On June 12, 2020, the IRS released proposed regulations on the enforcement of Section 4960 of the 2017 Tax Cuts and Jobs Act. Section 4960 imposes a 21% excise tax on “applicable tax-exempt organizations” (ATEOs), including certain tax-exempt hospitals, that pay executive employees more than $1 million a year or provide large “parachute” payments upon an employee’s separation from the company. The proposed regulations define which tax-exempt executives qualify as a “covered employee” and provide other important clarifications and definitions that would guide IRS enforcement of this tax. Comments are due by August 10, 2020.

The 21% excise tax applies to “covered employees” of ATEOs for tax years beginning after December 31, 2017. A “covered employee” is defined in the Act as an employee who is one of the five highest-compensated employees of the ATEO in tax years beginning after December 31, 2016. For purposes of identifying the covered employees of an ATEO, compensation includes not only the payments provided directly by the ATEO, but also payments to those employees by any “related organization,” such as a taxable parent company.

After Section 4960 was passed, there was concern that this excise tax would extend to foundations and other exempt organizations established by larger, taxable corporations, where highly paid executives of the parent corporation might spend a portion of their time in the management of the ATEO and would therefore be subject to the 21% excise tax. To address this concern, the regulations provide exclusions to the definition of covered employee under Section 4960. Under the proposed rule, excluded executives would include those who are not compensated by the ATEO or related tax-exempt organizations and spend less than 100 hours a year performing services for the ATEO, as well as those who work primarily for the taxable parent company and whose compensation does not come directly or indirectly from the ATEO.

In addition to the exceptions to the definition of “covered employee,” the proposed regulations clarify that neither directors nor officers-in-name-only (i.e., an individual having the title of an officer, but who provides only minor services and does not receive and is not entitled to receive compensation for such services) are treated as employees of the ATEO. (Prop. Treas. Reg. §§53.4960-1(e)(2) and 53.4960-1(e)(1), respectively.)

The proposed rule also provides guidance on various other issues, including the definition of “related organizations” through the concept of board control tests, the definition of excess parachute payments, and IRS proposed treatment of split-dollar life insurance arrangements as compensation subject to the excise tax.

The proposed rule comes over a year after the IRS issued Notice 2019-09 on December 31, 2018, which also provided guidance on these issues. Until final regulations are issued, an organization may rely on Notice 2019-09, or on these proposed regulations, or the organization may adopt its own reasonable, good faith interpretation of the statutory rules.

The proposed regulations can be found here.