludes any designated Roth contributions to a 403(b), 401(k) or 457(b) plan. This generally includes salary and bonuses, taxable fringe benefits, taxable tuition remission, severance pay (but not including any excess parachute payment that is subject to the separate excise tax calculation discussed below), distributions from a 457(b) plan sponsored by a non-governmental tax-exempt employer, ineligible deferred compensation subject to Code section 457(f) and deferred compensation provided under a governmental employer’s qualified excess benefit arrangement under Code section 415(m). However, remuneration does not include amounts paid to a licensed medical professional (e.g., medical doctors and veterinarians) directly related to the performance of medical or veterinary services (but not administrative services).
This remuneration is treated as “paid” for purposes of the Code section 4960 excise tax on the first date the right to the remuneration is no longer subject to a substantial risk of forfeiture within the meaning of Code section 457(f)(3)(B), regardless of whether the arrangement is subject to Code section 457(f). That is, deferred compensation (including qualified excess benefit arrangements under Code section 415(m) sponsored by a governmental employer and contributions to a 457(b) plan sponsored by a non-governmental tax-exempt employer) will be included in remuneration for the year in which it vests rather than the year paid. This could result in bunching of deferred compensation earned over many years (and that may be paid out in multiple years) if it all vests in a single year.
Excise Tax on Excess Parachute Payments
The excise tax under Code section 4960 also applies to any excess parachute payment made to a covered employee. However, the excise tax does not apply to payments to an employee who is not a highly compensated employee under Code section 414(q) (for 2019, an employee paid less than $125,000 in 2018). An excess parachute payment is the amount by which a parachute payment exceeds the employee’s base amount allocated to that payment. (A special calculation for allocation of the base amount is required when there are separate parachute payments made by an applicable tax-exempt organization or related organizations.)
A parachute payment is any compensation to be paid by an applicable tax-exempt organization or related organizations on account of an involuntary separation from employment (including separation for good reason), but also includes payments under any “window program” (even though participation in the window program is voluntary), if the aggregate present value of the payments equals or exceeds three times the base amount. (Unlike the excess parachute payment rules applicable to taxable employers, the Code section 4960 excise tax does not invoke “change in control” concepts.)
The base amount is the covered employee’s average annual compensation for the five years ending before the date of the employee’s separation from employment (with special rules applicable if the employee has worked less than those five years).
Although the payments must be at least three times the base amount to trigger the excise tax, the excise tax is paid on the entire amount by which the parachute payment exceeds the base amount. For example, if the base amount is $150,000 and the parachute payment equals $500,000, then the excise tax applies to $350,000.
Unrelated Business Taxable Income From Qualified Transportation Fringe Benefits
The Tax Cuts and Jobs Act also added new Section 512(a)(7) to the Internal Revenue Code, requiring tax-exempt organizations (including public colleges and universities) to include in their unrelated business taxable income subject to income taxes under Code section 511 any amount paid or incurred to provide parking or other qualified transportation fringe benefits (such as transit passes) to their employees.
This includes amounts provided to employees at the employee’s expense through a pre-tax salary reduction arrangement. The qualified transportation fringe benefit can still be excluded from the employee’s taxable income under Code section 132(f), but the employer ends up including the amount in its unrelated business taxable income. (Thus, parking and transit passes provided to employees through pre-tax salary reduction arrangements essentially benefit the employee by transferring the tax burden from the employee to the employer.)
IRS Notice 2018-99 provides guidance to help determine the value of parking provided by the employer to employees. The value of free parking provided to the general public as well as employees is not included in the calculation if the parking is used primarily by the general public (including students). However, the value of parking reserved for employees is included in the calculation of the employer’s unrelated business taxable income.
IRS Notice 2018-100 provided transition relief for tax-exempt employers that had failed to pay estimated taxes on this unrelated business taxable income in 2018. However, that relief is not available for estimated taxes due in 2019.