Colleges that pay seven-figure salaries to coaches—dwarfing salaries paid to educators—are sometimes criticized for prioritizing athletics over academics. What if tax law made those coaches’ contracts even more expensive?
Enter the newly finalized Section 4960 of the federal tax code.
Pursuant to final regulations issued in January by the U.S. Department of Treasury, certain types of nonprofits that employ coaches and other executives who earn more than $1 million annually in compensation are subject to a 21% excise tax on the portion of compensation exceeding $1 million.
The excise tax is a function of the Tax Cuts and Jobs Act of 2017, more colloquially referred to as the Trump Tax Cuts. In amending the Internal Revenue Code of 1986, the Act generally lowered federal income and corporate taxes. However, by adding Section 4960, it took aim at what it termed “excess tax-exempt organization executive compensation.”
An excise tax is normally imposed on a specific activity, such as indoor tanning services or cell phone calls, or a good, like alcohol or tobacco. Here, the tax reflects what the federal government considers excess income paid to high-earning executives at nonprofits.
Section 4960 only applies to “covered employees” at nonprofits. Among other qualifications, these employees must receive least $1 million a year in compensation and represent one of the nonprofit’s five highest-compensated employees. Compensation is a broader term than salary. It includes fringe benefits, certain types of pensions, life insurance contributions, housing and car allowances—a common perk in coaches’ contracts—as well as severance pay and buyout terms.
Section 4960 has attracted numerous concerns that are detailed in the 176-page final regulations. For example, commenters cite confusion about the extent “compensation” covers payments by related but separate entities, and how that classification impacts who the five highest-paid executives are. Commenters also worry about applicable hours, with the Treasury Department (seemingly) resolving that concern by adopting a “limited hours” exception so that those performing fewer than 100 hours of work for the nonprofit are excluded.
Back to college coaches. Athletic departments are units within nonprofit colleges and universities. Nonprofit status normally also extends to affiliated athletic associations or “foundations” that support athletic departments. For instance, the University of Southern Mississippi Athletic Foundation is a nonprofit with a mission to “provide financial support to the University of Southern Mississippi Athletic Program.”
Section 501(c)(3) of the tax code is the legal source for the nonprofit status of college sports. This section exempts qualified entities from the duty to pay corporate income taxes, so long as the income is related to the organization’s exempt purpose. Organizations that provide educational purposes are eligible, with athletic departments instructing on athletics, teamwork and related concepts. Organizations that “foster national or international amateur sports competition” are also eligible.
The fact that college sports generate billions of dollars in annual revenue has sparked objections about the appropriateness of the nonprofit designation. Sen. Chris Murphy of Connecticut is an outspoken critic. “Tax-exempt non-profit institutions of higher education,” Murphy wrote in his Madness, Inc. report, “condone and endorse broadcasting and apparel contracts that surpass $250 million, coaches’ salaries that beat their professional equivalents, and lavish spending on facilities that amount to amusement parks aimed at seducing the nation’s top teenagers in their sport.”
Similar objections apply to coaches’ salaries—including those of FBS head coaches, whose average annual total pay, USA Today projected last year, was $2.7 million. Former U.S. Rep. Donna Shalala said she is “mortified” by coaches’ salaries while college athletes are restrained by amateurism rules. According to an ESPN survey in 2020, college football and men’s basketball coaches at public universities were the highest paid state employee in 40 of the 50 states—earning much more than the federal government’s highest paid employee, Dr. Anthony Fauci, director of the National Institute of Allergy and Infectious Diseases and chief medical adviser to President Joe Biden.
Yet from a legal vantagepoint, those critiques are less impactful. As detailed in his 2009 law review article, “The NCAA, Tax-Exemption and College Athletics,” University of Illinois tax law professor John Colombo explained why high coaches’ salaries don’t necessarily undermine the nonprofit designation:
“….the actual law states quite clearly that the only issue involving [coaches’] salaries in the tax exemption world is whether they are ‘reasonable’—that is, comparable to the market rate for similar work in both the nonprofit and for-profit sector. We might blanch at the decision of the University of Alabama to pay Nick Saban $32 million over eight years for his services . . . but these salaries certainly are not out of line with other highly successful coaches in the collegiate and pro ranks.”
To be clear, not all nonprofit colleges are subject to the excise tax, and those that are can potentially restructure their accounting strategies accordingly. Although application of 4960 is relatively new and thus lacks established precedent, the final regulations indicate that the tax doesn’t apply if neither the nonprofit nor its related entities claim tax exempt status under Section 501(a) of the tax code or exclude income under Section 115(1) of the tax code.
Should the excise tax apply, it would mean real dollars for a school. Take Penn State and its head football coach, James Franklin. Franklin is reportedly the school’s highest paid employee. His contract calls for him to receive $5.5 million in base and supplemental pay in 2021. He is also eligible for a retention bonus of $500,000 payable on Dec. 31, and is due various other benefits, including payment of life insurance premiums and allowances.
Assuming, strictly for purposes of illustration, that Franklin receives $6 million in compensation from Penn State in 2021 and that 4960 applies, the school would be on the hook to pay 21% tax on the amount over $1 million. That translates into an excise tax of $1.050 million.
Colleges that already pay millions in salaries, pay raises, bonuses and buyouts can add another category of expense: taxes.