When the 2017 Tax Cuts and Jobs Act initially passed, there were a lot of questions about how Internal Revenue Code Section 4960 — the new 21 percent excise tax on “excess” executive compensation and parachute payments by tax-exempt organizations — would be implemented. The IRS took a first pass at answering some of those questions in its New Year’s Eve release of 92 pages of interim guidance in Notice 2019-09. While the Notice relieves some of the uncertainty, it has also raised new questions and concerns. It is important for organizations that may be impacted by Section 4960 to understand and assess their potential exposure.
This alert focuses on new excise taxes applied to “excess” executive compensation under Section 4960 (the tax also applies to parachute payments to a “highly compensated employee” upon involuntary separation that exceed three times that employee’s annual compensation).
On the surface, the new 21 percent excise tax would seem to apply only to a small, elite group of exempt organizations with one or more current executives who earn compensation exceeding $1 million. But upon closer examination of the statute and the Notice, the ambit of Section 4960 is far broader than meets the eye. Consider the following examples:
- Because amounts that vest under a Section 457(f) deferred compensation plan in a given year count toward the $1 million 4960 threshold, organizations with Section 457(f) plans could face liability even though no covered employee makes anywhere near $1 million a year.
- If the interim guidance holds, certain “related organizations” that share executive employees with an exempt organization may incur liability where volunteer or low-paid officers, directors or employees of the nonprofit organization are highly compensated by the related organization. Related organizations that are not publicly traded corporations could be even more severely impacted (as in the company foundation context).
Avoiding these traps for the unwary will require careful planning by an exempt organization’s compensation committee, in-house counsel, and tax and employee benefits advisors. To assist in that effort, this article provides a deeper understanding of how the IRS has proposed interpreting two key terms: “remuneration” and “related organization.”
Section 4960’s Tax on “Excess” Executive Compensation
Section 4960(a)(1) imposes a new 21 percent excise tax on “remuneration paid … by an applicable tax-exempt organization … to employment of any covered employee in excess of $1,000,000.” Thus, to trigger liability, three elements must be met:
(1) an “applicable tax-exempt organization”
(2) has a “covered employee”
(3) whose “remuneration” from the ATEO (and related organizations) exceeds $1 million.
The definition of ATEO is straightforward, and includes:
- All organizations exempt from taxation under Section 501(a) — this includes public charities, private foundations, social welfare organizations, trade associations and all other Section 501(c) exempt organizations.
- Organizations with income excluded under Section 115(1) — this could include some state colleges and universities.
- A lingering issue exists with regard to the extent of the interaction between Section 4960 and Section 115. The issue arises because, unlike Section 501(c)(3), Section 115 applies whether or not a private letter ruling has been issued to an organization that asserts that its income is excluded under that section. General Counsel Memorandum 37657 (1978), in reconciling Section 511(a)(2)(B) and Section 115(1), suggests that the related income of all separately incorporated state colleges and universities is exempt only by virtue of Section 115(1), not by notions of intergovernmental immunity. As a result, it is possible that all state colleges and universities that are formed as separate legal entities from the related state or local government could be subject to Section 4960.
- Political organizations exempt under Section 527(e)(1).
- Farmers’ cooperatives exempt under Section 521(b)(1).
The remaining two elements — determining who is a “covered employee” and whether “remuneration” by the ATEO and related organizations exceeds $1 million — are much less clear.
Who is a “Covered Employee”?
Section 4960(c)(2) defines a “covered employee” as “any employee (including a former employee)” of an ATEO who “is one of the 5 highest compensated employees of the organization for the taxable year” or “was a covered employee” in any year starting in 2017.
While this statutory language defines “covered employee” based solely on compensation by the ATEO, the Notice requires that an ATEO calculate its five highest-compensated employees by “including remuneration for services performed as an employee of a related organization.” Notice 2019-09 at 43 (emphasis added). In doing so, the IRS appears to conflate the broad definition of “remuneration,” which does include compensation from related organizations, with the more narrowly drawn definition of “covered employee,” which is focused only on compensation by the ATEO.
The IRS’s expansion of who constitutes a covered employee under 4960 could have broad consequences for many organizations, permanently sweeping in many individuals who receive little, if any, compensation from an ATEO. For example, the Notice provides that covered employees include an ATEO’s officers, whether compensated or not. Notice 2019-09 at 13. Yet the Notice fails to acknowledge that an unpaid officer who “performs only minor services” is not considered an employee under applicable regulations. See Treas. Reg. 31.3121(d)-1(b); 31.3306(i)-1(e). Indeed, IRS representatives at a March 20, 2019, D.C. Bar event stated that 4960 was not intended to displace the minor services exception, expressly welcoming comments on this point and even citing for the audience a relevant Revenue Ruling.
Perhaps recognizing the absurd result of Section 4960 applying when “covered employee” status is triggered almost entirely by compensation from a related organization, the interim guidance creates a “limited service exception.” The exception — which lacks any clear statutory basis — carves out an individual from being considered a covered employee if “the ATEO paid less than 10 percent of the employee’s total remuneration for services performed as an employee of the ATEO and all related organizations.” However, as written, the limited services exception does not apply if an individual receives less than 10 percent of her compensation from just a single ATEO with the remaining 90 percent coming from related for-profit entities. Notice 2019-09 at 43-44. As a result, the limited services exception would not address any of the absurd results described above.
Definitions of “Remuneration” and “Related Organization”
“Remuneration” is defined by Section 4960(c)(3) to include not just wages (as defined in Section 3401(a)) but also deferred compensation accumulated even prior to enactment of the new law when it is included in gross income under Section 457(f). Thus, even when employees make nowhere near $1 million per year, 4960 tax liability could suddenly be triggered for their employer when their supplemental retirement plan vests. See Notice 2019-09 at 47-48.
Example 1: An ATEO without any related organizations pays its CEO $400,000 in annual compensation while also contributing to a Section 457(f) deferred compensation retirement plan. After five years, her Section 457(f) plan vests with a value of $1.25 million. With all three elements of Section 4960(a)(1) met, the exempt organization will be liable for $136,500 in new tax liability, that is, excess remuneration ($400,000 + $1.25 million - $1 million) x 0.21).
It is critical that exempt organizations evaluate and restructure the timing of their Section 457(f) retirement programs to avoid inadvertently triggering excise taxes.
The calculation of remuneration also includes remuneration by a related organization. A “related organization” is an organization or governmental entity that is one of the following:
- Controls, or is controlled by, the ATEO.
- Is controlled by one or more individuals or entities which control the ATEO.
- Is a supported or supporting organization, or a voluntary employees’ beneficiary association.
Examples of related organizations include corporations that control a trade association, corporate-sponsored foundations, subsidiaries owned by an ATEO, sister organizations that are jointly controlled and many others.
Importantly, the definition of remuneration excludes any amounts “the deduction for which is not allowed by reason of 162(m),” meaning only the first $1 million in compensation from a publicly held corporation that is a related organization will count as covered remuneration. It also excludes compensation paid to a licensed medical professional for medical services (but does not exclude compensation for administrative, managerial or other nonmedical services).
Consequences of Section 4960 Tax Liability
When all three elements of Section 4960(a)(1) are met, then the question becomes how to distribute the resulting tax liability. Significantly, each employer — whether an ATEO or a taxable for-profit entity — will be subject to its pro rata share of the resulting liability. Notice 2019-09 at 56.
Example 2: Consider an ATEO that compensates its treasurer $100,000. The Treasurer would not be one of the ATEO’s five highest-compensated employees but for consideration of $1.5 million in compensation from a related organization that is not a publicly traded company. Under the Notice, all three prongs of Section 4960(a)(1) will be met, and the new tax liability will be $126,000, that is, excess remuneration ($100,000 + $1.5 million - $1 million) x 0.21. The ATEO’s share of the overall compensation is 6.25 percent ($100,000/1.6 million), so its share of the tax liability is $7,875. The related organization, responsible for the remaining 93.75 percent of the compensation, will have to pay $118,125.
Example 3: Same facts, but here the related organization is a publicly traded company. Here, the new tax liability will be $21,000, that is, excess remuneration ($100,000 + $1.5 million - $500,000 - $1 million) x 0.21. The ATEO’s share of the overall compensation is 6.25 percent ($100,000/$1.6 million), so its share of the tax liability is $1,312. The related organization, responsible for the remaining 93.75 percent of the compensation, will have to pay $19,688.
The above examples highlight the differential impact Section 4960 has on publicly traded versus nonpublicly traded companies. Even more significant, it is notable that in neither example would there be any new tax liability under Section 4960(a)(1) absent the inclusion of remuneration from the related organization in calculating the ATEO’s five highest-compensated employees.
It thus becomes a critical question whether remuneration from a related organization must be considered when calculating an ATEO’s five highest-compensated employees. The language of the statute indicates that only compensation from the ATEO counts, while the Notice includes compensation from both the ATEO and any related organizations.
Uncertainty over the scope of Section 4960 may lead some highly compensated executives to rethink their involvement as volunteer officers and directors of related nonprofit organizations to avoid triggering potential tax liability for their employers. While that result is not certain, additional clarification from the IRS would help ease those concerns.
Hopefully the IRS will correct course before it issues its final regulations.