The tax reform law signed by President Trump just before Christmas means nonprofit organizations are in for some surprises.
Though it might yet prove fiscally irresponsible, the new tax law has been lauded by many not only for its tax cuts for corporations and individuals, but also for the fact that its expanded standard deduction has simplified tax planning for many, making itemizing of tax returns unnecessary beginning in 2018.
But the Tax Cut and Jobs Act hasn't simplified things for nonprofit organizations. Far from it. It's made things much more complex and, potentially expensive, especially when it comes to paying top leaders.
The new law, broadly, imposes a 21% excise tax on the amount of compensation that exceeds $1 million a year on the organization's top five executive salaries. But it's not that simple.
Many nonprofits don't know how far their tax liability might yet reach, say two attorneys who have studied the law's effects on nonprofit executive compensation.
In subsequent years, many more executive salaries could be ensnared in the excise tax net.
"This provision, this 21% excise tax, once you start getting into it, is not going to be an easy provision to comply with," says Jacqueline Henson, an attorney and specialist in tax-exempt organizations with the Washington, D.C., office of the Baker Donelson law firm. "It will make life difficult not necessarily for the largest of the largest organizations, but for the mid-sized. I don't think nonprofits know what's going to hit them yet."
Leveling the playing field?
The new excise tax was an attempt by Congress to curb some of what many find egregious compensation levels (see college football coaches) for what are supposed to be charitable organizations.
Therefore, Congress mirrored the nonprofit excise tax on a similar tax that applies to public for-profit companies.
But the law will ensnare many more than just the biggest nonprofits.
"On the surface, it looks like you're lining them up to compete on a level playing field [with for-profits] but that's not really what's going on," says Bill Robinson, an attorney with Baker Donelson, who specializes in compensation and benefits. "The mid-size nonprofits, who may pay a million in compensation, might be competing with private companies, who aren't subject to this rule, and that puts these folks at a disadvantage."
The threat of a 21% excise tax also makes it more difficult to compete for even the larger nonprofits, both attorneys say, but while it's too early to tell whether it will have much impact on salaries for the top executives who run those organizations, it is likely to materially increase tax bills for nonprofits.
But here's the catch: The tax doesn't only apply to the top five, and it's not just limited to salaries. It could touch many more people.
A running list
Initially, the law covers the top five paid employees of the entity. But those covered employees just scratch the surface, says Robinson.
"Once you become a covered employee, you're always a covered employee," he says.
Nonprofits will have to create an initial list of the top five but, thereafter, they will have to track compensation subject to the tax with a "running list" of covered employees.
"It might be five one year, and 10 the next year," says Robinson.
That's largely for one key reason: deferred compensation.
An organization might have employees who, for example, have never made more than $200,000 in a single year, but, who, after leaving employment, have a deferred compensation agreement that says if they're still alive five years after retirement, the nonprofit will pay them $1.5 million in deferred compensation.
It's subject to a lot of variables but "five years later, bang, this jumps forward, and you have to pay 21% excise tax on everything over a million," says Robinson.
One caveat about the law is the exclusion of licensed medical or veterinary medical professional compensation tied to the provision of services.
But this will cause other headaches in tracking how much time and what percentage of a medical professional's salary (think chief medical officers) comes from providing medical services, if any.
Targets on their backs
Other parts of the legislation also show that nonprofits were marked with a bull's-eye during its creation, says Henson.
"Eighty percent of charitable contributions are made by people who itemize," she says.
So how is that going to affect their giving to hospitals and other healthcare-related charities, among others?
It probably means an estimated reduction for those who itemize charitable deductions from 37 million tax units to about 16 million.
Those who don't itemize don't have a tax incentive to give to charity, so nonprofits should prepare for fewer and lower levels of contributions.
"It doesn't make your life easier if you're tax-exempt," says Henson.
Not only does the law add an operating burden to tax-exempt organizations, but it also adds a compliance burden. They will need to seek benefits and compensation law services, which also adds cost.
Some people will be studying the law to try to figure out how not to bump up against the million-dollar level, and they will doubtless come up with some strategies.
One idea would be to rearrange their corporate structure so that the nonprofit entity only pays the base salary, and other organizations which the nonprofit doesn't control, such as a joint venture, might pay compensation that wouldn't have to be included in the 21% excise tax analysis.
"That could be one possibility, but the entity gives up a little control," says Henson. "I expect people to take a look at their entire corporate structure. Hospitals and health systems certainly have the monkey on their back; universities, too."
Philip Betbeze is the senior leadership editor at HealthLeaders.