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Friday, June 12, 2020

Detailed Summary of Proposed Regulations on Excess Tax-Exempt Organization Executive Compensation (IRC Section 4960)


On June 5, 2020, the IRS and Treasury Department released the much-anticipated Proposed Treasury Regulations under Internal Revenue Code (IRC) Section 4960, Tax on Excess Tax-Exempt Organization Executive Compensation. These proposed regulations generally follow the interim guidance in IRS Notice 2019-09 that provided an explanation of the excise tax that came out of the 2017 Tax Cuts and Jobs Act.

The proposed regulations adopt some of the interim guidance, clarify certain open questions, provide additional details and explanations, and specifically request public comments on other areas. We will highlight some of the key takeaways below, along with some areas where organizations will need to take a deeper dive.

Although many organizations will not be directly affected by IRC Section 4960 because they do not pay any employee sufficient remuneration to trigger the tax, it is important for all nonprofit organizations to review the regulations if either:

  1. Your organization, combined with all related organizations, does pay any individual over $1 million in compensation for services as an employee, or
  2. Your organization makes any payment to an individual contingent on their separation from employment. The separation payment is not based on a $1 million threshold, but rather a three-times base compensation threshold.

Background

In general, IRC Section 4960 imposes a 21% excise tax on nonprofit organizations or their related organizations that provide compensation for the five highest-compensated employees (or any other covered employee) in excess of $1 million, or that provide excess parachute payments. Although seemingly simple, the complexity becomes apparent as organizations try to understand who is a “covered employee,” what is an “Applicable Tax-Exempt Organization (ATEO),” what is “remuneration,” what is an “excess parachute payment,” and how do we treat related organizations and any compensation they pay to the shared employees. Many of these areas have been discussed in IRC 4960 and the interim guidance and remain unchanged, so our focus below will be on areas that may be new or highlighted by the proposed regulations.


Key Areas of the Regulations

  • Applicable year - The taxable year for remuneration is the calendar year ending with or within an ATEO’s taxable year which is consistent with Form W-2 and Form 990 Part VII and Schedule J reporting. In addition, the proposed regulations provide rules addressing the first taxable year an organization becomes an ATEO and the taxable year in which ATEO status terminates.
  • Tax due – Consistent with the interim guidance, the excise tax is reported on Form 4720, which is due the 15th day of the fifth month after the close of the tax year. The proposed regulations clarify that quarterly estimates are NOT required for the excise tax.
  • Five highest-compensated employees - The IRS did not adopt several suggestions for determining the five highest-compensated employees but did invite comments on any modifications with respect to identifying the ATEO’s five highest-compensated employees that are consistent with the statutory provisions, do not permit improper avoidance, and are administrable and not overly burdensome.
  • Covered employee exceptions – One of the most anticipated items that came in these proposed regulations is the clarification on volunteers from related taxable organizations. Many commenters expressed concern that a non-ATEO, such as a for-profit corporation that maintains a charitable foundation, would be subject to the excise tax on remuneration it pays to an employee who performs limited or temporary services for a related ATEO and who typically receives remuneration only from the non-ATEO. The IRS did not provide a broad volunteer exception to exclude remuneration received from a related organization. Rather, an individual who is a common-law employee (including an officer of the ATEO) must meet at least one of three defined exceptions. Two of these are new to this proposed regulation and one is consistent with Notice 2019-09. The exceptions are: 1) limited hours exception, 2) nonexempt fund exception, and 3) limited service exception:
    • Limited-hours exception (new to proposed regulations)
      • General requirements
        1. Remuneration requirement: Neither the ATEO nor any related ATEO paid the individual for services as an employee of the ATEO; and
        2. Hours of service requirement: The individual performed services as an employee of the ATEO and all related ATEOs for no more than 10% of the total hours worked as an employee of the ATEO and all related ATEOs.
      • Disregarded payments - A payment made to the individual by a related organization that is an employer of the employee which is not reimbursed by the ATEO is not deemed paid by the ATEO.
      • Safe harbor - An employee meets the limited hour exception if the employee performed no more than 100 hours of service for the ATEO and all related ATEOs during the applicable year.
    • Nonexempt fund exception (new to proposed regulations)
      • General requirements
        1. Remuneration requirement: Neither the ATEO, nor any related ATEO, nor any taxable related organization controlled by the ATEO paid remuneration to the individual for services the individual performed as an employee of the ATEO; and
        2. Hours of service requirement: The individual performed services as an employee of the ATEO and all related ATEOs for less than 50% of the total hours worked as an employee of the ATEO and all related organizations; and
        3. Related organization requirement: No related organization that paid remuneration to the individual provided services for a fee to the ATEO, to any related ATEO, or to any taxable related organization controlled by the ATEO.
      • Disregarded payments - A payment made to the individual by a related organization that is an employer of the employee which is not reimbursed by the ATEO is not deemed paid by the ATEO.
    • Limited service exception (originally included in Notice 2019-09)
      1. Remuneration requirement: The ATEO did not pay 10% or more of the employee’s total remuneration for services performed as an employee of the ATEO and all related organizations; and
      2. Related organization requirement: The ATEO had at least one related ATEO and one of the following conditions apply:
        1. 10% remuneration condition: A related ATEO paid at least 10% of the remuneration paid by the ATEO and all related organizations; or
        2. Less remuneration condition: No related ATEO paid at least 10% of the remuneration paid by the ATEO and all related organizations and the ATEO paid less remuneration to the employee than at least one related ATEO.
  • Management company - Remuneration paid by a separate organization to an individual for services the individual performed as an employee of the ATEO is deemed paid by the ATEO for the excise tax.
  • Payments contingent on a separation from employment – The proposed regulations generally treat a payment as contingent on an employee’s separation if there is an involuntary separation from employment. There are exceptions to this requirement, so we suggest carefully reviewing any separation agreements that could result in the excise tax.
  • Medical services - The regulations provide some clarification on what does and does not constitute medical services. Medical service means directly performed by a licensed medical professional for the diagnosis, cure, mitigation, treatment, or prevention of disease in humans or animals. Administrative services may be integral to directly providing medical services. For example, documenting the care and condition of a patient is integral, as is supervision of an accompanying licensed professional providing medical services. However, managing an organization’s operations, including scheduling, staffing, appraising employee performance and other similar functions are not integral. The IRS is seeking comments on allocation methods between medical and non-medical services of an employee.
  • Medical professionals - For the exception, the regulations expand the definition of those who perform medical services to include dentists, nurse practitioners and other medical professionals, depending on the applicable state or local law.
  • Related organizations – The proposed regulations’ definition of control for a related organization is consistent with Notice 2019-09, so organizations should review the control test for nonstock corporations, including the removal power and representative tests. However, the proposed regulations did provide an exception to the representative test if a director or trustee of a nonstock organization who is also a lower-level employee of the person or governmental entity is not acting as a representative of the person or governmental entity in his or her service with the nonstock organization. A nonstock organization that is relying on this exception must report the reliance on the exception on the applicable Form 990 and provide details supporting the application of the exception.
  • Certain governmental entities – For organizations like universities that are direct instrumentalities of a state government, the new proposed regulations make clear that the Section 4960 tax does not apply. For those organized as a separate 501(c)(3) or as an organization that excludes its income from tax under Section 115(1), the tax will apply. We will see different schools with different outcomes. Many of these schools have highly paid athletic coaches who receive compensation significantly in excess of $1 million.
  • Grandfather rule – Commenters requested a “grandfather” rule on written binding contracts in effect on November 2, 2017, and not materially modified on or after December 31, 2017. The proposed regulations do not provide a grandfather rule. However, the proposed regulations provide that any nonqualified deferred compensation that vested prior to the first day of the first taxable year of the ATEO beginning after December 31, 2017, is not considered remuneration for purposes of Section 4960.

Areas Where Detailed Analysis Is Required

  • Predecessor organizations – The proposed regulations define predecessor organizations where there has been an organizational change, including acquisitions, mergers, other reorganizations, and changes in tax-exempt status. This provides a framework for when an acquiring organization needs to include covered employees of the target. Treasury specifically requested comments on the application of these rules, including whether or not the predecessor rules do or should apply.
  • Common-law employer – Although not a new concept related to IRC 4960, organizations will need to analyze which organizations are the common-law employer and pay the excise tax.
  • Involuntary separation (material negative change)
  • Organizations subject to IRC Section 162(m) disallowance should review the calculation requirements within the proposed regulations, but also follow updates, as the IRS is specifically seeking comments in this area.
  • Excess parachute payments - Payments related to a covenant not to compete are not included as parachute payments. There are a variety of detailed rules around what must be included and what is excluded, and each individual situation should be researched on its facts and circumstances.

These proposed regulations and preamble provide details (177 pages) for determining the excise tax on excess tax-exempt organization executive compensation. The IRS answered some questions that were not clear in the interim guidance, but organizations that may be subject to this excise tax should take a deeper dive into their factual circumstances and how the proposed regulations may apply. Some of the concepts are detailed and nuanced, so impacted organizations should take the time to work through the proposed regulations to ensure compliance and plan accordingly where there may be mitigation opportunities.

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