Tax on Executive Comp at Tax-Exempt Organizations

Tax on Executive Comp at Tax-Exempt Organizations (Section 4960)

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Last month, the Department of the Treasury and the IRS published final regulations regarding select aspects of executive comp at tax-exempt organizations and at organizations related to the tax-exempt entity. The final regulations address IRC Section 4960, which imposes an excise tax on remuneration in excess of $1,000,000 and any excess parachute payment paid by an applicable tax-exempt organization (ATEO) to any covered employee.

Perspective

Section 4960 was added to the Tax Code as part of the Tax Cuts and Jobs Act. It imposes an excise tax on certain executive compensation arrangements of applicable tax-exempt organizations. Included under Section 4960 are organizations exempt under section 501(a) of the Code, such as 501(c)(3), 501(c)(4), and 501(c)(6) organizations, and some governmental entities, as well as related organizations of the ATEOs. The imposed tax is equal to the corporate tax rate, which is currently 21 percent, however a future increase to a 28 percent corporate tax rate is anticipated under the Biden administration.

Specifically, the final regulations restate certain statutory definitions and define various terms set forth in section 4960, and provide rules for determining:

  • the amount of remuneration paid for a taxable year for purposes of identifying covered employees and calculating the excise tax;
  • whether excess remuneration has been paid and in what amount;
  • whether a parachute payment has been paid and in what amount;
  • the allocation of liability for the excise tax among related organizations;
  • and the date of applicability of these final regulations.

The full contents of the regulations are more than 50,000 words in length (roughly 170 text pages). The following is a very brief and highly summarized look at a few key points and definitions addressed by the regulations.

Timing: Choose One or the Other

Published in the Federal Register on January 19, 2021, the new regulations became effective on that date but apply only to tax years after December 31, 2021. The guidance provided in these final regulations and the earlier proposed regulations generally is consistent with the interim guidance provided in Notice 2019–09 (published December 2018).

Until the applicability date of these final regulations, taxpayers may rely on the guidance provided in Notice 2019–09 in its entirety or on the proposed regulations in their entirety. Alternatively, taxpayers may choose to apply these final regulations to taxable years beginning after December 31, 2017, and on or before December 31, 2021, provided the taxpayer applies the final regulations in entirety and in a consistent manner[i].

Noteworthy is that the IRS rejected requests to grandfather amounts paid under agreements that were in effect before Section 4960 was passed. Also worth noting is that the regulations provide that the applicable tax year is the calendar year ending with or within the ATEO’s tax year.  

Definition of Applicable Tax-Exempt Organizations

Chapter 42 of the Code applies generally to private foundations and other tax-exempt organizations and the excise taxes in Chapter 42 generally are payable by exempt organizations and in some cases by persons associated with them.

An ATEO organization includes an organization that:

  • is exempt from tax under section 501(a)
  • is a farmers’ cooperative organization described in section 521(b)(1)
  • has income excluded from taxation under section 115(1)
  • or is a political organization described in section 527(e)(1)

Under the final regulations, Chapter 42 does not apply to

  • a foreign organization that has not received substantial support (other than gross investment income) from United States sources, or
  • governmental entities (such as state colleges and universities) that have not been recognized as exempt under section 501(a) and do not exclude income under section 115(1), although such entities may still be subject to the excise tax as related organizations of an ATEO.

Again, it is important to recognize that the caveats further defining “included and excluded” ATEOs are both numerous and nuanced.

Definition of Covered Employee

Section 4960(c)(2) defines ‘‘covered employee’’ as any individual (including a former employee) who is one of the five highest-compensated employees of the ATEO for a taxable year or was a covered employee of the ATEO (or any predecessor) for any preceding taxable year beginning after December 31, 2016.

Once an employee is a covered employee of an ATEO, the employee continues to be a covered employee for all subsequent taxable years of that ATEO, although there can be exceptions. The regulations provided that whether an employee is one of the five highest-compensated employees of an ATEO is determined separately for each ATEO and not for an entire group of related organizations.

As stated in the Code, “a group of related ATEOs could have more than five  ‘‘five highest compensated employees’’ for a taxable year. Similarly, an employee could be a covered employee of more than one ATEO in a related group of organizations for a taxable year.”

A covered employee can be a part- or full-time employee. Not included in the definition are non-employee directors or independent contractors. Under the final regulations, every ATEO must have its own list of covered employees. Where two or more ATEOs are related to one another, each of the ATEOs must have its own list. Again, the checklist of what precisely constitutes a covered employee is complex.

It Doesn’t Take a Million Dollars

Published on JDSupra.com, in a Proskauer Rose LLP article titled, Final Regulations on Executive Compensation Excise Tax (Section 4960) Carries Forward Most Concepts from Proposal is the thoughtful warning to “beware of parachutes: they’re easier to trigger than you might expect.”

Included in the article, authored by James Huffman, Katrine Magas, Amanda Nussbaum, and Seth Safra, is this critical insight “…separation pay to covered employees can trigger the “parachute payment” tax even if the individual’s compensation never reaches $1 million.”

While recognizing that IRC Section 4960 is uniquely complex and requires navigation and guidance by skilled legal, tax, and executive compensation professionals, there’s one additional takeaway to understand: the excise tax under Section 4960 will be broad reaching, impacting many currently unsuspecting tax-exempt organizations and their affiliates.


[i] Source: 26 CFR Parts 1 and 53; [TD 9938]; IN 1545–BO99; Tax on Excess Tax-Exempt Organization Executive Compensation

Other sources consulted in preparation of this material include:

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any tax advice contained herein is of a general nature. You should seek specific advice from your tax professional before pursuing any idea contemplated herein.

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