The IRS’s final regulations for the 21% excise tax levied against credit unions based on the income of certain highly compensated employees have been in place since January 2021. The IRS actually began to levy this tax in 2018, after it was included in the Tax Cuts and Jobs Act of 2017. Even if your credit union hasn’t been affected by the tax so far, it’s a good idea to know how it works, including some key changes and clarifications contained in the final regulations.
CUNA Mutual Group’s John Pesh, Director of Executive Benefits, overviews key modifications within these final regulations for IRS Section 4960 that could affect your credit union in a new, downloadable regulatory update.
Here’s a quick review of the excise tax:
- The excise tax is contained in Internal Revenue Code, Section 4960 (“Tax on Excess Tax-Exempt Organization Executive Compensation”), added by the Tax Cuts and Jobs Act of 2017.
- The final regulations are effective as of January 19, 2021.
- The IRS requires a 21% excise tax on any wages above $1 million paid to covered employees, which include the five highest-paid employees in a taxable year. The tax also applies when any employee earns a parachute payment of more than three times the employee’s annual base compensation.
- Even credit unions that don’t have employees earning more than $1 million in annual salary/bonuses have been affected by the excise tax. Often, that’s when a 457(f) plan becomes vested, pushing an executive’s recognized annual income above the $1 million threshold.
The final version of IRC Section 4960 clarifies a few details of the excise tax that credit union boards and executives should note, including which employees and which types of remuneration are subject to the tax.
Who is considered a “covered employee”?
Under IRC Section 4960, a “covered employee” includes any of your credit union’s five highest paid employees in a taxable year. But you actually may have more than five covered employees.
According to the final regulation, the tax is levied on credit unions for anyone who was a covered employee in any tax year beginning after December 31, 2016. This is true even if that person is not among the five highest paid employees in a subsequent year.
Which types of compensation apply to the excise tax?
While this excise tax is based on employee compensation (which Section 4960 calls “remuneration”), it is levied against the credit union, not the employee. Let’s break down some common types of executive income that do and do not contribute to this excise tax:
Subject to excise tax:
- Salary, bonuses, and incentives as identified in IRC Section 3401(a).
- Contributions to 457(b) plans: These contributions are fully vested as soon as they are made, so they’re part of the remuneration subject to the excise tax.
- 457(f) vesting amounts: Even if the executive doesn’t take a payout from a 457(f) plan, any amounts that become vested in a given tax year count toward the amount subject to the excise tax.
- Excess parachute payments. These are payments made to an executive as a result of an involuntary separation of employment or a material reduction of duties. Read on for more about this form of income.
Excluded from the excise tax:
- Contributions to retirement plans included in IRC Section 3401(12), such as 401(k) plans.
- Withdrawals from a split-dollar life insurance policy. Although withdrawals are excluded, imputed interest from a below-market loan to the recipient of a collateral assignment split-dollar (CASD) arrangement could add a relatively small amount to an executive’s W-2 total, and therefore in rare circumstances could add to an excise tax.
About Excess Parachute Payments
The final Section 4960 regulations clarify that an organization is considered to have made a “parachute payment” if the aggregate of any payments resulting from a covered employee’s involuntary separation from employment total three times that employee’s base compensation, or more. This includes the value (at the time of separation) of any payments to be made in future years as a result of the separation.
“Separation,” in this case, can mean the executive’s employment is terminated, but it can also mean that person’s duties are significantly reduced.
A couple of key takeaways about the excise tax and parachute payments:
- Although three times the executive’s base compensation is the threshold for designating this type of remuneration as a parachute payment, the excise tax is levied on the “excess parachute payment” amount, which is the amount of the parachute payment that exceeds the executive’s base compensation.
- Excess parachute payments trigger the excise tax even if the executive’s total compensation doesn’t exceed $1 million.
For examples of how to calculate the excise tax on parachute payments and other remuneration, download the full Regulatory Update below.
How to Reduce Exposure to the Excise Tax
Now that the final regulations are established for Section 4960, work with your executive benefit plan providers to determine whether you have excise tax liabilities now or in future tax years. You may be able to make adjustments to eliminate or minimize your exposure.
One possibility is adjusting 457(f) plans to spread out vesting dates, so the vesting amounts are smaller in a given tax year. Another option may be to replace or augment 457(f) plans with CASD arrangements.
When considering plan modifications, first identify whether the plan is considered contractual. For example, annual bonuses can be included in employment agreements, in which case they may be contractual. If contractual, they may be difficult to modify and likely will require the executive to agree to any modifications.
On the other hand, if annual bonuses are bestowed by a board of directors, outside of any employment agreement, they may not be considered contractual. In that case there may be more flexibility to plan whether and how to pay the bonus to manage the excise tax.
Consult with an attorney to learn which of your executive benefit plans are contractual, and to negotiate benefit modifications.
To Which Entities Does the Excise Tax Apply?
The final regulations define an Applicable Tax-Exempt Organization to include an organization that is exempt from tax under section 501(a), which includes organizations exempt from tax under section 501(c).
Download the “Excise Tax Regulatory Update: Finalization of IRS Section 4960 Regulations,” for more details on all the material covered above, and on other issues arising from these regulations.