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A Better Partnership


May 2019
May 01, 2019

Unexpected New Tax Applies to Certain Highly Compensated Employee Pay

What: A new federal tax law imposing a 21% excise tax on pay to certain employees is surprising many employers. This tax may apply to any of the following:
  • Nonprofit employer
  • Governmental employer
  • For-profit employer related to a nonprofit or governmental employer

When/Why: Federal tax legislation passed in late 2017 added Code Section 4960 to impose this tax. It is currently effective and the IRS has issued two lengthy pieces of guidance interpreting it. Now the IRS is working on proposed rules.

Who: The tax generally applies to pay of certain current or former highly compensated employees (HCEs) in two situations:
  1. Pay upon a separation from service of more than three times an employee’s average pay for the past five years, if there is an argument the separation is involuntary (referred to as an excess parachute payment), or
  2. If the employee earns remuneration of more than $1 million for the year.

If any employee earns, or has earned, over the dollar limit ($125,000 for 2019, indexed in future years), that employee could be an HCE whose pay is subject to the tax. Employers with more than five HCEs, generally only have to track the top five per year.

Amount: If the first situation occurs, the employer must pay a tax on amounts above one times the employee’s average pay. The tax applies to amounts above $1 million in the second situation.

Examples: Some examples of situations where the tax could apply, but might be unexpected, include:
  1. For-profit employer that jointly employs an employee with a nonprofit entity (e.g., a foundation),
  2. Nonprofit entity with no employees earning close to $1 million, but paying severance of more than three times average pay, and
  3. Governmental employer that has a 501(c)(3) letter and an employee whose total compensation and benefits package tips over $1 million in a year due to a 457(f) bonus vesting.

Next Steps:
  • Review existing arrangements that may be subject to the new law with benefits counsel to determine whether the tax may apply and what processes need to be put in place. It may be possible to make changes at this time to avoid the imposition of the tax.
  • All new arrangements should be designed taking the potential excise tax into account.
  • Potentially affected employers need to adopt a process for tracking their top five HCEs.

If you have any questions regarding this bulletin, please feel free to contact Tony Kolenic, Heidi Lyon or any other member of Warner's Employee Benefits/Executive Compensation Practice Group.

Note: This explanation is to help our clients determine whether to seek a review of their existing employment arrangements and processes. It is not intended to be a precise, technical description of the new law (which has many nuances and must be analyzed based on specific fact patterns).

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