IRS Guidance Regarding the Section 4960 Excise Tax Is (Somewhat) Helpful
IRS Notice 2019-09 provides guidance intended to help "applicable tax-exempt employers" determine whether compensation paid to their most highly compensated employees will be subject to the 21 percent excise tax imposed under Code Section 4960. Notice 2019-09 is indeed helpful to those of us who have to interpret the provisions of Code Section 4960. But tax-exempt employers subject to Code Section 4960 have serious work to do in order to comply with these relatively new rules, and some tax-exempt employers will be disappointed in the results. (In general, compensation paid by a Section 501(c)(3) organization will be subject to the requirements of Code Section 4960, so we will simply reference tax-exempt employers for these purposes.)
Excise Tax Under Code Section 4960
Enacted as part of the 2017 Tax Cuts and Jobs Act, Code Section 4960 imposes a 21 percent excise tax on: (1) compensation paid by a tax-exempt employer to a "covered employee" in excess of $1 million in any year; and (2) "excess parachute payments" paid by a tax-exempt employer to a covered employee. A Section 4960 excess parachute payment is a payment made contingent upon a termination of employment, if the payment amount equals or exceeds the terminating employee's average annual taxable compensation over the preceding five years. The tax on an excess parachute payment is due on the portion of the payment that exceeds the covered employee's average annual compensation (not just the portion in excess of $1 million).
Covered Employees and Related Organizations
The identification of covered employees is a major topic addressed by Notice 2019-09. In general, a covered employee is an individual who is one of the five highest paid employees of the exempt organization in any taxable year beginning after December 31, 2016. There is no minimum compensation threshold that applies in determining covered employee status. And, perhaps most important, once an individual is identified as a covered employee she will remain a covered employee – forever. This means that a tax-exempt employer must identify its covered employees every year and keep track of them on an ongoing basis.
A tax-exempt employer must identify its covered employees based not only on remuneration paid by that employer, but also taking into account remuneration for services performed by the individual as an employee of any "related organization" of the employer. Under Notice 2019-09, a related organization is any entity that is under common control with a tax-exempt employer using a more-than-50 percent control test. This approach may create headaches for many tax-exempt employers, who are used to the 80 percent control test that generally applies in determining the members of a controlled group of exempt organizations. So a tax-exempt employer within an integrated health system, for example, must determine the extent to which remuneration must be imputed to an employee for services from a related organization that may only be 50 percent owned by the employer in determining covered employee status. Moreover, an individual can be deemed to be an employee of more than one tax-exempt employer. Therefore, it is possible that a single employee could be a covered employee with respect to more than one tax-exempt employer within a system. Finally, given the "forever" status of covered employees, the recordkeeping headaches will multiply when, for example, two health systems merge.
Compensation Is Considered Paid When Vested and on a Calendar Year Basis
Code Section 4960 states that compensation will count toward the $1,000,000 threshold when it ceases to be subject to a substantial risk of forfeiture (i.e., when it vests), rather than when it is paid. But Notice 2019-09 includes a helpful grandfathering rule. Specifically, amounts that were earned and vested prior to the employer's taxable year beginning in 2018 do not count toward the threshold.
Notice 2019-09 also clarifies that the excise tax is determined on a calendar year basis, not based on the taxable year of the employer. This should reduce the administrative burden that might otherwise arise if employers were required to allocate compensation paid during a single calendar year to multiple fiscal years.
Severance Pay Below $1 million Can Be Subject to the Excise Tax
Excess parachute payments paid to a covered employee can be subject to the 21 percent excise tax even if those payments amount to less than $1 million. While conceptually similar to the "golden parachute" concept under Code Section 280G, which applies where a payment is made in connection with a change in control of a for-profit company, Notice 2019-09 takes an expansive view as to what is an excess parachute payment under Section 4960. Subject to only a few exceptions, most types of compensation triggered by an involuntary separation can potentially be considered a parachute payment. For example, payments made contingent upon complying with a non-compete are included, as is the value of benefits where vesting is accelerated, even if no actual payment is made. An involuntary separation from service for this purpose generally includes an employee's termination of employment without cause, an employee's failure to renew a contract, and a termination of employment by an employee for good reason. There are also special provisions defining separation from service broadly to include certain changes to the service relationship, even if an employee is still employed by the tax-exempt employer. The total payments in the nature of compensation that are contingent upon an involuntary separation from service will only be parachute payments if they are three or more times the employee's base amount (which is the measure of taxable compensation applied under Code Section 280G). Excess parachute payments equal the portion of the parachute payments that exceeds the base amount.
Multiple Employers Within a Tax-Exempt Controlled Group Can Each Be Subject to Tax
Notice 2019-09 confirms that separate tax-exempt members of a controlled group can each be subject to the excise tax. (Think of a health system made up of multiple hospitals and other institutional health care providers.) This means that each tax-exempt employer must separately determine which of its employees are covered employees rather than determining the five highest paid employees across the entire integrated health system. So a controlled group of tax-exempt employers could potentially have several employers with dozens of employees earning compensation that triggers the excise tax. Consistent with this idea, the Notice includes rules for allocating the excise tax among a tax-exempt employer and related organizations. A careful application of these rules will be particularly important in a health system with covered employees who provide services to, and receive compensation from, more than one related organization.
The Good News?
The IRS expects to issue further guidance regarding the application of Code Section 4960. In the meantime, tax-exempt employers may determine the applicability of the excise tax based on a "good faith, reasonable interpretation" of Code Section 4960, informed by Notice 2019-09. Accordingly, tax-exempt employers who are subject to Code Section 4960 should adopt consistent and reasonable approaches to the application of the excise tax based on all of the facts and circumstances. For tax-exempt employers that are part of a large group, we suggest a coordinated strategy starting at the parent entity and working down from there.