IRS Year-End Guidance on Executive Compensation Excise Tax at Tax-Exempt Organizations

The Sum and Substance

Section 4960 of the Internal Revenue Code (“IRC”), passed as part of the Tax Cuts and Jobs Act more than a year ago, imposes a 21% excise tax on two categories of executive compensation paid by applicable tax-exempt organizations (“ATEOs”). The new tax applies to:

• Remuneration paid to “covered employees” in excess of $1 million per year (the “excess remuneration” excise tax), and
• “Excess parachute payments” paid to covered employees that are contingent upon their separation of employment (referred to as the “excess parachute” or “separation pay” excise tax).

On December 31, 2018, the IRS provided more guidance in the form of a 92 page document - Notice 2019-09 (the “Notice”). The Notice, intended as interim guidance before final regulations are issued, provides direction in the form of 39 questions and answers (Q&As) on how the rules are intended to operate by defining key terms and instructing taxpayers on how to compute, report, and pay the excise tax. It also announces that Treasury and the IRS intend to issue proposed regulations in the future. Until further guidance is issued, employers may base their positions on the excise tax on “good faith reasonable interpretations” of the statute; positions reflected in the Notice constitute good faith reasonable interpretations.

Some of the key points and concepts found within the Notice are outlined below:

Remuneration is the Basis for Determining Top Five Employees

Under Section 4960 a “covered employee” of an ATEO includes:

• Anyone who is one of the top five highest paid employees of the tax-exempt organization; and
• Anyone considered a covered employee of the organization in a preceding year beginning after December 31, 2016.

Surprisingly, the statutory language did not include definitions or guidelines for determining the top five employees. The Notice indicates that an ATEO should determine its covered employees using the same definition of pay (i.e., remuneration) that is used to determine the excess remuneration excise tax. (See further details below.)

Remuneration is Generally Considered Paid When it Vests

Remuneration is treated as paid for purposes of Section 4960 when there is no substantial risk of forfeiture of the rights to the remuneration, as defined by Section 457(f)(3)(b). This means that an amount of compensation is subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on either:

• The future performance of substantial services; or
• The occurrence of a condition related to the purpose of the transfer if the possibility of forfeiture is substantial.

The amount of remuneration treated as paid at vesting is the "present value" of the remuneration in which the employee vests, determined using reasonable actuarial assumptions regarding the time and likelihood of actual or constructive payment.

However, if an amount will actually be paid within 90 days of vesting, the company can use the present value on the vesting date.

The Determination Period is the Calendar Year

The statute was unclear on the relevant tax year for measuring remuneration and excess parachute payments, and for determining covered employees. The Notice clarifies that these amounts should be determined on a calendar year basis, using the calendar year that ends with or within the taxable year of the employing organization. The Notice treats remuneration vesting before the first taxable year that begins after December 31, 2017 (the effective date of Section 4960) as paid before the effective date and, therefore, not subject to the excise tax.

This should simplify administration, especially for non-calendar year fiscal filers and for tax-exempt groups having multiple entities with different tax years.

Each ATEO Must Separately Determine its Covered Employees

The Notice also provides that each ATEO must separately identify which of its employees are covered employees, rather than determining its employees on a related group basis. As a result, related tax-exempt employers may have multiple entities with multiple employees that are considered covered employees.

Only common law employees can be covered employees. However, the fact that a separate entity or related entity does the payroll reporting does not change the common law relationship and, therefore, the common law employer of an employee must generally count that individual’s compensation when determining its five most highly paid employees.

Covered Employee Status Does Not End

The Notice confirms that once an individual has been identified as a top five employee in a taxable year, the employee retains his or her status as a covered employee in all future years. There is no minimum dollar threshold for an employee to be a covered employee, and even if an ATEO has no excise tax liability under Section 4960 for one year, it can become subject to tax in a later year. Therefore, each ATEO will need to keep a record of its own covered employees indefinitely.

Remuneration Includes Pay from all Related Entities Including For-Profit and Governmental Entities

Adding to the complexity, when determining covered employees and the excess remuneration excise tax, total remuneration from all related entities must be considered. The Notice uses the same definition for related organization status as is used in the Form 990 which generally uses a more than 50% ownership or control test. Related organizations can include for-profit and government entities as well as not-for-profit entities.

Governmental Entities can be ATEOs

The Notice also indicates that the excise tax can apply to governmental entities that exclude income from gross income under Section 115(1) as well as to governmental entities that have applied and received recognition of tax-exempt status as Section 501(c)(3) organizations. Only governmental entities that do not meet either of these specifications (such as a state college or university that does not have an IRS determination letter) are exempted from the excise tax. The Notice indicates that state entities that also have Section 501(c)(3) letters can relinquish this status to become exempt from Section 4960.

The Exclusion for Medical Services is Very Limited

Section 4960 defines remuneration using the Section 3401(a) (federal income tax withholding) definition but it excludes designated Roth contributions and includes compensation that is required to be included in income under the deferred compensation rules under IRC Section 457(f) (i.e., when the compensation is no longer subject to a substantial risk of forfeiture). Remuneration also specifically excludes the portion of any remuneration paid to a licensed medical professional (including a veterinarian) for the performance of medical or veterinary services by that professional. 

Since adoption of the rules, there have been many questions on how the exception for medical services should be administered. The Notice, while providing needed guidance, adopts a narrow interpretation of this exclusion by allowing only compensation paid for the direct performance of medical services (including nursing services) to patients to be excluded. Compensation for teaching, research, and administration is not excluded compensation to the extent the services do not relate directly to the diagnosis, cure, mitigation, treatment, or prevention of disease.

The Notice also clarifies that qualified medical services are excluded when determining which ATEO employees are its covered employees.

If an employee provides both medical and other services, the Notice indicates that the employer must allocate remuneration using a “reasonable method.” In practice, allocating pay amongst various services may prove to be challenging for organizations to administer.

The Excise Tax Should be Apportioned Among Related Entities

As noted above, the Notice indicates that each ATEO calculates its excise tax liability taking into account the organizations to which it is related. The Notice provides some discussion of the general allocation rules for ATEOs that share employees. If the same employee is a covered employee and provides services for the ATEO and related entities, the entities add together the remuneration from all entities and then allocate based on the service to each common law employee.

An employer is liable only for the greater of the excise tax it would owe as an ATEO or the excise tax it would owe as a related organization with respect to that covered employee; the ATEO will not owe the excise tax liability in both capacities.

Excess Parachute Payments are Applied to Payments Contingent on Separation from Employment

The Notice provides that the rules for determining excess parachute payments under IRC Section 4960 are modeled after the rules outlined in IRC Section 280G covering payments that are contingent upon a change-in-control (“CIC”) of a corporation, except that the tax-exempt rules will generally apply to payments contingent upon a separation from employment. 

An “excess parachute payment” is the amount by which any “parachute payment” exceeds a covered employee’s “base amount.” 

• A “parachute payment” is generally any compensatory payment made by an ATEO (or predecessor or related organization) to (or for the benefit of) a covered employee that is contingent on the employee’s separation of employment for which the aggregate present value equals or exceeds three times the employee’s “base amount.”
• A covered employee’s “base amount” is generally the average annualized compensation includible in the employee’s gross income for the five taxable years ending before the date of the employee’s separation from employment.

The Preamble to the Notice provides a step by step instructive guide for how to determine whether excess parachute payments have been made. It also emphasizes that an excess parachute payment equals the excess of the parachute payment over the base amount and not just the portion of the payment that is in excess of three times the base amount.

Payments Contingent Upon a Separation of Employment are Generally Limited to Involuntary Separation Payments

While separation from employment (whether voluntary or involuntary) is often used in compensation arrangements as the trigger to pay vested amounts, the Notice generally limits the payments treated as contingent on an involuntary separation from employment, including qualifying terminations for good reason. If an employee can voluntarily terminate and receive a benefit, the payment is generally not subject to a substantial risk of forfeiture, and, therefore, would not be included as a parachute payment.

The Notice indicates that amounts included in taxable income in previous years and excess remuneration, as discussed above, are not considered parachute payments.

Parachute Values for Accelerated Time-Based Payments are Determined Using a Discounted Formula

The Notice borrows heavily from the 280G regulations in determining how the parachute values for service-based payments/awards that are accelerated as a result of an involuntary termination should be determined. The Notice permits an entity to use the formula provided under the 280G regulations that deeply discounts the parachute value attributable to the acceleration (rather than using the full value of the payment). However, the Notice cautions that if the facts and circumstances demonstrate that the accelerated vesting or payment of an amount would not have occurred but for the involuntary nature of the separation from employment, the whole amount may have to be treated as a parachute payment.

Excise Tax Liability Reported on Form 4720; No Estimated Payments are Required

The Notice indicates that employers should report their excise tax liability on IRS Form 4720. If remuneration from a related organization is included to determine the excise tax, each ATEO and related organization must file a separate Form 4720 to report its share of the liability. The Form 4720 must be filed and the excise tax paid by the 15th day of the fifth month after the end of the employer's taxable year. The Notice further clarifies that no quarterly estimated tax payments are required to be paid on the excise tax liability.

No Relationship Between Liability for 4960 Excise Taxes and Excise Taxes on Excess Benefit Transactions or Acts of Self-Dealing

The Notice indicates that there is no particular relationship between the liability for payment of 4960 excise taxes and the excise taxes for unreasonable or excessive compensation under Section 4958 or acts of self-dealing as described in Section 4941. The payment of 4960 excise taxes is not automatically considered an excess benefit transaction under Section 4958 or an act of self-dealing as described in Section 4941.

Closing Thoughts

The initial year for compliance with IRC Section 4960 was 2018, and while the Notice provides much needed guidance for tax-exempt employers, the particulars are quite detailed and highly technical in nature. As a result, tax-exempt organizations should begin now to evaluate how/whether the new excise tax will apply.

If you have any questions regarding this document or IRC Section 4960, please contact Margaret Black at margaret.black@pearlmeyer.com or Ed Steinhoff at ed.steinhoff@pearlmeyer.com.