On January 19, 2021, the Internal Revenue Service (IRS) published the final regulations of the Internal Revenue Code (IRC) Section 4960 of the Tax Cuts and Jobs Act of December 2017. Section 4960 imposes a 21 percent excise tax on an “applicable tax-exempt organization” (ATEO), or a related organization, if that ATEO pays (1) remuneration in excess of $1 million to a “covered employee,” one of the top five highest-paid employees at the organization, or (2) parachute payments in excess of three times the base salary of a covered employee. These regulations will apply for tax years starting after December 31, 2021. See the copy of the final regulations, which varied from the proposed regulations in a few minor ways, here.
A summary of the key take-aways from the final regulations and how they may impact executive compensation practices follows:
- No Grandfathering: The 21 percent excise tax under Section 4960 will apply to compensation that has been paid or becomes vested during taxable years starting after December 31, 2017, the year Section 4960 was passed. The IRS rejected proposals for grandfathering contracts existing before this date.
- Review Aggregate Compensation: ATEOs may pay covered employees through multiple entities of their organization or through “related organizations” (where the threshold for relatedness is 50 percent). Under the final regulations, the compensation a covered employee receives through all entities or related organizations is aggregated in the remuneration calculation. If this aggregate amount exceeds $1 million, the ATEO will pay a 21 percent excise tax.
- Once Covered, Always Covered Rule: Under this rule, once an individual has been identified as a “covered employee” of an ATEO, this status stays with them indefinitely, even after retiring from the ATEO. As a result, any backloaded arrangements to defer compensation to a covered employee shortly past the date of retirement is still subject to the $1 million cap. In addition, payment for service at a related ATEO is counted. As an example, suppose a former covered employee of a tax-exempt entity works for a related organization after such employee’s retirement from the prior entity. Future remuneration paid for service at the related organization would be subject to the $1 million cap.
- There are two exceptions to this rule: (1) nonexempt funds exception and (2) limited hours exception. These exceptions are meant to help ATEOs avoid paying the excise tax on behalf of their employees who provide them with limited services.
- Under the “nonexempt funds” exception, an employee’s time spent providing service to the ATEO over the applicable and preceding year must not exceed 50 percent of their total service time to the related organizations during that same period.
- Under the “limited hours” exception, an employee’s time spent providing services to the ATEO over the applicable year must be less than 10 percent of their total time for the related organizations during that same year.
- Special Timing Rule for Remuneration: This new rule states that deferred compensation must be included in the remuneration calculation the year it is vested (i.e., when the remuneration is no longer subject to a substantial risk of forfeiture), rather than the year it is paid out. For instance, if a covered employee is granted a $1 million dollar retention bonus that has a service requirement of five years, the bonus will be counted as remuneration in the fifth year. Alternatively, if the retention bonus vests ratably at $200,000 each year for five years, $200,000 will be counted as remuneration in each vesting year until the full retention bonus is fully vested.
- Remuneration Excludes Pay for Medical Services: The remuneration calculation disregards compensation that hospitals pay to doctors and nurses for medical services. Therefore, the “medical services” portion of compensation to a “covered employee,” such as Chief Surgeon, is not accounted for in the remuneration calculation. In contrast, compensation that is paid for an employee’s administrative services is included in the remuneration calculation.
- Split-Dollar Life Insurance Arrangements: Under the new regulations, ATEOs, especially those that are private foundations or Section 509(a)(3) supporting organizations, are cautioned from entering into split-dollar life insurance arrangements with their covered employees. Such loans to certain employees “may constitute an act of self-dealing under Section 4941 or an excess benefit transaction under Section 4958(c)(3).” The new regulations consider this type of compensation as a part of the renumeration calculation. De minimus loans, or loans under $10,000, are an exception.
One of the surest signs of spring — perhaps more so in our variable-weather world than flowers budding and geese flying north — is the onslaught of news stories about executive pay packages. Each spring, public companies release compensation data for the top five named executive officers, and the news stories quickly follow. Who is the highest paid CEO? Is pay really linked with company performance? Whose equity grants are worth the most? While public companies occupy the limelight and set the standard for what people think about executive pay, the number of United States-based public companies have declined to about 3,600. Private companies and nonprofits outnumber their publicly-traded peers, and offer compelling executive pay packages without fanfare and without publicly-traded stock. While the lack of publicly-traded stock creates challenges, particularly with regard to long-term incentives (LTIs), private companies and nonprofits can use a number of strategies to develop thoughtful and creative executive pay programs, and deliver competitive compensation.
Originally published in the June/July 2020 edition of WorldAtWork’s WorkSpan magazine.
The full article can be viewed in the PDF download.
Short-term incentive (STI) plans remain a prevalent practice at nonprofit and government organizations, according to a recent survey by CAP and WorldatWork. According to “2019 Incentive Pay Practices: Nonprofit/Government Organizations,” 68-percent of nonprofit and government organizations have STI plans. However, when nonprofits are broken out separately from government organizations, the prevalence rises to 76 percent.
Other key survey takeaways include:
- STI spending at nonprofits as a percentage of operating budget is two percent at median for 2019, which is slightly less than the 2.3 percent reported in 2017.
- Median 2019 target award levels at nonprofits remained steady across position levels: 40 percent of salary for the CEO, 25 percent for other executives/officers, and 10 percent for managers/supervisors.
- Long-term incentive (LTI) plans are used by a minority of respondents, with 22 percent reporting an LTI plan in 2019 (vs. 24% in 2017).
- The most common type of LTI plan is a long-term, cash-based incentive plan.
The full results of the nonprofit/government survey are available to WorldatWork members.
Short-term, cash incentives continue to dominate the incentive-pay landscape at nonprofit/government organizations according to salary and compensation survey research released in May 2018 by WorldatWork in partnership with Vivient Consulting.
“U.S. nonprofit organizations continue to make significant use of short-term cash incentives to motivate and reward employees. Long-term incentive (LTI) use is still a little-used compensation element, but prevalence increased modestly in 2017 and may signal an emerging trend,” said Bonnie Schindler, partner and co-founder of Vivient Consulting.
Additional Key Findings from the WorldatWork-Vivient Survey
Nonprofit/Government Compensation Survey Results:
- Nonprofit and government organizations favor simplicity by offering a limited number of STI plans. Of the respondents, more than 75% reported having three or fewer STI plans in place.
- By far, the most common type of STI plan at nonprofit and government organizations continues to be an annual incentive plan (AIP). However, prevalence of AIPs dropped to 77% in 2017 from 86% in 2015
The compensation survey Incentive Pay Practices: Nonprofit/Government was conducted in December 2017 among WorldatWork members. The salary and pay survey is the third edition for nonprofit/government entities with the last report data released in 2015.
In the last few weeks, we’ve seen mainstream media highlight the competition for talent at tax-exempt organizations. The Wall Street Journal reported that CEO pay at tax-exempt organizations increased in aggregate by a third from 2011 levels. While this increase can be explained in part by the economic rebound of these organizations since the Great Financial Recession, there are larger factors at work.
Complexity and organization size, two main drivers of executive compensation in the for-profit world, apply to tax-exempt organizations as well. From a complexity standpoint, tax-exempt CEOs must simultaneously attend to multiple priorities and constituents. They have a tough balancing act managing multiple stakeholders’ interests to achieve the organization’s mission. This visible position must serve his or her community, court donors, navigate the political landscape, handle the press, and fiscally steward the organization. In contrast, Fortune 500 CEOs’ primary focus is to satisfy shareholders’ financial expectations (with other demands being subordinate). Further, the number of executives with the experience of successfully leading significantly-sized tax exempt organizations is limited. As a result, the talent pool is small, and the demand for them is fierce. For example, the Los Angeles Times just reported that the storied but financially struggling New York Philharmonic hired Deborah Borda as its new CEO with the expectation that she can sprinkle on it the “same magic” she did during her tenure at the Los Angeles Philharmonic.
The structure of compensation reflects this intense demand for talent, as well as the strategic planning and economics of these tax-exempt organizations. The typical tax-exempt CEO receives a base salary and a bonus opportunity, which is prevalent in three-quarters of such organizations according to Vivient Consulting’s survey. Some organizations also provide longer-term financial arrangements that serve as a retention hook and provide financial security in retirement. Most large tax-exempt organizations have multi-year strategic objectives (such as passing important legislation, multi-year capital campaigns, etc.) and want to focus their top executive on the extended time horizon required to create lasting legacies. However, unlike for-profit companies, there is no equity compensation available. As a result, long-term incentives need to be designed to reflect both mission and fiscal success, incorporating qualitative and qualitative measures that support these organization’s values and mission.
From a governance standpoint, we find that CEO pay at larger tax-exempt organizations is governed in an independent and structured process that mirrors that of for-profit companies. In our experience, independent Boards of Directors spend a significant amount of time and attention to the reasonableness, fairness, and pay-for-performance (defined more broadly to include the achievement of the organization’s mission) of CEO compensation. This is not surprising as sophisticated businessmen and women who sit on these organizations’ boards of directors bring their independence and expertise to the pay discussion. Further, the boards are careful to maintain good governance process over CEO pay decisions in order to maintain the “rebuttable presumption of reasonableness” and avoid IRS intermediate sanctions.
With increased demand for talent, we see more cross-over of executives and compensation practices between tax-exempt and for-profit organizations. Thoughtful compensation practices and programs grounded to the organization’s mission and economics can help retain and motivate these uniquely skilled executives.
Principal Bonnie Schindler discusses the compensation survey research conducted by Vivient and WorldatWork around incentive pay practices for private, non-profits and government entities.
In November 2015, Vivient Consulting and WorldatWork invited a sample of WorldatWork’s non-publicly traded members to participate in their “Incentive Pay Practices: Nonprofit, Government Organizations” compensation survey. More than 125 nonprofit and government organizations representing state, local and federal government entities, charitable and education organizations participated in the survey. This compensation survey updates the original survey completed by Vivient and WorldatWork in 2013.
The new 2016 compensation survey research shows that short-term cash incentives and bonus programs continue to dominate the incentive-pay landscape as a vast majority of organizations use and rely on incentive-based pay practices to recruit, motivate and reward employees.
Vivient’s Bonnie Schindler reports: “Nonprofits and government organizations report their annual incentive plans are more effective than their for-profit counterparts — a sign that incentives are leveling the playing field for all organizations competing for top talent.”
Key Findings from the 2016 Compensation Survey for Nonprofits and Government Organizations
- In 2015, more than 75% of nonprofit and government organizations favored simplicity by offering three or fewer short-term incentive plans.
- While government incentive-pay budgets remain modest, nonprofit budgets have increased significantly. Nonprofit, short-term incentive budgets are starting to approach the levels reported by the private, for-profit organizations.
- More than 80% of nonprofit and government organizations said their AIPs were effective at achieving their objectives.
- Of the nonprofit/government organizations with AIPs in place, 65% reported the programs are used to reward employees while 62% use the incentives to focus employees on specific organizational goals.