Deferred compensation for tax-exempt organizations: Tax and 990 reporting issues to consider
It is common practice for tax-exempt organizations to provide deferred compensation to their employees, in part to attract and retain top talent, and to remain competitive in the marketplace. Deferred compensation plans may take many forms, including retirement plans and pensions, and there are many unique tax and other issues associated with setting up and maintaining deferred compensation arrangements.
Deferred compensation plans are basically divided into two types: qualified and nonqualified. This article discusses some of the common tax issues associated with nonqualified deferred compensation arrangements and possible areas of concern for tax-exempt employers.
Nonqualified retirement plans are used to provide supplemental retirement benefits to a select group of management or highly compensated employees. These plans are typically designed so that they are not subject to the requirements of the Employee Retirement Income Security Act of 1974 (ERISA). Special rules under Internal Revenue Code (IRC) Section 457 apply to nonqualified plans established by not-for-profit employers. If the plan meets the requirements of IRC Section 457(b), which includes a limitation of the amount of the annual contributions, no federal income taxation is imposed unless and until such time as the benefits are paid out. Conversely, and often used in conjunction with a Section 457(b) plan, an IRC Section 457(f) plan imposes no limit on contributions; however, the benefits under a Section 457(f) plan are taxable for federal income tax purposes at the earliest time they are not/no longer subject to a “substantial risk of forfeiture.” Code Section 409A imposes additional rules on nonqualified plans which are applicable to Section 457(f) plans (but not to Section 457(b) plans), and not-for-profit employers need to be aware of those requirements.
Many tax-exempt organizations are facing increased IRS scrutiny for their deferred compensation arrangements. To address this, there are a number of steps an organization can take to determine the reasonableness of executive compensation and avoid IRS scrutiny and the imposition of penalties under the safe harbor rule of IRC Section 4958 taxes on excess benefit transactions. The requirements to establish a “rebuttable presumption of reasonableness” can be summarized as follows:
- Establish an independent authorized body, such as a compensation committee, that approves the compensation arrangement in advance;
- Obtain and rely on appropriate comparability data, which includes data from similarly sized organizations in similar regions for a similar position; and
- Adequately and timely document the deliberation and decision-making process
Without these formal policies and procedures in place, the IRS could more easily challenge the compensation and even impose penalties. If these procedures are followed, then the organization is entitled to a rebuttable presumption that the compensation provided is reasonable. The IRS can refute the presumption of reasonableness “only if it develops sufficient contrary evidence to rebut the probative value of the comparability data relied upon by the authorized body,” IRS guidance says.
Another consideration in establishing a deferred compensation plan is to structure compensation arrangements to be under the $1 million limit to minimize exposure to the 21% excise tax under IRC Section 4960 on executive compensation. In addition, organizations may avoid the tax on any excess parachute payment by ensuring that any severance agreements do not exceed three times the “base” salary.
Form 990 reporting for deferred compensation presents another area for scrutiny if:
- Amounts that are not yet vested are not properly disclosed;
- Amounts that are vested and no longer subject to substantial risk of forfeiture are not reported as taxable income; and
- Appropriate disclosures are not included for the individuals who participate in deferred compensation arrangements or receive severance payments.
Tax-exempt organizations may be looking at implementing or revising deferred compensation plans as an incentive to retain their top executives – or even offering deferred compensation arrangements to employees other than C-suite employees.
There are many tax implications and issues associated with these types of arrangements. Organizations that do not have formal policies and procedures in place may find themselves at risk of being assessed excise taxes on total compensation packages. Planning strategies, such as spreading out vesting periods of deferred compensation arrangements over several years or minimizing large fluctuations in compensation from year to year, can be implemented to avoid or reduce exposure to the tax on excess compensation, as well as public criticism.
Finally, it’s important for an organization to confirm that appropriate disclosures are included in its Form 990, as it is a public document that may stir up unwanted publicity and scrutiny by the media, watchdog agencies, and even peer organizations if the form does not completely and accurately report any deferred compensation arrangements.
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.
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