Internal Revenue Service Notice 2019-09 gives tax-exempt organizations interim guidance on how to identify covered employees, calculate remuneration, and allocate excise tax under Section 4960.
The 2017 Tax Cuts and Jobs Act introduced Internal Revenue Code Section 4960, which imposes a 21% excise tax on certain executive compensation paid to employees of tax-exempt organizations. Specifically, the 21% tax is imposed on (1) remuneration over $1 million paid with respect to a “covered employee” of an “applicable tax-exempt organization” (ATEO), and (2) “excess parachute payments” paid with respect to a covered employee of an ATEO.
The IRS has released interim guidance in the form of Notice 2019-09 (Dec. 31, 2018) (the Notice), which addresses some of the many questions raised by the new tax law. Taxpayers may rely on the Notice while further guidance is being developed and may base their positions on a “good faith, reasonable interpretation of the statute.”
Section 4960 defines a “covered employee” as
any employee (including any former employee) of an applicable tax-exempt organization if the employee (A) is one of the 5 highest compensated employees for the organization for the taxable year, or (B) was a covered employee of the organization (or any predecessor) for any preceding taxable year beginning after Dec. 31, 2016.
According to the Notice, each ATEO has its own covered employees, regardless of whether the ATEO is part of a group of related ATEOs. As a result, a group of related tax-exempt organizations may have many more than five covered employees whose compensation may trigger the excise tax. This will be a particular issue for large tax-exempt organization systems, such as healthcare systems. Notably, the Notice says that for purposes of Section 4960, an individual’s employer is the common law employer, as generally determined for federal income tax purposes. This means that each entity within a related group of tax-exempt organizations must make a determination each year concerning who is a covered employee for common law purposes (including officers). Each ATEO must identify its covered employees each year, even if no employee earns more than $1 million for that year. Covered employees identified for a year are those employees who (1) receive more than $125,000 of remuneration from the ATEO and related organizations during the year and (2) are among the five highest compensated employees of the ATEO for the year. Section 4960 has a “once a covered employee, always a covered employee” rule, under which a covered employee of an ATEO remains a covered employee of the ATEO forever. Each ATEO must keep a cumulative list of covered employees indefinitely, in case a covered employee has compensation above $1 million, or receives “excess parachute payments” (which may be less than $1 million), in a future year.
Calendar Year Compensation
In a helpful bit of guidance, the Notice provides that, for purposes of Section 4960, remuneration is determined based on the calendar year ending with or within the fiscal year of the ATEO. This aligns with Form 990 reporting, which is also based on calendar year compensation.
Compensation of Related Organizations
In determining its covered employees, an ATEO must include remuneration provided to the employee by any related organization (including related governmental entities and for-profit entities) for services performed as an employee of that organization. Related organizations include organizations controlled by, under the control of, or under common control with the ATEO, and supporting organizations. “Control” is based on more than 50% control, which is consistent with the Form 990 rules but lower than the 80% control threshold for 403(b) and tax-qualified retirement plans.
Applicability to Employees of a Corporate Charitable Foundation
In situations where a corporation has a related tax-exempt foundation, an issue arises as to whether the excise tax applies to remuneration paid by the corporation to its employees who are also officers or other common law employees of the related foundation—. Corporate employees often serve as officers or other employees of the related foundation. For example, could the total remuneration of the corporation’s CEO be subject to the Section 4960 excise tax where the CEO serves as the chair of the related foundation?
As an ATEO, the foundation has covered employees, and all remuneration paid by related entities to such covered employees is included as remuneration for purposes of Section 4960. The Notice provides that an employee is not a covered employee of an ATEO for a year if the ATEO paid less than 10% of the employee’s total remuneration for services performed as an employee of the ATEO and its related entities for the year. However, if an employee would not be treated as a covered employee of any ATEO in the group of related entities because no one ATEO paid at least 10% of the covered employee’s total remuneration for the year, then this exception does not apply to the ATEO that paid the employee the most remuneration during the year. On its face, this exception would not provide an exemption for an ATEO that is the only ATEO in the related group.
The Notice provides that, for a publicly traded corporation, any remuneration for which a deduction is not allowed by reason of Section 162(m) will not be taken into account for purposes of the Section 4960 excise tax. However, the excise tax will apply to remuneration that falls outside the Section 162(m) deduction limitation and with respect to entities that are not publicly held.
What Is Remuneration?
Remuneration for purposes of Section 4960 may differ from compensation calculated for Form 990 or Form W-2. Under Section 4960, “remuneration” is defined as wages for federal income tax purposes, except that it excludes Roth contributions and includes amounts as they vest (i.e., cease to be subject to a substantial risk of forfeiture). In certain situations, such as severance pay and short-term deferrals, compensation may vest in one calendar year and be paid (and taxed for federal income tax purposes) in a subsequent calendar year, so the Form W-2 compensation may not match the Section 4960 remuneration for the year of vesting.
The treatment of Section 457(f) plans is particularly problematic for benefits that are earned over a period of time but vest all once at the end of the service period (cliff vesting). When the benefits vest, an ATEO may owe a significant excise tax with respect to a covered employee whose compensation may never have otherwise exceeded $1 million. In some cases, the effect of the excise tax can be minimized by accelerating or delaying the vesting of Section 457(f) benefits, but any change to the vesting schedule needs to comply with Sections 409A and 457(f), as applicable.
Limited Grandfather Relief
The Notice confirms that amounts that vested or were paid before the effective date of Section 4960 are exempt from the excise tax. However, no other grandfather provision applies. Thus, any portion of a benefit that vests after the effective date will be considered remuneration under Section 4960, even if the benefit is attributable to service prior to the effective date.
Remuneration for Performance of Medical or Veterinary Services
Section 4960 remuneration does not include remuneration paid for the direct performance of medical or veterinary services by licensed medical or veterinary professionals. The Notice takes the position that direct performance of medical or veterinary services means only services for the diagnosis, cure, mitigation, treatment, or prevention of disease, and does not include administrative, teaching, and research activities. ATEOs that provide medical or veterinary services will have to allocate remuneration among direct medical or veterinary services and other duties using a reasonable method where the applicable employment agreements do not make such allocation.
Section 4960 imposes a 21% excise tax on remuneration above $1 million in a year that is considered paid by an ATEO and its related organizations with respect to a covered employee of the ATEO. The excise tax on payments above $1 million does not apply to excess parachute payments on which the 21% excise tax is applied so that there is no duplicate payment of the tax.
Section 4960 imposes a 21% excise tax on any excess parachute payment paid to a covered employee by an ATEO or related organizations, even if the excess parachute payments are less than $1 million. The excess parachute payment calculation is similar to the calculation under Section 280G (applicable to for-profit corporations), except that an excess parachute payment under Section 4960 is triggered by a separation from service, and not by a change in control.
An excess parachute payment under Section 4960 is a payment to a covered employee (1) that is contingent on separation from service and (2) the present value of which equals or exceeds three times the covered employee’s average annual compensation over the last five years. The excess parachute payment is the excess of the parachute payment over the base amount (not three times the base amount). According to the Notice, the payment must be contingent on the employee’s involuntary separation from employment, which may include a termination for “good reason” if appropriately defined.
The definition of separation from employment generally has the same meaning as separation from service under Section 409A. For example, an anticipated reduction in service to not more than 20% of the employee’s prior level of service will be considered a separation from service. However, a purported ongoing employment relationship will be disregarded if facts and circumstances demonstrate that it is not bona fide or its primary purpose is avoidance of the application of Section 4960. A payment made under a covenant not to compete generally will be considered a payment in the nature of compensation for purposes of Section 4960 if the covenant is negotiated as part of a severance arrangement arising from an involuntary separation.
Section 4960 imposes liability for the excise tax on the common law employers of each covered employee. The common law employer, as determined for federal tax purposes, is liable for the tax, regardless of any third-party payor arrangement or the terms of any arrangement between an ATEO and a related organization to bear the cost of the tax.
If an individual is paid remuneration by both an ATEO and a related organization, then each employer is liable for the excise tax in an amount proportional to the remuneration paid by the employer as compared to the total remuneration paid by all employers to the covered employee. In a scenario where several related ATEOs may be liable for excise tax with respect to the same covered employee, double taxation is avoided by making each employer liable for the greater of the tax amount it would owe as an ATEO or the tax amount it would owe as a related organization with respect to the covered employee. The Notice outlines the steps for calculating this liability. As described above, there is a limited exception for an organization that pays less than 10% of a covered employee’s remuneration, as long as another ATEO accounts for a greater proportion of the excise tax liability for the covered employee.
Each employer liable for tax is responsible for separately reporting and paying its share of the tax on Form 4720. For calendar year ATEOs, the excise tax for the 2018 year must be paid on May 15, 2019, which is the due date for Form 4720. The due date for the tax payment is determined without regard to whether the employer files for an extension to file Form 4720.
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