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Final regs clarify tax-exempt excise tax on pay

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Young woman doing home finances in the evening The IRS released final regulations (TD 9938) under Section 4960 on Jan. 11 that substantially adopt the proposed regulations issued in June 2020 on the excise tax on tax-exempt pay plans, but make several changes to certain provisions.

Section 4960 was enacted by the Tax Cuts and Jobs Act (TCJA) and imposes a 21% excise tax on applicable tax-exempt organizations (ATEOs) 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 final regulations rejected several proposed changes from commenters and retained key concepts from the proposed regulations. However, they do offer new guidance and clarifications in a number of areas, such as the “non-exempt funds” exception, exclusion from the excise tax for certain foreign organizations and renumeration paid for medical services.

The final regulations are applicable to tax years beginning after Dec. 31, 2021. Until the then, taxpayers can choose to rely on the guidance provided in Notice 2019-09 (the initial Section 4960 guidance), the proposed regulations or the final regulations, provided a taxpayer relies on the particular guidance item in its entirety and in a consistent manner.

Until the applicability date, 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 the prior guidance, the preamble to the final regulations provides that certain specific positions will continue to be treated as inconsistent with a reasonable, good faith interpretation of the statutory language (see our prior coverage for a full discussion of the proposed regulations, including the specific positions identified as not constituting reasonable, good faith interpretations).

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 proposed regulations The final regulations retain many of the key concepts provided in the proposed regulations, including, but not limited to, the following:

Grandfathering rule rejected The IRS rejected a commenter’s request for a grandfathering rule that would have excluded from the definition of “remuneration” amounts paid under contracts executed on or before Nov. 2, 2017. The IRS noted that, unlike other changes made by TCJA like the changes made to Section 162(m), neither the statutory language nor the legislative history provides for an express grandfathering rule. However, the final regulations expressly include the “effective date transition rule” described in the preamble to the proposed regulations. Section 4960 generally does not apply to remuneration and parachute payments that vested before the effective date (except for purposes of determining whether an employee is a covered employee). Any earnings on those vested amounts that accrue or vest after the effective date are treated as remuneration for Section 4960 purposes.

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 (the applicable year is the calendar year ending with or within the tax year). However, for purposes of applying the excise 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 2018 calendar-year remuneration would have to be taken into account for purposes of determining the ATEO’s covered employees for the 2018 taxable year.

The final regulations also retain similar rules for vested compensation from years prior to the taxable year in which an employee first becomes a covered employee – such amounts generally are not subject to Section 4960, but any subsequent earnings on such amounts would have to be taken into account.

No short-term deferral timing rule The IRS also rejected commenters’ requests for a special short-term deferral timing rule that would have allowed short-term deferrals to be taken into account for Section 4960 purposes when such deferrals are actually or constructively paid instead of when vested under the general Section 4960 timing rule. For this purpose, the commenters suggested that a short-term deferral be defined in a manner similar to the definition under Sections 409A and 457(f) – generally amounts paid no later than two and a half months after the close of the taxable year in which the amounts vest.

However, the final regulations retain the 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 does 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.

Taxable companies related to ATEOs The final 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 final regulations retain a number of 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) The final 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.

Once a covered employee, always a covered employee As discussed above, the final 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. In addition, once an individual is a covered employee of an ATEO, the employee remains a covered employee of the ATEO for all subsequent years, even after the employee stops performing services. Based on these principles, the IRS rejected a suggestion from a commenter that the final regulations exclude any remuneration paid by a related organization if a covered employee is not employed by the ATEO at any time during an applicable year. Thus, even if a covered employee of an ATEO stops providing services to the ATEO, but provides services to a related organization (for example, transfers full-time employment from an ATEO to a related organization after the individual became a covered employee of the ATEO), all compensation paid by the related organization would have to be treated as paid by the ATEO for purposes of Section 4960.

Excess parachute payment guidance The guidance in the proposed regulations with respect to the excess parachute payment rules was adopted in the final regulations without any changes – the IRS noted that they did not receive any comments on this guidance.

The IRS explained that the excess parachute payment rules under Section 4960 are modeled after the golden parachute rules under Section 280G, but noted that Section 4960 defines “parachute payment” differently than Section 280G. The definition in the Section 4960 final regulations refers to payments contingent on an employee’s involuntary separation from employment, whereas the Section 280G definition refers to payments contingent on a change in control of a corporation. The IRS also noted that the proposed and final regulations incorporate many of the applicable concepts found in the Section 280G regulations, with modifications to reflect the statutory differences between the two sections.

No joint Form 4720 for related employers The excise taxes under Section 4960 are reported on Form 4720, “Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code.” Notice 2019-09 required each employer liable for the excise taxes imposed by Section 4960 to file a separate Form 4720 to report its share of the liability. The IRS rejected two commenters’ requests that related employers be allowed to file a single, joint Form 4720.

Key new guidance Although the final regulations retain many of the key concepts from the proposed regulations, they also include 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 final regulations retain the exceptions from the proposed regulations 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 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, 1) pays the employee of the ATEO any remuneration for services performed for the ATEO or 2) 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, the proposed regulations provided that 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 final regulations make several modifications to the non-exempt-funds exception. The final regulations expand the “more than 50%” measurement period from one applicable year to two applicable years. As such, the current and preceding applicable years are treated as a single measurement period for purposes of determining whether an employee provided services to the “ATEO and all related ATEOs” for not more than 50% of the employee’s total hours worked as an employee of the ATEO and all related organizations.

The final regulations also modify the attribution rules that apply for purposes of determining eligibility for the non-exempt funds exception, which generally is not available if the employee provides services for a fee to a taxable entity. Under the modification, this prohibition only applies if the ATEO actually owns a controlling interest in the taxable entity, as opposed to being attributed the ownership interest under the Section 318(a)(3) attribution rules.

In addition, the final regulations clarify that taxable fringe benefits that are wages within the meaning of Section 3401(a), such as employer-provided parking in excess of the value excluded under Section 132, are considered for purposes of determining an ATEO’s covered employees and for purposes of applying the exceptions from covered employee status, including the non-exempt-funds exception.

Exclusion of certain foreign related organizations The final regulations exclude from Section 4960 taxation any foreign organization that is both described in Section 4948(b) (generally any foreign organization which has received substantially all of its support (other than gross investment income) from sources outside the United States – determined at the end of the organization’s tax year) and is either exempt from tax under Section 501(a) or a taxable private foundation (“Section 4948(b) related organization”). However, any remuneration paid to a covered employee of an ATEO by a Section 4948(b) related organization must be taken into account by the ATEO and any related organizations subject to Section 4960 for purposes of determining an ATEO’s (and related organizations’) liability under Section 4960 and the ATEO’s covered employees.

Remuneration related to medical services Remuneration that is paid to a licensed medical professional for medical services is excluded from the definition of Section 4960 remuneration. When an employer pays remuneration to an employee for both medical and nonmedical services, the employer must allocate the remuneration between the two types of services using a reasonable, good faith allocation method. The final regulations clarify that this reasonable, good faith allocation standard applies to both current remuneration and to contributions and earnings under a deferred compensation plan.

Remuneration and below-market split-dollar loans The final regulations retain the clarification in the proposed regulations that Section 4960 remuneration includes amounts treated as compensation under Section 7872 (for example, amounts includible as compensation under a below-market split-dollar loan). This clarification was necessary because remuneration for Section 4960 purposes is generally defined as wages for federal income tax withholding purposes within the meaning of Section 3401(a), but Section 7872(f)(9) expressly excepts such compensation from federal income tax withholding. The IRS takes the position that such compensation is Section 4960 remuneration because it falls within the broad definition of wages under Section 3401(a) and is not expressly excluded under that section.

In response to a specific request from a commenter, the final regulations clarify further that Section 4960 remuneration does not include amounts that are not treated as compensation under the $10,000 de minimis exception under Section 7872(c)(3), which excludes forgone interest attributable to any day on which the aggregate outstanding amount of loans between the employee and the employer does not exceed $10,000.

Determining present value The final regulations retain the rule that the amount of remuneration treated as paid is generally 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.

The final regulations do not prescribe rules for determining present value. The IRS anticipates that final regulations addressing the determination of present value for Section 4960 purposes will be issued when final regulations under Section 457(f) are issued. However, the preamble to the final regulations confirms that an employer may determine the present value using the rules in proposed Treas. Reg. Sec. 1.457-12(c) until further guidance is issued.

To reduce the administrative burden of determining the present value of remuneration in certain circumstances that would involve minimal discounting, the final regulations retain the guidance that allows an employer to treat the entire amount to be paid on a future date (without making a present value determination) as the present value on the date of vesting. The proposed regulations generally limited this special present value rule to non-account balance plans. The final regulations expand this rule to apply to any vested amount scheduled to be paid within 90 days, including amounts under account balance plans.

Coordination between Sections 162(m) and 4960 The final regulations do not address the coordination between Sections 162(m) and 4960 – remuneration for which a deduction is disallowed under Section 162(m) is not taken into account for purposes of Section 4960, other than for purposes of determining an ATEO’s covered employees. Section 162(m) imposes a $1 million cap on the deduction of compensation for the covered employees of publicly held corporations.

The IRS noted that this provision raises significant issues stemming largely from the difference in timing between the payment of remuneration under Section 4960 (when the right to the amount vests), and the availability of a deduction that may be restricted by Section 162(m) (generally when the amount is paid).

The final regulations do reserve a section for future guidance. Until then, taxpayers may use a reasonable, good faith approach with respect to the coordination of Sections 4960 and 162(m) in circumstances in which it is not known whether a deduction for the remuneration will be disallowed under Section 162(m) by the due date (including any extension) of the relevant Form 4720. Taxpayers can also rely on the two proposed approaches described in the preamble to the proposed regulations.

Federal instrumentalities The final regulations do not address the extent to which federal instrumentalities may be subject to Section 4960, but the IRS reserved sections to address this issue in future guidance. The IRS also indicated in the preamble that, until further guidance is provided, a federal instrumentality for which an enabling act provides for exemption from all current and future federal taxes under Section 501(c)(1)(A)(i) may treat itself as not subject to tax under Section 4960 as an ATEO or related organization, but noted further that, if the federal instrumentality is a related organization of an ATEO, remuneration it pays must be taken into account by that ATEO.

Next steps The final regulations are generally consistent with the proposed regulations but provide 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 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, contact:
Jeffrey Martin
Partner
Washington National Tax Office
Grant Thornton LLP
T +1 202 521 1526

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

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