Excise Tax, 457 Plans, and Other Non-Salary Compensation In Independent Schools

Organizations in the nonprofit sector have always faced challenges when it comes to competing for top-level leadership talent. Salaries in most tax-exempt organizations tend to be less than the equivalent role in the for-profit sector. As a result, many organizations take a creative approach to structuring attractive compensation packages for key employees, making use of various forms of non-salary compensation. 

However, in the nonprofit industry, the compensation of key employees, executives, and directors is public knowledge, reported each year on Form 990. Organizations should determine a reasonable level of compensation based on an analysis of the salaries of key employees at comparable organizations. At the same time, nonprofits must also carefully consider which elements of the non-salary compensation of key employees are considered taxable. 

In this overview, we explore some of the key forms of non-salary compensation that an independent school might offer key employees such as heads of school, directors of development, or other notable employees. We outline the key considerations that compensation committees must keep in mind to create an attractive compensation package that avoids triggering unnecessary taxes. 

Interested in diving deeper into this topic? This overview is the first in an upcoming series of articles exploring different forms of non-salary compensation in independent schools. Subscribe to the Smith + Howard newsletter to be updated when new articles are published.

Common Types of Non-Salary Compensation for Independent Schools

The compensation of a tax-exempt organization’s key employees must be reported each year on Form 990. This filing includes the base salary of key employees as well as any other compensation they might receive: from housing and vehicle benefits to retirement plans and health benefits. 

The compensation of key employees is an important governance issue. Board compensation committees should strive for a transparent, data-backed process that justifies their decision to award their chosen level of compensation. Depending on the way different elements of this compensation package are structured, nonprofits may face an additional tax burden – one many organizations are keen to avoid.

Below, we outline some of the most common forms of non-salary compensation in independent schools.  

Housing Benefits

Many independent schools offer housing benefits to their key personnel, either providing on-campus housing or accommodation in an off-campus property located nearby. Determining whether housing benefits are a form of taxable compensation can be a tricky issue that requires a nuanced interpretation of the tax code. 

Generally speaking, the question of whether housing benefits are considered taxable benefits boils down to whether the housing is provided for the convenience of the school or the convenience of the employee. Take the example of a teacher at a boarding school who has been given on-campus housing but has nighttime duties to fulfill such as checking dorms and being available to respond to emergencies. The employee’s housing would likely not be deemed a taxable benefit since it benefits the organization, reducing staffing costs and enabling the school to provide care to students. 

On the other hand, if a teacher was given housing benefits with no additional responsibilities, the benefits would likely be considered taxable since they benefit one employee at the expense of others. It’s important to note this is a simplified example: various facts and circumstances guide the determination of whether housing benefits are qualified as taxable benefits. 

Excise Tax

When designing executive compensation packages, independent schools and other nonprofits should be careful to avoid triggering any excise taxes. Excise tax, introduced in the 2017 Tax Cuts & Jobs Act, can be triggered in a couple of different ways. 

If an employee has reportable compensation of $1 million or more, a 21% excise tax applies to the excess compensation above $1 million. For example, if an employee was paid $1.1 million in a calendar year, the nonprofit organization would be required to pay a $21,000 excise tax.

While it is uncommon for leaders of independent schools to receive this level of compensation, several events could trigger this tax. Perhaps the executive vests significant retirement benefits or has a significant accrual of vacation days or sick leave. 

The second way excise taxes can be triggered is through “golden parachute” retirement or severance packages. If an employee makes more than three times their annual compensation (calculated from the average of the previous five years of compensation), excise tax will be assessed. 

Here is an example. An employee earned an average of $400,000 over a five-year period. In year six, they retire, receiving a retirement benefit of $1.5 million. Because the $1.5 million payment is more than three times the employee’s average compensation, the nonprofit must pay excise tax. In this scenario, the tax owed would be calculated by subtracting the five-year base pay from the retirement benefit and applying the 21% excise tax rate, as follows:

($1,500,000 – $400,000) x 0.21 = $231,000

We should note that neither of these scenarios is common, and when they do occur, can usually be mitigated by spreading payments over consecutive years. Nevertheless, proactive planning is important to ensure that your nonprofit does not face an unexpected tax bill. 

457(f) Nonqualified Deferred Compensation Plans

A 457(f) nonqualified deferred compensation plan is a unique retirement planning account offered to the officers and highly compensated employees of tax-exempt organizations. These plans allow nonprofit organizations to make unlimited contributions to a plan that will be paid to key employees upon their retirement. 

These plans provide powerful retention incentives, representing a powerful wealth accumulation tool that enables key employees to build significant wealth. The terms of the plan will be structured by the nonprofit organization’s board compensation committee, which will determine the amount the organization will contribute, the vesting schedule, and other important details. 

When offering 457(f) plans to qualified employees, compensation committees must be careful to structure these plans in a way that mitigates excise tax concerns. Plans should be structured to provide maximum benefit to employees without placing an undue tax burden on the organization. 

Other Forms of Non-Salary Compensation

There are some other notable forms of non-salary compensation that independent schools should consider:

• Tuition: for a tuition plan to be considered a non-taxable benefit, every employee must be given equal opportunity to participate. If treatment is unequal, for example, a head teacher receiving 100% tuition reimbursement while other employees only receive 50%, only the additional 50% reimbursement the head teacher receives would be considered a taxable benefit. 

• Vehicle Allowance: if a vehicle is used exclusively for school business, it is deemed a non-taxable form of compensation, although it would still be disclosed since the organization is paying a lease on the employee’s behalf. If some portion of a vehicle’s use is for personal use, an equivalent percentage of the lease would be considered a taxable benefit. 

• Travel: travel is typically considered an accountable plan or expense reimbursement, but there may be instances where certain types of travel may be considered a taxable benefit. Form 990, Schedule J outlines an organization’s travel policies. Travel related to approved sabbaticals for school employees can have a mixture of taxable and non-taxable treatment depending on the circumstances. Schools must track the business intent and expenses incurred when traveling to determine whether the benefit needs to be included in the employee’s salary. 

Smith + Howard: Experienced Advisors to Nonprofit Organizations

Creating an attractive compensation package that makes use of non-salary compensation such as housing allowances and 457(f) plans can help independent schools attract and retain dynamic leaders that take their organization to new heights. But it’s important for nonprofits to take a considered approach to designing these compensation plans, ensuring that packages are both reasonable and minimize the organization’s tax liabilities. 

At Smith + Howard, our nonprofit accounting experts have a decades-long track record of assisting independent schools with a wide range of accounting, governance, and tax issues. Calling on their significant levels of domain expertise, our professionals are equipped to support your organization in designing attractive compensation plans that help recruit visionary leaders. 

To learn more about how Smith + Howard can support your independent school, contact an advisor today.