New Excise Tax Reporting Obligation For Tax-Exempt Entities
Attention tax-exempt entity employers: Starting with tax filings this year (for your taxable year that began in 2018), you will need to make a special report to the IRS and pay an excise tax if you provided certain current or former highly compensated employees more than $1 million in compensation or paid part of a severance package that was worth more than three times their average compensation over the five years prior to their separation from employment.
Questions and Answers
- What sort of tax-exempt entity employer is subject to this new reporting and excise tax obligation?
Answer: Generally, any tax-exempt entity that is required to file an IRS Form 990, certain churches that are exempt from the Form 990 filing requirement, and certain governmental entities that are exempt from income tax under Internal Revenue Code §115(1) [usually those public entities whose governing board is not publicly elected or appointed by state officials and do not have the power to tax, the power of eminent domain and the police power]. Public hospitals (especially those that in the past obtained 501(c)(3) letters from the IRS) and public universities need to carefully look at whether they are covered by this new reporting and excise tax requirement.
- What is the reporting/excise tax payment due date and what IRS forms must be used?
Answer: If your entity owes this new excise tax, the due date for payment and filing is the 15th day of the fifth month after the end of your entity’s taxable year that ended in 2018. (Filing is only required if you owe the tax.) For example, in the case of a 2018 calendar year taxable year, the due date will be May 15, 2019, and, for a July 1 through June 30 taxable year, the due date will be November 15, 2019. This is the same filing date as used for your Form 990 if your entity files that form. IRS Form 4720 should be used to report this new excise tax liability and its payment. You will also need to answer “yes” to question 15 in Part V of Form 990 if your entity files that form. You can request and receive an automatic six-month extension for the Form 4720 due date by filing IRS Form 8868 no later than the initial Form 4720 due date. However, the excise tax remains payable on the initial due date and, if you wait to pay until the extended Form 4720 filing due date, your entity will owe late payment interest and penalties.
- Which of your employees can trigger the excise tax?
Answer: Any current or former employee who is one of your entity’s five highest compensated employees in any calendar year after December 31, 2016. Compensation for this purpose is generally Form W-2 Box 1 earnings provided to the employee by your entity or a related entity (based on a greater than 50 percent control of governing directors or ownership interest) with respect to the employee’s employment by that related entity. [Note: Compensation for this purpose will include certain items that vest in a year but will not show up in Form W-2 Box 1 until a later year; e.g., bonuses that vest in one year and are paid out within 2 1/2 months of the following year and certain severance promises.] Compensation paid to a licensed medical professional (such as a doctor, nurse, or veterinarian) for the direct performance of medical services does not count. For example, if the doctor spends 25 percent of her time treating patients and 75 percent of her time acting as a medical director or manager, then only 25 percent of her compensation will be excluded from consideration for purposes of this analysis. These top five compensated individuals are known as “covered employees” under the new rules. Once a person has been designated as a “covered employee” for a year, he retains that status for the rest of his employment with your entity. Although the standards are not exactly the same, in any given year you should expect to find your top five “covered employees” among the “Officers, Key Employees and Highly Compensated Employees” listed in Part VII §A of your entity’s Form 990 if it files one. Once you have designated your “covered employees” for 2017 and 2018, start keeping a running list that you add to each year.
- Under what circumstances will your entity owe this new excise tax?
Answer: Your entity will owe this new excise tax for its taxable year beginning in 2018 if (i) the compensation (as defined in Q&A 3 above) paid to a “covered employee” in the 2018 calendar year exceeds $1 million, or (ii) payments are made in 2018 to a “covered employee” under an involuntary separation severance package that had, on the date the “covered employee” involuntarily separated from employment, a present value equal to more than three times the “covered employee’s” average compensation for the five calendar years preceding the “covered employee’s” involuntary separation from employment (“excess severance package”). Compensation paid or vested during the calendar year ending within your entity’s taxable year is treated as having been paid in that taxable year.
- How is this new excise tax calculated?
Answer: For compensation over $1 million paid to a “covered employee” in a taxable year, the excise tax is the amount of the “covered employee’s” compensation over $1 million multiplied by the corporate tax rate under Code §11 (currently this is 21 percent). For payments made during your entity’s taxable year under an “excess severance package,” the excise tax is the Code §11 corporate tax rate multiplied by the portion of the “covered employee’s” severance payment that exceeds the amount of the “covered employee’s” average annual compensation allocated to them under a rather complicated formula developed by the IRS. In the end, after the entire excess severance package has been distributed, you will have paid the excise tax on an amount equal to the present value of the excess severance package reduced by one year of your average annual compensation.
- What is the effective date for this new excise tax and reporting obligation?
Answer: The effective date is the first day of your entity’s first taxable year beginning after December 31, 2017; i.e., January 1, 2018, if your entity has a calendar taxable year, and the first day of your entity’s taxable year starting in 2018 if it has a non-calendar taxable year (e.g., a July 1, 2018, effective date if your entity has a July 1 to June 30 taxable year). [Note: If your entity has a non-calendar taxable year, then for purposes of determining whether you owe the excise tax for the taxable year that began in 2018, your entity will only count the 2018 calendar year wages that were paid or vested during your entity’s first affected taxable year. For example, in the case of a July 1 to June 30 taxable year, your entity will only count 2018 calendar year compensation that was paid or vested after June 30, 2018. This is a special rule just for the first non-calendar taxable year; thereafter, your entity will be required to count all compensation for the calendar year that ended within the non-calendar taxable year in question.]
This new rule is fairly complicated and this article is not an exhaustive treatise on the subject, but rather is designed to give you just enough information to “issue spot” and decide if you might be subject to this excise tax and need to file a form 4720 for your entity’s taxable year starting in 2018. If, after reading this article, you think that your entity might have an issue, you should investigate the matter in more detail. The statutory source of this new requirement is Internal Revenue Code §4960 and the IRS has issued a helpful 92-page explanation of its take on the new law. (See IRS Notice 2019-09 “Interim Guidance Under §4960.”)