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Proposed regs clarify tax-exempt excise tax on pay

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Businessman looking out conference room window The IRS released proposed regulations (REG-122345-18) on June 5 that significantly build on prior guidance on the new excise tax imposed on the excessive compensation of applicable tax-exempt organizations (ATEOs).

Section 4960 was enacted by the Tax Cuts and Jobs Act (TCJA) in December 2017, and imposes a 21% excise tax on tax-exempt organizations that pay their highest-paid employees (covered employees) remuneration in excess of $1 million or parachute payments (compensation contingent on separation from employment) equal to at least three times a covered employee’s average pay. The new taxes are effective for taxable years beginning after 2017. The proposed regulations build on the initial guidance provided in Notice 2019-09 and are generally consistent with the initial guidance. However, they include significant new guidance and clarifications, which are highlighted below.

Taxpayers should review the new guidance and their existing compensation arrangements to identify opportunities to mitigate the impact of the excise taxes on excess remuneration and parachute payments. Taxpayers should also go through this exercise when entering into new compensation arrangements with employees or redesigning existing arrangements to reduce or eliminate exposure to the excise taxes.

Key concepts retained from initial guidance The proposed regulations retain many of the key concepts provided in Notice 2019-09, including the following:

Taxes apply based on the calendar year Compensation paid during the calendar year ending with or within an organization’s taxable year (even if an ATEO has a fiscal taxable year) is used to determine remuneration and parachute payments as well as to identify an organization’s covered employees.

Remuneration determined using special Section 457(f) timing rules Remuneration is defined as “wages” for federal income tax withholding purposes under Section 3401(a), but modified to exclude (1) any amounts subject to the excess parachute payment tax (applied based on a separate definition of “parachute payment”), (2) Roth 401(k) contributions and (3) amounts paid to a licensed medical professional for the direct performance of medical or veterinary services. These modified wages are counted as remuneration when they are no longer subject to a substantial risk of forfeiture within the meaning of Section 457(f). Thus, an amount is generally taken into account for purposes of the excess remuneration tax in the year the amount vests, no matter when the amount is paid, taxed or included in withholding wages. The proposed regulations confirmed that this special timing rule does not include the exceptions under Section 457(f) that defer taxation until the actual payment even though vesting occurs earlier (e.g., it does not include the exceptions for short-term deferrals, certain severance payments and earnings on vested nonqualified deferred compensation).

Taxable companies related to ATEOs could be subject to the new excise taxes The proposed regulations provide that compensation paid by all related organizations to an ATEO employee must be taken into account for purposes of applying the new taxes, even compensation paid by taxable organizations. Thus, if a taxable company is related to an ATEO and the company’s employees provide services to the ATEO, the remuneration paid by both the company and the ATEO to the shared employees generally must be aggregated for purposes of applying the new taxes, including determining the covered employees of the ATEO. However, as discussed below, the proposed regulations do provide a number of new exceptions for employees of non-ATEOs who perform only limited services for a related ATEO and meet other requirements, such as a taxable company with a related ATEO like a foundation, for which certain of its executives perform services on a volunteer basis.

Certain governmental entities (including certain colleges and universities) may not be ATEOs The proposed regulations provide that a governmental entity (including a state college or university) that does not have a determination letter (or relinquishes a letter previously issued) and that does not exclude income from taxable income under Section 115(1) is not an ATEO. However, such a governmental entity may be liable for excise taxes under Section 4960 if it is a related organization to an ATEO.

Parachute payments taxed only to the extent they are contingent on involuntary separation For purposes of the excess parachute payment tax, a “parachute payment” means any payment in the nature of compensation to (or for the benefit of) a covered employee if the payment is contingent on the employee’s separation from employment with the employer. The proposed regulations generally treat a payment as contingent on an employee’s separation from employment only if there is an involuntary separation from employment. Thus, if a covered employee does not experience an involuntary separation from employment, any amounts paid in connection with the separation generally will not constitute a parachute payment.

Taxes do not apply to compensation vesting before the effective date The taxes are effective for taxable years of ATEOs beginning after Dec. 31, 2017, – that is, the taxes first apply to the 2018 taxable year. Although the proposed regulations do not provide a grandfather rule or other specific transition relief, the IRS emphasized in the preamble that the excise taxes generally do not apply to remuneration and parachute payments that vested before the effective date. However, that special effective date rule does not apply for purposes of determining whether an employee is a covered employee.

For example, an ATEO with a taxable year beginning July 1, 2018, and ending June 30, 2019, generally would take into account compensation paid during the 2018 calendar year. However, for purposes of applying the taxes for that taxable year, the ATEO would not have to take into account any compensation that vested before July 1, 2018, (i.e., the effective date of the new taxes). But the full calendar-year remuneration would have to be taken into account for purposes of determining the ATEO’s covered employees for the 2018 taxable year.

Key new guidance Although the proposed regulations retain many of the key concepts from Notice 2019-09, they also include significant new guidance and clarifications, including the key issues discussed below:

Volunteer services and similar exceptions As discussed above, under the related organization rules, compensation paid by all related organizations to an ATEO employee must be taken into account for purposes of applying the new taxes, even compensation paid by taxable organizations. Thus, if a taxable company has a foundation that is an ATEO and the company’s employees provide services to the foundation or are officers of the foundation, the compensation paid by the company and foundation to the shared employees generally must be aggregated for purposes of applying the new taxes, including determining the covered employees of the ATEO foundation. Under this scenario, the company’s employees could be considered covered employees of the ATEO foundation even if the employees receive little or no (volunteer) compensation from the foundation, and the taxable company could then be subject to one or both of the new excise taxes.

The proposed regulations include a number of exceptions that are intended to ensure that certain employees of a related non-ATEO providing services as an employee of an ATEO are not treated as one of the five highest-compensated employees of the ATEO, provided that certain conditions related to the individuals’ remuneration or hours of service are met.

Under the “limited-hours” exception, an employee of an ATEO is disregarded for purposes of determining the ATEO’s five highest-compensated employees for a taxable year if neither the ATEO nor any related ATEO pays remuneration or grants a legally binding right to non-vested remuneration to the employee for services performed for the ATEO, and the employee performs only limited services for the ATEO. In addition, an employee qualifies for this exception only if the hours of service the employee performs as an employee of the ATEO comprise 10% or less of the employee’s total hours of service for the ATEO and all related organizations during the applicable year. For this purpose, the proposed regulations also provide a safe harbor under which an employee who performs fewer than 100 hours of services as an employee of an ATEO (and all related ATEOs) during an applicable year is treated as having worked less than 10% of the employee’s total hours.

Under the “non-exempt funds” exception, an employee is disregarded for purposes of determining an ATEO’s five highest-compensated employees for a taxable year if neither the ATEO, nor any related ATEO, nor any taxable related organization controlled by the ATEO, pays the employee of the ATEO any remuneration for services performed for the ATEO or grants a legally binding right to nonvested remuneration to the employee. In addition, the employee must have provided services primarily to the related taxable organization or other non-ATEO (other than a taxable subsidiary of the ATEO) during the applicable year. For purposes of this exception, an employee is treated as having provided services primarily to the related taxable organization or other non-ATEO (other than a taxable subsidiary of the ATEO) only if the employee provided services to the related non-ATEO for more than 50% of the employee’s total hours worked for the ATEO and all related organizations (including ATEOs) during the applicable year.

The proposed regulations also incorporate several exceptions from the definition of employee for payroll tax purposes that may be applicable in these scenarios, including the rules that a member of a board of directors of a corporation is not an employee of the corporation (in the capacity as a director), and that an officer generally is not an employee of the entity for which the officer serves as an officer if the officer performs no services or only minor services and neither receives, nor is entitled to receive, any remuneration.

Special timing rule for end-of-year regular wages As discussed above, the proposed regulations retain the concept that the special timing rules under Section 457(f) apply without regard to any of the exceptions under that section (e.g., the short-term deferral exception). However, the proposed regulations provide a special timing rule for regular wages, which are defined as remuneration paid at a regular hourly, daily or similar periodic rate (and not an overtime rate) for the current payroll period or at a predetermined fixed determinable amount for the current payroll period.

Under this special timing rule, regular wages are treated as paid when actually or constructively paid (and not when vested). Thus, if a pay period ends Dec. 26, 2020, but the salary for that period is not actually paid until Jan. 2, 2021, then the salary is treated as paid in 2021 and the employer need not treat any amount as vested in 2020. But if the employee also vested in a bonus on Dec. 26, 2020, that is actually paid on Jan. 2, 2021, the bonus is treated as paid in 2020.

Determining present value These proposed regulations provide that the amount of remuneration treated as paid generally is the present value of the remuneration on the date on which the covered employee vests in the right to payment of the remuneration. The employer must determine the present value using reasonable actuarial assumptions regarding the amount, time, and probability that the payment will be made. These proposed regulations do not provide rules for the determination of present value. However, the preamble to the proposed regulations confirms that an employer may determine the present value using the rules in proposed Treas. Reg. Sec. 1.457-12(c).

Excess parachute payment tax generally applies only with respect to ATEOs The proposed regulations differ in one respect from the guidance on parachute payments provided in Notice 2019-09. The notice provided that an ATEO or related organization may be liable for the tax on an excess parachute payment 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. The proposed regulations provide that only an excess parachute payment paid by an ATEO is subject to the excise tax on excess parachute payments.

Proposed applicability date The proposed regulations are proposed to apply to taxable years beginning on or after the date final regulations are published in the Federal Register.

As noted above, the guidance in the proposed regulations generally is consistent with the guidance provided in Notice 2019-09, but, in certain instances, the proposed regulations modify the guidance provided in Notice 2019-09. Until the applicability date of the final regulations, taxpayers may rely on the guidance provided in Notice 2019-09 or, alternatively, on the guidance provided in these proposed regulations, including for periods prior to the issuance of the proposed regulations.

Taxpayers may also base their positions upon a reasonable, good faith interpretation of the statute that includes consideration of any relevant legislative history. Consistent with Notice 2019-09, the preamble to the proposed regulations provides that the following positions will continue to be treated as inconsistent with a reasonable, good faith interpretation of the statutory language:

  • Remuneration paid by a separate employer that is a related for-profit or governmental entity (other than an ATEO). The position that a related for-profit or governmental entity (other than an ATEO) is not liable for its share of the excise tax under Section 4960 even though the remuneration paid by the separate entity is taken into account in determining whether employee remuneration exceeds $1 million will not be considered consistent with a reasonable, good faith interpretation of the statutory language.
  • Continued treatment of a covered employee as a covered employee. The position that a covered employee ceases to be a covered employee after a certain period of time will not be considered consistent with a reasonable, good faith interpretation of the statute.
  • Remuneration for medical services for purposes of determining the five highest-compensated employees. The position that remuneration for medical services is taken into account for purposes of identifying the five highest-compensated employees will not be considered consistent with a reasonable, good faith interpretation of the statute.
  • Covered employees of a group of related organizations. The position that a group of related ATEOs may have only five highest-compensated employees among all the related ATEOs will not be considered consistent with a reasonable, good faith interpretation of the statute.

Next steps The proposed regulations are generally consistent with the initial guidance issued in Notice 2019-09 but provide significant new guidance and clarifications. Taxpayers should review their existing compensation arrangements in light of the new guidance to identify opportunities to mitigate the potential impact of the new excise taxes. Employers should also consider this interim guidance when entering into new compensation arrangements with executives or redesigning existing arrangements to reduce or eliminate exposure to the new excise taxes.

For more information contacts:
Jeffrey Martin
Partner
Washington National Tax Office
T +1 202 521 1526

Keith Mong
Managing Director
Washington National Tax Office
T +1 202 521 1554

To learn more visit gt.com/tax

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