Proposed Regulations Clarify Application of Excise Tax under Code Section 4960
Proposed Regulations published by the Treasury Department last month provide helpful clarifications regarding the application of the excise tax under Section 4960 of the Internal Revenue Code of 1986, as amended (the “Code”). The content of the Proposed Regulations is generally consistent with the guidance provided early last year in the form of Notice 2019-09, and employers may rely upon the Proposed Regulations until final regulations are issued.
Code Section 4960
As a reminder, Code Section 4960 was enacted as part of the Tax Cuts and Jobs Act of 2017 in order to address the asymmetrical treatment of tax-exempt employers and for profit employers with respect to the compensation of highly paid employees. Specifically, the Code limits the deductions that can be taken by for profit employers for compensation paid to an individual in excess of $1,000,000 (Code Section 162(m)) and the deductions that can be taken by for profit employers for payments made to an employee in connection with a change in control of the employer (Code Section 280G). However, those limitations do not apply to compensation paid by tax-exempt employers. Code Section 4960 remedies that perceived inequity by imposing a 21% excise tax on exempt organizations that pay to any “covered employee”: (1) “remuneration” in excess of $1,000,000 in any year; or (2) an “excess parachute payment” in connection with a separation from service.
The Proposed Regulations address all of the ground covered by Notice 2019-09 and provide additional guidance regarding the types of tax-exempt employers that are subject to the excise tax, the “covered employees” whose compensation could trigger the imposition of the excise tax, the computation of remuneration, and the application of the tax on excess parachute payments in the case where an entity related to an exempt organization may contribute to the payment. (Our commentary on Notice 2019-09 can be found here.)
Applicable Tax-Exempt Organizations
The excise tax under Code Section 4960 applies to most organizations that are exempt from tax under Code Section 501(a), including all section 501(c)(3) organizations. The Proposed Regulations confirm that a governmental entity – including a public university – that has received an IRS determination of tax exemption under Code Section 501(c)(3) will be considered to be an “applicable tax-exempt organization” and, therefore, will be subject to the excise tax. By contrast, governmental entities such as counties, municipalities, and public water districts, which are exempt from tax under Code Section 115, are not subject to the excise tax. Voluntary employee beneficiary associations (“VEBAs”) are also considered applicable tax-exempt organizations and, therefore, are subject to the excise tax.
The Proposed Regulations also explain how to determine whether an organization is related to an exempt organization to which the excise tax applies. Specifically, an entity will be considered related to an applicable tax-exempt organization if it: (1) is controlled by, or controls, the exempt organization; (2) is supported by, or is considered a supporting organization (as defined under Code Section 509) of the exempt organization; or (3) maintains or contributes to a VEBA. For these purposes, control is determined by applying a 50% threshold for the ownership of stock or the appointment of directors or trustees (in the case of non-stock entities) rather than the 80% control threshold that applies to tax-exempt organizations in other contexts. Related entity status is relevant because compensation from related organizations is added to compensation from the applicable tax-exempt organization for purposes of computing “remuneration” and “excess parachute payments.”
The excise tax applies to compensation paid to any “covered employee” that exceeds the limitations prescribed under Code Section 4960. A “covered employee” is any individual who is one of the five highest paid employees of the exempt organization for any given taxable year and any individual who was considered a covered employee in any preceding taxable year beginning on or after January 1, 2017. Importantly, this includes former employees. The Proposed Regulations confirm that once an individual is determined to be a covered employee, she will always be considered a covered employee for these purposes. It is important to note that neither the statute nor the subsequent guidance specify a minimum compensation threshold for purposes of determining covered employees. The Proposed Regulations are completely consistent with Notice 2019-09 regarding the rules for determining who is a covered employee.
The Proposed Regulations do, however, provide new guidance regarding the treatment of individuals who are employed by an entity related to an applicable tax-exempt organization but provide uncompensated services to the applicable tax-exempt organization. This can be important in cases where an individual is found to be a covered employee whose compensation is subject to the excise tax because the excise tax liability is allocated among the exempt organization and the related entities based on their contributions to the pertinent compensation. With respect to an individual who provides services for an exempt organization in a “volunteer” capacity, the Proposed Regulations confirm that the individual will not be considered a covered employee if she: (1) has no legally binding right to receive compensation or deferred compensation from the applicable tax-exempt organization; and (2) performed services for the exempt organization for not more than 10% of the total hours the individual worked for the exempt organization and all related organizations. In addition, an individual who performs no more than 100 hours of service for an exempt organization and all related entities will be considered an employee for no more than 10% of the total hours worked for the exempt organization and the related entities, thus making it extremely unlikely that such an individual would be treated as a covered employee.
As noted, if a covered employee receives remuneration in excess of $1,000,000 in any taxable year, the applicable tax-exemption organization will be subject to a 21% excise tax on the excess amount (with related organizations being liable for their allocable share of the tax if they contributed to the remuneration). For purposes of determining an organization’s covered employees, and determining whether any of them received remuneration in excess of $1,000,000, all compensation paid by the exempt organization and its related organizations is counted. As a general matter, all taxable wages count for this purpose, other than compensation paid to a licensed medical professional in respect of the performance of medical services. (The distinction between medical and non-medical services is important in cases where a physician may be receiving compensation for services provided in administrative or leadership capacities, which is quite common in hospitals and health systems.)
In this regard, the Proposed Regulations confirm that compensation will count toward the $1,000,000 threshold if it is not subject to a substantial risk of forfeiture (i.e., if the compensation is either not subject to a service-based vesting requirement or has become fully vested). Therefore, if in addition to regular compensation, a covered employee becomes vested in her benefit under a deferred compensation plan that is subject to Code Section 457(f), the vested benefit will be considered remuneration under Code Section 4960 for the taxable year in which it vests. (Vesting of benefits under a section 457(b) plan does not count toward the annual dollar limit on remuneration.)
Excess Parachute Payments
Separate and apart from any excise tax attributable to remuneration in excess of $1,000,000, Code Section 4960 imposes a 21% excise tax on the payment of compensation that is contingent upon a covered employee’s separation from service if the payment exceeds a certain threshold. Such a “parachute payment” will be considered an “excess parachute payment” subject to the excise tax if the present value of the payment equals or exceeds three times the individual’s “base amount,” which is her annual compensation over the five most recent taxable years of employment with the exempt organization. If the payment is considered an excess parachute payment, the excise tax is imposed on the amount by which the parachute payment exceeds one times the individual’s base amount. For this purpose “compensation” includes all taxable wages and any other forms of compensation that are includible in an employee’s gross income. (Nontaxable fringe benefits and health care benefits are not included in determining the base amount.)
With respect to excess parachute payments, the Proposed Regulations provide a new rule regarding the allocation of the excise tax liability among the applicable tax-exempt organization and its related entities. The Proposed Regulations effectively relieve related entities from liability for this component of the excise tax by providing that only an excess parachute payment paid by an applicable tax-exempt organization will be subject to excise tax (and, consequently, that only the exempt organization will be liable for payment of the tax). Nevertheless, the Proposed Regulations reaffirm the guidance provided in Notice 2019-09 that all payments of compensation from related entities are used to compute the covered employee’s base amount and to determine the payments in the nature of compensation that are contingent upon a separation from service.
With a few minor exceptions, the Proposed Regulations under Code Section 4960 are consistent with the interim guidance provided in Notice 2019-09, and it seems likely that final regulations, when published, will be consistent with the Proposed Regulations. (The comment period regarding the Proposed Regulations closes August 10, 2020.) Most tax-exempt employers who have pay scales that are implicated by the excise tax have already factored the effects of the tax into their compensation planning based on the Notice, so those employers should not need to make further adjustments in light of the Proposed Regulations. Employers who have not already done so, should take the excise tax into account as they enter into new compensation arrangements with highly paid employees. The primary planning opportunities lie in optimizing the combination of current compensation, deferred compensation (where the judicious use of vesting schedules can moderate the computation of “remuneration”), and tax-favored welfare benefits in a way that will allow the exempt organization to minimize the effects of the excise tax and plan for the payment of the excise tax in situations where it not avoidable. Finally, because the “once a covered employee, always a covered employee” rule has been reaffirmed, exempt organizations should be sure to keep track of their covered employees and be mindful of the risk that increases in their current pay and severance pay could produce unwanted outcomes for the organization in the form of the 21% excise tax.
If you have questions regarding the application of the Code Section 4960 excise tax, please contact a member of the Employee Benefits & Executive Compensation Group at Verrill.