Some state colleges and universities, as well as other state and local government entities, may not be subject to a new excise tax on excess compensation.
Excise Tax Background
As part of tax reform laws, commonly referred to as the Tax Cuts and Jobs Act of 2017, Internal Revenue Code Section 4960 was enacted, establishing a 21% excise tax on the amount of remuneration more than $1 million and on any excess parachute payment that an applicable tax-exempt organization (ATEO) paid to a covered employee.
Under the new code, remuneration is defined as wages paid for services performed by an employee for his or her employer, as well as a parachute payment that’s not an excess parachute payment. Remuneration excludes any designated Roth contribution but does include any deferred 457(f) plan compensation required to be included in gross income.
According to the new law, an ATEO would include any entity that’s exempt from taxation under Section 501(a), as well as any entity that cites Section 115(1) to exclude income on a tax return. Section 115(1) provides that gross income for federal tax purposes doesn’t include income earned by a state or political subdivision of a state.
On December 31, 2018, the IRS released Notice 2019-09, which offers interim guidance on Section 4960.
Notice 2019-09 includes clarification on how Section 4960 applies to government entities, such as state colleges and universities. The notice states that a government entity is considered an ATEO if one of the following applies:
- It has a determination letter from the IRS recognizing its tax-exempt status
- It uses Section 115(1) to exclude income on a tax return
If a government entity doesn’t meet either of those criteria, it isn’t an ATEO and wouldn’t be subject to the excise tax.
Many state government organizations don’t use Section 115(1) to exclude income, and the IRS has historically taken the stance that states and political subdivisions avoid income tax through the doctrine of implied statutory immunity, rather than Section 115(1). According to Notice 2019-09, under the doctrine of implied statutory immunity, the income of a governmental unit generally isn’t taxable unless there’s a specific law authorizing such taxation.
Therefore, many government entities don’t file tax returns because of the doctrine of implied statutory immunity, and don’t need to cite Section 115(1) to exclude income on a tax return.
Excise Tax Liability
A government entity that doesn’t have a determination letter and doesn’t exclude income through Section 115(1) may still be liable for the excise tax, according to the new guidance, if it’s related to an ATEO.
A government entity is related to an ATEO if the government entity controls or is controlled by the ATEO, is controlled by one or more people who control the ATEO, or is a supported organization or supporting organization with respect to the ATEO. For example, an entity that’s not an ATEO may be related to an entity that’s an ATEO and that has an employee with excess compensation. If the non-ATEO organization also compensates that employee, it would be subject to the excise tax.
Ceding 501(c)(3) Status
Notice 2019-09 also states that a government entity may voluntarily give up its 501(c)(3) status by requesting a determination letter. Before relinquishing 501(c)(3) status, however, a government entity should look at all pertinent factors, not just avoiding the excise tax, in making its decision.
The Treasury Department and the IRS intend to issue further guidance on Section 4960 in the form of proposed regulations. Taxpayers may rely on Notice 2019-09 until further guidance is released.
We’re Here to Help
To learn more about how the new guidance could affect your organization, including whether to voluntarily give up 501(c)(3) status, contact your Moss Adams professional.