Benefits review for nonprofit executives
The compensation arrangements for senior management of an exempt organization are often quite complex in their scope and makeup. In addition to the normal benefits, such as qualified retirement plans and health plans, provided to all employees of an organization, senior management often receives additional nontaxable and taxable benefits. The additional benefits provided to senior management can include items such as nonqualified deferred compensation plans, life insurance benefits, spousal travel benefits, club memberships, housing and tuition remission. Each of these benefits should be reviewed on a regular basis to ensure the proper tax treatment is being applied to the value of the benefits being provided.
Nonqualified deferred compensation plans
The nonqualified deferred compensation plans of exempt organizations normally fall under either section 457(b) or section 457(f). The plans defined in these federal tax code sections are to be limited to participants who are highly compensated employees or groups of executives, managers, directors or officers of the organization. The plans may not cover rank-and-file employees.
Section 457(b) plans
A section 457(b) plan is available to governmental units or entities exempt under section 501(c). Plan assets are not held in trust for the employee but remain the property of the employer and are subject to the claims of creditors of the organization. There are specific deferral limits for a section 457(b) plan. The limits are the same as the employee elective deferral limits for section 401(k) plans and section 403(b) plans ($17,500 for 2013). Organizations should review deferral amounts to make sure the deferrals fall within the allowable range. Age 50 catch-up plan contributions are not available for nongovernmental plans. For nongovernmental plans, special catch-up contributions are available within three years of normal retirement age (the age as specified in the plan document, but no later than age 70 1/2) if permitted under the plan. The catch-up rules for nongovernmental plans limit participation to those who have not previously deferred the maximum amount into the section 457(b) plan in prior years. The catch-up is limited to prior unused amounts up to the lesser of (1) twice the annual limit ($35,000 for 2013), or (2) the basic annual limit plus the annual limit not used in prior years. Organizations should review deferral amounts to ensure the deferrals are within the allowable amounts under section 457(b). Excess deferrals, if caught early enough, can be corrected. If the excess deferrals are not corrected, the benefits will be taxed under the section 457(f) plan rules.
In general, the annual deferral of amounts of a section 457(b) plan should be made (but are not required to made) subject to FICA and Medicare taxes (payroll taxes). If the deferrals are made subject to payroll taxes, then upon payment of the 457(b) plan amounts to the participant, the payment will be subject to income tax but not subject to payroll taxes. If, on the other hand, the deferrals are not made subject to payroll taxes at the time of deferral, the payment to the participant will be subject to both income taxes and payroll taxes. Organizations should review how deferrals to their plans are being handled in regards to payroll taxes.
Section 457(f) plans
A section 457(f) plan is a nonqualified retirement plan that gives the tax-exempt employer an opportunity to supplement the retirement income of its select management group or highly compensated employees. A section 457(f) plan is usually established as a way of retaining executives, officers and select groups of highly compensated employees through the provision of supplemental retirement benefits. Sometimes called “golden handcuffs,” such plans stipulate certain periods of service be met in order to receive the additional amounts of compensation. Assets are owned by the institution, subject to the claims of the institution’s creditors, and normally invested as determined by the institution and the executive.
A section 457(f) plan is subject to section 409(A), a federal tax code section that was established to set very strict rules as to the operation of the nonqualified deferred compensation plans. As such, all amounts deferred under the section 457(f) plan will be includable income to the extent not subject to a substantial risk of forfeiture unless the plan meets certain restrictions set forth in section 409(A). Property is subject to a substantial risk of forfeiture if the individual's right to the property is conditioned on the future performance of substantial services or on the nonperformance of services. In addition, a substantial risk of forfeiture exists if the right to the property is subject to a condition other than the performance of services and there is a substantial possibility that the property will be forfeited if the condition does not occur. Employers had until Dec. 31, 2008, to amend plan documents to comply with section 409A and the final regulations issued thereunder.
Organizations should review the current documentation concerning any section 457(f) plans that are in force to confirm that the deferrals are following the schedule set out in the plan document. In addition, the review should focus on whether there has been a lapse in the substantial risk of forfeiture that will require the recognition of taxable income by an executive of the organization. Further, the organization should review the plan document to ascertain if, in the near future, a substantial risk of forfeiture will lapse. The lapsing of the substantial risk of forfeiture results in taxable income to the participant in the plan. If the lapse will occur in the near future, the organization should develop a plan with the affected executive as to the timing, withholding and place of payment from the section 457(f) plan. In addition, since these amounts are often substantial, the organization should determine the language that will be required as part of the reporting of the payment on Form 990, Schedule J, Part II, Page 2. In addition, this disclosure should be included in Schedule J, Part III and include the name of the executive benefiting under the plan, as well as amounts paid to said executive, including the terms and conditions.
Life insurance benefits
Under section 79, group term life insurance (GTLI) premiums are excluded from the income of an employee where the cost of coverage under the plan does not exceed $50,000. The employer is required to include in the taxable income of the employee the cost of the coverage that exceeds $50,000. The plan cannot discriminate in favor of key employees. A key employee is an officer of the employer with annual compensation in excess of $165,000 (for 2013), a more-than-5-percent owner or a more-than-1-percent owner who has compensation in excess of $150,000. Nondiscrimination testing would have to be performed to determine if the GTLI coverage is discriminatory.
If an organization is paying the premiums on a life insurance policy owned by the organization's top executives, or where insurance benefits are payable to a beneficiary other than the organization, the amount of the premium is required to be reported as taxable income to the top executive. If, however, the organization is paying the premiums on a life insurance policy covering the executive’s life and the organization is the owner and beneficiary under the plan (a key-person life insurance policy), those premiums are not includable in the executive’s taxable income.
Organizations should review GTLI policies and confirm the inclusion in taxable income of premiums related to coverage greater than $50,000. In addition, nondiscrimination testing should be performed periodically to insure the organization's GTLI program complies with the nondiscrimination rules of section 79. For those policies other than GTLI and key-person policies, organizations should confirm that premiums being paid on behalf of the executives in question are being properly picked up in the taxable income of the executives, if required.
Spousal travel benefits are often provided to the executives and board members of an organization. The IRS has set stringent rules regarding when spousal travel shall be excluded from the taxable income of an employee or board member of an organization. Spousal travel is excludable from the executive's income only in those cases where the travel of the spouse (or dependent) is for a bona fide business purpose and the expenses can be substantiated.
The IRS has set a rather high bar regarding the bona fide business purpose income exclusion for spousal travel. The IRS has made clear that where a spouse (1) is only "expected to attend," (2) provides incidental business services, (3) attends receptions, (4) participates in group tourist activities and (4) is only beneficial, not essential, to the function, the expenses for the spousal travel should be included in the income of the executive. On the other hand, where the organization can show that the spouse (1) is required to attend meetings, (2) gives presentations at meetings, (3) officially hosts an event where the spouse is responsible for planning the event and (or) (4) dedicates time in a substantive way to the organization's business and not to personal activities, the cost of the spousal travel should fall under the bona fide business purpose exclusion.
When considering the exclusion of spousal travel from the executive’s pay under the bona fide business purpose exclusion, an organization should ensure the existence of sufficient documentation and descriptions to support the position that the spousal travel was for a legitimate business purpose and thus excludable from income. The bar is set very high in this area, and formal documentation, not rationalization, is required to keep this benefit from being treated as taxable income.
Club memberships cover all types of clubs, including social, athletic, sporting, luncheon, airline, hotel and "business" clubs. Some organizations pay the club dues on behalf of the executives of the organization. The tax treatment of the club dues is based on the use of the club. If the dues are for membership to a club that is used for business purposes, the dues associated with the business use percentage of the club are not included in the executive’s income. The dues associated with the nonbusiness use percentage are included in the taxable wages of the executive. If, however, the reason for club membership is recreational or personal in nature, with no business use of the club occurring, those dues are includable in full in the income of the executive benefiting from the membership. Further, if the club membership is distributed to a departing executive, the value of the membership is treated as taxable wages to the executive. Reg. section 1.132-5(s) covers the application of the rules concerning club dues and provides examples where less than 100 percent of the use of the club is for business use.
Organizations should ensure that any club memberships provided to an executive are provided for a business purpose. Further, the business and nonbusiness use needs to be tracked. Any nonbusiness use of the club should be documented and treated as taxable income to the executive.
Housing can be treated as a nontaxable benefit, a taxable benefit or a taxable benefit subject to specific rules. Section 119(a)(2) provides that there shall be excluded from the gross income of an employee the value of any lodging furnished to the employee, the employee's spouse or any of the employee's dependents by or on behalf of the employer for the convenience of the employer, but only if the employee is required to accept such lodging on the business premises of the employer as a condition of employment. Failing any one of these tests (i.e., the convenience of employer, requirement of acceptance or the business premises tests) will result in the housing benefit being considered taxable compensation.
Educational institutions that provide a housing benefit are afforded a second test under section 119. Section 119(d)(1) provides that in the case of an employee of an educational institution, gross income shall not include the value of qualified campus lodging furnished to such employee during the taxable year. Section 119(d)(3) provides that the term “qualified campus lodging” means lodging to which section 119(a) does not apply and which is located on, or in the proximity of, a campus of the educational institution and furnished to the employee, his spouse and any of his dependents by or on behalf of such institution for use as a residence. It should be noted that this definition does not include a requirement to pay rent or reference a minimum amount of rent to be determined and utilized in applying section 119(d)(1). Section 119(d)(2) provides for income to be included in the compensation of those employees of an educational institution who pay inadequate rent to it. Specifically, it provides that the exclusion from income shall not apply to the extent of the excess of the lesser of (i) 5 percent of the appraised value (safe harbor amount) of the qualified campus lodging, or (ii) the average of the rentals paid by individuals (other than employees or students of the educational institution) during such calendar year for lodging provided by the educational institution which is comparable to the qualified campus lodging provided to the employee, over the rent paid by the employee for the qualified campus lodging during such calendar year.
Organizations should review the employment contracts of the individuals receiving the housing benefit and compare the aspects of the benefit to the requirements outlined in section 119(a)(2). If an organization is an educational organization and the housing benefit does not conform to section 119(a)(2), the organization should also review the housing benefit provided and compare it to the rules in section 119(d)(1).
Section 117(d) provides that any qualified tuition reduction is excludable from gross income. A qualified tuition reduction is the amount of any reduction in tuition provided to an employee of an education institution for education below the graduate level at such organization. Under section 117 (d), neither the educational institution as an employer nor the employee pays federal income tax on the amount paid by the institution for tuition expenses. This lowers the federal tax liability of the employee. The income exclusion applies to tuition paid for education below the graduate level (including K-12). Section 117(d)(3) states that the tuition remission must not discriminate in favor of highly compensated employees. The limitation used for the definition of a highly compensated employee for 2013 is $115,000.
If an organization's tuition remission plan discriminates in favor of highly compensated employees, those highly compensated employees receiving the tuition benefit will be taxed on the full value of the benefit, not just the amount greater than the benefit provided to others who are not highly compensated employees. However, the fact that the tuition remission plan discriminates in favor of highly compensated employees will not cause the tuition benefit given to employees other than highly compensated employees to be treated as a taxable benefit.
Education institutions providing tuition remission benefits should evaluate the benefits provided under the plan. If the plan does discriminate in favor of highly compensated employees, the value of the benefit should be treated as taxable income to the employees and reflected on the employees’ Forms W-2. The educational institution should take care in setting benefit classification levels under such a plan to ensure that such a classification level does not only contain highly compensated individuals.
Reviewing the organization’s benefits package on a routine basis should be on every finance department’s “to do” list. This is especially the case when a new benefit is offered, a new employee is hired under a contract or an existing employee contract is renegotiated. Routine reviews can ensure that tax laws are being appropriately followed, and if an oversight is uncovered in the application of a tax law, corrective action can be taken before nonaction becomes a large tax liability issue for the organization and/or for the employee. To ensure compliance with applicable tax laws, organizations should work with their tax advisors to conduct periodic reviews of existing employee benefits packages.