Even during the recent government shut down, the Internal Revenue Service issued guidance on the “excess parachute” provisions applicable to tax-exempt organizations under the 2017 Tax Cuts and Jobs Act (the “Act”). IRS Notice 2019-09 (the “Notice”) provides some welcome, and some unwelcome, guidance on the application of the excess parachute provisions under Internal Revenue Code Section 4960.

Code Section 4960 provides that remuneration in excess of $1 million and excess parachute payments paid by an applicable tax-exempt organization to a covered employee are subject to a 21% excise tax. The Notice provides interim guidance that defines (a) applicable tax-exempt organization, (b) covered employee, (c) excess remuneration, and (d) excess parachute payment. The Treasury Department is developing regulations under Code Section 4960, and this Notice will be incorporated into any regulations issued later by the Treasury Department.

Applicable Tax-Exempt Organizations

The Notice defines applicable tax-exempt organizations to include:

• Organizations exempt from taxation under Code Section 501(a);                                     
• Farmers’ cooperative organizations described in Code Section 521(b)(1);   
• Organizations that have income excluded from taxation under Code Section 115(1); and

• Political organizations described in Code Section 527(e)(1).

The Notice states that Code Section 4960 is not applicable to state colleges or universities unless they either claim an exemption from tax under Code Section 501(a) or they exclude income under Code Section 115(1). The Notice goes on to state that a governmental entity may voluntarily relinquish its Code Section 501(c)(3) status to avoid being subject to the excise tax, but only if it does not exclude income under Code Section 115(1).

Covered Employees

A covered employee includes any employee who is one of the organization’s five highest-paid employees for the current taxable year OR who was a covered employee for any preceding taxable year beginning after December 31, 2016. This determination will be based on remuneration paid in the calendar year ending with or within the organization’s taxable year. Therefore, organizations will need to track their covered employees each year because, once an individual is a covered employee (after 2016), the individual will always be a covered employee.

Excess Remuneration

The Act defines remuneration as taxable wages paid during the applicable calendar year but including amounts required to be included in the employee’s wages under the Code Section 457(f) deferred compensation rules. The Notice states that remuneration includes any parachute payments (see below) that are not excess parachute payments. Generally, contributions to and payments from qualified retirement plans (but excluding any Roth contributions), Code Section 457(b) plans and Code Section 403(b) plans are excluded from remuneration.

Excess remuneration is remuneration that exceeds $1 million in a taxable year. The organization will be required to pay a 21% excise tax each year on the amount that a covered employee’s remuneration exceeds $1 million. For this purpose, remuneration is paid for a taxable year if it is paid during the calendar year that ends with or within the organization’s taxable year.

Note that remuneration will include compensation that becomes vested and treated as paid in a year, such as Code Section 457(f) arrangements that become vested.

Exception for Medical Services Remuneration: In a nod to the sometimes high salaries commanded by medical professionals, note that remuneration does NOT include compensation paid for medical, nursing or veterinary services by a licensed medical professional. The Notice states that medical services are those directly related to the performance of services that constitute medical care as defined in Code Section 213(d). Medical care includes amounts paid “for the diagnosis, cure, mitigation, treatment, or prevention of disease, or which affect the structure or function of the body.” Administrative, teaching, or research services generally are not considered medical services. However, to the extent a licensed medical professional provides direct medical care to a patient in the course of administrative, teaching, or research services, the remuneration allocable to those services is excluded from remuneration under the Notice. Organizations are required to apportion the remuneration between medical and non-medical services using a reasonable, good-faith method.

Excess Parachute Payment

In addition to the excise tax payable for excess remuneration, the organization also must pay a 21% excise tax on any excess parachute payment paid to a covered employee who is also a highly compensated employee under Code Section 414(q) (for 2019, those earning more than $120,000 in 2018 and for 2020, those earning more than $125,000 in 2019).

An excess parachute is (a) a payment that is contingent on an employee’s separation from employment, and (b) the aggregate payment is three times or more the employee’s “base amount.” The employee’s base amount is his or her average annual taxable compensation in the preceding five years (or such shorter period of actual employment). The excise tax applies to the amount that exceeds the base amount (not three times the base amount).

Amounts that are contingent upon an employee’s separation from service will include severance payments and amounts that become vested upon a separation from service, but will not include qualified retirement plan payments.

Some Thoughts

• Note that an employee need not earn $1 million to be covered employee. Any employee who is or was one of the organization’s top-paid five employees would be a covered employee (although the excess parachute provisions would only apply if such employee earns more than $125,000 in 2019, which is indexed for future years).                                  
• Code Section 4960 could trigger extremely high excise taxes. For example, assume that a covered employee is involuntarily terminated from employment at a time that her base amount is $250,000. If she collects $100,000 of severance pay and $700,000 of 457(f) plan benefits (which vest due to her involuntary termination), then she will have exceeded the three times the base amount limit (which was $750,000) by $50,000. But, that amount is not the amount subject to the 21% excise tax. Instead, the excise tax is based on the excess of her $800,000 of parachute payments over her $250,000 base amount. The excise tax will be $115,500 (21% of $550,000).
• The Notice does not provide for any grandfathering for amounts already accrued (but not vested) under Code Section 457(f) plans. We can always hope that the IRS will provide grandfathering relief in future guidance.

• Remuneration paid from a related organization must also be considered in applying these rules. Code Section 4960 states that a person or entity is a related organization if the person or entity (i) controls, or is controlled by, the organization; (ii) is controlled by one or more persons which control the organization; (iii) is a supported organization (as defined in Code Section 509(f)(3)) during the organization’s taxable year; (iv) is a supporting organization described in Code Section 509(a)(3) during the organization’s taxable year; or (v) in the case of an organization which is a voluntary employees’ beneficiary association described in Code Section 501(c)(9), establishes, maintains, or makes contributions to such voluntary employees’ beneficiary association.