When the Tax Cuts and Jobs Act passed into law at the end of 2017, it contained a new 21% excise tax for the highest paid executives at nonprofits—if they earn more than $1 million, that is.
Known as Section 4960, this small provision of the much larger package raised plenty of questions, particularly within the complex world of healthcare.
"This tax is going to hit a lot of organizations and organizations are going to have to be concerned about it, know these rules and be ready to make these kinds of calculations," said Ralph DeJong, a partner at law firm McDermott Will & Emery LLP who advises on the compensation, executive benefits and employee benefits of tax-exempt organizations.
A 92-page report clarifying many of those questions was released recently just as many of those organizations are preparing to calculate their own tax liability under the law.
FierceHealthcare chatted with DeJong about the answers to some of the biggest questions for nonprofit health organizations when it comes to Section 4960.
Question: What are the details? How are covered employees going to be determined?
Specifically, the section says the 21% excise tax is on "remuneration" that exceeds $1 million to the top five highest compensated individuals of an organization.
“The tax will be due by the 15th day of the fifth month after the employer’s taxable year ends,” DeJong said. “Organizations will have to apply their good faith reasonable interpretation with the help of their tax advisers and figure out this excise tax.”
There's also a golden parachute aspect to these rules, he said. "The same tax applies if an organization pays a parachute payment to someone that is more than three times what their average total compensation was over the preceding five years even if that amount is less than $1 million."
For example, if a top paid employee is paid an average of $150,000 a year and receives a parachute payment at the separation of service of more than $450,000, the amount over their annual compensation of $150,000 will be subject to the same tax.
Question: For a health system, does this just apply to top executives of the system or to the top executives of each of its entities such as its individual hospitals?
One general rule of thumb here is: If your organization has to file a 990, it likely has to file the tax.
“If they are related to each other by more than 50% control—where you have a parent organization that controls more than half of the governing board of various entities, whether those are hospitals or foundations or other kinds of operating entities—then all of them are related to each other,” DeJong said. “They all share the liability for this tax if someone is being paid by more than one organization. Each has to calculate their own five highest paid individuals separately.”
Question: And when it comes to compensation or “remuneration” that is subject to the tax, what does that encompass?
If it’s considered wages subject to federal income tax withholding at the time of payment, it counts, DeJong said. There are a couple of implications to that, he said.
“There are certain forms of benefits that will not be included [under the tax] such as qualifying retirement plan benefits, amounts under a 457B deferred compensation plan. But organizations may want to review their tax positions if they have previously followed the interpretation that fringe benefits are excluded from taxable income."
Another scenario to consider is if someone in a leadership position is serving as an independent contractor rather than as an employee. “Even if it's a large amount which would otherwise be subject to this tax, it doesn’t fall within the scope of this tax. It’s only for employee services because pay to an independent contractor is not wages subject to federal income tax withholding at the time of payment.”
Question: Will there be any grandfather rules or transition rules? For instance, if an executive technically earned the compensation years ago but still hasn’t collected, would that be subject to the tax?
There is some unusually good news here for impacted organizations: The IRS provided an exclusion for amounts that vested prior to the effective date of the statute.
“They are applying the same concept that applies to deferred compensation arrangements: If an amount of deferred compensation or any kind of remuneration, if it was no longer subject to a substantial risk of forfeiture, if it was effectively vested before the statute became effective, then it’s not subject to the tax,” he said. “That’s a good grandfather rule or transition rule for healthcare systems.”
Question: But one of our highest paid employees is a physician whose compensation is coming from a number of different sources—not compensation directly for their work seeing patients. Is there an exclusion?
There is a piece of bad news for health organizations and physicians, he said. Put simply: There are no exclusions for them based on what they are being paid for.
That means if a physician is performing any kind of administrative service, any kind of supervision, any kind of medical administrative service, any type of clinical administrative service—and even if those services can be performed only by a licensed and trained physician—it is not excluded from the scope of the tax.
"That’s a rather simplistic view of how physicians get paid," DeJong said. "Physicians are doing work on quality of care, on protocols of care, on admission and readmission standards for hospitals. A lot of things that are critical to the delivery of care but may not be provided to a patient standing in front of them. All of those services will end up being counted for purposes of this tax."
Questions: Are there any actions healthcare organizations can take to limit their liability under this tax?
They might want to think about organizing themselves a bit differently, DeJong said.
"I think if organizations want to stop the growth of their cumulative covered employee group over time, a system of interrelated organizations should look seriously at combining or consolidating their payrolls so they don’t have multiple organizations with multiple payrolls and multiple groups of covered employees," he said. "That’s something that a lot of organizations have been looking at but may not have grasped the necessity for doing that until this guidance came out and made it a pretty clear priority."