IRC Section 4960, enacted as part of the Tax Cuts and Jobs Act (TCJA), 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 IRS has issued Notice 2019-09 to provide interim guidance on the new taxes, and is expected to provide additional guidance in the form of proposed regulations in the next few months.
Calendar-year organizations subject to one or both of the new excise taxes generally were required to file a Form 4720 to report and pay the taxes on or before May 15, 2019. Alternatively, such organizations could have filed a Form 8868 by that date to request an automatic extension to file, but there was no extension for paying the excise taxes (so organizations had to, at least, estimate the amount of taxes due for 2018 by that date).
Returns and taxes for a fiscal year tax-exempt organization are due by the 15th day of the fifth month following the end of the organization’s 2018-2019 taxable year. For example, for organizations with a fiscal year that ended March 31, 2019, the returns and taxes are due no later than Aug. 15, 2019. Similarly, for organizations with a fiscal year ending June 30, 2019, the returns and taxes are due no later than Nov. 15, 2019.
For fiscal year organizations going through the process of determining the extent to which, if any, the new excise taxes may actually apply to their 2018-2019 taxable years, and calendar-year organizations contemplating their 2019 taxes, this article discusses several of the key lessons learned from the first round of filings for 2018 calendar year organizations.
Lessons learned to dateAll tax-exempt organizations should do an assessment and document the analysis
. The new taxes apply to almost all organizations exempt from federal income taxes, including all Section 501(a) tax-exempt organizations and certain governmental entities. Organizations subject to the new taxes are referred to as “applicable tax-exempt organizations,” or “ATEOs.” In addition, compensation paid by related organizations to ATEO employees must be taken into account and can subject the related organizations to the new taxes, including both taxable and tax-exempt related organizations. For purposes of identifying an ATEO’s related organizations, a more than 50% ownership/control standard generally applies, but there are a number of special rules that apply for this purpose.
Even though a particular ATEO may think it is not going to be subject to the new taxes because of its current compensation structure and levels (e.g., it does not pay any employees total compensation anywhere close to $1 million per year), there are scenarios where such an organization may be subject to one or both of the new excise taxes, some of which are discussed below. Accordingly, all tax-exempt organizations should do an assessment and, even if they are not actually subject to the new taxes, should document the analysis so they can demonstrate the taxes do not apply to their 2018 taxable year if any questions are ever raised (e.g., in connection with an IRS audit).
The assessment should be started as soon as possible
. All ATEOs should begin the assessment as soon as possible because of the volume of information that needs to be gathered to do a proper analysis. In addition, in most cases, there will be a lot of follow-up questions and analysis that may need to be addressed based on the initial information gathered (e.g., clarifications regarding the underlying compensation documents and terms). To determine the extent to which, if any, the two new taxes may actually apply to the 2018 taxable year, ATEOs should consider gathering the following four categories of information as a starting point:
Taxable companies with related foundations (or similar tax-exempt organizations) could be subject to the new excise taxes.
- Information sufficient to confirm/determine whether the organization is an ATEO and whether the organization has any related organizations
- Information sufficient to determine the covered employees for the 2017 and 2018 taxable years (e.g., remuneration for those years, including any remuneration paid by related organizations)
- For fiscal year organizations, information necessary to determine the portion of 2018 remuneration that vested before the first day of the 2018 taxable year (discussed further below and which does not have to be taken into account for purposes of applying the taxes)
- To determine whether the excess parachute payment tax actually applies, information sufficient to determine whether any covered employee experienced an involuntary separation from employment on or after the first day of the ATEO’s 2018 taxable year and, if so, to compute any such covered employee’s base amount and parachute payments.
Under the current 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 and/or are officers of the foundation, the compensation paid by both 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 company could then be subject to one or both of the new excise taxes. The IRS is aware of this issue and has indicated that it is considering options for providing some type of relief in certain circumstances (e.g., by not requiring compensation to be aggregated when a company employee is providing only minimal services to the ATEO foundation).
A permanent, cumulative list of covered employees should be established beginning with the 2017 taxable year
“Covered” employees include any employee (including any former employee) of an ATEO who (i) is one of the five highest-compensated employees of the ATEO for the taxable year (Top 5), or (ii) was a covered employee of the ATEO (or any predecessor) for any of the ATEO’s preceding taxable years beginning after 2016. An employee who becomes a covered employee by making the Top 5 in any taxable year remains a covered employee for all future taxable years, even after separating from employment. The list of covered employees starts with the Top 5 for 2017 even though the new taxes are not effective until 2018. This base list is then updated each year by adding any new employees who make the Top 5 that year, but who are not already on the list. Thus, the list of covered employees is likely to include more than five over time. This need for a cumulative list is another example of why ATEOs that may not actually be subject to the new taxes in 2018 should identify and document the covered employees beginning with the 2017 year. The taxes may apply in future years as the compensation structure of an organization changes (or there is a significant payment or vesting event) and it may be difficult to gather the information for 2017 and 2018 to make that determination in a future year.
Calculating remuneration can be difficult because of the required modifications and special timing rules.
Remuneration is defined as “wages” for federal income tax withholding purposes (Section 3401(a)), but modified to exclude (i) any amounts subject to the excess parachute payment tax (applied based on a separate definition of “parachute payment”), (ii) Roth 401(k) contributions, and (iii) 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 taken into account for purposes of the tax in the year the amount vests, no matter when the amount is paid, taxed or included in withholding wages. However, this special timing rule does not include the exceptions under Section 457(f) that defer taxation until 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). Accordingly, in many cases, remuneration will not equal the amounts reported in Box 1 of a covered employee’s Form W-2, and therefore, those amounts should be used only as a starting point and will have to be adjusted to reflect the required modifications and special timing rules.
The new excise taxes are applied based on compensation for the calendar year ending with or within the organization’s taxable year. Compensation paid during the calendar year (even if a tax-exempt organization has a fiscal taxable year) is used to determine remuneration and parachute payments as well as to identify an organization’s covered employees. This structure was adopted by the IRS with the intent that it would ease the administrative burdens of applying the taxes because employers must generally track, report and use the definition of wages on a calendar-year basis to comply with the federal income tax withholding and reporting requirements. However, as discussed above, that information generally can be used only as a starting point because of the required modifications and special timing rules that apply.
The new excise taxes do not apply to compensation that vested before the effective date.
The new 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 Notice 2019-09 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. For fiscal year organizations, the compensation taken into account generally is the compensation paid in the calendar year ending within the taxable year. Thus, the portion of the 2018 calendar year remuneration that vested before the first day of the 2018 taxable year does not have to be taken into account for purposes of applying the taxes. However, that special transition 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.
The excess parachute payment tax can apply to parachute payments significantly below $1 million.
The excess parachute payment 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 over the past five calendar years (“base amount”). Parachute payments generally include payments that are contingent on a covered employee’s involuntary separation from employment. However, if the “three-times” threshold is met, the 21% excise tax applies to the extent the total parachute payments (not present value) exceed the covered employee’s base amount (not three times the base amount). Because there is no minimum threshold like there is with the excess remuneration tax ($1 million), the excess parachute payment tax can apply at relatively lower levels of compensation, and therefore, can apply to ATEOs that generally do not pay regular compensation anywhere near $1 million.
The excess parachute payment tax applies to parachute payments, which are defined differently than remuneration.
The term “parachute payment” generally 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. Parachute payments are also subject to special timing rules that differ from those that apply to remuneration under the excess remuneration tax. For purposes of determining whether the excess parachute payment tax is triggered – that is, applying the three-times base amount threshold – the present value of any parachute payment as of the date of separation from employment generally is taken into account (even if one or more of the parachute payments are payable to the covered employee at a later date). However, for purposes of computing and paying the excise tax if the three-times threshold is met, the parachute payments generally are taken into account in the taxable year in which they are includible in the covered employee’s taxable income.
The common-law employer is liable for the new excise taxes.
Whether a particular entity is the common-law employer generally depends on the facts and circumstances. A common-law employer cannot avoid liability under Section 4960 by reason of a payment by a related organization (that is not the common-law employer), or by reason of a third party payor arrangement, such as an arrangement with a payroll agent, common paymaster, statutory employer under Section 3401(d), certified professional employer organization or any similar arrangement. Thus, the common-law employer of each covered employee must be confirmed/determined based on the particular facts and circumstances (and not necessarily based on the payor of the compensation).
ATEOs should consider opportunities to avoid or minimize the new excise taxes.
ATEOs should review their existing compensation arrangements to identify opportunities that may avoid or minimize the new excise taxes on excess remuneration and parachute payments. For example, the vesting of deferred compensation could be staggered over several years (as opposed to cliff vesting) to avoid or minimize the excess remuneration tax. Similarly, severance payments could be reduced to avoid triggering the excess parachute payment tax. In addition, an organization could seek to avoid or minimize fluctuations in the compensation paid in calendar years that could cause employees to go in and out of the Top 5 each year, which would minimize the number of covered employees. ATEOs 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 new excise taxes.
The IRS has indicated that it will issue additional guidance under the new excise taxes in the form of proposed regulations. Until the proposed regulations are issued, taxpayers can rely on the statutory language, legislative history and interim guidance issued under Notice 2019-09. The two key takeaways from the first round of filings by calendar-year organizations are that all tax-exempt organizations should (i) assess and document whether one or both of the two new taxes actually apply for the 2018 taxable year, and (ii) start that process as soon as possible given the volume of information and analysis that may be required to do a proper assessment.
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