10 Keys to Excise Tax on Executive Compensation Paid by Tax-Exempt Organizations
Proposed Regulations under Section 4960 of the Internal Revenue Code provide important guidance for tax-exempt organizations and their affiliates regarding an excise tax on certain executive compensation. The U.S. Department of the Treasury (“Treasury”) and Internal Revenue Service (the “IRS”) are accepting comments until August 10, 2020. (Throughout this post, “Sections” refer to sections of the Internal Revenue Code.)
As a refresher, Section 4960 was enacted as part of the 2017 Tax Cuts and Jobs Act (the “TCJA”). Effective for taxable years beginning after December 31, 2017, Section 4960 imposes an excise tax at the corporate tax rate (currently at 21%) on certain remuneration in excess of $1 million and on certain separation pay (“excess parachute payments”). The excise tax falls on “applicable tax-exempt entities” (“ATEOs”) and related organizations. It is intended to have the same economic effect as a for-profit corporation losing a tax deduction.
The Proposed Regulations are generally consistent with the IRS’s interim guidance under Notice 2019-09 (the “Notice”), which is discussed here and here. But the Proposed Regulations elaborate on certain points and include some helpful changes in response to comments.
If finalized, the Proposed Regulations will apply for tax years beginning on or after the final regulations are published in the Federal Register. Until then, tax-exempt organizations may apply a “reasonable, good faith” interpretation of the statute. For this purpose, tax-exempt organizations may rely on the Proposed Regulations or the Notice. Although the Proposed Regulations are not binding, they include a list of positions that the IRS considers to be an unreasonable interpretation of the statute.
Below we discuss 10 key points under the Proposed Regulations.
The excise tax under Section 4960 applies for compensation that is paid or becomes vested during taxable years that start after December 31, 2017. In developing the Proposed Regulations, the IRS rejected requests to grandfather amounts paid under agreements that were in effect before the TCJA was passed. The IRS reasoned that the statute did not provide authority for grandfathering.
In contrast, the TCJA included a grandfathering provision for changes made to Section 162(m). Based on the statutory language, the IRS concluded that if Congress intended to allow grandfathering for Section 4960, it would have said so.
Grandfathering is on the list of positions that the IRS considers to be an unreasonable interpretation of the statute.
“ATEO” (Applicable Tax-Exempt Organization) Includes Most Tax-Exempts
Like the Notice, the Proposed Regulations clarify that ATEOs include all organizations that: (i) are exempt from taxation under Section 501(a) (i.e., organizations described in Section 501(c) or (d)), (ii) are farmers’ cooperatives organizations described in Section 521(b)(1), (iii) have income that is excluded under Section 115(1), or (iv) are political organizations described in Section 527(e)(1).
Under the Proposed Regulations, Section 4960 does not apply to a governmental entity that claims exemption from federal income tax based on sovereign immunity (such as many public universities), but only if the entity is not also tax-exempt under Section 501(a). A governmental entity that also has Section 501(a) tax-exempt status may relinquish its Section 501(a) status if it wishes to avoid designation as an ATEO. Even if a governmental entity is not an ATEO, compensation paid by the governmental entity is still taken into account for purposes of identifying covered employees of related ATEOs; and the governmental entity can still be subject to the Section 4960 tax if it is related to an ATEO.
Must Aggregate ATEOs With Related Organizations (the “Related Group”): 50% Test
The Proposed Regulations require that remuneration for each covered employee must include not only remuneration from the ATEO but also remuneration from all “related organizations.” For this purpose, relatedness is similar to a controlled group test, except that the threshold for relatedness is 50% rather than 80%. As with a controlled group, organizations can be related on the basis of different factors, including voting rights or rights to value of a corporation, profits or capital interests in a partnership, beneficial interests in a trust, or control over the organization’s board or similar governing body.
Throughout this post, we refer to the ATEO and its related organizations as the “Related Group.”
Covered Employees: Once Covered Always Covered
In general, covered employees are the top five highest paid employees of the ATEO. All “common law” employees of the ATEO must be taken into account, even if they are part-time. There is no compensation threshold in order to be covered: the top five highest-paid employees are covered even if no one in the organization has compensation approaching $1 million.
Individuals who are not common law employees, such as non-employee directors and independent contractors, are disregarded. But officers are presumed to be common law employees, and therefore generally must be taken into account unless one of the exceptions below applies.
Identifying the covered employees and tracking them is critically important for two reasons:
First, even if an individual does not receive $1 million, separation payments to the individual could trigger the “parachute payment” tax described under #6, below.
Second, the statute has a “once covered, always covered” rule, which means that “covered employee” status stays with an individual indefinitely—even after the individual’s service with the ATEO has ended.
For example, suppose a former employee of a tax-exempt foundation is later hired into the corporate office of a related for-profit. If that individual was a covered employee of the foundation for any taxable year beginning after December 31, 2017, future compensation for service to the for-profit would be subject to the $1 million cap—leaving the possibility that the excise tax could be triggered long after the individual’s service to the foundation, even if the individual never again provides services to the foundation.
The Proposed Regulations include two exceptions for ATEOs that are affiliated with for-profits: (1) a “non-exempt funds” exception and (2) a “limited hours” exception. To qualify for either exception, the ATEO must not pay or promise any remuneration to the individual. In addition to not paying compensation directly, the ATEO must not promise deferred compensation, even if it is subject to vesting conditions, and the ATEO must not reimburse another entity for any part of the individual’s remuneration (whether through a direct reimbursement or a fee). In addition, the following conditions must be satisfied:
For the non-exempt funds exception, the employee’s time spent providing services to the ATEO (and any related ATEOs) must not exceed 50% of his or her total time for the Related Group. For purposes of this test, service time can be measured by hours or days (where any day in which the individual works for at least an hour on behalf of an ATEO counts as a full day worked for the ATEO). For this exception, the prohibition against paying or promising remuneration to the employee applies not only to the ATEO but also to any for-profit organization that is controlled by the ATEO.
For the limited hours exception, the employee’s time spent providing services to the ATEO (and any related ATEOs) must be less than 10% of his or her total time for the Related Group. Again, service time can be measured by hours or days (where any day in which the individual works for at least an hour on behalf of an ATEO counts as a full day worked for the ATEO). Also, the proposed regulations include a safe harbor, under which an individual who does not work more than 100 hours for the ATEO (and any related ATEOs) in a year will automatically be treated as below the 10% threshold. Unlike the nonexempt funds exception, this exception does not prohibit compensation paid or promised by a taxable organization that is controlled by the ATEO.
The exceptions should help to avoid excise taxes as a result of compensation paid by for-profits to employees who provide limited services to ATEOs. But it is important to keep the “once covered, always covered” rule in mind. If an individual ever becomes a covered employee, he or she will retain covered status even if service and compensation levels later drop below the level for an exception.
Under the Proposed Regulations, every ATEO must have its own list of covered employees. Where two or more ATEOs are related to one another, each ATEO must have its own list. Consequently, if an individual is employed by more than one related ATEO, he or she could be a covered employee of more than one ATEO.
However, the Proposed Regulations include a “limited service” exception (carried forward from the Notice) for cases where an individual provides service to more than one related ATEO. Under the limited service exception, an ATEO can disregard an individual for a tax year if, for that year, the ATEO paid less than 10% of the individual’s total remuneration from the Related Group, and at least 10% of the individual’s total remuneration from the Related Group is paid by another related ATEO. If no other related ATEO paid at least 10% of the individual’s total remuneration, the individual must be included in the covered employee analysis for the ATEO that paid the highest percentage of the individual’s total remuneration.
Again, the exception does not erase covered employee status for someone who was a covered employee in a prior year. As described below, failure to apply the “once covered, always covered” rule is on the list of positions that the IRS considers to be an unreasonable interpretation of the statute.
Special Timing Rule for Remuneration
For purposes of the $1 million cap, “remuneration” generally has the same definition as wages under Section 3401 (the income tax withholding rules), but there is an important timing difference for amounts that are earned in one year and paid in a later year. Rather than wait until remuneration is paid, deferred compensation must be included in remuneration for the year in which it becomes vested under Section 457(f)—i.e., when the remuneration is no longer subject to a substantial risk of forfeiture.
Unlike Section 457(f), the Proposed Regulations do not have a short-term deferral rule. This means, for example, that a bonus payable in January or February for service during the prior year could count toward the $1 million cap for the prior year. The analysis turns on whether the bonus is conditioned on continuing to provide services during the year of payment. If the bonus is conditioned on continuing to provide services during the year of payment, it would count for the year of payment; but if the bonus is not conditioned on providing services during the year of payment, it would count for the prior year.
In light of this rule, the vesting schedule for retention bonuses and other deferred compensation can have a dramatic impact on the excise tax. For example, suppose an executive’s five-year employment agreement provides for $150,000 per year of deferred compensation, to be paid only if the individual serves out the term. If the deferred compensation vests at the end of the term, the full $750,000 ($150,000 per year times 5 years) would count for Section 4960 purposes in the last year of the term. If the individual has more than $250,000 of salary or other remuneration for that last year, the organization would have to pay an excise tax—even though the accruals never reach $1 million per year. In contrast, if the deferred compensation were to vest ratably (for example, $150,000 at the end of each year), the excise tax might not be triggered.
If deferred compensation becomes vested before the year of payment, the remuneration for the year of vesting would be the present value as of the end of that year. Earnings (or growth in value) for the period after vesting would count for Section 4960 purposes each year as they accrue. In contrast, income tax on earnings would generally be deferred until the year of payment.
Beware of “Parachutes”: They’re Easier to Trigger Than You Might Expect
As noted above, separation pay to covered employees can trigger the “parachute payment” tax even if the individual’s compensation never reaches $1 million. For this purpose, separation pay includes any amount that becomes payable as a result of a covered employee’s involuntary separation from employment with an employer—i.e., amounts that would not become payable if not for the involuntary separation. Similar to Section 409A, “involuntary” separation includes resignation for “good reason” if certain conditions are satisfied.
In general, the parachute tax is triggered if separation pay equals or exceeds 3 times a covered employee’s “base amount.” For the following reasons, the tax can be triggered even if an individual’s severance never gets close to 3 times salary:
First, the “3 times” test is not based on current compensation, but rather is based on the individual’s “base amount.” The base amount is the individual’s average taxable wages (as reported in Box 1 of Form W-2) over the preceding five years (or, if less, the individual’s period of employment with the ATEO). If an individual’s compensation has increased over the years, the base amount can be significantly smaller than the individual’s salary at the time of separation.
Second, for purposes of parachute payments, remuneration is not limited to taxable compensation. With limited exceptions (such as payments under a tax-qualified or Section 403(b) plans), all amounts in the nature of compensation must be taken into account. For example, the value of continued health insurance, which is often more than $30,000 per year, and life insurance must be taken into account for purposes of the parachute analysis.
Third, separation pay includes not only severance, but also vesting of bonuses, equity and deferred compensation. For example, if an individual has a deferred compensation balance that is conditioned on continued service but becomes vested upon involuntary termination without cause, the full balance would count for purposes of the parachute payment calculation.
It is important to analyze separation payments carefully, because the consequences of hitting the 3 times threshold can be dramatic. Although the threshold for triggering the excise tax is 3 times the base amount, the tax applies to separation pay in excess of 1 times the base amount. For example, suppose an individual’s base amount is $100,000. The excise tax would be triggered if the individual’s separation pay (taking into account the value of deferred compensation that becomes vested and fringe benefits) is $300,000 or more. If the individual’s separation pay is $299,999.99, the excise tax would not be triggered. But if the individual’s separation pay is $300,000.00, the excise tax would be $42,000 (21% of the excess of $300,000 over $100,000). The penny makes a big difference.
The Proposed Regulations include anti-abuse rules to prevent organizations from shifting the time of payment proximate to an involuntary separation from service in order to avoid the payments being classified as parachute payments. For example, if an employer accelerates the vesting of a bonus or deferred compensation so that it is paid shortly before employment is terminated, the amount accelerated could be treated as contingent on the separation of employment that soon followed.
Medical Services Exception: Reasonable, Good Faith Allocation
By statute, the excise tax under Section 4960 does not apply for amounts paid for medical and veterinary services; and amounts paid for medical and veterinary services must be disregarded for purposes of determining the ATEO’s five highest paid employees. For example, compensation that hospitals pay to doctors and nurses must be disregarded to the extent that the compensation is for medical services (as distinct from compensation for administrative services, whether paid directly by the ATEO or by a related organization such as a management services organization).
Where an individual performs both medical/veterinary and administrative services (for example, a Chief Surgeon), the Proposed Regulations carry forward the “reasonable allocation” rule from the Notice. Like the Notice, the Proposed Regulation provides that the employer can follow an allocation specified in an employment agreement (or other written arrangement), if the allocation is reasonable. Another possible approach would be to allocate based on time records or to allocate based on compensation for individuals with comparable duties (e.g., determine the medical portion based on compensation paid to other doctors in the same field who do not have administrative responsibility, or determine the administrative portion based on compensation paid to administrators who do not also have medical responsibility). The IRS has requested comments on other examples of reasonable methods of allocation.
Applicable Year for Organizations With Non-Calendar Fiscal Years
Like the Notice, the Proposed Regulations provide that the applicable tax year is the calendar year ending with or within the ATEO’s tax year. For example, if an ATEO’s fiscal year ends on June 30, the applicable year for the tax year ending June 30, 2020, is calendar year 2019. If the excise tax applies for compensation paid during 2019, it would have to be reported on Form 4720, and paid, by the Form 990 filing deadline for the ATEO’s tax year ending June 30, 2020—i.e., by November 15, 2020. For amounts paid in calendar year 2020, the excise tax would have to be reported and paid by the Form 990 filing deadline for the ATEO’s tax year ending June 30, 2021—i.e., by November 15, 2021, subject to extension. An extension for filing Form 990 automatically extends the deadline for filing Form 4720, but an estimated tentative tax must be paid by the due date without extension.
The applicable year for purposes of Section 4960 is the same as for purposes of Form 990. But the compensation calculations for Section 4960 are not the same as for Form 990. For example, the requirement to count compensation in the year of vesting (described in #5, above) does not apply in the same way for Form 990 purposes. Consequently, the amount treated as current compensation for Section 4960 will not necessarily be the same as the amount reported as current compensation on Form 990.
Allocation and Payment of Excise Tax
If a covered employee receives compensation from more than one affiliated organization (taxable or non-taxable), and the excise tax is triggered, the tax must be allocated among the organizations, including for-profit organizations. In general, each organization’s allocation is determined by a ratio. The numerator is the amount of remuneration that is paid or payable by the organization for the year, and the denominator is the covered employee’s total remuneration for the year from the Related Group. Like the Notice, the Proposed Regulations include rules to prevent double-counting.
Per Se Unreasonable and Non-Good Faith Interpretations
While the Proposed Regulations allow a reasonable, good faith interpretation of the statute, the Proposed Regulations provide that the following positions are per se not reasonable, good faith interpretations of the statutory language:
Failing to apply the “once covered, always covered” rule—for example, treating an individual as no longer covered after a certain period of time has passed.
Failure of a related organization—which may be a for-profit or a governmental entity that is not an ATEO—to pay its share of the excise tax under Section 4960.
Counting remuneration for medical or veterinary services for purposes of identifying the ATEO’s five highest-compensated employees.
Having a single group of five covered employees for a group of related ATEOs. Each ATEO must have its own list of covered employees.