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If the new year and new tax laws haven’t stretched credit unions enough already, they can add another recurring item to the list: avoiding the new 21 percent excise tax on “excessive” employee compensation.
The tax reform bill—the Tax Cuts and Jobs Act—added a new Section 4960 to the tax code that imposes a 21 percent employer-paid excise tax on compensation over $1 million a year and on large severance payments. The new rules apply only to tax-exempt employers, including credit unions.
Before you tune out because your credit union doesn’t pay any salaries of $1 million, beware that other types of pay, including deferred compensation plans, can trigger this tax in some subtle ways.
Starting Now
The rules apply for taxable years starting after Dec. 31, 2017, so in all likelihood you’re already operating under the new regulation. The short notice wouldn’t have been so bad on its own, but the act contains no grandfathering rule for existing arrangements, meaning deferred compensation plans or employment contracts from earlier years fall under these new rules. Many practitioners are hoping Congress will pass a follow-up technical corrections bill that either includes a grandfathering provision or at least allows the IRS to consider one.
Covered Employees
The excise tax applies to the five highest-paid employees (or former employees) of the credit union in a given year—the “covered employees.” While this seems simple enough, the list of covered employees also includes anyone who was one of the five highest-paid employees for any preceding year starting in 2017, even if they are not one of five highest-paid employees in the current year.
There is no threshold earnings requirement before becoming a covered employee.
This creates a “once-on, always-on” list of current and former employees that must be maintained indefinitely. For example, if a credit union’s CEO is its highest paid employee in 2018 (even if she never earns more than $1 million a year), then retires and receives nothing for five years, then receives a $1.5 million lump-sum deferred compensation payout in 2023, she would be a “covered employee” and trigger this rule, creating a $105,000 tax paid by the credit union.
Counting Compensation
After determining their covered employees, credit unions need to calculate the amount of compensation paid to those employees.
This generally includes everything on the employee’s W-2. Specifically, the new rules count all wages, including salary, bonuses, taxable fringe benefits, etc. They also include amounts taxed under Section 457(f), covering most deferred compensation plans and requiring the value of benefits to be taxed upon vesting, even if not paid until later.
It's unclear where credit union 457(b) plans fall. The law arguably can be read to include 457(b) balances as they vest or when they are distributed. Again, many practitioners are hoping Congress or the IRS will clarify.
Certain pay is excluded, like employee Roth deferrals and 401(k) distributions. These types of pay aren’t counted when determining whether a covered employee receives more than $1 million a year or in calculating the tax if the employee receives over $1 million.
Excess Parachute Payments
The new tax also kicks in if any covered employee receives an “excess parachute payment,” which is essentially a severance payment that exceeds three times the employee’s average pay over the preceding five years. They do not have to reach $1 million before becoming subject to the tax.
Like the $1 million excise tax, certain types of pay are excluded, even if they are paid upon the employee’s termination, including distributions from 401(k) and 457(b) plans. (Unlike the $1 million excise tax, the language excluding 457(b) distributions is clear here.)
Planning Ahead
All credit unions, regardless of whether they pay anyone over $1 million, should immediately determine who was a “covered employee” for 2017, who is likely to be covered in 2018 and whether any current pay arrangements could trigger one of the new excise taxes. They should also create a running list of individuals who are covered employees for reference in future years.
CUs also should factor in these new rules—including the entire life cycle of the agreement or plan—when negotiating new employment agreements or deferred compensation plans.
Robert Q. Johnson is a Member in the Employee Benefits practice group at Kaufman & Canoles. He helps employers and self-employed individuals navigate the entire spectrum of employee benefits and executive compensation fields. Johnson works alongside private, governmental and tax-exempt employers and plan sponsors to create and maintain qualified retirements plans, nonqualified deferred compensation plans, and health and welfare plans. He also provides broad compensation counseling and plan drafting for companies needing to attract and retain key employees and executives. Johnson provides comprehensive ERISA advice and, if problems arise, guides employers and plan sponsors through self-compliance efforts, correction procedures and audits. Reach him at (757) 873-6318 or rqjohnson@kaufcan.com.
