With tax filing season in full swing, tax-exempt organizations are beginning to determine how much excise tax they may owe on compensation and severance amounts paid to their most highly compensated employees after 2017. The IRS recently provided guidance on several issues relating to this new tax regime, imposed by the 2017 legislation commonly known as the Tax Cuts and Jobs Act.
Nature of the Section 4960 Tax. The new rules impose a 21 percent excise tax on two kinds of compensation that an applicable tax-exempt organization (ATEO) or related organization pays to certain highly compensated employees (covered employees) — the amount of remuneration above $1 million, which will not be indexed for inflation, and any excess parachute payment contingent on the employee’s separation from service. They apply generally for each tax year of the ATEO beginning after 2017, without grandfathering any existing contractual arrangements.
Affected Organizations. ATEOs are organizations exempt under Section 501(a) of the Internal Revenue Code, including charities [501(c)(3)], social welfare organizations [501(c)(4)], and business and professional associations [501(c)(6)], as well as political organizations [527(e)(1)], farmers’ cooperatives [521(b)(1)] and certain kinds of governmental entities [115(1)].
Governmental units — such as states, localities and their integral parts — are not classified as ATEOs. As a result, the excise tax does not apply to state colleges, universities, hospitals and other institutions that claim tax exemption based on their governmental status and have not actively sought tax exemption under section 501(c)(3). The new guidance confirms that any government entity that did actively seek tax exemption under section 501(c)(3) may voluntarily relinquish its status and thereby avoid this new excise tax as it is currently drafted. Any technical corrections bill Congress proposes in 2019 is likely to try to extend this excise tax to all such state-related organizations. But for now, the IRS acknowledges that compensation of, for example, top administrators and athletic coaches at certain state institutions remains exempt from the tax, while compensation of an administrator or coach at a similar private university or college would be subject to tax.
An entity that is not itself an ATEO, such as a for-profit affiliate or a governmental unit, will nevertheless be subject to the excise tax on remuneration it pays to individuals who are also employees of an ATEO. Any entity that supports or is supported by an ATEO, or one that controls, is controlled by or is under common control with an ATEO, is treated as a related organization of that ATEO. Remuneration it pays to a covered employee of the ATEO is counted in applying the excise tax, and it may be liable for a proportionate share of any resulting tax liability.
Covered Employees. Each of the five highest-compensated employees of an ATEO for the current year is a covered employee, regardless of the individual’s title or position. The determination is based on remuneration paid in the calendar year ending with or within the ATEO’s tax year for services as an employee of the ATEO or any related entity. Individuals who were covered employees for any year beginning after 2016 remain so classified for all future payments, regardless of how their compensation compares to that of other employees in later years.
Independent contractors are not covered employees. Neither are employees of an ATEO that pays less than 10 percent of their total remuneration, if another related ATEO includes those employees among its five highest. The IRS reiterated that ATEOs could not avoid liability for this new excise tax by using a third-party payor, such as a payroll agent, common paymaster, certified professional employer organization, or any similar arrangement.
Remuneration. Remuneration includes amounts treated as wages for federal tax withholding purposes and amounts received from certain deferred compensation plans, but not Roth IRA contributions. It is counted when actually paid or when no longer subject to a substantial risk of forfeiture. As a result, amounts that vested before 2017 or before an individual became a covered employee are not treated as remuneration.
Payments to licensed professionals for medical or veterinary services are not considered remuneration for purposes of the $1 million threshold or the parachute payment test. For these purposes, licensed professionals typically include doctors, dentists, nurses, nurse practitioners and veterinarians. The IRS, however, intends to apply this exception narrowly — only to services for the diagnosis, cure, mitigation, treatment or prevention of disease, and not to teaching, research or administrative services that do not involve direct medical care of patients. For cases where a licensed professional has both “medical care” and other duties, the IRS guidance directs employers to determine the proper allocation of compensation by reference to the employment agreement and suggests that ATEOs apply a reasonable, good-faith allocation method if an employment agreement is silent.
If an individual is employed by two or more entities that are subject to Section 4960, remuneration from all employers is aggregated to determine whether the tax applies. The resulting excise tax liability is allocated among the employers in proportion to the remuneration they paid, although related entities can agree among themselves to allocate the actual payment responsibility on some other basis.
Parachute Payments. A parachute payment is compensation paid to a covered employee contingent on the employee’s separation from employment. Usually, the separation must be involuntary, but the definition also includes an employee’s voluntary separation “for good reason,” change from employee to contractor status, reduction to less than 20 percent of prior employment, acceptance of a retirement window program, acceptance of non-compete terms, or release of claims.
Parachute payments can be subject to excise tax even if the covered employee’s remuneration is less than $1 million, provided only that the employee also qualifies as “highly compensated” for purposes of the employer’s retirement plans. For 2018, that category included employees who received at least $120,000 of compensation in 2017.
Application of Tax. If an ATEO and related organizations pay a covered employee more than $1 million for any year, that excess is subject to the 21 percent excise tax. A payment contingent on separation from employment is taxable if it exceeds three times the covered employee’s “base amount,” i.e., the employee’s average annual compensation over the prior five years. In that event, the tax is imposed on everything above the base amount, not just the amount that exceeds three times the base.
Filing Requirements. An ATEO or related organization, including a for-profit entity, reports its share of Section 4960 excise tax on IRS Form 4720, filed with its annual Form 990 information return. The returns and any associated tax are due by the 15th day of the fifth month after the end of the employer’s tax year (May 15 for a calendar-year filer), although the return filing deadline (but not the deadline for paying the tax) can be extended for up to six months. The filing organization need not have taken the excise tax liability into account in calculating its quarterly estimated tax payments; instead, the entire amount is payable with the Form 4720.
Application of the Excess Benefit and Self-Dealing Rules. Paying remuneration subject to these excise taxes is not necessarily an excess benefit transaction under Section 4958, nor is it automatically an act of self-dealing under the private foundation rules. On the other hand, no presumption arises that such payments are reasonable or proper, so each compensation arrangement must be reviewed separately for potential excess benefit or self-dealing.