The Tax Cuts and Jobs Act of 2017 (TCJA) added Section 4960 to the IRC. Section 4960 imposes an excise tax (currently 21 percent) on the amount of remuneration in excess of $1 million and any excess parachute payments paid by an applicable tax-exempt organization (ATEO) to a covered employee. Section 4960 is effective for the first tax year beginning after Dec. 31, 2017.
While Section 4960 comprises only a few paragraphs in the IRC, exempt organizations have raised many questions since its passage in 2017 about its application. On Dec. 31, 2018, the IRS issued Notice 2019-09, which sets forth 92 pages of guidance on the application of Section 4960. Although Notice 2019-09 answers many questions raised by the exempt organization community, the U.S. Department of the Treasury and the IRS intend to issue subsequent guidance in the form of proposed regulations. In the meantime, taxpayers may base their positions on “a good faith, reasonable interpretation of the statute,” as well as the guidance provided in Notice 2019-09.
General clarificationsNotice 2019-09 clarifies that the excise tax imposed on excess remuneration and excess parachute payments under Section 4960 is determined based on amounts paid to an employee during the calendar year ending with or within the taxable year of the employer. This clarification addresses concerns raised by fiscal year exempt organization filers and aligns more closely with the calendar year reporting of compensation on Form W-2 and Form 990. Furthermore, any remuneration in which a covered employee was vested before the effective date of Section 4960 is not subject to tax.
Notice 2019-09 also clarifies that the common-law employer, as determined generally for federal tax purposes, is the entity liable for Section 4960 tax. Often, exempt organizations use third-party payor arrangements, such as payroll agents, common paymasters, or other arrangements in which related or unrelated entities make payments to individuals for services rendered to a common-law employer (including related organizations and management companies). A common-law employer may not avoid treating a payment as remuneration because of a third-party payor arrangement. The sole owner of a disregarded entity is treated as the common-law employer for purposes of Section 4960.
Applicable tax-exempt and related organizationsOne fundamental question that exempt organizations have raised is whether Section 4960 applies to governmental entities. According to Notice 2019-09, the answer depends. A governmental entity may be subject to Section 4960 in two ways: as an ATEO or as a related organization.
- Governmental entity as ATEO. A governmental entity (including a state college or university) that excludes income from gross income under Section 115(1) (even if the entity has other income that is not excluded under Section 115(1)), or is recognized as exempt from taxation under Section 501(a), is an ATEO for purposes of Section 4960. To that end, federal instrumentalities exempt from tax under Section 501(c)(1) and public universities with IRS determination letters recognizing their tax-exempt status under Section 501(c)(3) are governmental entities exempt from tax under Section 501(a) and thus are ATEOs. Conversely, a governmental unit (a state, political subdivision of a state, or integral part thereof) that does not have a determination letter recognizing its exempt status under Section 501(a) and does not exclude income under Section 115(1) (in other words, neither condition applies) is not an ATEO. Notice 2019-09 permits governmental entities to voluntarily relinquish Section 501(c)(3) status to avoid classification as an ATEO.
- Governmental entity as related organization. Section 4960 extends to any remuneration paid with respect to employment of an employee by any related person or governmental entity. Relatedness for purposes of Section 4960 exists if a person or governmental entity controls (or is controlled by) an ATEO, common control exists, a supporting organization relationship exists, or the person or governmental entity establishes, maintains, or makes contributions to a voluntary employees’ beneficiary association. The definition of control for purposes of Section 4960 generally aligns with the definition of related organization for purposes of the annual reporting requirements on Form 990. That is, more than 50 percent actual or constructive ownership constitutes control.
Covered employeesA covered employee is any employee who is one of an ATEO’s five highest-compensated employees for the current taxable year or who was a covered employee of the ATEO (or any predecessor) for any preceding taxable year beginning after Dec. 31, 2016.
To identify its five highest-compensated employees, an ATEO must include remuneration paid in the calendar year ending with or within the employer’s taxable year by any related organization, which includes a for-profit organization or governmental entity, for services performed as an employee of the related organization. Remuneration paid for medical or veterinary services, however, is not taken into account for purposes of identifying the five highest-compensated employees. Whether an employee is one of the five highest-compensated employees is determined separately for each ATEO, not for the entire group of related organizations. A limited services exception applies if an ATEO pays less than 10 percent of an employee’s total remuneration for services performed as an employee of the ATEO and all related organizations (unless no ATEO in the group paid at least 10 percent of the total remuneration paid by the group during the calendar year).
Notice 2019-09 clarifies that once an employee is a covered employee, he or she continues to be a covered employee for all subsequent tax years and that there is no minimum-dollar threshold for an employee to be a covered employee.
Excess remunerationContrary to what the exempt organization community had anticipated, the IRS and the Treasury have concluded that, with regard to defining remuneration, it is inappropriate to use the amounts reportable in Form W-2, Box 1 or 5. Section 4960 defines “remuneration” as wages (as defined in Section 3401(a)), with certain exceptions. Remuneration does not include any designated Roth contribution or the portion of any remuneration paid to a licensed medical professional (including a veterinarian) that is for the performance of medical or veterinary services by the professional. However, the term does include amounts required to be included in gross income under Section 457(f). Thus, according to Notice 2019-09, not only is the definition of remuneration for purposes of Section 4960 different from the definition of wages for purposes of W-2 reporting, but the timing rules for inclusion as remuneration or wages differ as well.
For an employee who might be a covered employee of more than one ATEO, the employer is liable only for the greater of the excise tax it would owe as an ATEO or the excise tax it would owe as a related organization with respect to that covered employee.
Notice 2019-09 offers detailed discussion (including examples) about when remuneration is treated as paid and the amount of remuneration treated as paid, for purposes of Section 4960. Generally, remuneration is treated as paid on the first date that the right to the remuneration is not subject to a substantial risk of forfeiture. The amount of remuneration treated as paid upon vesting is the present value (on the vesting date) of the future payments to which the participant has a legally binding right.
Medical and veterinary servicesSection 4960 excludes from remuneration and parachute payments the portion of any compensation that is for the performance of medical or veterinary services by a licensed medical professional (including a veterinarian). Notice 2019-09 clarifies that a licensed medical professional is an individual licensed under state or local law to perform medical or veterinary services and generally includes dentists, nurses, and nurse practitioners (and may include other medical professionals depending on state or local law).
In response to the exempt organization’s request for clarification on the definition of “medical services” for purposes of Section 4960, Notice 2019-09 adopts the definition of medical care under Section 213(d), which provides for services for the diagnosis, cure, mitigation, treatment, or prevention of disease (applied by analogy to veterinary services).
A fundamental question raised by healthcare institutions is whether activities related to medical services, such as administrative, teaching, and research services, are medical services. According to Notice 2019-09, these activities generally are not considered medical services. To the extent that a licensed medical professional provides direct medical care to a patient in the course of these activities, however, remuneration allocable to those services is not taken into account for purposes of Section 4960. Taxpayers may rely on a reasonable allocation set forth in an employment agreement, patient records, insurance records, Medicare and Medicaid billing records, internal time reporting mechanisms, or other reasonable methods of allocation.
Excess parachute paymentsSection 4960(a)(2) imposes an excise tax on “any excess parachute payment.” A parachute payment generally refers to any payment in the nature of compensation to (or for the benefit of) a covered employee if (i) the payment is contingent on the employee’s separation from employment and (ii) the aggregate present value of the payments equals or exceeds three times the base amount. Notice 2019-09 clarifies that excess parachute payment rules under Section 4960 are modeled after Section 280G, which disallows a deduction for any excess parachute payment. Notice 2019-09 offers significant discussion about various differences between sections 280G and 4960, and it incorporates many of the questions and answers under Section 280G regulations, with modifications. Notice 2019-09 provides six basic steps to determine the amount of excise tax with respect to excess parachute payments, and it limits payments treated as contingent on a separation from employment to payments contingent on an involuntary separation from employment. The six steps are as follows:
Step 1: Determine if a covered employee is entitled to receive payments in the nature of compensation that is contingent on an involuntary separation from employment.
Step 2: Calculate the total aggregate present value of the contingent payments.
Step 3: Calculate the covered employee’s base amount, which is generally the average of W-2, Box 1 wages for the five calendar years immediately preceding the calendar year in which separation from employment occurs.
Step 4: Determine if the contingent payments are parachute payments (for example, if the aggregate present value equals or exceeds three times the base amount).
Step 5: If they are parachute payments, calculate the amount of excess parachute payments (excess of such payments over one times the base amount).
Step 6: Calculate the amount of the excise tax (currently 21 percent of any excess parachute payments).