The Business-Charity Connection
As our readers know, this blog is dedicated to addressing the tax-related business and succession planning issues that are most often encountered by the owners of a closely held business. Occasionally, however, we have crossed over into the space occupied by tax-exempt charitable organizations inasmuch as such an exempt organization (“EO”) may be the object of a business owner’s philanthropy, either during the owner’s life or at their demise.
For example, we have considered grant-making private foundations (“PF”) that have been funded by the business owner and, thus, are not reliant upon the general public for their financial survival. In particular, we have reviewed a number of the penalty (“excise”) taxes applicable to PFs. These are rooted in the government’s tacit recognition that the activities of such a PF cannot be influenced by the withholding of public support from the foundation. Rather, the threatened imposition of these taxes is intended to encourage certain “good” behavior and to discourage certain “bad” behavior by a PF.[i]
Although PFs are important players in the charitable world, a business owner is far more likely to support charitable activities by making direct financial contributions to publicly-supported charities that operate within their community, rather than to create a PF through which to engage in such charitable giving.[ii]
Where the business owner has a personal connection to an EO’s charitable mission, the owner may seek to become a member of the organization’s board of directors. In other cases, the EO itself may solicit the owner’s involvement, in part to help secure their financial support, not to mention the access they can provide to other potential donors from the business world.
Another reason that business owners may be attractive candidates for an EO’s board of directors is that they are experienced in . . . running a business.[iii] This skillset may be especially important in light of recent changes to the Code that reflect Congress’s heightened skepticism toward EOs, and that are aimed at limiting the amount of executive compensation payable by EOs.
Increased Public Scrutiny
Congress’s reaction to EO executive compensation is, in part, attributable to the public’s own changing perspective. As the charitably-inclined segment of the “public” has become more sophisticated, and better informed, it has demanded more accountability as to how its charitable contributions are being utilized, including what percentage of the contributions made to a charity is being used for executive compensation.[iv]
These “economic” concerns are magnified when viewed in light of the reality that the vast majority of charitable organizations are governed by self-perpetuating boards of directors,[v] which in turn hire the executive employees who operate these organizations on a day-to-day basis.
In response to these concerns, Congress has slowly been adding provisions to the Code that are intended (as in the case of the excise taxes applicable to PFs) to dissuade public charities and their boards from engaging in certain behavior.
Until the passage of the Tax Cuts and Jobs Act of 2017,[vi] the most notable of these provisions was that dealing with “excess benefit transactions.”[vii]
Blurring the Lines
As a result of these economic pressures, not to mention the attendant governmental scrutiny, most public charities have sought to fulfill their charitable missions on a more efficient basis. In other words, they have tried to become more “business-like” in performing their charitable functions. In furtherance of this goal, many EOs have tried to attract and retain the services of talented and experienced executives, while also inviting successful business owners onto their boards.
Notwithstanding these efforts, many EOs continue to be in the Congressional crosshairs. In particular, some larger EOs have been accused, in some circles, of taking advantage of their tax-preferred status to generate what critics have characterized as large profits, a not-insignificant portion of which find their way, or so these critics assert, into the hands of the organizations’ key executives in the form of generous compensation packages.
The Act represents the latest Congressional effort to rein in what its proponents perceived as abuses in the compensation of EOs’ top executives.
In order to stem these “abuses,” the Act draws liberally from the tax rules applicable to executive compensation paid or incurred by business organizations. Before delving into these provisions, it would be helpful to briefly review the “for-profit” rules from which they were derived.
For-Profit Compensation Limits
In determining its taxable income from the conduct of a trade or business, an employer may claim a deduction for reasonable compensation paid or incurred for services actually rendered to the trade or business.[viii] Whether compensation is reasonable depends upon all of the facts and circumstances. In general, compensation is reasonable if the amount thereof is equal to what would ordinarily be paid for “like services by like enterprises under like circumstances.”[ix]
However, Congress has determined – without stating that it is per se unreasonable – that compensation in excess of specified levels may not be deductible in certain situations.
Prior to the Act, and in order to protect shareholders from grasping executives, a publicly-held corporation generally could not deduct more than $1 million of compensation in a taxable year for each “covered employee,”[x] unless the corporation could establish that the compensation was performance-based.[xi]
In addition, a corporation generally cannot deduct that portion of the aggregate present value of a “parachute payment” – generally a payment of compensation that is contingent on a change in corporate ownership or control[xii] – which equals or exceeds three times the “base amount” of certain shareholders, officers and highly compensated individuals.[xiii] The nondeductible excess is an “excess parachute payment.”[xiv]
The purpose of the provision is to prevent executives of widely-held corporations from furthering their own interests, presumably at the expense of the shareholders, in the sale of the business.[xv]
Quite reasonably, certain payments are excluded from “parachute payment status” – in particular, the amount established as reasonable compensation for services to be rendered after the change in ownership or control is excluded.[xvi]
In addition, the amount treated as an excess parachute payment is reduced by the amount established as reasonable compensation for services actually rendered prior to the change in ownership or control.[xvii]
Finally, the individual who receives an excess parachute payment is subject to an excise tax of 20% of the amount of such payment.[xviii]
EO Compensation Limits
Prior to the Act, the foregoing deduction limits generally did not affect an EO.
That being said, there were other provisions in the Code that addressed the payment of unreasonable compensation by an EO to certain individuals.
PFs are prohibited from engaging in an act of “self-dealing,” which includes the payment of compensation by a PF to a disqualified person.[xix]
However, the payment of compensation to a disqualified person by a PF for the performance of personal services which are reasonable and necessary to carry out the PF’s exempt purpose will not constitute self-dealing if the compensation is not excessive.[xx]
In other words, the EO-PF may pay reasonable compensation to a disqualified person.[xxi]
Where it has paid excess compensation, the EO is expected to recover the excess from the disqualified person.[xxii]
Excess Benefit Transaction
A public charity is prohibited from engaging in an “excess benefit transaction,” meaning any transaction in which an economic benefit[xxiii] is provided by the organization to a disqualified person if the value of the economic benefit provided exceeds the value of the consideration, including the performance of services, received for providing such benefit.[xxiv]
To determine whether an excess benefit transaction has occurred, all consideration and benefits exchanged between the disqualified person and the EO, and all entities that the EO controls, are taken into account.[xxv]
In other words, the EO-public charity may pay reasonable compensation to a disqualified person without triggering the excess benefit rules.
As in the case of a PF, the public charity is expected to recover the amount of any excess payment made to the disqualified person.[xxvi]
An organization is not operated exclusively for one or more exempt purposes if its net earnings inure, in whole or in part, to the benefit of private individuals.[xxvii]
Whether an impermissible benefit has been conferred on an individual is essentially a question of fact. A common factual thread running through the cases where inurement has been found is that the individual stands in a relationship with the organization which offers them the opportunity to make use of the organization’s income or assets for personal gain. This has led to the conclusion that a finding of inurement is usually limited to a transaction involving “insiders.”
Whereas the excise taxes on acts of self-dealing and on excess benefit transactions are intended to address situations that do not rise to the level at which the EO’s tax-favored status should be revoked, a finding that the organization’s net earnings have inured to the benefit of its “insiders” connotes a degree of impermissible benefit that justifies the revocation of its tax-exemption.
Congress must have believed that the foregoing limitations were not adequate to police or control the compensation practices of EOs. The committee reports to the Act, however, do not articulate the reason for the enactment of the provisions we are about to consider.
The only rationale that I can think of is that Congress was attempting to maintain some sort of “parity” between for-profits and EOs with respect to executive compensation.[xxviii]
Thus, the new provision draws heavily from the limitations applicable to business organizations, described above, and its purpose likewise may be deduced from the purposes of such limitations: to prevent certain individuals in the EO from paying themselves “excessive” salaries and other benefits, and thereby ensuring that those amounts are instead used in furtherance of the EO’s exempt purpose and for the benefit of its constituents.[xxix]
Under the Act, effective for taxable years beginning after December 31, 2017, an employer (not the individual recipient of the payment) is liable for an excise tax equal to 21 percent[xxx] of the sum of:
(1) any “remuneration” in excess of $1 million paid to a covered employee by an EO for a taxable year, and
(2) any excess parachute payment paid by the EO to a covered employee.[xxxi]
Accordingly, the excise tax may apply as a result of an excess parachute payment, even if the covered employee’s remuneration[xxxii] does not exceed $1 million; in other words, there are two events that may trigger the imposition of the tax.
Where both provisions may apply, the remuneration that is treated as an excess parachute payment is not accounted for in determining if the $1 million limit is exceeded.
For purposes of the provision, a covered employee is an employee (including any former employee) of an applicable tax-exempt organization if the employee
is one of the five highest compensated employees of the organization for the taxable year (the current year; there is no minimum dollar threshold for an employee to be a covered employee), or
was a covered employee of the organization (or of a predecessor organization) for any preceding taxable year beginning after December 31, 2016.[xxxiii] Thus, if the individual was a covered employee in a prior year (beginning with 2017), they continue to be treated as such for purposes of determining whether any payments made to them in subsequent years violate one of the two limitations described above.[xxxiv]
Remuneration of a covered employee also includes any remuneration paid with respect to employment of the covered employee by any person related to the EO.
A person is treated as related to an EO if the person:
(1) controls, or is controlled by, the organization,
(2) is controlled by one or more persons that control the organization,
(3) is a supported organization with respect to the organization, or
(4) is a supporting organization with respect to the organization.
Under the provision, an excess parachute payment is the amount by which any parachute payment exceeds the portion of the base amount allocated to the payment.
A parachute payment is a payment in the nature of compensation to a covered employee if:
the payment is contingent on the employee’s separation from employment and
the aggregate present value of all such payments equals or exceeds three times the base amount.[xxxv]
It should be noted that this definition differs from that applicable in the case of a business organization, where the disallowance of the employer’s deduction, and the imposition of the excise tax on the employee-recipient, are not contingent on the employee’s separation from employment.
It should also be noted that the Act did not provide an exception for a payment that represents reasonable compensation. Thus, even where the payment is reasonable in light of the services provided by the employee, and thus would not be trigger an excise tax for self-dealing or an excess benefit, the excise tax will nevertheless be applied.[xxxvi]
The employer of a covered employee – not the employee – is liable for the excise tax.
This is to be contrasted with the case of an employer that is a business organization. The employer is denied a deduction for the excess parachute payment, but an excise tax is also imposed upon the employee to whom the payment was made.
In addition, if the remuneration of a covered employee from more than one employer is taken into account in determining the excise tax, each employer is liable for the tax in an amount that bears the same ratio to the total tax as the remuneration paid by that employer bears to the remuneration paid by all employers to the covered employee.[xxxvii]
The rules described above are complicated, and the IRS has yet to propose interpretive regulations, though it recently published interim guidance[xxxviii] to assist EOs with navigating the new rule, and on which they may rely, until regulations can be issued.
Of course, an EO will not be impacted by these provisions if it does not pay an employee enough remuneration to trigger the tax; there can be no excess remuneration if an EO (together with any related organization) pays remuneration of less than $1 million to each of its employees for a taxable year, and there can be no excess parachute payment if the EO does not have any “highly compensated” employees for the taxable year.[xxxix]
Does this mean that an EO should not pay any of its executives an amount that would trigger the imposition of the above tax? Should it walk away from candidates whom the EO can only hire by paying a larger amount? Or should it seek out the best people, pay them an amount that would trigger the tax but that the EO determines would be reasonable,[xl] and accept the resulting tax liability as a cost of doing business?[xli]
These are the kind of decisions that I have seen business owners make every day, and these are usually preceded by another set of inquiries: Will the return on our investment (in this case, in intellectual capital) justify the cost? Are we overpaying, or is the amount reasonable under the circumstances? Is there another way by which we can secure the same benefit – perhaps through a different mix of incentives, payable in varying amounts and at different times so as to skirt the literal terms of the Act, while also securing the services of a great executive?
The ability to bring this type of business analysis to an EO’s board discussion on executive compensation may be at least as valuable, in the current environment, as one’s willingness to open one’s wallet to the EO.
[i] See Subchapter A of Chapter 42 of the Code. Examples include the excise tax on a foundation that fails to pay out annually, to qualifying charities, an amount equal to at least five percent of the fair market value of its non-charitable assets, and the excise tax on certain “insiders” (with respect to the foundation) who engage in acts of self-dealing with the foundation (e.g., excessive compensation).
[ii] There are many reasons a business owner chooses to form a foundation; ego, tax planning, continued control, and family involvement are among these. There are also many reasons not to form one; the resulting administrative burden and the cost of tax compliance should not be underestimated.
[iii] Take a look at the board of any local charity. It is likely populated, in no small part, by the owners of businesses that operate within, or employ individuals from, the locality in which the EO is headquartered or that it services.
[iv] Instead of, say, furthering the charitable mission. It should be noted that these expenditures are not necessarily mutually exclusive.
[v] That’s right. The members of these boards elect themselves and their successors. It is rare for a larger charity to have “members” in a legal, “corporate law” sense– i.e., the counterparts to shareholders in a business organization – with voting rights, including the right to elect or remove directors. Rather, these charities depend upon honest, well-intentioned individuals to ensure that their charitable mission is carried out. Many of these individuals – the directors of the organization – are drawn from the business community. Of course, the Attorney General of the State in which a charity is organized also plays an important role in ensuring that the charity and those who operate it stay the course.
[vi] P.L. 115-97 (the “Act”).
[vii] IRC Sec. 4958; P.L. 104-168; enacted in 1996, it is generally applicable to public charities. More on this rule later.
[viii] IRC Sec. 162(a)(1).
[ix] Reg. Sec. 1.162-7.
[x] Specifically, its CEO, CFO, and the three other most highly compensated officers.
[xi] IRC Sec. 162(m); enacted in 1993 as part of the Omnibus Budget Reconciliation Act, P.L. 103-66. The Act eliminated the exception for performance-based pay.
[xii] IRC Sec. 280G(b)(2) and (c).
[xiii] An individual’s base amount is the average annualized compensation includible in the individual’s gross income for the five taxable years ending before the date on which the change in ownership or control occurs. IRC Sec. 280G(b)(3).
[xiv] IRC Sec. 280G(a) and (b)(1); enacted in 1984; P.L. 98-369.
[xv] The provision does not apply to “small business corporations” or to non-traded corporations that satisfy certain shareholder approval requirements. IRC Sec. 280G(b)(5).
[xvi] IRC Sec. 280G(b)(4)(A).
[xvii] IRC Sec. 280G(b)(4)(B).
[xviii] IRC Sec. 4999. Presumably because they would have been in a position to contractually obligate the corporation to make the payment.
[xix] IRC Sec. 4941. “Disqualified person” is defined in IRC Sec. 4946. https://www.law.cornell.edu/uscode/text/26/4946.
[xx] IRC Sec. 4941(d)(2)(E).
[xxi] The key, of course, is for the board to be able to demonstrate the basis for its determination of reasonableness.
[xxii] A “correction” under IRC Sec. 4941(e). The “obligation” to recover the excess portion is implicit in the calculation of the penalty.
[xxiii] For purposes of this rule, an economic benefit provided by an EO will not be treated as consideration for the performance of services rendered to the EO unless the EO clearly indicated its intent to treat such benefit as compensation.
[xxiv] IRC Sec. 4958(c)(1)(A).
[xxv] Reg. Sec. 53.4958-4. Congress foresaw that some individuals may try to circumvent the proscription by drawing down salaries from non-exempt organizations related to the EO.
[xxvi] IRC Sec. 4958(f)(6).
[xxvii] Reg. Sec. 1.501(a)-1.
[xxviii] Query whether EOs have been enticing executives away from business organizations in droves – I don’t think so.
[xxix] Interestingly, the Act made no distinction between public charities and PFs. In contrast, the comparable limitations for business organizations do not apply to “small business corporations” or certain non-publicly traded corporations.
[xxx] I.e., the newly established flat rate for C corporations – in order to mirror the amount of tax that such a corporation would have to pay in respect of the disallowed portion of the compensation paid to the individual service provider.
[xxxi] IRC Sec. 4960. https://www.law.cornell.edu/uscode/text/26/4960.
[xxxii] Remuneration includes amounts required to be included in the employee’s gross income under IRC Sec. 457(f).
Such amounts are treated as paid (and includible in gross income) when there is no substantial risk of forfeiture of the rights to such remuneration within the meaning of section 457(f). Sec. 4960(c)(3). For this purpose, a person’s rights to compensation are subject to a substantial risk of forfeiture if the rights are conditioned on the future performance of substantial services by any individual, or upon the achievement of certain organizational goals.
Up until now, the only cap on 457(f) arrangements was that the payment be reasonable for the services actually rendered.
In determining reasonableness, one looks to the totality of the recipient’s services to the EO, not only for the year paid; in other words, the payment may be “prorated” over many years for this purpose. Accordingly, the tax imposed by this provision can apply to the value of remuneration that is vested even if it is not yet received. Indeed, the excise tax can apply to amounts that are paid currently though they were earned in earlier years.
[xxxiii] Sec. 4960(c)(2).
[xxxiv] The list of covered employees may grow to include individuals who are no longer included in the five highest paid.
[xxxv] The base amount is the average annualized compensation includible in the covered employee’s gross income for the five taxable years ending before the date of the employee’s separation from employment.
[xxxvi] That being said, the Act does exempt compensation paid to employees who are not “highly compensated” employees from the definition of parachute payment.
Significantly for EO-hospitals, compensation attributable to medical services of certain qualified medical or veterinary professionals is exempted from the definitions of remuneration and parachute payment; remuneration paid to such a professional in any other capacity is taken into account.
Unfortunately, neither the Act nor the committee reports provide any guidance regarding the allocation of a medical professional’s remuneration between their medical services and, say, their administrative functions within the EO-employer.
[xxxvii] It should be noted that the Act authorizes the IRS to issue regulations to prevent the avoidance of the excise tax through the performance of services other than as an employee.
[xxxviii] Notice 2019-09, which consists of ninety pages of Q&A.
[xxxix] Within the meaning of IRC Sec. 414(q).
[xl] It should always be reasonable under the facts and circumstances.
[xli] Assuming the amount is reasonable within the meaning of the self-dealing and excess benefit rules, will there be any argument under state law that the imposition of the tax reflects a per se breach of the board’s fiduciary duty?
If the amount is not reasonable, such that the excise taxes on self-dealing and excess benefits become payable, what is purpose of the new tax?