Understanding the Excise Tax on Executive Compensation Paid by Tax-Exempt Organizations—Part II: Who Are My Organization’s Covered Employees, and What Counts as Remuneration?
As discussed in our prior client alert, new Internal Revenue Code Section 4960 (“Section 4960”) imposes a 21 percent excise tax on “excess remuneration” and “excess parachute payments” paid by an organization that is exempt from tax under section 501(a) of the Code to certain “covered employees” during a taxable year. Section 4960 applies for taxable years beginning after December 31, 2017 – for employers on a calendar year tax year, this means Section 4960 took effect with respect to amounts paid in 2018. As the deadline to report and pay the excise tax approaches (May 15, 2019, is the deadline for calendar year taxpayers), tax-exempt employers have questions about how Section 4960 is meant to be applied.
IRS Notice 2019-09 (the “Notice”), published at the start of 2019, provides guidance on the application of Section 4960 and sheds light on, among other things: (i) what is an applicable tax-exempt employer, (ii) who is a covered employee, (iii) what constitutes excess remuneration and excess parachute payments, and (iv) how to report and pay the excise tax. Until the Treasury Department and IRS issue regulations implementing Section 4960, the Notice describes “a good faith, reasonable interpretation of [S]ection 4960” on which taxpayers may rely.1
Getting Ready for May 15, 2019 (for ATEOs whose taxable year is the calendar year)
For tax-exempt employers that are looking toward May 15, 2019, and wondering how Section 4960 will affect them, we’ve outlined several steps that an employer may want to take now to prepare. This article is the second in a series of alerts providing additional detail about certain key concepts in the Notice that may help guide an employer’s analysis.
- Determine if your organization is an applicable tax-exempt employer (ATEO) subject to Section 4960. The definition of “ATEO” is discussed in Part I of this Client Alert Series.
- Identify any related organizations that will need to be taken into account to compile the ATEO’s list of covered employees and to determine the total remuneration paid and excess parachute payments made to covered employees. The related organization rules are discussed in Part I of this Client Alert Series.
- Compile the list of covered employees. To prepare the initial list, an ATEO will need to identify both covered employees for 2018 and covered employees for 2017 (i.e., an ATEO may have more than five covered employees on its initial list). Identification of covered employees for 2017 is necessary due to the “once a covered employee, always a covered employee” rule (i.e., if an employee is a covered employee for a taxable year beginning after December 31, 2016, he or she will always be a covered employee for purposes of Section 4960). Remuneration from related employers needs to be taken into account for this purpose, so ATEOs will need to obtain compensation data from all related organizations. The definition of “covered employee” and the definition of “remuneration” are discussed below.
- Determine if any covered employee received excess remuneration during 2018. The rules for determining excess remuneration will be discussed in Part III of this Client Alert Series.
- Determine if any covered employee received an excess parachute payment during 2018. The rules for identifying and quantifying the value of excess parachute payments will be discussed in Part III of this Client Alert Series.
- If excess remuneration was paid and/or excess parachute payments were made to any covered employee in 2018, calculate the amount of excise tax owed by the ATEO and each related organization. The rules for calculating the excise tax and apportioning liability among related organizations will be discussed in Part III of this Client Alert Series.
- File Form 4720 to report and pay the excise tax. The filing requirements for Form 4720 will be discussed in Part III of this Client Alert Series.
Remuneration for purposes of Code Section 4960 means wages as defined in section 3401(a) of the Code and includes deferred compensation that becomes vested pursuant to section 457(f) of the Code but excludes designated Roth contributions as well as pre-tax contributions to cafeteria plans, qualified retirement plans and transportation benefit plans. Remuneration includes an amount that is a parachute payment, but there is no double-dipping on the excise tax – so if a parachute payment is subject to the excise tax as an excess parachute payment, it is not also subject to the excise tax as excess remuneration. In addition, as discussed below, remuneration does not include the portion of any remuneration paid to a licensed medical professional (including a veterinarian) that is directly related to the performance of medical, nursing or veterinary services by such professional. Remuneration paid by another organization, whether or not a related organization, with respect to the covered employee’s employment by an ATEO, is treated as remuneration paid by that ATEO.
Remuneration is not the same as W-2 compensation. Therefore, ATEOs and related organizations will need to establish mechanisms specific to tracking employee “remuneration” for purposes of Section 4960.
Remuneration includes remuneration paid to a covered employee by any related organization with respect to the employee’s employment by that related organization. ATEOs will need to assess whether remuneration paid from related organizations needs to be taken into account for purposes of determining its covered employees.
Remuneration is considered paid for a taxable year if it is paid during the calendar year ending with or within the ATEO’s or related organization’s taxable year. For example, if an ATEO’s taxable year runs from February 1, 2018 – January 31, 2019, to determine covered employees during the ATEO’s taxable year, only remuneration paid during calendar year 2018 is taken into account.
Special rules apply to determine the timing and amount of deferred compensation that is taken into account for this purpose. With regard to timing, remuneration is treated as paid on the first date that it is not subject to a substantial risk of forfeiture within the meaning of section 457(f)(3)(B) of the Code. This timing rule applies even if the payment is not subject to section 457(f) of the Code or section 409A of the Code, as may be the case if an amount paid under an ATEO’s nonqualified deferred compensation plan is treated as a short-term deferral that is not “deferred compensation” for certain tax purposes. With regard to the amount, the present value of the right to future payments as of the vesting date is taken into account for this purpose. The present value may be determined using reasonable actuarial assumptions. Net earnings on previously vested amounts are included in remuneration and are treated as paid at the close of the calendar year in which they accrue.
Remuneration for Medical Services
Remuneration paid to a licensed medical professional for the direct performance of medical services (or veterinary services) is not taken into account for purposes of determining the five highest-compensated employees, for purposes of determining a covered employee’s excess remuneration, or for purposes of determining whether a payment is a parachute payment. However, remuneration paid to the professional for any other services, including administrative and management services associated with the performance of medical or veterinary services, is considered remuneration for this purpose. The Notice clarifies that the term “medical services” includes nursing services and incorporates the definition of “medical care” under section 213(d)(1)(A) of the Code to define what constitutes the direct performance of medical services. Notably for ATEOs with physicians and nurses who serve in multiple capacities within the organization, the Notice also includes a discussion of how to apportion remuneration paid to a covered employee for both the direct performance of medical services and the performance of non-medical services.
Example: H is a hospital and an ATEO, and A is a covered employee of H. A provides patient care services, as well as management and administrative services, to H. Based on a representative sample of insurance and Medicare billing records, as well as time reports that A submits to H, H determines that A spends half of her time providing medical care to patients and half of her time performing administrative services. H allocates half of A’s remuneration to medical services so only the portion of A’s remuneration allocated to the non-medical services is remuneration for 4960 purposes.
Tax-exempt hospitals will need to determine how to allocate compensation between medical and non-medical services when an employee performs both medical and non-medical functions. Hospitals may rely on a reasonable allocation set forth in an employment agreement that explicitly allocates a portion of the remuneration as for medical services or other services.
Previously Paid Remuneration
Certain types of compensation are treated as “previously paid remuneration.” In general, remuneration is treated as previously paid remuneration for a taxable year to the extent it becomes vested by the end of the calendar year ending with or within the taxable year but that is not actually or constructively paid to the executive in that year. Any earnings on previously paid remuneration are treated as paid at the close of the calendar year in which they accrue. For example, X is a covered employee of an ATEO (Z) and Z’s taxable year is the calendar year. In 2019, X receives an account credit for $100,000 under Z’s deferred compensation plan subject to the requirement that X remain employed through June 30, 2021. For 2019 and 2020, the $100,000 (and any earnings thereon) are not taken into account as remuneration. On June 30, 2021, X’s account balance is $110,000, and assuming that X remains employed through June 30, 2021, the $110,000 is taken into account as remuneration for 2021. The $110,000 is now viewed as previously paid remuneration. As of December 31, 2021, X’s account balance increases to $115,000. The additional $5,000 attributable to earnings on previously paid remuneration ($110,000) is treated as remuneration in 2021. It should be noted that any future investment losses would not reduce amounts previously treated as income but would be available to offset any future earnings on previously paid remuneration. Thus, an ATEO will be required to maintain detailed records to track the increases to the amount of previously paid remuneration and the availability of offsets for losses against future income on the amounts treated as previously paid remuneration.
ATEOs (and related organizations) will now need to track when compensation becomes vested (but is not paid) in order to properly account for compensation as previously paid remuneration and any earnings and/or losses on previously paid remuneration.
With regard to an employee who becomes a covered employee, any remuneration that is vested but is not paid by the end of the calendar year preceding the calendar year ending with or within the taxable year of the ATEO is treated as paid for ATEO’s preceding taxable year. For example, if an executive first becomes a covered employee for the ATEO’s taxable year ended June 30, 2022, then any remuneration that becomes vested (but is not paid) by December 31, 2020, is treated as paid for the ATEO’s taxable year ending June 30, 2021, and is not taken into account for purposes of the excise tax.
On a similar note, any remuneration that was vested but was not paid as of the close of the taxable year preceding the first taxable year in which Section 4960 is effective for the ATEO is treated as paid for the previous taxable year and is not subject to the excise tax. For example, for an ATEO that uses a calendar year taxable year, the present value of any remuneration that is vested but was not paid by December 31, 2017, is treated as paid for taxable year 2017 and is not subject to the excise tax.
The determination of whether an individual is a covered employee is made on an ATEO-by-ATEO basis (and not on a “controlled group” basis).
The 21 percent excise tax applies to “excess remuneration” and “excess parachute payments” paid by an ATEO to certain covered employees during a taxable year. A covered employee means any employee (including a former employee) if the employee (i) is one of the ATEO’s five highest-compensated employees in the current taxable year or (ii) was a covered employee for any of the ATEO’s preceding taxable years beginning after December 31, 2016. There is no minimum dollar threshold for an employee to be a covered employee. Once an employee is deemed a covered employee, he or she will always be a covered employee for purposes of Section 4960.
ATEOs will need to develop mechanisms to track covered employees on an annual basis and, due to the “once a covered employee, always a covered employee” rule, the list of covered employees will need to be maintained indefinitely.
The determination of whether an employee is one of an ATEO’s five highest-compensated employees (and therefore a covered employee of the ATEO) is made on the basis of the employee’s remuneration (as discussed in Section III above) for services performed as an employee of the ATEO (including remuneration for services performed as an employee of a related organization with respect to the ATEO).
An employee may be a covered employee of more than one ATEO. For example, Hospital A and Clinic B are ATEOs and are related organizations, and both employ E (in a non-medical capacity). Of E’s total remuneration paid in 2018, 50 percent was for services to Hospital A and 50 percent was for services to Clinic B. Based on E’s aggregate remuneration, E is one of the highest-compensated employees of both Hospital A and Clinic B. Therefore, E is a covered employee of both Hospital A and Clinic B for 2018 and for all later calendar years. Note, however, that an employee is not a covered employee of an ATEO if the ATEO paid less than 10 percent of the employee’s remuneration for services performed as an employee of the ATEO and all related organizations.
If this “limited services” exception would result in an employee not being treated as a covered employee of any ATEO within the ATEO’s group of related organizations (because no ATEO in the group paid at least 10 percent of the total remuneration paid to the employee for the year), but the employee is nonetheless one of the five highest-compensated employees, then the ATEO that paid the employee the most remuneration during the year must include the employee on its covered employee list.
If you have questions about how to identify covered employees for Section 4960 purposes, or if you would like assistance in determining which payments are included in “remuneration” under Section 4960, contact a member of our Employee Benefits and Executive Compensation Team.
If you aren’t sure whether your organization is an applicable tax-exempt organization that is subject to Section 4960, see Part I of this Client Alert Series for additional discussion.
If you have already determined that your organization is an ATEO and compiled your organization’s covered employee list, stay tuned for Part III of this Client Alert Series, which will include discussion of how to calculate “excess remuneration” for the taxable year, how to identify “excess parachute payments,” and how to report and pay any excise tax that may be owed for 2018.
1 The Notice also notes certain positions that do not constitute a good faith, reasonable interpretation of Section 4960 (for example, it is not reasonable for an employer to take the position that an individual ceases to be a covered employee after a certain period of time).