On January 11, 2021, the IRS released final regulations governing the excise tax levied against certain tax-exempt organizations that pay remuneration over $1 million or pay excess parachute payments. These final regulations were largely similar to the proposed regulations.
Internal Revenue Code (IRC) Section 4960, which was created as part of 2017 tax reform legislation, imposes an excise tax on applicable tax-exempt organizations (ATEOs) on remuneration over $1 million paid to a covered employee. The current rate on the excise tax is 21%. 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 IRC Section 4960. Proposed regulations, which generally adhered to the notice, followed in June 2020.
The final regulations will apply to taxable years beginning after December 31, 2021. Until the final regulations go into effect, taxpayers may apply the final regulations. They may also rely on the guidance provided in Notice 2019-09 or in the proposed regulations, which are described in more detail in our article.
Although the final regulations have only minor differences from the proposed regulations, it’s important to understand these modifications. Below, discover key changes and potential implications for tax-exempt organizations that pay excess remuneration or excess parachute payments.
A covered employee is one of an ATEO’s five-highest compensated employees for the taxable year, as well as anyone who was a covered employee in an earlier tax year beginning after December 31, 2016. The final regulations don’t set a minimum dollar threshold for a covered employee, nor do they provide for a horizon when covered employees are no longer treated as such.
The final regulations provide several exceptions in which an employee wouldn’t be considered one of an ATEO’s five-highest compensated employees:
- The nonexempt funds exception
- The limited hours exception
- The limited services exception
Only the nonexempt funds exception (NFE) had modifications from the proposed regulations.
Nonexempt Funds Exception
The NFE may be used in situations such as when an employee of a controlling taxable organization performs substantial services as an employee of an ATEO. Under the final regulations, the criteria for the NFE didn’t change, but the measurement period for those criteria did.
Now, the measurement period is expanded from a one-year period to a two-year period—the applicable year and the preceding applicable year. The change allows for flexibility when an employee rotates or provides services to an ATEO for a period longer than six months.
The final regulations also modify the attribution rules applying to the NFE by generally disregarding the application of IRC Section 318(a)(3) downward attribution.
The attribution rules apply if, for example, an individual is the sole shareholder of two taxable corporations and also controls an ATEO by having the power to appoint a majority of the ATEO’s board of directors. In addition, one taxable corporation pays a fee to the other taxable corporation.
The IRC Section 318(a)(3) attribution rules result in the ATEO controlling the two taxable corporations, even though there’s no actual ownership or control by the ATEO of the taxable entities. Under this attribution—as was the case in the proposed regulations—no shared employee of the taxable corporation and the ATEO would meet the NFE and therefore would be considered for five-highest compensated employee status.
Without the attribution, which is the case in the final regulations, a shared employee that otherwise meets all the criteria of the NFE wouldn’t be considered one of an ATEO’s five-highest compensated employees.
The definition of remuneration remains from the proposed regulations, with one change: The final regulations add that remuneration doesn’t include amounts that aren’t taxable under IRC Section 7872(c)(3), which covers compensation-related loans falling under a $10,000 de minimis exception.
Allocation for Medical Services
The final regulations adopt the recommendation that an employer be permitted to make a reasonable, good faith allocation between remuneration for providing medical services and remuneration for providing nonmedical services.
This allocation is permitted with respect to both current remuneration and contributions and earnings under a deferred compensation plan.
Commentators asked for a grandfathering rule for contracts executed on or before November 2, 2017, allowing any payment under these preexisting contracts to be excluded from the new excise tax.
The final regulations don’t provide for this grandfathering rule but do include rules that exclude from taxation any remuneration that vested before the first taxable year after December 31, 2017.
In the preamble to the proposed regulations, the Treasury Department and the IRS considered federal instrumentalities described in IRC Section 501(c)(1), Corporations Organized Under Act of Congress, to be subject to the excise tax. Examples of federal instrumentalities include:
- Federal credit unions
- State schools
- Agencies, such as the Federal National Mortgage Association
Such federal instrumentalities are considered exempt from all current and future taxes. Commenters requested further clarification, but the final regulations don’t address whether federal instrumentalities are subject to the tax. Instead, this issue will be addressed in the future.
Until further guidance is issued, a federal instrumentality isn’t considered an ATEO or related organization subject to the tax. If a federal instrumentality is a related organization of an ATEO, however, remuneration the federal instrumentality pays must be considered by the ATEO.
An ATEO pays $700,000 in remuneration to an employee, and a related federal instrumentality pays $500,000 to the same employee. The ATEO would include the $500,000 in remuneration from the related federal instrumentality to its remuneration—a total of $1.2 million—in determining its five-highest compensated employees.
If that employee was among the five-highest compensated employees, the ATEO would pay excise tax on its share of remuneration, while the related federal instrumentality wouldn’t be subject to the tax at this time.
A foreign organization that receives substantially all of its support from sources outside the United States isn’t an ATEO. The final regulations, however, add a provision for when a foreign organization is related to an ATEO.
Any renumeration a foreign related organization pays to a covered employee should be taken into account when determining the five-highest compensated employees of an ATEO and total remuneration paid to a covered employee during the applicable year.
In addition, the final regulations now provide that an organization’s status as a foreign related organization is determined at the end of the taxable year.
If an ATEO and its foreign related organization each paid $600,000 to a covered employee, there would be excess compensation of $200,000—or $1.2 million less $1 million. The ATEO would be liable for tax on $100,000—50% of the excess compensation—but the foreign related organization wouldn’t be liable for the tax allocated to it because it isn’t an ATEO under the final regulations.
Coordination with Section 162(m)
IRC Section 4960(c)(6) provides that remuneration for which a deduction is disallowed under IRC Section 162(m) isn’t taken into account for purposes of the excise tax, but it’s taken into account when determining the ATEO’s five-highest compensated employees. IRC Section 162(m) states that no deduction is allowed for a publicly held corporation for any remuneration over $1 million paid to a covered employee.
The final regulations don’t yet address the coordination of IRC Sections 4960 and 162(m), allowing taxpayers to use a reasonable, good faith approach in circumstances when it isn’t known whether a deduction will be disallowed under IRC Section 162(m) by the due date of Form 4720.
Related Employers and Form 4720
Two commenters suggested related employers be allowed to file a joint Form 4720. Unfortunately, that request was denied because:
- Joint filing of Form 4720 is incompatible with the electronic filing of the form for certain tax-exempt organizations.
- The request was beyond the scope of the regulations.
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If you have questions about the final regulations and how they apply to you or your organization, please contact your Moss Adams professional.