How Tax-Exempt Groups Can Plan for Excise Tax On Executive Compensation

The IRS released Notice 2019-09 on December 31, 2018, providing interim guidance related to Section 4960 of the internal revenue code that imposes an excise tax on executive compensation. With this guidance, released more than a year after tax reform, commonly referred to as the the Tax Cuts and Jobs Act (TCJA), organizations can now take steps to begin planning for tax liabilities or implementing changes to mitigate the liability.

The guidance begins by communicating the IRS’ intention to develop further guidance on Section 4960 and that taxpayers should ensure that any tax position is based on a good faith, reasonable interpretation of the statute and legislative history. Reliance on the notice would be considered such interpretation.

While the code section is simply written, the guidance takes into account the code and regulations that have been established in the compensation area. These can be complex and lead to more questions than answers. The guidance centers around defining each element of Section 4960 and provides answers to some common questions.

The 4960 Excise Tax

The excise tax rate is equal to the rate of tax imposed on corporations, currently 21%, under Section 11. This could change with future legislation that alters the tax code. This excise tax is filed on Form 4720, which is due four and a half months after the end of an organization’s fiscal year with an extension available. Organizations don’t have to account for estimated tax payments when planning for the excise tax, however the tax is due with the extension and late payment could result in accrued penalties and interest.

Applicable Organizations

An applicable tax exempt organization (ATEO) is generally a tax exempt organization under Section 501(a), but the term can also apply to farmer’s cooperatives, political organizations under Section 527(c)(1), and entities that have income excluded under Section 115(1).

The notice clarifies that this definition doesn’t include all government entities. A government entity that’s not recognized as exempt from tax under Section 501(a) and doesn’t exclude gross income under Section 115(1) wouldn’t be considered an ATEO. If a government entity has previously sought or obtained tax exemption under Section 501(c)(3), they would be eligible to relinquish status with the IRS. 

Covered Employees

A covered employee is defined as any employee who’s one of an ATEO’s five highest compensated employees in a given year. Once an employee is a covered employee, they remain a covered employee indefinitely. Highlights of the IRS’ interpretation of this designation include:

  • No minimum dollar threshold exists for a covered employee. All organizations will need to keep a list of their five highest compensated employees each year and consider that once an employee is a covered employee, they remain so indefinitely.
  • Organizations should determine a covered employee based on the remuneration paid to that employee for the calendar year ending within the tax year.
  • Covered employee appears to be a narrow definition that doesn’t take into account compensation paid to family members or entities controlled by the covered employee.
  • Compensation for medical services isn’t counted when determining who counts as a covered employee.
  • Only an ATEO’s common law employee, including officers, can be considered a covered employee. When determining who counts as a covered employee, it’s important to look at to whom the employee is providing services.

Compensation for the $1 Million Threshold

The calculation of excess remuneration takes into account various types of compensation, both taxable and nontaxable. The first step for calculating begins with looking at compensation paid to an employee within the tax year ending within an organization’s fiscal year end, with certain adjustments for the first year the tax is applicable. 

The calculation of remuneration starts with wages subject to federal income tax withholding, but excludes designated Roth contributions and any compensation that’s considered an excess parachute payment for which 4960 is imposed. Parachute payments that aren’t considered excess under the 4960 definition are otherwise included as excess remuneration.

Medical and veterinary services are also excluded for the calculation of excess remuneration, however when an employee provides a combination of both medical and veterinary services and other includable services, an organization will have to take steps to bifurcate that compensation.

In Notice 2019-09, the IRS specifically rejects certain requests to simplify the calculation of excess remuneration. It’s stated that it’s not reasonable to simply use W-2 wages to determine remuneration. Additionally, it’s rejected that a grandfather clause be imposed for arrangements made before the changes of Section 4960. 

Excess Parachute Payments

A parachute payment is a payment that an employee is entitled to receive in the nature of compensation that’s contingent on an involuntary separation from employment. Notice 2019-09 provides a step by step process for calculating taxes on excess contributions.

After determining that a payment resulting from an involuntary separation has occurred, an organization should then calculate the total present value of all contingent payments that result from the separation. Payments include more than just cash payments. If there’s an acceleration of vesting of a right to payment or certain other noncash compensation like continued health benefits, these could be included with the parachute payment calculation.

An organization would then need to determine if this parachute payment is considered an excess parachute payment, which would be three times more than the base compensation of an employee calculated over five years. If not, then it’s not subject to the excess parachute payment tax but could still be includable as excess remuneration over $1 million. If it’s three times more than the base, then the excess payment over the base is taxed.

The excess parachute payment rules apply only to the top five highest compensated employees whether or not they’ve been subject to the $1 million excess remuneration calculation in the past and regardless of their compensation amount. All organizations with employees should plan to track annually their five highest compensated employees and to ensure that parachute payments have been made. 

Related Organizations 

There’s an additional layer of complexity for organizations that are related based on common control and majority ownership. Even though this tax is specifically on tax exempt organizations and excludes governmental entities and for-profit organizations, compensation paid by all related organizations is considered when calculating excess compensation.

Generally speaking, related organizations are entities that are controlled by or control the ATEO, are a supported or supporting organization of an ATEO, or are a sponsoring organization of a voluntary employees beneficiary association (VEBA). In this notice, the IRS clarified that a related organization, whether it’s a government entity, a tax exempt entity, or a for-profit organization, will still be liable for its portion of the tax.

Each related organization will need to separately determine its own covered employees. Calculating the remuneration applied to each organization will also be important.  Oftentimes, an employee will provide services to different entities, even though they receive one pay check from a common paymaster. However, the liability for the tax will fall on the employee’s common law employer, the entity for which she or he is legally providing services. Organizations will need to reasonably allocate the compensation based on services to the various organizations so each can pay its share of the liability on excess remuneration. 

Next Steps

The notice ends with a request for comments regarding six main points. Comments will need to be submitted by April 2 and can address the following questions.

  • Should an employer be permitted to rely on an employee’s written representation on services performed to other employers in a calendar year?
  • Is there an alternative for handling a change in status of related organization midyear for purpose of calculating the amount paid to employees while the organizations were related?
  • How should remuneration based on the appreciation and depreciation of the fair market value of the stock underlying stock options and stock appreciation be taken into account?
  • How should a related organization treat remuneration on which it was subject to excise tax under Section 4960 in a prior taxable year and for which it’s denied a deduction under Section 162(m) in the current taxable year?
  • How should the term predecessor be defined for purposes of defining covered employees?
  • How should remuneration paid to medical service providers be reasonably allocated between medical services and other services?

We expect the IRS will develop more detailed regulations in the future based on comments it receives.  

We’re Here to Help

If you have questions or concerns about how this new guidance will affect your organization, contact your Moss Adams professional.