The Internal Revenue Service and US Department of the Treasury have released proposed regulations governing the excise tax imposed by Internal Revenue Code Section 4960 on certain executive compensation paid to employees of tax-exempt organizations. These proposed regulations address several important questions about the applicability of Section 4960, including the treatment of employees of a taxable company who serve as officers or other volunteers of a related exempt organization, and the treatment of Section 457(f) plans.
The proposed regulations released by the Internal Revenue Service (IRS) and US Department of the Treasury respond to the numerous comments received in response to the subregulatory interim guidance set forth in IRS Notice 2019-09 (Dec. 31, 2018) (the Notice), including those that raised the issue of whether the excise tax should apply to businesses that supply highly compensated volunteers to affiliated nonprofits. Please see our prior LawFlash the Notice.
While the proposed regulations provide some relief to nonprofit volunteers, they still may impose significant disincentives for businesses to contribute the time and treasure of highly compensated executives to nonprofit affiliates. The issue is particularly relevant for small businesses because it indirectly imposes a tax on the remuneration of privately held businesses that Congress has otherwise determined not to be subject to deduction limitations, such as under Section 162(m). The proposed regulations are especially unforgiving with respect to the treatment of benefits accruing under a Section 457(f) plan that may result in unexpectedly large excise taxes.
There is still time to comment before the proposed regulations are binding. The IRS requests comments on numerous aspects of the proposed regulations, and the revised approach to volunteers demonstrates a willingness on the part of the IRS to accommodate common fact patterns into the guidance process. Those interested in submitting comments on the proposed regulations have until August 10, 2020 to do so.
CODE SECTION 4960 AND RELATED GUIDANCE
The 2017 Tax Cuts and Jobs Act introduced Internal Revenue Code Section 4960, which imposes a 21% excise tax on certain executive compensation paid to employees of tax-exempt organizations. Specifically, the 21% tax is imposed on (1) remuneration over $1 million paid with respect to a “covered employee” of an “applicable tax-exempt organization” (ATEO), and (2) “excess parachute payments” paid with respect to a covered employee of an ATEO.
The proposed regulations reassert the interim guidance originally set forth in the Notice, with some adjustments. Until the applicability date of the final regulations, taxpayers may base their positions on a reasonable good-faith interpretation of the statute, and may rely either on the Notice or the proposed regulations. However, the proposed regulations identify certain interpretations of Section 4960 that are not considered to be consistent with a reasonable, good-faith interpretation of the statutory language.
DEFINING EMPLOYEES, COVERED EMPLOYEES, AND FIVE HIGHEST-COMPENSATED EMPLOYEES
Section 4960 defines “covered employee” as the following:
[A]ny employee (including any former employee) of an applicable tax-exempt organization if the employee (A) is one of the 5 highest compensated employees for the organization for the taxable year, or (B) was a covered employee of the organization (or any predecessor) for any preceding taxable year beginning after Dec. 31, 2016.
Under the proposed regulations, there is no minimum dollar threshold for an employee to be a covered employee. Thus, an ATEO has covered employees, which may have consequences in later years, even if it does not pay any employees more than $1 million. The proposed regulations define “employee” consistent with the definition of “employee” for purposes of federal income tax withholding in Section 3401(c) and the regulations thereunder.
These rules confirm that a member of a board of directors of a corporation is not an employee of the corporation in his or her capacity as a director. These rules also provide that an officer is considered an employee of any entity for which the officer serves as an officer, even if the officer would not meet the common law test for identifying employees, unless the officer performs no services or only minor services and neither receives, nor is entitled to receive, any remuneration from the ATEO.
Neither the statutory language of Section 4960 nor the Notice explicitly addressed the Section 4960 consequences of employees of a taxable entity who provide services to a related exempt organization without compensation from the exempt organization. Shortly after the Notice was issued, commenters raised concerns about the application of the excise tax to these arrangements, which are extremely common in the context of company foundations.
Commenters expressed concern that highly paid employees of a corporation who spend some of their time performing services for the corporation’s foundation—a related ATEO—without receiving compensation from the foundation may be subject to the excise tax. This liability might discourage the provision of such services and even lead to the dissolution of the foundation. The proposed regulations do not comprehensively address this issue, but propose two exceptions that limit the applicability of the tax to these arrangements.
Limited Hours Exception
The limited hours exception ensures that an individual is not considered one of an ATEO’s five highest-compensated employees for a taxable year if
- neither the ATEO nor any related ATEO pays remuneration or grants a legally binding right to nonvested remuneration to the individual for services performed for the ATEO; and
- the individual’s services performed for the ATEO make up 10% or less of the employee’s total hours of service for the ATEO and all related organizations during the applicable year.
In calculating whether an individual meets the 10% test, an ATEO may use a percentage of total days worked by the employee, instead of tracking specific hours, provided that the ATEO counts any day that the employee worked for at least one hour for the ATEO toward that percentage. The proposed regulations provide a safe harbor by providing that any individual who dedicated 100 hours or fewer to work for the ATEO and all related ATEOs is treated as meeting the 10% test.
Nonexempt Funds Exception
The nonexempt funds exception ensures that an individual is not considered one of an ATEO’s five highest-compensated employees for a taxable year if
- neither the ATEO, nor any related ATEO or taxable organization controlled by the ATEO, pays remuneration or grants a legally binding right to nonvested remuneration to the individual for services performed for the ATEO;
- the individual provided services primarily (i.e., more than 50%) to the related taxable organization or other non-ATEO; and
- no related taxable organization or other non-ATEO paying the employee remuneration provided services for a fee to the ATEO, related ATEOs, or their controlled, taxable related organizations.
Exempt organizations that currently have a resource-sharing agreement under which they pay for or reimburse a related taxable organization or other non-ATEO for any services, such as back-office, legal, or information technology services, may be ineligible for this exception.
Identifying an ATEO’s Five Highest-Compensated Employees
Each ATEO must identify its covered employees each year, even if no employee earns more than $1 million for that year. Whether an employee is one of the five highest-compensated employees of an ATEO is determined separately for each ATEO and not for the entire group of related organizations. As a result, a group of related tax-exempt organizations may have many more than five covered employees whose compensation may trigger the excise tax.
Similarly, an employee may be a covered employee of more than one ATEO in a related group of organizations for a taxable year. Navigating these rules may be particularly difficult for large groups of related organizations, such as healthcare systems and educational institutions.
Remuneration for which a deduction is disallowed under Section 162(m) is taken into account as remuneration paid for purposes of determining an ATEO’s five highest-compensated employees, even though it is not otherwise taken into account for purposes of determining the amount of remuneration paid for a taxable year.
Section 4960 has a “once a covered employee, always a covered employee” rule, under which a covered employee of an ATEO remains a covered employee of the ATEO forever. Each ATEO must keep a cumulative list of covered employees indefinitely, in case a covered employee has compensation above $1 million, or receives “excess parachute payments” (which may be less than $1 million), in a future year.
Furthermore, the proposed regulations provide rules that would maintain covered employee status even after dissolution under its proposed rules regarding “predecessor” organizations. The proposed definition of predecessor also addresses organizations that lose and regain exempt status, such as a governmental hospital that voluntarily relinquishes its tax-exempt status.
IDENTIFYING THE EMPLOYER
The proposed regulations define “employer” as the person for whom an individual performs any service: control of the payment of wages is not relevant and a person or governmental entity does not avoid status as an employer under Section 4960 by using a third-party payor like a payroll agent, common paymaster, statutory employer, or certified professional employer organization to pay remuneration to an employee.
As a result, remuneration that is paid by a separate organization to an individual for services the individual performed as an employee of an ATEO, whether related to the ATEO or not, is deemed remuneration paid by the ATEO for purposes of Section 4960, except as provided in the exceptions to covered employee status described above.
Calendar Year Compensation
For purposes of Section 4960, remuneration is determined based on the calendar year ending with or within the fiscal year of the ATEO. This aligns with Form 990 reporting, which is also based on calendar year compensation. The proposed regulations include special rules for allocating remuneration in the first taxable year an organization becomes an ATEO and in the taxable year in which ATEO status terminates.
Compensation of Related Organizations
In determining its covered employees and calculating remuneration paid to a covered employee, the proposed rule requires an ATEO to include remuneration provided to the employee by any related organization (including related governmental entities and for-profit entities) for services performed as an employee of that organization. Related organizations include any organization that controls, is controlled by, or is under common control with the ATEO, and supporting or supported organizations. The proposed regulations define “control” based on a more than 50% test that applies to stock, partnership interests, and voting control/representatives on a nonprofit board.
The proposed regulations define a “representative” as a trustee, director, officer, agent, or employee, which can cause two or more organizations to unintentionally be considered related if more than half of their boards happen to be made up of employees of the same company. In order to address that issue, the proposed regulations provide that an employee is not treated as a “representative” if the employee “does not act as a representative of the person or governmental entity,” and if the nonprofit board on which that person is serving as a director provides the facts supporting that conclusion on its Form 990. The proposed rule adopts a more than 50% threshold consistent with the Form 990 rules, which is lower than the 80% control threshold that applies for qualified plan purposes.
What Is Remuneration?
Remuneration for purposes of Section 4960 may differ from compensation calculated for Form 990 or Form W-2. Under Section 4960, “remuneration” is defined as wages for federal income tax purposes, except that it excludes Roth contributions and certain retirement benefits and, generally, includes amounts as they vest (cease to be subject to a substantial risk of forfeiture). In certain situations, such as severance pay and short-term deferrals, compensation may vest in one calendar year and be paid (and taxed for federal income tax purposes) in a subsequent calendar year, so the Form W-2 compensation may not match the Section 4960 remuneration for the year of vesting.
The proposed regulations clarify that regular wages, i.e., remuneration for the current payroll period, are treated as paid at the time of actual or constructive payment, whereas remuneration that is not a regular wage but that is never subject to a substantial risk of forfeiture is treated as paid on the first date the service provider has a legally binding right to the payment. For example, if a pay period ends December 26, 2020, but the salary for that period is not actually paid until January 2, 2021, then the salary is treated as paid in 2021 and the employer need not treat any amount as vested in 2020. But if the employee also vested in a bonus on December 26, 2020, that is actually paid on January 2, 2021, the bonus is treated as paid in 2020 for purposes of Section 4960.
Remuneration That Falls Under the Section 162(m) Deduction
For a publicly traded corporation, any remuneration for which a deduction is not allowed by reason of Section 162(m) will not be taken into account for purposes of the Section 4960 excise tax. However, the excise tax will apply to remuneration that falls outside the Section 162(m) deduction limitation and with respect to entities that are not publicly held. The proposed regulations provide special rules for remuneration that is included in one year for purposes of Section 4960, but is subject to the Section 162(m) deduction limitation in a later year.
The proposed regulations explicitly reject proposals to allow taxpayers to allocate ratably over the vesting period benefit amounts accruing under Section 457(f) plans and subject to cliff vesting. This issue remains highly problematic for ATEOs that may owe a significant excise tax with respect to a covered employee whose compensation may never have otherwise exceeded $1 million in any year, and who may have been obligated to make such payments under a written binding agreement that predated the enactment of Section 4960. While, in some cases, the effect of the excise tax can be minimized by accelerating or delaying the vesting of Section 457(f) benefits, any change to the vesting schedule needs to comply with Sections 409A and 457(f), as applicable.
Limited Grandfather Relief
The proposed regulations provide rules that have the effect of grandfathering certain compensation. First, any vested remuneration, including vested but unpaid earnings accrued on deferred amounts, that is treated as paid before the effective date of Section 4960 (January 1, 2018, for a calendar year employer) is not subject to the excise tax.
Second, vested remuneration, including vested but unpaid earnings, that would have been treated as remuneration paid for a taxable year before the taxable year in which an employee first became a covered employee under Section 4960 is not remuneration subject to the excise tax for the first taxable year in which the employee becomes a covered employee or any subsequent year. However, earnings that accrue or vest after the effective date of Section 4960 will be considered remuneration under Section 4960, even if the benefit is attributable to service prior to the effective date.
Remuneration for Performance of Medical or Veterinary Services
Section 4960 remuneration does not include remuneration paid for the direct performance of medical or veterinary services by licensed medical or veterinary professionals. The proposed regulations define “medical services” as the diagnosis, cure, mitigation, treatment, or prevention of disease in humans or animals, services provided for the purpose of affecting any structure or function of the human or animal body, and other services integral to providing such medical services, in each case that are directly performed by a licensed medical professional.
Further, they note that certain administrative tasks, such as creating patient records, are so integral to performing medical services that they constitute the performance of medical services. In addition to doctors, nurses, and veterinarians, “licensed medical professionals” include dentists and nurse practitioners and may include others, depending on the applicable state or local law. ATEOs that provide medical or veterinary services will need to allocate remuneration among direct medical or veterinary services and other duties using a reasonable method where the applicable employment agreements do not make such allocation.
REMUNERATION ABOVE $1 MILLION
Section 4960 imposes a 21% excise tax on remuneration above $1 million in a year that is considered paid by an ATEO and its related organizations with respect to a covered employee of the ATEO. The excise tax on payments above $1 million does not apply to excess parachute payments on which the 21% excise tax is applied, so that there is no duplicate payment of the tax.
EXCESS PARACHUTE PAYMENTS
Section 4960 imposes a 21% excise tax on any excess parachute payment paid by an ATEO to a covered employee, even if the excess parachute payments are less than $1 million. The excess parachute payment calculation is similar to the calculation under Section 280G (applicable to for-profit corporations), except that an excess parachute payment under Section 4960 is triggered by a separation from service, and not by a change in control.
An excess parachute payment under Section 4960 is a payment to a covered employee (1) that is contingent on separation from service and (2) the present value of which equals or exceeds three times the covered employee’s average annual compensation over the last five years. The excess parachute payment is the excess of the parachute payment over the base amount (not three times the base amount). The payment must be contingent on the employee’s involuntary separation from employment, which may include a termination for “good reason,” if appropriately defined.
The definition of separation from employment generally has the same meaning as separation from service under Section 409A. For example, an anticipated reduction in service of more than 80% is considered a separation from service and an anticipated reduction of 50%–80% may be considered a separation depending on the facts and circumstances. However, a purported ongoing employment relationship will be disregarded if facts and circumstances demonstrate that it is not bona fide or its primary purpose is avoidance of the application of Section 4960. A payment made under a covenant not to compete generally will be considered a payment in the nature of compensation that is contingent on a separation from employment for purposes of Section 4960 if the covenant is negotiated as part of a severance arrangement arising from an involuntary separation.
Unlike the Section 280G rules, these proposed regulations do not presume that a payment made pursuant to an agreement entered into or modified within 12 months of a separation from employment is a payment that is contingent on a separation from employment. Reasonable payments for bona fide services after an involuntary separation from employment will not be considered as contingent on the involuntary separation from employment. Notably, the proposed regulations add that damages for breach of contract pursuant to an employment agreement are treated as a payment that is contingent on a separation of employment.
The proposed regulations make changes to the calculation of an excess parachute payment provided under the Notice. Under the proposed regulations, amounts paid by all related organizations, including a related non-ATEO, are considered for purposes of calculating the base amount and for calculating the amount of payments made that were contingent on a separation of employment.
Departing from the Notice, only an excess parachute payment paid by an ATEO is subject to the excise tax. Any payments made by a non-ATEO that would otherwise be an excess parachute payment are not subject to the excise tax. However, the IRS may reallocate excess parachute payments to an ATEO if facts and circumstances show that excess parachute payments were made by a non-ATEO for the purpose of avoiding the tax under Section 4960.
ALLOCATION OF EXCISE TAX
Section 4960 imposes liability for the excise tax on the “employer(s)” of each “covered employee,” according to the definitions of these terms described above.
If an individual is paid remuneration by both an ATEO and a related organization, then each employer is liable for the excise tax in an amount proportional to the remuneration paid by the employer as compared to the total remuneration paid by all employers to the covered employee.
In a scenario where several related ATEOs may be liable for excise tax with respect to the same covered employee, double taxation is avoided by making each employer liable for the greater of the tax amount it would owe as an ATEO or the tax amount it would owe as a related organization with respect to the covered employee. The proposed regulations outline the steps for calculating this liability.
Each employer liable for tax is responsible for separately reporting and paying its share of the tax on Form 4720. For calendar year ATEOs, the excise tax for the 2020 year will have to be paid on May 15, 2021, which is the due date for Form 4720 without extensions. The due date for the tax payment is determined without regard to whether the employer files for an extension to file the Form 4720.
 The definition of “predecessor organization” in the proposed regulations is complex. Please contact us to discuss specific facts.