Tax-Exempt Organizations to Feel Effects from Section 4960

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The IRS issued Notice 2019-09 on December 31, 2018. The interim guidance provided in the notice, through multiple questions and answers, helps define some of the key terms included in Section 4960. From the notice:

This notice provides interim guidance regarding Internal Revenue Code Section 4960, enacted as part of the Tax Cuts and Jobs Act. Section 4960(a) imposes an excise tax equal to the rate of tax under §11 (currently 21 percent)on the amount of remuneration in excess of $1 million and any excess parachute payment paid by an applicable tax-exempt organization (ATEO) to a covered employee.

Section 4960 was enacted to mirror the rules under §162(m), which limit the deduction for corporations to “covered employees” in excess of $1 million, and §280G, which limits the deduction of a “parachute payment.” As tax-exempt organizations do not deduct the compensation—except to the extent the compensation is directly connected to an unrelated trade or business—§4960 imposes an excise tax equal to the corporate tax rate (currently 21 percent). The notice also gives the following information:

The interim guidance is intended to assist taxpayers in applying §4960 while the Department of the Treasury (Treasury) and the IRS develop further guidance on the application of §4960, and addresses certain issues under §4960 on which stakeholders have indicated that they would benefit from interim guidance. Specifically, the Treasury and the IRS intend to issue proposed regulations that will incorporate the guidance provided in this notice.

The §4960 excise tax is applicable for the first taxable year beginning after December 31, 2017. The notice clarifies that the excise tax imposed on excess remuneration and excess parachute payments is determined based on remuneration paid in the calendar year (CY) ending within the taxable year of the employer. For example, a June 30 year-end ATEO would consider remuneration paid during CY 2018 for its June 30, 2019, tax year. The notice provides a helpful example on how this will apply. In the example, a June 30 year-end ATEO pays a covered employee $1.2 million of remuneration in CY 2018. The remuneration is paid ratably throughout the year. Section 4960 is first applicable to the organization on July 1, 2018 (its first tax year beginning after December 31, 2017), so the ATEO only has to consider the $600,000 of remuneration paid from July 1 to December 31 for determining if it has an excise tax liability for the June 30, 2019, tax year. For the June 30, 2020, tax year, the ATEO would consider a full year of CY 2019 compensation. Many fiscal year ATEOs may catch a break in the first tax year after December 31, 2017, because of this transition rule.

The notice is full of helpful examples like the one above, but it also provides many definitions that should help determine which organizations this new excise tax affects and to what extent.

ATEOs & Related Organizations

ATEOs include:

  • Organizations exempt from taxation under §501(a)
  • Farmers’ cooperative organizations described in §521(b)(1)
  • Organizations with income that is excluded under §115(1)
  • Political organizations described in §527(e)(1)

The notice clarifies that certain governmental entities are not ATEOs within the meaning of §4960(c)(1). A governmental entity (including a state college or university) that is not recognized as exempt from taxation under §501(a) and does not exclude income from gross income under §115(1) is not an ATEO. However, a “dual status” entity, which excludes income under §115(1) or is recognized as exempt from taxation under §501(a), is an ATEO.

Based on the conference report and previous comments from Congress, it appears the intent was to include state colleges or universities as ATEOs; however, absent a technical correction bill being passed, those organizations are not included in the definition of ATEOs.

A related organization is one that:

  • Controls, or is controlled by, the organization
  • Is controlled by one or more persons who control the organization
  • Is a supported organization (as defined in §509(f)(3)) during the taxable year with respect to the organization
  • Is a supporting organization described in §509(a)(3) during the taxable year with respect to the organization
  • In the case of an organization that is a voluntary employees’ beneficiary association described in §501(c)(9), establishes, maintains or makes contributions to such voluntary employees’ beneficiary association

Section 4960(c)(4)(A) provides that remuneration paid to a covered employee by an ATEO includes any remuneration paid with respect to employment of the employee by any related person or governmental entity. Treasury and the IRS interpret the phrase “any related person or governmental entity” to include not only related ATEOs but also related taxable organizations and related governmental units or other governmental entities.

“Control” is based on the definition under §512(b)(13). Thus, the definition of related organization for purposes of §4960 generally aligns with the definition of related organization for purposes of the annual reporting requirements on Form 990. This helps reduce the burden on organizations to identify related organizations, calculate compensation from related organizations and determine liability under §4960.

Covered Employees

Section 4960(c)(2) defines a covered employee as one of an ATEO’s five highest-compensated employees for the current taxable year or anyone who was a covered employee of the ATEO (or any predecessor) for any preceding taxable year beginning after December 31, 2016. Therefore, once an employee is a covered employee, he or she maintains that status for all subsequent taxable years. This does differ significantly for the Form 990 rules for reporting highest-compensated employees. In addition, the notice provides that remuneration paid for medical services is not taken into account for purposes of identifying the five highest-compensated employees.

There is no minimum dollar threshold for an employee to be a covered employee; thus, an employee need not be paid excess remuneration or an excess parachute payment or be a highly compensated employee within the meaning of §414(q) to be a covered employee for a taxable year and all future years. The notice also provides that remuneration paid by a separate organization on behalf of the ATEO for services performed as an employee of the ATEO, whether related to the ATEO or not, is treated as remuneration paid by the ATEO for purposes of §4960.

The notice provides that whether an employee is one of an ATEO’s five highest-compensated employees is based on remuneration paid in the CY ending with or within the employer’s taxable year. Whether an employee is one of the five highest-compensated employees is determined separately for each ATEO and not for the entire group of related organizations. As a result, in many cases, a group of related organizations will have more than five covered employees.

To prevent circumstances in which an employee to whom the ATEO paid minimal remuneration displaces an employee who would otherwise be a covered employee of the ATEO, the notice provides a limited services exception. Under this, unless an ATEO pays at least 10 percent of the total remuneration paid by the ATEO and all related organizations to an employee during the CY, the employee is not treated as one of the ATEO’s five highest-compensated employees. However, if no ATEO pays at least 10 percent of an employee’s total remuneration during a CY, this exception does not apply to the ATEO that paid the most remuneration to the employee during the CY. In addition, a payment to the employer’s employee from a third-party payer is considered a payment to the employee from the common-law employer.

Remuneration & Excess Remuneration

Section 4960(c)(3)(A) generally defines “remuneration” as wages under §3401(a) (wages subject to federal income tax withholding), but excluding designated Roth contributions under §402A(c) and including amounts required to be included in gross income under §457(f). The notice clarifies that remuneration also includes a parachute payment that is not an excess parachute payment. Remuneration does not include certain retirement benefits, including payments from or contributions to qualified retirement plans.

For purposes of §4960(a), remuneration is treated as paid when there is no substantial risk of forfeiture of the rights to the remuneration, as defined by §457(f)(3)(B). This timing rule for determining when remuneration is treated as paid applies to all forms of remuneration. The amount of remuneration treated as paid at vesting is the present value of the remuneration in which the covered employee vests. The employer must determine the present value using reasonable actuarial assumptions regarding the time and likelihood of actual or constructive payment. The notice also provides specific rules for the timing of inclusion for earnings and losses on previously paid remuneration.

Compensation for the performance of medical or veterinary services by a licensed medical professional (including a veterinarian) is excluded from remuneration and parachute payments under §4960(c)(3)(B) and (c)(5)(C)(iii) respectively. A “licensed medical professional” is defined as an individual who is licensed under state or local law to perform “medical” or “veterinary” services. In addition to those professionals listed, this generally includes dentists and nurse practitioners and may include other medical professionals depending on state or local law.

Medical services are defined using the definition of medical care under §213(d), which provides that medical care consists of services for the diagnosis, cure, mitigation, treatment or prevention of disease, including services for the purpose of affecting any structure or function of the body. For a veterinarian or other licensed veterinary professional, §213(d)(1)(A) applies by analogy to determine whether the activity constitutes veterinary services.

Activities related to medical services, such as administrative, teaching and research services, generally are not medical services. However, to the extent a licensed medical professional provides direct medical care to a patient in the course of these activities, he or she performs medical services, which means remuneration allocable to those services is not taken into account.

When a covered employee is compensated for both medical services and other services, the employer must allocate remuneration paid to such employee between medical services and such other services. The notice permits the use of any reasonable good faith method to allocate remuneration between medical and other services.

To calculate liability under this provision, an ATEO should take the following steps:

  1. Calculate remuneration paid (other than any excess parachute payment) for each of its covered employees, including remuneration from any related organization; if remuneration for any covered employee calculated in step (1) is more than $1 million, then the remuneration exceeding $1 million is subject to the excise tax under §4960(a)(1) at the rate of tax under §11
  2. Calculate the share of liability for each employer that employs the covered employee who was included in step (1); the ratio of this fraction of the total excise tax liability to the total excise tax should match the ratio of the amount of remuneration paid by the employer to the total remuneration calculated in step (1)
  3. Inform any related organization of its share of liability calculated in step (2)
  4. Obtain information on the ATEO’s share of liability as a related organization for any covered employee of another ATEO. If the ATEO is a related organization to more than one other ATEO, treat the ATEO’s highest share of liability as a related organization as its liability as a related organization for the covered employee
  5. Compare the ATEO’s liability as an ATEO in step (2) to its share of liability as a related organization under step (4) for each of the ATEO’s covered employees. The ATEO reports the greater of the share calculated under step (4) or the share calculated under step (2) as the ATEO’s share of liability for remuneration paid to the covered employee

Parachute Payments & Excess Parachute Payments

For purposes of §4960(a)(2), a “parachute payment” means any payment arising out of an employment relationship to (or for the benefit of) a covered employee if (i) such payment is contingent on such employee’s separation from employment with the employer and (ii) the aggregate present value of the payments in the nature of compensation to (or for the benefit of) such individual that are contingent on such separation equals or exceeds an amount equal to three times the base amount.1 Section 4960(c)(5)(C) provides exceptions for certain retirement plans, certain payments to licensed medical professionals and payments to individuals who are not highly compensated employees2 as defined in §414(q).

For purposes of §4960, an anticipated reduction of the level of service of less than 50 percent is not treated as a separation from employment, an anticipated reduction of more than 80 percent is treated as a termination of employment, and the treatment of an anticipated reduction between those two levels is determined based on the facts and circumstances. The determination of whether a separation from employment is involuntary also is based on all the facts and circumstances.

If the aggregate present value of all compensation paid to a covered employee that is contingent on employment separation equals or exceeds the amount equal to three times the individual’s base amount, the payments are considered parachute payments. If this aggregate present value is less than the amount equal to three times the individual’s base amount, no portion of the payments is a parachute payment.

An excess parachute payment is the excess of the amount of any parachute payment made by an ATEO (or related organization or predecessor organization) over the portion of the covered employee’s base amount that is allocated to the payment. Note that this is the excess over one times the base amount and not the excess over three times the base amount.

The notice provides the following basic six-step process for determining the amount of any excise tax under §4960(a)(2) as well as whether any excess parachute payments exist:

  1. Determine if a covered employee is entitled to receive payments in the nature of compensation that are contingent on an involuntary separation from employment and are not subject to an exclusion.
  2. Calculate the total aggregate present value of the contingent payments, taking into account the special valuation rules that apply when an involuntary separation from employment accelerates payment or vesting of a right to a payment.
  3. Calculate the covered employee’s base amount with respect to the base period.
  4. Determine if the contingent payments are parachute payments.
  5. Calculate the amount of excess parachute payments.
  6. Calculate the amount of excise tax under §4960(a)(2). The excise tax is the amount equal to the product of the rate of tax under §11 and the sum of any excess parachute payments paid by an ATEO or related organization to the covered employee.

Payment & Reporting

On November 7, 2018, Treasury and the IRS issued proposed regulations to address reporting and the due date for paying the tax. The proposed regulations provide that the excise tax under §4960 is reported on Form 4720, Return of Certain Excise Taxes. Each employer liable for §4960 tax, whether an ATEO or a related organization as described in the notice, is responsible for separately reporting and paying its share of the tax. The proposed regulations provide that Form 4720 and payment are due the 15th day of the fifth month after the end of the taxpayer’s taxable year—May 15 for a CY employer, subject to an extension of time for filing that generally applies. There is no requirement under §6655 for ATEOs or related organizations to pay estimated taxes on excise taxes imposed under §4960. Instead, the excise tax is reported and paid annually on Form 4720.

Summary

Treasury and the IRS are requesting comments on topics addressed in the notice as well as any other issues arising under §4960. The notice includes specific topics on which Treasury and the IRS are requesting comments to facilitate the issuance of proposed regulations with respect to §4960. The notice indicates any future regulations issued will be prospective and will not apply to tax years beginning before the issuance of those future regulations.

Tax-exempt organizations will be able to use the interim guidance provided by Notice 2019-09 in applying the new excise tax implemented in §4960 relating to remuneration in excess of $1 million and any excess parachute payments paid by an ATEO or related organizations to covered employees. The notice provides clarification on numerous issues, including that the remuneration is for the CY ending with or within the taxable year similar to the reporting on Form 990; however, the remuneration is calculated using the rules within the notice and is not based on reporting on the employee’s Form W-2.

The new requirements under §4960 will create new challenges and administrative burdens on tax-exempt organizations that must comply with the law. In addition, tax-exempt organizations may see an additional tax burden for compensation agreements that were put in place prior to the enactment of the Tax Cuts and Jobs Act.

Contact Greg or your trusted BKD advisor if you have questions.

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The base amount is defined as a covered employee’s average annual compensation for services performed as an employee of the ATEO (including compensation for services performed for a predecessor entity of the ATEO), or a related organization with respect to which there has been a separation from employment, if the compensation was includible in the gross income of the individual for taxable years in the base period. 
Under §414(q), a highly compensated employee generally is defined as any employee who was a 5 percent owner at any time during the year or the preceding year or who had compensation from the employer in the preceding year in excess of an inflation-adjusted amount—$120,000 for 2018. 

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