Proposed Treasury regulations published earlier this month contain limited relief for tax-exempt entities. If followed carefully, those regulations can enable tax-exempt entities (and any related for-profit corporations) to avoid the application of the Internal Revenue Code Section 4960 excise tax imposed on certain executive compensation. The proposed regulations are a welcome relief to for-profit entities that have established tax-exempt charitable foundations, and that want to encourage the involvement of their officers and employees in the foundation’s activities as part of their civic responsibilities. Taxpayers are permitted to rely on the proposed regulations until final regulations are published.

Background

The Tax Cuts and Jobs Act of 2018 included provisions affecting tax-exempt organizations with respect to the compensation paid by certain tax-exempt organizations to their senior officers. In general, under Code Section 4960, the payment of so-called excess remuneration (annual compensation in excess of $1 million) and parachute payments (payments triggered by an executive’s separation from service where the total amount of those payments exceeds three times the executive’s average annual compensation) result in an excise tax of 21% imposed on the tax-exempt entity or, if different, the payor of the remuneration.

The excise tax applies to payments of remuneration by the tax-exempt organization or any related entity to any individual who is or has been, for any year after Dec. 31, 2016, one of the five highest-paid employees of the tax-exempt organization. The definitions of “remuneration” and “related entity” under the statute are quite broad and include, for example, amounts paid by a for-profit corporation to one of its employees if that individual also serves as an officer of a charitable foundation related to the for-profit corporation. This would be the case even if the individual served the foundation in an unpaid capacity.

The proposed regulations offer two scenarios in which an employee will not be considered one of the tax-exempt organization’s top-5 employees:

1. The “Limited Hours” exception. An employee of a for-profit corporation who also performs services for a related tax-exempt organization will not be considered one of the tax-exempt organization’s top-5 employees, if both of the following apply:

• Neither the tax-exempt organization nor any other tax-exempt organization (or any taxable entity controlled by the tax-exempt organization) pays the individual remuneration.
• The services provided by the individual for the tax-exempt organization do not comprise more than 10% of the total hours of service for all related organizations.

The proposed regulations contain a safe harbor rule for individuals who do not work more than 100 hours for a tax-exempt organization during a year.

2. The “Non-Exempt Funds” exception. An employee of a for-profit organization who also performs services for a related tax-exempt organization also may be excluded from being considered one of the top-5 employees of the tax-exempt organization, if all of the following apply:

• Neither the tax-exempt organization nor any other tax-exempt organization (or taxable entity controlled by the tax-exempt organization) pays the individual remuneration.
• The for-profit organization paying the employee’s remuneration does not provide services for a fee to the tax-exempt organization or any related tax-exempt organization.
• The individual provides services “primarily” to the for-profit employer during the year. This standard will be met if the employee’s services for the for-profit employer are more than 50% of the total hours worked for all related entities.

The proposed regulations include guidance on how to count hours worked for purposes of applying these exceptions.

While the regulations address two common scenarios involving short-term or limited scope assignments, they do not help with longer term employee secondments or other arrangements which may arise between tax-exempt organizations and related taxable employers. In those situations, additional analysis and careful attention to the structural relationship between the organizations may be necessary to avoid unintended tax consequences.