The IRS released interim guidance (Notice 2019-09
) under new Section 4960 for identifying and calculating the remuneration and parachute payments subject to the 21% excise taxes, as well as numerous examples illustrating the statute’s application.
Section 4960 was added by the Tax Cuts and Jobs Act (TCJA). It imposes a 21% excise tax on tax-exempt organizations that pay their highest-paid employees (covered employees) remuneration in excess of $1 million or that make parachute payments (compensation contingent on separation from employment) equal to at least three times a covered employee’s average pay.
The taxes were intended to create parity between taxable and tax-exempt organizations, and Section 4960 adopts rules similar to those under Section 162(m) for the $1 million cap on public companies’ deduction for certain executive compensation and under Section 280G for the excise tax on excess parachute payments paid to certain key individuals of a corporation contingent on a change in control.
The new taxes are effective for taxable years of tax-exempt organizations beginning after Dec. 31, 2017. Although the notice does not provide any transition relief, it emphasizes that the new excise taxes generally do not apply to remuneration and parachute payments that are vested before the effective date.
In light of the notice, tax-exempt organizations should review existing compensation arrangements to identify opportunities to mitigate the new excise taxes. They should also consider this interim guidance when entering new compensation agreements or revising existing arrangements for covered employees.
The interim guidance is discussed in more detail below.
Organizations subject to the excise tax
For Section 4960 purposes, the 21% excise tax applies only to applicable tax-exempt organizations (ATEOs) and related organizations that pay remuneration in excess of $1 million or excess parachute payments to covered employees. In general, the common law employer, as determined for federal tax purposes, is liable for the excise tax, regardless of who pays the compensation. Section 4960 defines an ATEO as any organization which for the taxable year:
- Is exempt from taxation under Section 501(a)
- Has income excluded from taxation under Section 115(1)
- Is a farmers’ cooperative organization described in Section 521(b)(1)
- Is a political organization described in Section 527(e)(1)
Whether governmental entities, including state colleges and universities, are subject to Section 4960 has garnered significant attention. The notice distinguishes between “governmental units” and “governmental instrumentalities,” providing that the latter is an entity organized separately from the state while the former is not.
The notice states that a governmental unit is generally an ATEO only if it has an IRS determination letter recognizing its tax-exempt status under Section 501(a). However, it further provides that such a governmental unit may relinquish the letter to fall outside the definition of an ATEO. State colleges and universities, depending on how they are organized, may be a governmental unit, and therefore not subject to the tax. However, the Joint Committee on Taxation’s Blue Book states that Congress’s intent was for Section 4960 to cover state colleges and universities. It appears a technical correction to the statue may be needed to achieve this congressional intention.
While not an ATEO itself, a governmental unit without a determination letter may become subject to Section 4960 as a related organization to an ATEO. The related organization concept is discussed in more detail below.
In addition, if a governmental instrumentality meets the requirements of Section 115(1) to exclude income from taxation, the notice provides that the instrumentality is an ATEO.
An organization, including a governmental entity, is related to an ATEO if it:
- Controls, or is controlled by, the ATEO
- Is controlled by one or more persons who control the ATEO
- Is a supported organization (as defined in Section 509(f)(3)) during the taxable year with respect to the ATEO
- Is a supporting organization described in Section 509(a)(3) during the taxable year with respect to the ATEO
- Establishes, maintains, or makes contributions to a voluntary employees’ beneficiary association (VEBA) (in the case of an ATEO which is a VEBA described in Section 501(c)(9))
The notice clarifies that a related organization is not limited to tax-exempt organizations, but includes all types of entities. Therefore, if a taxable related organization pays a portion of any excess remuneration or parachute payments to a covered employee of an ATEO, the taxable entity is subject to the Section 4960 excise taxes, even though the entity is not tax-exempt.
For example, consider a tax-exempt hospital that is exempt from taxation under Section 501(c)(3) wholly owns a taxable clinic. The hospital is an ATEO because it is exempt from taxation under Section 501(a) and the taxable clinic is related to the hospital because the hospital controls the clinic. Under this fact pattern, the remuneration of an employee who works for both is combined for purposes of applying the Section 4960 excise taxes.
Each ATEO in a group of related organizations must determine its own group of covered employees separately, but must take into account all remuneration and parachute payments paid to any of its employees who are also employed by any other organizations in the related group. A covered employee is any employee (including any former employee) of an ATEO who is one of the five highest-compensated employees of the organization for the taxable year, or was a covered employee of the ATEO (or any predecessor, which is not defined in the notice) for any of the ATEO’s preceding taxable years beginning after Dec. 31, 2016.
The determination of the five highest-compensated employees is based on an employee’s remuneration paid during the calendar year ending with or within the organization’s taxable year for services performed as an employee of the ATEO, including as an employee of a related organization. Thus, when an employee works for both an ATEO and a related organization, the remuneration paid by both is aggregated for purposes of identifying the covered employees of the ATEO as well as applying the excises taxes to both the ATEO and the related organization. Compensation paid during the calendar year (even if a tax-exempt organization has a fiscal taxable year) is also used in determining excess remuneration and excess parachute payments as discussed below. The IRS clarifies in the notice that only an ATEO has covered employees, but the remuneration of covered employees includes remuneration from related organizations, including related taxable entities and governmental units which are not ATEOs.
For example, consider a trade association that controls a foundation, each of which is an ATEO. Both the trade association and the foundation will have their own groups of covered employees. One employee performs services for, and is paid by, both organizations. The trade association pays the employee $750,000 each year and the foundation also pays the employee $500,000 each year. When identifying the covered employees for each ATEO, each organization is treated as paying the employee $1,250,000 because the ATEOs are related. As a result, the employee could be a covered employee of one or both ATEOs to the extent the employee falls into the top five paid employees of each ATEO.
Remuneration paid to employees for medical or veterinary services (as determined by state or local law) is not taken into account in identifying the top five highest-paid employees. If a contract separately states the remuneration for medical and non-medical services, the remuneration must be allocated to the services based on the amounts stated in the contract unless it is unreasonable. If a contract does not specify the amount of remuneration paid for medical services, any reasonable allocation method may be used to determine that amount. The notice provides examples of reasonable allocation methods.
The IRS provides a limited services exception that excludes certain employees from being treated as covered employees when the employees provide services to multiple related ATEOs. An employee generally is not considered one of the top five highest-paid employees of an ATEO if the ATEO paid less than 10% of the employee’s aggregate remuneration for services performed as an employee of the ATEO and all related organizations during the calendar year. However, for a group of ATEOs and related organizations, if no ATEO in the group paid at least 10% of the total remuneration paid by the group during the calendar year, the exception does not apply to the ATEO that paid the employee the most remuneration during that year.
Under Section 4960, excess remuneration is the amount of compensation over $1 million (other than excess parachute payments) paid to a covered employee by an ATEO (including related organizations) in a taxable year. These amounts are subject to a 21% excise tax. As mentioned above, remuneration is treated as paid for the ATEO’s taxable year if it is paid during the calendar year ending with or within the employer’s taxable year. For example, an ATEO has a taxable year ending Sept. 30. A covered employee’s remuneration for the ATEO’s taxable year ending Sept. 30, 2020, is the covered employee’s remuneration for the 2019 calendar year. The notice defines the term remuneration and provides guidance on when the remuneration is taken into account in determining if there is excess remuneration.
For purposes of the tax on compensation over $1 million, remuneration is generally defined as wages under Section 3401(a), except that it excludes designated Roth contributions and remuneration paid for medical or veterinary services (as determined by state or local law). Section 3401(a) defines wages for federal income tax withholding, and these amounts are generally reported on a Form W-2 in Box 1. However, because of the timing rules discussed below, the remuneration taken into account when determining whether excess remuneration is paid will not always equal the amount reported in Box 1 of a covered employee’s Form W-2.
The notice also provides that the timing for when wages are taken into account for purposes of Section 4960 is determined by the rules under Section 457(f), regardless of whether the wages are subject to Section 457(f). Section 457(f) generally applies to nonqualified deferred compensation plans and requires plan participants to recognize income when the deferred compensation vests, rather than when it is paid, with certain exceptions. The notice clarifies that all remuneration is taken into account when determining whether compensation is paid in excess of $1 million, regardless of whether Section 457(f) is applicable to the plan or remuneration.
Specifically, remuneration is treated as paid on the first date that the right to the remuneration is not subject to a substantial risk of forfeiture within the meaning of Section 457(f)(3)(B), which generally provides that rights to compensation are subject to a substantial risk of forfeiture if conditioned upon the future performance of substantial services. Certain forms of compensation, such as short-term deferrals and some severance payments, are exempt from Section 457(f), and therefore, are generally included in an employee’s taxable income in the year of actual payment instead of the year of vesting. Those exceptions to Section 457(f) do not apply for purposes of determining when remuneration is taken into account in calculating excess remuneration.
For example, consider a covered employee who is paid $700,000 of salary in 2019 and earns a $500,000 bonus in 2019, which is paid on Mar. 15, 2020. The covered employee is not required to work past Dec. 31, 2019, to receive the bonus payment, so the employee is vested in the bonus in 2019. As a result, the employee’s remuneration for the 2019 calendar year is $1,200,000, even though the $500,000 bonus is actually paid and included in the employee’s income in 2020.
For a covered employee of an ATEO with multiple related organizations, the excise tax on excess remuneration is prorated among all related entities based on the portion of the remuneration paid by each entity to the covered employee.
Excess parachute payments
This second excise tax is triggered if the present value of any parachute payments payable to a covered employee equals or exceeds three times the employee’s average annual compensation (base amount discussed further below). However, if the three-times threshold is met, this second excise tax applies to the amount of the covered employee’s excess parachute payments, which equals the amount by which the total parachute payments (not present value) exceed the employee’s base amount (not three times the base amount).
For this purpose, the term “parachute payment” is defined as any payment in the nature of compensation made by an ATEO or a related organization to a covered employee if the payment is contingent on the employee’s involuntary separation from employment with the employer, and if the aggregate present value of the compensation payments to the individual that are contingent on the separation equals or exceeds an amount equal to three times the base amount.
The notice clarifies that “separation from employment” generally follows the definition of separation from service under Section 409A, which provides that an employee generally separates from service with the employer if the employee dies, retires or otherwise has a termination of employment with the employer. The notice provides a number of exceptions to the Section 409A rules. For example, under the Section 409A rules, an employer has some discretion to set the level of the anticipated reduction in future services that would give rise to a separation from employment. In contrast, for purposes of Section 4960, the notice requires the employer to use the default rules under Section 409A, which require an employer to treat an anticipated reduction in the level of services of less than 50% as not constituting a separation from employment, an anticipated reduction of more than 80% as constituting a separation from employment, and the treatment of an anticipated reduction between those two levels as having to be determined based on the particular facts and circumstances. As another example, the notice provides that a change from employee status to bona fide independent contractor status would be a separation from employment for Section 4960 purposes, even though it generally would not be under the Section 409A rules.
Payments in the nature of compensation are defined broadly to include any payment, in whatever form, that arises out of an employment relationship, including holding oneself out as available to perform services and the refraining from performing services, for example, under a non-compete. Payments in the nature of compensation include (but are not limited to) wages and salary, bonuses, severance pay, fringe benefits, life insurance, pension benefits and other deferred compensation, including interest or earnings on deferred compensation. In addition, payments in the nature of compensation include cash when paid, the value of the right to receive cash, including the value of accelerated vesting or transfers of property. However, parachute payments do not include payments made to or from the following:
- Certain retirement and annuity plans
- Section 403(b) or 457(b) plans
- A licensed medical professional or veterinarian (as determined under state or local law)
- Individuals who are not highly compensated employees, as determined under Section 414(q), which generally includes any employee who was a 5% owner at any time during the year or preceding year, or who had compensation in the preceding year in excess of an inflation-adjusted amount ($120,000 in 2018; $125,000 in 2019)
Payments in the nature of compensation are considered made in the taxable year in which they are includible in the covered employee’s income, or, for fringe benefits excludible from income, in the taxable year the benefits are received. The present value of any payments to be made in the future is used for purposes of applying the “three-times-base-amount test,” but the actual timing and amount of any such payments is used for purposes of computing and paying the amount of the excise tax (i.e., the amount in excess of the base amount).
Under the three-times-base-amount test, if the present value of the payments paid to a covered employee with respect to separation from employment is equal to or greater than three times the covered employee’s base amount, then the payments are considered parachute payments subject to Section 4960. The base amount generally is the average annual taxable compensation of a covered employee over the five calendar years ending before the separation from employment. For base periods that include short or incomplete taxable years, compensation for the short or incomplete taxable year must be annualized before determining the average annual compensation for the base period.
Once payments are identified as parachute payments under Section 4960 following the three-times base amount test, the 21% excise tax is applied to an amount of parachute payments equal to the aggregate parachute payments that exceed one times the base amount. For covered employees receiving parachute payments from multiple ATEOs or related organizations, a prorated portion of the base amount is allocated to each parachute payment based on the present value of the parachute payment paid by an organization to a covered employee over the aggregate present value of all parachute payments paid by all organizations to that covered employee.
The following example illustrates the determination and computation of excess parachute payments:
E is a covered employee of ATEO X and an employee of related organization Y. E’s base amount is $200,000 with respect to X and $400,000 with respect to Y. E receives $1 million from X and $1 million from Y contingent on E’s involuntary separation from employment from X and Y. E has an aggregate base amount of $600,000 ($200,000 + $400,000). The two $1 million payments are parachute payments subject to Section 4960 because their aggregate present value is at least three times E’s base amount (3 x $600,000 = $1.8 million). The portion of the base amount allocated to each parachute payment is $300,000 ([$1 million / $2 million] x $600,000). Thus, the amount of each excess parachute payment is $700,000 ($1 million - $300,000).
Each ATEO and related organization must separately file a Form 4720 for taxes imposed by Section 4960. Excise taxes must be paid and reported by the 15th day of the fifth month after the employer’s taxable year end. Employers may file Form 8868 to request an automatic extension to file Form 4720, but there is no extension for time to pay the excise taxes.
Employers can rely on the guidance included in the notice for purposes of applying Section 4960 until further guidance is issued by the IRS. Tax-exempt organizations should review their existing compensation arrangements in light of the new guidance to identify opportunities to mitigate the new excise taxes on excess remuneration and parachute payments. 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.
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