June 21, 2024

Understanding the IRS Tax on Excessive Executive Compensation for Nonprofits

By Christopher Granucci, CPA, Senior Manager, Tax & Business Services

Understanding the IRS Tax on Excessive Executive Compensation for Nonprofits Nonprofit Tax Services

Nonprofit organizations with highly compensated employees or executives about to retire and collect a large payout may be subject to tax on what the Internal Revenue Service (IRS) calls “excess executive compensation.” If subject to this tax, the organization will need to comply with additional requirements to report and pay the amount due.

In general, the excess executive compensation tax applies to domestic organizations exempt from income taxes under IRC Section 501(a) (Form 990 filers), farmers’ cooperatives, public utility companies, states, municipalities, and political organizations. These are referred to as Applicable Tax-Exempt Organizations or ATEOs.

While referred to as the “excess executive compensation excise tax,” an employee does not actually have to be an executive of the organization for the tax to apply. Rather, the organization’s five highest-paid employees are considered “covered employees” for purposes of the excise tax. Once someone becomes a covered employee, they continue to be considered a covered employee in future years regardless of whether they remain one of the organization’s top 5 highest paid employees.

Compensation is determined based on “remuneration paid during the calendar year ending with or within” the organization’s tax year. Remuneration essentially means wages but includes any amounts required to be included in the recipient’s gross income on their tax return for that year. This includes amounts in certain deferred plans if there is no substantial risk of forfeiture of the funds by the recipient, as well as taxable fringe benefits such as first-class travel, tax indemnification and gross-up payments, and other similar benefits. Remuneration also includes compensation paid to the employee by domestic and foreign-related organizations, not solely by the filing organization. Note the period to which the remuneration relates – the calendar year. For organizations with a fiscal year-end, be sure to use the calendar year that ends during your fiscal year when calculating the remuneration the covered employee receives. For example, an organization with a year-end of June 30, 2023, has the calendar year 2022 ending within its fiscal year. So, the remuneration used to determine the tax will be based on the January 1 – December 31, 2022 period, but the filing will be due at the same time as the June 30, 2023 year’s returns.

Remuneration becomes “excess compensation” when either 1) it exceeds $1,000,000 or 2) an “excess parachute payment” is made. An “excess parachute payment” is an amount paid to the employee leaving the organization that exceeds three times the employee’s average annual compensation (based on the previous five years), subject to several exceptions. Note that with a parachute payment, the employee’s total compensation does not have to exceed $1,000,000; it only has to exceed three times their average annual pay to trigger the excise tax requirement.

The tax is calculated on Form 4720, Return of Certain Excise Taxes, Under Chapters 41 and 42 of the Internal Revenue Code. The corporate tax rate of 21% is applied to the excess portion of a covered employee’s compensation. This tax is due by the original due date of the return.

If your organization has individuals whose compensation is approaching $1,000,000 or one of its highest-paid employees will receive a sizeable payout upon leaving employment, be sure to have someone review the facts to see if this excise tax may apply.