By Marc Berger, CPA, JD, LLM, Alex Lifson, MBA, MST, Norma Sharara, JD, and Joan Vines, CPA
In June 2020 the IRS proposed regulations under Internal Revenue Code (IRC) Section 4960 that, among other things, would allow certain tax-exempt organizations and related for-profit entities to avoid paying 21% excise taxes on certain executive compensation. Even better, taxpayers may rely on the proposed regulations until final regulations are issued. The new rules are generally consistent with, and build further on Notice 2019-09 (issued on Dec. 31, 2018), which provided helpful initial guidance on Section 4960. See our primer on 4960. With a few exceptions, the proposed regulations are consistent with the interim guidance provided in Notice 2019-09, so it seems likely that final regulations will not include any major changes to the proposed rules. Comments on the proposed rules were due by Aug. 10, 2020.
The Tax Cuts and Jobs Act of 2017 (Public Law 115-97) created IRC Section 4960. As a result, starting in 2018, most tax-exempt organizations and certain governmental units, as well as for-profit employers who “control” or who are “controlled by” an “applicable tax exempt organization” (ATEO), may owe a 21% excise tax on (1) annual “remuneration” over $1 million paid to “covered employees” or on (2) any “excess parachute payments” (even if those are under $1 million).
ATEOs of all sizes (and their related for-profit entities) might owe this tax if they paid any employee $125,000 or more during any year beginning on or after Jan. 1, 2018. So even if the ATEO never paid any employee more than $1 million, the tax on excess parachute payments made to “highly compensated employees” could still be owed.
Section 4960 introduced several important new defined terms, including the following:
“Excess parachute payments” are amounts that exceed three times the covered employee’s five-year average wages and are contingent on an involuntary termination of employment.
“Remuneration” generally means Code Section 3401(a) wages paid during a calendar year ending with or within the employer’s tax year, excluding (1) Roth, tax-qualified retirement plans, 403(b) plan and governmental 457(b) plan contributions and distributions and (2) amounts paid to a licensed medical professional for the direct performance of medical services, but including amounts required to be included in income under 457(f)’s special timing rules (i.e., amounts are generally taken into account for the 4960 excise tax in the calendar year when the amount vests, regardless of when it is paid or included in income).
- The proposed rules confirm that this special timing rule for determining annual remuneration does not include the 457(f) exceptions for short-term deferrals, certain severance payments and earnings on vested nonqualified deferred compensation (so such amounts would be included when determining 4960 excise tax). For example, short-term deferrals under 457(f) and 409A may be included in an employee’s taxable income in a different year than the year that those amounts must be included in 4960 excise tax calculations. Likewise, subsequent earnings on vested 457(f) amounts would be included in taxable income in a different year than the year those amounts must be included in 4960 excise tax calculations (for 4960, subsequent earnings on vested amounts are treated as paid annually, even if the amounts are not actually paid until later).
- Under the proposed rules, remuneration and parachute payments that vested before the date in 2018 that the rules became effective for the ATEO are generally exempt from 4960 taxes (but would still count for purposes of determining whether an employee is a covered employee).
This clarification attempts to take some of the sting out of the fact that 4960 does not have a “grandfather” rule (and the IRS will not create one, since the IRS said that it lacks authority to do so).
Any entity that paid the excise tax in the 2018 or 2019 tax year on a payment that was vested prior to the applicable effective date for that entity should file a refund request.
- The proposed rules also clarify that remuneration includes taxable, below-market, compensation-related loans made to employees (which might arise, for example, in connection with certain split-dollar life insurance arrangements). The proposed rules clarify that nontaxable expense allowances and reimbursements (such as under an accountable plan) and other nontaxable benefits (like directors’ and officers’ liability insurance coverage) are not included in remuneration. The IRS asked for comments on whether certain taxable employee benefits (like group term life insurance over $50,000) should be included in remuneration.
- The proposed rules create an administrative exception for payroll periods that cross over calendar years, which tracks the Form W-2 reporting rule. Specifically, regular wages are treated as paid when actually or constructively paid (not when vested). So, if a pay period ends on Dec. 30, 2020, but salary for that period is not actually paid until Jan. 6, 2021, then the salary is treated as paid in 2021 (and the salary is not treated as being vested in 2020). But that exception would not apply to bonuses or other irregular compensation, so if those amounts vest on Dec. 31, 2020, they are included in 4960 for 2020, even if they are not paid until 2021.
“Covered employee” means a common law employee (including any former employee) of an ATEO if the employee is one of the five highest-compensated employees of the organization for the taxable year or was a covered employee of the organization (or a predecessor) for any preceding taxable year beginning after Dec. 31, 2016. This means that ATEOs need to identify who their common law employees are under Code Section 3401 (i.e., for purposes of withholding federal income tax from paychecks).
Despite much publicity about highly paid, public university sports team coaches being subject to the $1 million tax, some of those schools may avoid paying the 4960 tax unless Congress enacts a technical correction.
NEW VOLUNTEER/LIMITED SERVICES EXCEPTIONS
One of the most sought-after changes the IRS adopted in the proposed regulations is that certain employees of a related for-profit employer providing services to an ATEO will no longer be treated as a “covered employee,” provided that the individual’s remuneration or hours of service satisfy specific limits. Generally, the exception will apply if (1) the services provided by the individual for the ATEO are not more than 10% of the total hours of service that the individual performs for all related organizations and (2) neither the ATEO nor any other entity controlled by the ATEO pays the individual for such services. The proposed rules set out a safe harbor for individuals who do not work more than 100 hours per year for the ATEO.
Many stakeholders wanted this exception to avoid 4960 excise taxes on the compensation paid to executives of for-profit companies that volunteer at a related ATEO, perform minor services as unpaid officers, perform limited services, or work limited hours. For example, many for-profit executives serve as officers of a corporate foundation created by the for-profit entity and many corporations have employee-sharing arrangements with their corporate foundation. Under the statute and Notice 2019-09, those arrangements would have subjected their compensation from the corporation to 4960 excise taxes.
The proposed rules also set out a more complicated “non-exempt funds” exception that might rescue certain situations where the individual who primarily works for the for-profit entity provides no more than 50% of his/her services to the ATEO and other conditions are satisfied. The proposed rules also include details on how to count hours of service for purposes of these exceptions.
Further, the proposed rules confirm that 4960 taxes apply only to employees, not to independent contractors or members of the board of directors who are not also employees of the ATEO.
It is not clear whether for-profit entities that paid 4960 excise taxes on IRS Form 4720 (Schedule N) for 2018 or 2019 would be eligible to claim a refund for those amounts based on the new position set out in the proposed regulations, because it is not specifically stated that this provision is retroactive. For-profit entities that have paid 4960 excise tax should set up a reminder to check for updates each year and discuss whether it would be appropriate to file a protective refund claim before the statute of limitations closes on the Form 4720.
NEW CONTROLLED GROUP/PREDECESSOR RULES
Generally, the proposed regulations define “control” for 4960 excise taxes by using Section 512(b)(13) (i.e., the same rules for reporting related organizations on IRS Form 990). For example, the proposed rules provide that a person (or governmental entity) controls a nonstock corporation if (1) the person has the power to remove and replace more than 50% of the organization’s directors; or (2) more than 50% of the organization’s directors are “representatives” (trustees, directors, officers, employees or agents) of that person. But the proposed rules create a new exception, where an employee will not be considered a “representative” if the employee lacks authority commonly exercised by an officer, doesn’t actually act as a representative of the person, and this fact is reported on the organization’s Form 990. So, if a majority of lower-level corporate employees serve as directors or trustees of an ATEO, the for-profit entity would not be “related” to the ATEO for 4960 purposes. This alleviates concerns over “accidental control.” The IRS also clarified how “indirect control” and attribution principles work for 4960 purposes.
The proposed rules also confirm that the owner of a single member entity (such as an LLC) is the employer of the employees of that entity.
In addition, the proposed regulations clarify that federal government “instrumentalities” are subject to 4960, but requested comments on that issue.
Although the proposed rules say that a foreign organization that otherwise qualifies as an ATEO would be subject to 4960 excise taxes, the IRS has asked for public comments on whether foreign organizations that are related to an ATEO should be subject to 4960 excise taxes. The proposed regulations also clarify that a foreign organization that receives substantially all of its support from sources outside the United States would not be an ATEO.
Keep in mind that a “covered employee” includes any employee who was a covered employee of a predecessor ATEO. The proposed regulations outline when an entity is considered to be a predecessor ATEO, including asset acquisitions, corporate reorganizations and chains of predecessors.
NEW SHORT TAX YEAR RULE
The proposed regulations provide guidance for determining how to handle short tax years, such as the initial or final calendar year that the ATEO is subject to 4960. For 4960 purposes, the applicable year for measuring remuneration and excess parachute payments is the calendar year that ends “with or within” the ATEO’s taxable year. For example, for an ATEO with a fiscal year from July 1, 2021 to June 30, 2022, the applicable tax year is calendar year 2021 for determining who is a covered employee and what remuneration is subject to 4960 excise taxes.
Although this timing rule is generally the same method used for reporting compensation on Form 990, the definition of “remuneration” for 4960 differs from the definition of “compensation” reported on Form 990, so ATEOs cannot simply copy information reported on Form 990 for 4960 purposes.
ONLY ATEOS OWE PARACHUTE EXCISE TAX
The proposed regulations revise Notice 2019-09 by providing that only ATEOs could owe an excess parachute payment excise tax, based on a separation from employment with the ATEO. Notice 2019-09 implied that an ATEO or its related organizations are liable for excess parachute payment excise tax based on the aggregate parachute payments made by the ATEO and its related organizations, including parachute payments based on separation from employment from a related organization. Now it is clear that a separation from employment from a related entity that is not itself an ATEO would not trigger 4960 tax liability. Nevertheless, the proposed rules retained the concept that payments from for-profit related organizations must still be counted when determining the “base amount” and total payments that are contingent on involuntary separation from employment for 4960 excise tax purposes.
In the proposed regulations, the IRS repeated the warning it gave in Notice 2019-09 by confirming that the following are not reasonable, good faith interpretations of 4960:
- Related for-profit or governmental entities are not liable for their share of the 4960 excise taxes.
- A covered employee ceases to be a covered employee after a period of time.
- A group of ATEOs may have only five highest-compensated employees among all related ATEOs.
ATEOs that do not have 4960 tax liability for a year would still need to make a list of covered employees each year, since there is no minimum dollar test to be a covered employee, and once someone is a covered employee that individual remains so forever, even after termination of employment. The IRS declined to adopt any minimum dollar threshold, grandfathering rule or sunset rule for determining covered employees.
The proposed regulations may help ATEOs design and implement employment, deferred compensation, severance and other agreements. For example, they could spread out when remuneration is included in 4960 calculations on remuneration in excess of $1 million by using vesting schedules for deferred compensation arrangements and may be able to avoid 4960 entirely (such as with a split dollar life insurance arrangement). ATEOs may also want to consider whether changing existing management service arrangements among related entities may reduce 4960 liability exposure.
Since 4960 took effect on Jan. 1, 2018 (with no grandfather or transition rules), ATEOs should already be complying. Until final rules are issued, ATEOs can continue to apply a reasonable, good faith interpretation of 4960, except where the proposed regulations or Notice 2019-9 specifically identified what will not qualify as a good faith interpretation.
This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Fall 2020). Copyright © 2020 BDO USA, LLP. All rights reserved. www.bdo.com