Casner & Edwards

Client Alert: Taxing Tax-Exempt Organizations: IRS Issues Guidance Regarding Excise Tax on Compensation Paid by Tax-Exempt Organizations



By: Sharon C. Lincoln


In a move that put tax-exempt organizations – including churches and soup kitchens – on par with publicly traded corporations, the Tax Cuts and Jobs Act (TCJA) added section 4960 to the Internal Revenue Code (the Code).  The law imposes an excise tax on remuneration in excess of $1 million and “excess parachute payments” paid to an employee (or former employee) of a tax-exempt organization who is (or has been) one of the top five highest paid employees of the organization (a “covered employee”).    
 

Under section 4960, “remuneration” also includes any remuneration paid to a covered employee by a related organization or governmental entity.
 

During the recent extended government shutdown, the Internal Revenue Service (IRS) released Notice 2019-09, which contains guidance regarding this new excise tax.   At 92 pages long, the Notice contains a tremendous amount of information.  Even so, many questions regarding the potentially vast scope of the new law remain unanswered.  These questions are particularly acute regarding the applicability of the excise tax to remuneration paid by related organizations, including for-profit entities, to a covered employee.   
 

In addition, religious organizations that are otherwise not required to provide transparency to the public regarding their finances will be required to file Form 4720 – a publicly available document – if they incur the excise tax under section 4960.  
 

Although relatively short by comparison to other sections of the Code, section 4960 is complex.  This client alert is divided into the following sections in order to give a meaningful overview to section 4960 and the issues it raises:
 

  1.  Overview of Section 4960
    1. Excise Tax on Excess Compensation
    2. Excise Tax on Excess Parachute Payments
  2. IRS Guidance
    1. Clarifications
    2. Open Questions
  3. Surprising Hypotheticals Regarding Related Entities
  4. Brief Commentary:  False Parity

Until further guidance is released by the IRS, tax-exempt organizations covered by section 4960 – as well as organizations related to any such tax-exempt organization – may want to be mindful of the potential scope of the new law, especially as it relates to shared highly compensated employees. 


             1. Overview of Section 4960

 

Excise Tax on Excess Compensation
 

In the TCJA, Congress made a policy decision to discourage compensation over $1 million for top executives at tax-exempt organization by adding section 4960 to the Code, which imposes an excise tax at the existing corporate rate (i.e., 21 percent) on: 

 

“(1) so much of the remuneration paid (other than any excess parachute payment) by an applicable tax-exempt organization for the taxable year with respect to employment of any covered employee in excess of $1,000,000, plus,

 

(2) any excess parachute payment paid by such an organization to any covered employee.”[1]


Section 4960 defines “applicable tax-exempt organizations” (ATEOs) as organizations exempt under section 501(a) of the Code (including charitable organizations exempt under section 501(c)(3)), farmers cooperatives under 521(b)(1), organizations with income excluded from tax under section 115(1) and political organizations described in section 527(e)(1).  The statute does not expressly apply to organizations such as state schools that are instrumentalities of the state, which do not rely on a determination letter from the IRS or the exclusion under Code section 115 for their tax-exempt status (as confirmed by the Notice).


Faith-based organizations exempt under section 501(c)(3) are also covered by section 4960.


Employees whose compensation is under scrutiny as a result of this provision are defined as “covered employees,” and include an employee who is one of the five highest compensated employees of the ATEO for the taxable year, or was a covered employee of the ATEO “or any predecessor” for any preceding year beginning after December 31, 2016.  Notably, the impact of this rule is that once an employee is a covered employee, he or she is always a covered employee, even if such an employee left the ATEO (or predecessor organization) for a period and then returned at a lower salary level.  This will require careful and consistent record keeping on the part of each tax-exempt employer.  Related organizations that employ a covered employee will also need to track covered employee status in order to ensure compliance with the rules under section 4960.


Remuneration under section 4960 includes wages (as defined in Code section 3401(a)) as well as all amounts included in gross income and subject to withholding under Code section 457(f). 


The statute expressly provides that “remuneration of a covered employee by an [ATEO] shall include any remuneration paid with respect to employment of such employee by any related person or governmental entity.”  This is presumably intended to forestall tax planning strategies that would employ the use of more than one employer to compensate an ATEO’s top executives above the limits provided in section 4960 and skirt the excise tax. 


An organization or governmental entity is “related” for purposes of section 4960 (i) if the ATEO controls or is controlled by the other organization, (ii) if both organizations are controlled by the same one or more persons or (iii) if the other organization is a supported or a supporting organization of the ATEO.  The Notice provides that the control threshold that establishes that two or more organizations are related is “more than 50%.”  This means that in the case of:
 

  • a stock corporation, control means ownership (by vote or value) of more than 50 percent of the stock in such corporation;
  • a partnership, control means ownership of more than 50 percent of the profits interest or capital interest in such partnership;
  • a trust with beneficial interests, control means ownership of more than 50 percent of the beneficial interests in such trust; and
  • a nonprofit organization or other organization without owners or persons having beneficial interests (a “nonstock organization”), including a governmental entity, control means that (i) more than 50 percent of the directors or trustees of the ATEO or nonstock organization are either representatives of, or are directly or indirectly controlled by the other entity; or (ii) more than 50 percent of the directors or trustees of the nonstock organization are either representatives of, or are directly or indirectly controlled by, one or more persons that control the ATEO.
 

When more than one employer provides remuneration to a covered employee, the excise tax is apportioned among the employers in proportion to their share of the total remuneration paid. 


There is a notable carve-out under section 4960, such that the terms “parachute payments” and “remuneration” do not include amounts paid to a licensed medical professional (including a veterinarian) to the extent that such payment is for the performance of medical or veterinary services by such professional.  The Notice takes the position that this carve-out applies only to remuneration paid for the direct performance of medical or veterinary services.


Excise Tax on Excess Parachute Payments


A parachute payment is compensation paid to a covered employee that is contingent upon the employee’s separation from service.  The excise tax under section 4960 is triggered when the aggregate present value of a parachute payment equals or exceeds three times the “base amount.”  The base amount is defined in the statute as the average annual compensation which was includible in the covered employee’s gross income for the most recent five taxable years ending before the date of the employee’s separation from employment.  If the excise tax is triggered, the employer must pay a tax on that portion of the parachute payment that exceeds the portion of the base amount allocable to such payment.[2]


The excise tax may be triggered by excess parachute payments that do not exceed $1 million.


The term “parachute payment” does not include any payment—
 

  1. described in section 280G(b)(6) (relating to exemption for payments under qualified plans);
  2. made under or to an annuity contract described in section 403(b) or a plan described in section 457(b); or
  3. to an individual who is not a highly compensated employee as defined in section 414(q).


As noted above, the term also does not include amounts paid to a licensed medical professional (including a veterinarian) to the extent that, under the Notice, such payment is for the direct performance of medical or veterinary services by such professional.


In addition, there can be no excess parachute payment under section 4960(a)(2) if the ATEO (or related party) does not have any “highly compensated employees” under section 414(q) for the taxable year.  For 2019, the threshold for determining whether an employee is a “highly compensated employee” under section 414(q) is $125,000. 


             2. IRS Guidance

 

Clarifications  
 

Many issues and questions were clarified by the Notice, including (but not limited to):
 

Calendar Year Calculation

Remuneration for the purposes of section 4960 is calculated on a calendar year basis, regardless of the fiscal year of the ATEO or related organization. 

 

No Minimum

There is no minimum dollar threshold for an employee to be a covered employee.  So even if an ATEO (or related organization) has no highly compensated employees in a given taxable year (and thus, would not be at risk for making an excess parachute payment in that year), the organization still needs to keep track of the top five highest-compensated employees on an annual basis since in a future year, those covered employees might be paid excess remuneration or excess parachute payments.

 

Certain Services Not Taken into Consideration

Remuneration paid for medical or veterinary services is not taken into account for purposes of identifying the five highest-compensated employees. 

 

Related Organizations

Related organizations for purposes of section 4960 include related ATEOs, related taxable organizations, and related governmental units or other governmental entities.  A section 509(a)(3) supporting organization and its supported organization(s) are also related for purposes of section 4960.

 

Control Threshold for Determining Relatedness

As noted above, the threshold of control for determining if two or more organizations are related is “more than 50 percent.”

 

Entity-by-Entity Determination

The determination of whether an employee is one of the five highest-compensated employees of an ATEO is made on an entity-by-entity basis.  Related ATEOs are required to track and account for covered employee status separately, even though once an employee is a covered employee for one ATEO, he or she is a covered employee with respect to all related ATEOs (and related taxable organizations and governmental entities).  

 

Limited Services Exception

An employee is not one of an ATEO’s give highest-compensated employees for a taxable year if (during the calendar year ending on or within the taxable year), the ATEO paid less than 10 percent of the employee’s total remuneration for services performed for the ATEO and all related organizations.  However, if no ATEO in the group paid at least 10 percent of the total remuneration, then this exception does not apply to the ATEO that paid the employee the most remuneration during that year.

 

No Quarterly Tax Payments Required

Since Code section 6655 was not amended to include section 4960, no quarterly payments of estimated section 4960 tax are required under section 6655.

 

Liability Imposed on Common-Law Employer

Even if a third-party is the payor (e.g., payroll agent, common paymaster, statutory employer under section 3401(d)(1), an unrelated management company, etc.), the compensation paid to the employee is considered to be a payment from the common-law employer.  In addition, a payment to the employee from a related entity – including a related entity that is an ATEO – for services rendered to the common-law employer, is considered a payment to the employee from the common-law employer for purposes of calculating remuneration and determining liability for the excise tax.  (This is significant in the context of the surprising hypotheticals discussed below.)

 

Involuntary Separation From Employment

The Notice limits payments contingent on a separation from employment (for purposes of determining excess parachute payments) to payments contingent on an involuntary separation from employment.  The Notice explains that payments that vest upon a separation from employment typically vest only upon an involuntary separation from employment.  This position would therefore exclude severance payments that vest upon the termination of employment under a contractually agreed-upon date (e.g., a 457(f) incentive retention plan that vests at the end of the term of the employment agreement).

 

Section 409A Criteria Apply

The Notice states that the standards of the regulations under section 409A generally apply for purposes of determining whether there has been a separation from employment, except that a bona fide change from employee to independent contractor status is treated as a separation from employment.

 

State Colleges and Universities Potentially Exempt

The section 4960 excise tax does not apply to a governmental entity (including a state college or university) that is not tax-exempt under section 501(a) and does not exclude income under section 115(1).  Thus, if an institution does not rely on either of those statutory exemptions from taxation, the institution will not be subject to the excise tax provisions of section 4960 unless it is a related organization with respect to an ATEO.

 

This exclusion from section 4960 means the institution could compensate its athletic coaches (or other covered employees) in excess of the $1 million threshold and not be subject to the 21 percent excise tax.

 

This exclusion may be short-lived, since the Committee on Ways and Means of the U.S. House of Representatives released a draft technical corrections bill that seeks to correct “technical and clerical” issues in the Tax Cuts and Jobs Act of 2017. The corrections bill seeks to clarify section 4960’s application by stating that any college or university that is an agency or instrumentality of any government or any political subdivision, or that is owned or operated by a government or political subdivision, is subject to section 4960.

 

Section 4958 Intermediate Sanctions

The Notice states that the payment of the excise tax under section 4960 – in and of itself – will not be a determinative factor in section 4958 enforcement actions.

 

Filing Details

Form 4720 should be used to report and pay the excise tax imposed under section 4960.  The form is due on the 15th day of the fifth month following the close of the ATEO’s (or related organization’s) tax year.   

 


Note that Form 4720 is available for public inspection (Internal Revenue Manual 3.20.13.4), which means that religious organizations that incur the excise tax under section 4960 may be exposed to a level of transparency regarding their finances to which they are not accustomed.
 

The Notice also provides significant guidance regarding:
 

  • the calculation of remuneration;​​​​​​
​​​​​​ 
  • the determination regarding when such remuneration is paid for purposes of determining covered employee status under section 4960;
 
  • what is a payment in the nature of compensation for purposes of determining excess parachute payments; and
 
  • when such an excess parachute payment is considered to be made.
 

Open Questions
 

Open questions regarding the excise tax applicable to remuneration in excess of $1 million include:
 

  • Will Forms 4720 filed by religious organizations be exempted from public inspection?
  • Will the payment of section 4960 excise taxes influence whether the IRS initiates a church tax inquiry under section 7611?
  • For purposes of determining covered employee status, do “predecessor” organizations include merged organizations, the recipient of all or substantially all of an organization’s assets in the context of the dissolution of a tax-exempt organization, or a “successor” 501(c)(3) organization?
  • Is the excise tax under section 4960 deductible to the extent that compensation is allocated to unrelated business activities?
  • What if a covered employee of an ATEO leaves the ATEO and goes to work for a related taxable entity – will the related entity be liable for the excise tax under section 4960 if the (former) covered employee’s compensation exceeds $1 million?
  • What exactly does it mean to provide “direct” medical services?  Does this include directly supervising residents or surgical teams in a hospital setting? 
 
             3. Surprising Hypotheticals Regarding Related Entities
 

The complexity and breadth of section 4960 – as currently drafted and interpreted by the Notice – give rise to certain curious consequences. 


For example, since the rules under section 4960 apply to compensation paid to a covered employee by an ATEO as well as by a related organization, any organization related to an ATEO for whom the covered employee performs services as an employee will also need to consider the rules under section 4960 in connection with the compensation paid to such individual.  This would appear to require information sharing regarding covered employee status. 


Since the rule covers someone who had been – but no longer is – among the top five highest paid employees at the ATEO, it could encompass someone who is no longer employed by the ATEO but who subsequently is an employee of a related organization, even a related for-profit organization.


The rules under section 4960 also appear to encompass covered employees whose services may be donated to the ATEO by a related taxable entity.  The following three scenarios highlight some of the issues related to the application of section 4960 to ATEOS and their related organizations.


Hypothetical #1 – Information sharing.  Under section 4960, and as confirmed by the Notice, supporting organizations are unconditionally related to their supported organizations.


Suppose Ms. Smith is a covered employee works for a Type I supporting organization located in New York, which has a broad class of supported organizations that are not all named in its charter (e.g., certain universities are named in the charter but it also specifies that all institutions of higher learning comprise the class of supported organizations).  However, the supporting organization focuses primarily on universities and colleges on the east coast. 


If Ms. Smith leaves the supporting organization and goes to work for a university in New Mexico that has had no contact at all with the former employer, it would appear that she is a covered employee of the New Mexico university, which would need to treat her as a covered employee, even though there is no contact or communication between the supporting organization based in New York and the university in New Mexico and even though Ms. Smith may not even be aware that she was a covered employee of the supporting organization. 


Hypothetical #2 – Related For-Profit Organization.  Under section 4960, the determination of whether someone is a covered employee takes into consideration not only remuneration for services performed as an employee of the ATEO, but also remuneration for services performed as an employee of a related organization with respect to the ATEO. 


Suppose a corporation has an affiliated private foundation and they are related under section 4960.  The highest-paid full-time employee of the foundation does not earn more than $1 million per year. 


If Mr. Jones, one of the corporation’s executives who earns $1 million per year, performs services for the foundation as the corporate secretary and is paid $25,000 per year for this work, it appears as though (i) Mr. Jones would be a covered employee with respect to the foundation and (ii) the excise tax under section 4960 would apply to the $25,000 of compensation in excess of the $1 million.  Both the corporation and the foundation would be liable for their allocable share of the excise tax (which admittedly in this case, would be small – approximately $5,000).  This is the curious result, since Mr. Jones earns only $25,000 for services performed for the foundation.


Hypothetical #3 – Donated Services.  The Notice provides that only common law employees (including officers) may be covered employees. 


Suppose the same facts as the hypothetical above, except the corporation donates all of Mr. Jones’ time to the affiliated foundation.  As an officer of the foundation, Mr. Jones is technically a common law employee of the foundation, even though all of his time is provided free of charge to the foundation.  If Mr. Jones’ compensation places him within the top five highest-compensated employees of the foundation and if he earns more than $1 million, it appears as though Mr. Jones would be a covered employee with respect to the foundation and the corporation would be liable for the excise tax under section 4960 on the excess remuneration above $1 million that it paid to Mr. Jones.


Hypothetical #4 – Related For-Profit Organization.  Under section 4960, a covered employee includes “any former covered employee” of an ATEO and remuneration includes “any remuneration paid with respect to employment of [a covered employee] by ay related person.”


Suppose Ms. Murray, a senior executive at a tax-exempt hospital that comprises part of a large health-care system, is a covered employee during her last year of employment at the hospital.   After working for another (unrelated) hospital for a period of years, Ms. Murray accepts an offer to join a related for-profit affiliate of her former employer.  The for-profit affiliate is very successful and Ms. Murray earns more than $1 million per year.  It would appear that since the for-profit affiliate is paying a former covered employee of a related ATEO remuneration in excess of $1 million per year, the affiliate is liable for the excise tax under section 4960 on any excess remuneration above $1 million paid to Ms. Murray.


             4. Brief Commentary: False Parity 

 

Whether top executives at tax-exempt organizations should be paid at levels that compete with their peers at for-profit organizations is often a topic of some debate.  The policy stance behind section 4960 appears to be that they should not. 


Section 4960 mirrors section 162(m) in that it applies to remuneration in excess of $1 million paid by the organization to its top five highest compensated employees.  Section 162(m) was added to the Code in 1993, intended as a measure to discourage excessive compensation at publicly traded companies by capping a public company’s corporate income tax deduction at $1 million per year for remuneration paid to each of its top five highest-compensated executives. 


However, there already exist rules in the Code that discourage (and even prohibit) excessive remuneration paid by tax-exempt organizations.  For example:
 

  • The intermediate sanctions rules in section 4958 impose an excise tax of 25 percent on the amount of any excess benefit received by a “disqualified person” (including from an organization described in section 501(c)(3) or 501(c)(4).[3]  A second-tier excise tax of 200 percent is imposed if the excess benefit is not repaid to the tax-exempt organization in a timely manner.  The tax under section 4958 is paid by the disqualified person who received the excess benefit. 
 
  • There is an absolute prohibition against any sort of “private inurement” at charitable and several other types of tax-exempt organizations.  Private inurement is found when the resources of the organization are used for the personal benefit of an insider, with no commensurate return value received by the organization.  The IRS may revoke the tax-exempt status of an organization when any degree of private inurement is found.


In addition, tax-exempt organizations are subject to significant transparency requirements with respect to compensation paid to executives and other highly compensated employees.  Information regarding such compensation is disclosed in IRS Form 990 as well as state-specific charitable filings, which are scrutinized by many Attorneys General for improper uses of charitable assets.


Lastly, the risk of paying lordly sums to top executives is far lower at tax-exempt organizations because they do not have the same access to capital markets to fund their operations (and elaborate compensation structures) nor do they issue stock and stock options, which comprise a significant portion of the compensation packages for executives at public companies.  Also, tax-exempt organizations generally do not make generous payouts in the event of a change of control (merger, etc.)l.


Congress’ attempt to discourage the payment of excessive remuneration at for-profit organizations was limited in scope, however.  First, the rules that deny a deduction in connection with remuneration in excess of $1 million do not apply to performance-based compensation.  Generous stock incentive plans thus sidestep Congress’ intent to discourage “excess” executive compensation.    


In fact, recent research from the U.S. Treasury reveals that between 2005 and 2013:
 

  • Public corporations paid top executives in excess of $22.5 billion in nondeductible compensation, and;
  • More than 25 percent of all publicly traded corporations exceeded the $1 million limit and 75 percent of those exceeding it had been doing so for multiple years.


As a measure intended to influence corporate pay practices, section 162(m) may well be regarded as having failed in its attempt.


On a final note, the rules under section 162(m) and section 280G (taxing excess parachute payments) apply only to publicly traded companies and do not apply to for-profit organizations that are privately owned.  This leaves much of the for-profit business world unaffected by these limitations on executive compensation, while section 4960 – the tax-exempt analog to those rules – casts a wide net and applies to nearly all tax-exempt entities, including faith-based organizations.

 

[1] The tax on excess compensation under section 4960 is imposed upon the tax-exempt employer in contrast to the intermediate sanctions under section 4958 related to so-called “excess benefit transactions.”  Under section 4958, the excise tax is imposed upon the recipient of the “excess benefit” as well as upon officers and directors who knowingly approved of the excess benefit transaction. 

[2] This means that an excess parachute payment that is 2.99 times the base amount will not trigger the excise tax but an excess parachute payment that is 3.01 times the base amount will do so and incur a tax on nearly two-thirds of the payment (i.e., the amount the exceeds the base amount).

[3] Section 4958 does not apply to private foundations, which are subject to more stringent rules prohibiting “self-dealing” under section 4941 of the Code.

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