The IRS issued proposed regulations on June 5, 2020, concerning the excise tax levied against certain tax-exempt organizations that pay compensation over $1 million or excess parachute payments. The proposed regulations largely follow guidance issued in late 2018.
Several exceptions in the proposed regulations are intended to address concerns that initial guidance on Internal Revenue Code (IRC) Section 4960 could cause people with limited involvement in an organization to trigger the excise tax.
IRC Section 4960, created as part of tax reform legislation in December 2017, imposes a 21% excise tax on tax-exempt organizations on remuneration over $1 million paid to a covered employee. The excise tax also applies to any excess parachute payments that are more than three times the employee’s base salary.
The IRS released Notice 2019-09 in December 2018, to provide interim guidance on Section 4960. The proposed regulations generally follow Notice 2019-09, but also address issues raised during the public comment period.
The proposed regulations include definitions for the following:
- Applicable tax-exempt organizations
- Applicable year
- Covered employees
- Five highest-compensated employees, with exceptions
- Medical services
- Related organizations
The proposed regulations also cover:
- How remuneration is determined
- If a parachute payment exists
- The calculation, reporting, and payment of the tax on excess remuneration and excess parachute payments
Applicable Tax-Exempt Organizations
Section 4960 and the proposed regulations define an applicable tax-exempt organization (ATEO) as any of the following:
- Section 501(a) organizations, which includes federal instrumentalities
- Section 521(b)(1) farmers’ cooperatives
- Organizations that exclude income from taxation under Section 115(1)
- Section 527(e)(1) political organizations
Notice 2019-09 clarified that a state or local government entity is an ATEO if either of the following occurred:
- It requested an IRS determination letter seeking tax-exempt status under Section 501(c)(3).
- It used Section 115(1) to exclude income on a tax return.
The notice of proposed rulemaking confirmed if a government entity doesn’t meet either criteria, it isn’t an ATEO and isn’t subject to the excise tax unless it’s included as a related organization to an ATEO. This means government organizations such as public colleges and universities or district hospitals could be exempt from the excise tax.
The proposed regulations state a foreign organization that received substantially all of its support from foreign sources since being founded isn’t an ATEO.
In determining if an organization is a related organization, IRC Section 4960 doesn’t distinguish between domestic and foreign organizations. The US Department of the Treasury and the IRS are considering if foreign organizations should be included as related organizations and seek further public comment on the matter.
Definition of Applicable Year
Section 4960(a)(1) discusses remuneration for the taxable year, but doesn’t make clear whether that refers to the taxable year of the ATEO, the covered employee, or a related organization.
Under the proposed regulations, the applicable year would be defined as the calendar year ending with or within the ATEO’s taxable year. For example, if an ATEO operates on a fiscal year from July 1, 2019, through June 30, 2020, the applicable year would be calendar year 2019.
During the first year of operation, the applicable year begins on the date the ATEO first became an ATEO and ends on December 31 with or within the ATEO’s taxable year. If an ATEO ceases operations, the applicable year begins on January 1 of the calendar year of termination and ends on the date of termination.
Related organizations that existed before or after the ATEO only consider remuneration that falls within the applicable year of the ATEO for inclusion in the calculation.
Definition of Employee
The proposed regulations adopt the definition of employee as cited in Section 3401(c) and Treasury Regulation 31.3401(c)-1.
The regulation defines an employee as any individual performing services if the relationship between the individual and the person for whom the services are performed is the legal relationship of employer and employee.
The legal relationship exists when the person for whom the services are performed has the right to control and direct the individual performing services, not only regarding the results, but also in the way the results are accomplished.
- Common-law employees
- Officers or elected or appointed officials of government entities, agencies or instrumentalities
The definition of employee excludes:
- Members of the board of directors or trustees if that’s their only role
- Properly classified independent contractors
An officer of a corporation is generally considered an employee unless they:
- Don’t perform any services
- Perform only minor services
- Don’t receive or are entitled to any remuneration for those officer services
Definition of Covered Employees and Exceptions
Covered employees are the five highest-compensated employees of the ATEO for the taxable year, plus anyone who’s been a covered employee in any preceding taxable year beginning after December 31, 2016.
A minimum dollar threshold hasn’t been set. This means a tax-exempt organization’s five highest-compensated employees in a taxable year—regardless of whether their remuneration was over $1 million—would be considered covered employees for that taxable year and every year going forward.
The IRS and the Treasury denied commentator requests for a horizon when covered employees would stop being treated as such. Once a person becomes a covered employee, they continue as a covered employee indefinitely.
Determining Highest-Compensated Employees
In determining the five highest-compensated employees, the remuneration paid to an employee by an ATEO is aggregated with any remuneration paid by a related organization including any related for-profit organizations or government entities.
People commenting on this provision in Notice 2019-09 worried these rules could subject a non-ATEO—such as a related for-profit corporation—to pay the excise tax on the compensation paid to an employee who only provides limited services to an ATEO and who typically only receives pay from the non-ATEO.
For example, an officer with a related for-profit corporation could volunteer or perform limited work for that corporation’s foundation. Commenters feared such a person could be counted as one of the foundation’s highest-compensated employees despite doing minimal work for the foundation. To address these concerns, the proposed regulations provide several exceptions, based on conditions related to the person’s pay or hours of service.
Limited Hours Exception
An employee wouldn’t be one of an ATEO’s five highest-compensated employees if all of the following conditions are met:
- Neither the ATEO, nor any related ATEO, paid remuneration to the person for services performed as an employee of the ATEO, and didn’t grant a legally binding right to nonvested remuneration for services performed for the ATEO.
- The person who performed services as an employee of the ATEO, and all related ATEOs, worked for no more than 10% of the total hours as an employee of the ATEO and all related organizations.
As a safe harbor for this exception, a person is treated as meeting the 10% threshold if they performed no more than 100 hours of service for the ATEO and all related ATEOs during the applicable year.
Nonexempt Funds Exception
This exception may arise for employees of controlling taxable organizations who perform more substantial services as an employee of an ATEO than employees covered under the limited hours exception. The person wouldn’t be among an ATEO’s five highest-compensated employees if all of the following requirements are met:
- Neither the ATEO, any related ATEO, nor any related taxable organization controlled by the ATEO paid the person for services performed as an employee of an ATEO; the ATEO can’t reimburse the payer for services.
- The person worked primarily for the related nonexempt organization by performing services as an employee of the ATEO and all related ATEOs for less than 50% of the total hours worked.
- No related organization that paid the person provides services for a fee to the ATEO, any related ATEO, nor any related taxable organization controlled by the ATEO.
Limited Services Exception
An employee wouldn’t be among an ATEO’s five highest-compensated employees, even if the ATEO paid compensation to the person, if all of the following requirements are met:
- The ATEO didn’t pay 10% or more of the total remuneration received by the employee from the ATEO and all related organizations.
- The ATEO had at least one related ATEO and one of the following conditions applied:
- A related ATEO paid at least 10% of the employee’s total remuneration.
- No related ATEO paid at least 10% of the total remuneration, and the ATEO paid less remuneration than at least one related ATEO.
Definition of Medical Services
Compensation for medical and veterinary services doesn’t count when determining highest-compensated employees.
The proposed regulations define medical services as “services directly performed by a licensed medical professional… for the diagnosis, cure, mitigation, treatment, or prevention of diseases in humans or animals; services provided for the purpose of affecting any structure or function of the human or animal body; and other services integral to providing such medical services.”
Licensed medical professionals include:
- Nurse practitioners
Teaching and research services aren’t considered medical services unless they include such medical services as previously described.
Administrative tasks, such as documenting the care and condition of a patient, could be considered medical services. However, managing an organization’s operations are considered a nonmedical service, since they’re not integral to providing medical services—even if the operations are completed by those who perform medical services. Such tasks include scheduling, staffing, appraising employee performance, and other similar functions.
If an employer pays a covered employee for both medical and nonmedical services, the employer must make a reasonable, good faith allocation between the compensation for medical services and for nonmedical services.
An allocation based on an employment agreement is an initial source to determine such a breakdown. If there isn’t an employment agreement, the proposed regulations allow for the use of:
- Patient, insurance, and Medicare or Medicaid billing records
- Time-reporting records
Definition of Related Organizations
Under IRC Section 4960(c)(4)(B), another entity is related to an ATEO if the other entity meets one of the following conditions:
- Controls or is controlled by the ATEO
- Is controlled by one or more persons who control the ATEO
- Is a supported organization of the ATEO
- Is a supporting organization to the ATEO
- Establishes, maintains, or makes contributions to a voluntary employees’ beneficiary association (VEBA)
Removal of Power and Representative Tests
The proposed regulations outline use of the term control when determining a related organization. A person or entity controls:
- A stock corporation if it owns more than 50% of the stock
- A partnership if it holds more than 50% of the profit interests or capital interests
- A trust if it holds more than 50% of the beneficial interests
For a nonstock corporation, like most tax-exempt organizations, a person or entity can control such an organization through either a removal power test or a representative test.
Removal of Power Test
Under the removal power test, the person or entity controls a nonstock corporation if it has the power to remove more than 50% of the trustees or directors and appoint new ones.
Under the representative test, an entity controls a nonstock corporation if more than 50% of the nonstock corporation’s directors or trustees are also trustees, directors, officers, agents, or employees of the entity.
An important exception to the control definition is provided in the proposed regulations.
If a director or trustee of the ATEO is also a lower-level employee of a potentially related organization, an election can be made so the organizations aren’t treated as related. The employee must not be acting as a representative of the potentially related organization while on the board of the ATEO, and the only connection between the organizations must be this relationship.
Essentially, this avoids a board member’s employer from being treated as a related organization of the ATEO solely through board involvement. The election will have to be disclosed and explained on the Form 990.
Determination of Remuneration
- Wages subject to federal income tax withholding
- Any amount required to be included in gross income under Section 457(f)
- Imputed interest on a below-market split-dollar loan under certain arrangements
In general, the amount of remuneration treated as paid is the sum of regular wages plus the present value of all other remuneration vested during the applicable year. If a pay period ends on December 26, 2020, and salary is paid on January 2, 2021, the remuneration is treated as paid in 2021.
However, if the employee vests in a bonus on December 26, 2020, that isn’t paid until January 2, 2021, the bonus is treated as remuneration in 2020. The IRS and the Treasury are considering if a short-term deferral rule is needed for these types of situations.
Wages as remuneration are treated as paid at the time of actual or constructive payment. Remuneration that isn’t a regular wage, not subject to substantial risk of forfeiture, is treated as paid on the date the employee has a legally binding right to the payment. Wages with a substantial risk of forfeiture are treated as paid when they are no longer subject to a substantial risk of forfeiture as they’re no longer based on the future performance of substantial services.
Remuneration doesn’t include any excess parachute payment—defined below—but does include a parachute payment that isn’t considered in excess. It also excludes Roth contributions.
Compensation paid by a third-party payer for services performed as an employee of an ATEO is considered paid by the ATEO. In addition, compensation paid by a related organization to an ATEO’s employee for services performed as an employee of the related organization is considered paid by the ATEO.
Determination of Parachute Payments
A parachute payment is any compensation paid by an ATEO or related organization to a covered employee if:
- Payment is contingent on an involuntary separation from employment
- Present value of payments equals or exceeds three times the base amount
The excess portion of a parachute payment is the amount that exceeds the base amount.
Related nonexempt organizations aren’t liable for any portion of the tax on excess parachute payments. Although separation payments made by related organizations are included in the determination if there’s an excess parachute payment, the portion paid by that related organization isn’t subject to the 4960 tax and isn’t owed by the ATEO.
Material Negative Change
A payment is considered contingent on separation of employment if the facts and circumstances show that the employer wouldn’t have made the payment if there had been no separation of employment.
The proposed regulations define involuntary separation of employment as caused by “the independent exercise of the employer’s unilateral authority to terminate the employee’s services, other than due to the employee’s implicit or explicit request, if the employee was willing and able to continue performing services as an employee.”
An employee’s voluntary separation from employment can be treated as an involuntary separation if it’s shown the employer’s action caused a material negative change to their relationship.
A material negative change occurs if separation from employment takes place within two years of one or more of the following conditions:
- Material reduction in the employee’s base compensation
- Material reduction in the employee’s authority, duties, or responsibilities
- Material reduction in the authority, duties, or responsibilities of the supervisor to whom the employee reports
- Material reduction in the budget that the employee has authority over
- Material change in geographic location of work
- Any other action or inaction that is a material breach by the employer
The Treasury and the IRS are accepting written or electronic comments on the proposed regulations. The comment period ends on August 10, 2020.
Until final regulations are adopted, tax-exempt organizations may rely on the guidance provided in the proposed regulations or the guidance provided in Notice 2019-19. Tax-exempt organizations may also base their positions on a reasonable, good faith interpretation of Section 4960.
To recap, the following positions aren’t considered consistent with a reasonable, good faith interpretation of the law:
- The remuneration paid by a related for-profit or government entity is taken into account in determining if a covered employee has remuneration over $1 million, but the related entity isn’t liable for its share of the excise tax.
- A covered employee ceases to be a covered employee after a certain period of time.
- The remuneration for medical services is taken into account for the purposes of identifying the five highest-compensated employees.
- A group of related ATEOs may have only five highest-compensated employees among all of the related ATEOs.
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