Tax on excess compensation for tax-exempt organization executives

| 7/1/2020
Tax on excess compensation for tax-exempt organization executives

On June 11, the U.S. Department of the Treasury and the IRS published proposed regulations under IRC Section 4960. Section 4960 was added to the IRC by 2017 tax reform (also referred to as the Tax Cuts and Jobs Act (TCJA)) and imposes an excise tax on an applicable tax-exempt organization (ATEO) with respect to certain excessive compensation provided to certain executive employees of the ATEO. 

Background

Effective for each taxable year beginning after Dec. 31, 2017, an ATEO generally is liable for an excise tax (currently 21%) on the sum of any covered employee’s excess remuneration (remuneration exceeding $1 million, other than excess parachute payments) and any excess parachute payment paid to that covered employee.

An ATEO is any organization that is exempt from taxation under Section 501(a), that excludes income from taxation under Section 115(1), that is a farmers’ cooperative organization described in Section 521(b)(1), or that is a political organization described in Section 527(e)(1). 

A covered employee of an ATEO is one of the five highest-compensated employees of the organization (or a predecessor) for the current taxable year or in any preceding taxable year beginning after Dec. 31, 2016. Generally, all compensation paid by the ATEO to an employee, directly or indirectly, must be counted toward determining whether that employee is a covered employee and toward determining remuneration and parachute payments paid to that covered employee. Payments from a related organization (as defined) of an ATEO also must be counted.

For an applicable year (the calendar year ending with or within the ATEO’s taxable year), remuneration generally means wages as defined for income tax withholding purposes but also includes amounts required to be included in gross income under Section 457(f). Remuneration is treated as paid in the year when the covered employee’s right to the amount no longer is subject to a substantial risk of forfeiture as defined under Section 457(f)(3)(B), regardless of when the amount actually is paid. (Section 457(f) governs deferred compensation arrangements of tax-exempt and governmental organizations.) 

Generally, when the sum of all payments made due to involuntary separation from employment equals or exceeds three times the employee’s base amount (as defined), the amount in excess of the base amount is an excess parachute payment. 

The TCJA excludes remuneration directly related to the performance of medical services by licensed medical professionals (direct medical services payments) for purposes of determining covered employees. In addition, the statute excludes direct medical services payments and payments to employees who are not highly compensated employees (based on indexed dollar thresholds that apply for qualified retirement plan purposes) from treatment as parachute payments.

On Dec. 31, 2018, Treasury and the IRS issued Notice 2019-09 to provide initial guidance under Section 4960. The notice permits taxpayers to rely on its guidance and to base their positions on a reasonable, good faith interpretation of the statute (including legislative history, as appropriate) until further guidance is issued. The notice also outlines certain interpretations of Section 4960 that are not consistent with a reasonable, good faith interpretation of the statute and indicates that forthcoming proposed regulations are expected to cover these interpretations.

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Proposed regulations

Treasury and the IRS state that the guidance provided in the proposed regulations generally is consistent with the guidance provided in Notice 2019-09. Following are some of the proposed rules that add to or modify the notice:

  • Definition of employee and employer. The proposed rules define “employee” consistently with the definition of “employee” for purposes of federal income tax withholding and related regulations. This definition includes common law employees, officers or elected or appointed officials of governments or agencies or instrumentalities of governments, and certain officers of corporations. Specifically, the proposed rules confirm Congress’ intent that an officer of an ATEO (including an individual acting in that capacity) is a covered employee if the other requirements to be such are met, and that former employees remain covered employees. Similarly, “employer” is defined consistently with how the term is defined for purposes of federal income tax withholding and related regulations. Status as an employer cannot be avoided by using a third-party payer, including a management company. Additionally, the sole owner of a disregarded entity is treated as the employer of any of the disregarded entity’s employees.
  • Volunteer services. The proposed regulations address whether the excise tax applies to certain non-ATEO employees who perform limited or temporary services for a related ATEO and receive remuneration only from the non-ATEO. For example, an officer of a for-profit corporation might spend time on the board of a related tax-exempt foundation. The proposed regulations provide a “limited-hours exception” and a “nonexempt funds exception.” The preamble states that to avoid manipulation of the rules through the deferral of compensation, a grant of a legally binding right to vested remuneration by the ATEO (or related ATEO) is included to determine whether an employee is one of the five highest-paid employees – and any grant of a legally binding right to nonvested remuneration by the ATEO or a related ATEO automatically disqualifies the ATEO from claiming a relevant exemption. 

    While numerous other detailed requirements apply to both exceptions, generally the limited-hours exception applies if an employee’s hours of service performed as an employee of the ATEO and all related ATEOs make up 10% or less of the employee’s total hours of service for the ATEO and all related organizations during the applicable year. Under a safe harbor, if an employee performs fewer than 100 hours of service as an employee of an ATEO and all related ATEOs during an applicable year, that employee is treated as having worked less than 10% of the employee’s total hours of service for the ATEO and all related ATEOs. The nonexempt funds exception generally applies if an employee’s hours of service performed as an employee of the ATEO and all related ATEOs make up less than 50% of the employee’s total hours worked for the ATEO and all related organizations during the applicable year, and if no related organization that paid remuneration or granted a legally binding right to nonvested remuneration to the individual provided services for a fee to the ATEO or any related ATEO.
  • Related organization. The proposed regulations add some clarity on how to determine ATEO-related organizations. Among other things, remuneration of an employee generally is determined based on payments made by any related organization. The proposed regulations indirectly bring related non-ATEOs (including for-profit entities, not-for-profit entities that are not ATEOs, and governmental entities that are not ATEOs) into a related organization by including remuneration from such non-ATEOs.
  • Limited services exception. Notice 2019-09 provides that an employee is not one of an ATEO’s five highest-paid employees for a taxable year if the ATEO paid less than 10% of the employee’s total remuneration during the applicable year for services performed as an employee of the ATEO and all related organizations. In addition to this requirement in the notice, the proposed regulations clarify that this exception doesn’t apply if the ATEO has no related ATEOs and applies only if either of the following apply:
    • A related ATEO paid at least 10% of the remuneration paid by the ATEO and all related organizations.
    • No related ATEO paid at least 10% of such remuneration, and the ATEO paid less remuneration to the employee than at least one related ATEO paid to that employee.
  • Predecessor organization. A covered employee includes an employee who was a covered employee of an ATEO (or any predecessor) for any preceding taxable year beginning after Dec. 31, 2016. The proposed regulations provide comprehensive rules to determine predecessors for this purpose.
  • Remuneration. Amounts that are wages under Section 3401(a) are treated as remuneration even though such amounts may not be subject to income tax withholding. This includes, but is not limited to, income imputed from a below-market split-dollar loan between an employer and an employee. Additionally, remuneration includes parachute payments (but not excess parachute payments).
  • Interaction with Section 162(m) deduction disallowance. The proposed regulations clarify that remuneration subject to the Section 162(m) deduction disallowance (generally, amounts more than $1 million attributable to a covered employee of certain for-profit employers) must be counted to determine an ATEO’s covered employees, even though such amounts are not also subject to Section 4960. The proposed regulations also provide certain relief with respect to coordination when all of the circumstances are not known with respect to which statute applies to affect the other (for example, when the timing of the for-profit deduction is in a year after Section 4960 would apply, or a covered employee of an ATEO becomes a covered employee of a for-profit subject to Section 162(m)).
  • Excess parachute payments. The concept of excess parachute payments in Section 4960 generally is modeled on Section 280G, which imposes an excise tax on certain executives and a deduction disallowance on for-profit employers with respect to certain excess corporate transaction payments. The proposed regulations borrow Section 280G rules for this purpose and Section 457(f) rules to determine separation from employment and related issues. Significantly, the rules clarify that ATEOs cannot use for Section 4960 purposes the carveout permitted under Section 280G for payments made under a covenant not to compete. Such noncompete conditions are part of many tax-exempt Section 457(f) arrangements.
  • Calculation of excise tax. The proposed regulations add guidance on calculating the tax on excess remuneration when a covered employee performs services for one or more related organization during the same applicable year.

Next steps

Treasury and the IRS propose that the regulations apply to taxable years beginning after Dec. 31 of the calendar year that includes the date they are published as final. Until then, taxpayers may rely on the guidance in Notice 2019-09 or in the proposed regulations. For upcoming tax filings, tax-exempt organizations should consider the application of the proposed regulations to any position taken on which guidance was not previously available.

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Veena Murthy
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