On December 22, 2017, the Tax Cuts and Jobs Act (“TCJA”) was signed into law. The enactment of the TCJA created the most significant changes to our tax legislation since the Tax Reform Act of 1986. Not only did the TCJA introduce changes for individuals, businesses and foreign organizations, but it also implemented various regulations that would substantially impact Internal Revenue Code (“IRC”) §501(c) tax-exempt organizations as well. Many of the changes affecting tax-exempt organizations were as a result of the TCJA’s intent to essentially “level the playing field” and to hold tax-exempt organizations to the same standards as their for-profit counterparts.
One of the most substantial changes of the TCJA affecting tax-exempt organizations was the creation of IRC §4960. This new code section applies to “applicable tax-exempt organizations” and imposed a new 21% excise tax on excess executive compensation and excess parachute payments.
Who is subject to IRC §4960?
Organizations subject to §4960, applicable tax-exempt organizations (“ATEO”), were further defined as any organization that:
Organizations subject to IRC §4960 must determine excess compensation and excess parachute payments made to a “covered employee”. A covered employee is defined as any employee who is one of the ATEO’s five highest-compensated employees for the current taxable year or 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, they will continue to be a covered employee for all subsequent taxable years.
On December 31, 2018, over a year after the release of the TCJA, the IRS released Notice 2019-09, which provided 92 pages of much anticipated informal guidance regarding IRC §4960. The Notice provided some clarity for tax-exempt organizations, as further outlined below.
In general, the excise tax imposed under §4960(a)(1) is based on the remuneration paid (other than any excess parachute payment) by an ATEO for the taxable year with respect to employment of any covered employee in excess of $1 million. In order to alleviate the administrative burden involved in calculating excess compensation by the employer, the regulation indicates that excise tax imposed on excess remuneration and excess parachute payments is determined based on the remuneration paid and excess parachute payment made in the calendar year ending with or within the taxable year of the employer. This aligns with the Form W-2 reporting method currently used to report remuneration on Form 990, Return of Organization Exempt From Income Tax. It is important to note that “remuneration” is defined 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). For purposes of section 4960(a), remuneration is treated as paid when there is no substantial risk of forfeiture of the rights to the remuneration.
Furthermore, §4960 states that remuneration is considered paid only when there is no substantial risk of forfeiture. Net earnings on previously paid remuneration is treated as paid at the close of the calendar year in which they accrue. Additionally, any vested remuneration, including vested but unpaid earnings on deferred amounts, that is treated as paid before §4960 is applicable (January 1, 2018, in the case of a calendar year employer) is not subject to the excise tax imposed under §4960(a)(1), although earnings after the effective date on those amounts are treated as remuneration paid for purposes of § 4960(a)(1).
As seen in many integrated healthcare delivery systems, an individual may perform services as a common-law employee for two different related organizations during the calendar year, one or both of which is an ATEO. In these instances, remuneration paid for the taxable year is aggregated for purposes of determining whether excess remuneration has been paid. To address these cases, the Notice provides rules for allocating liability for the excise tax among the employers. As provided in §4960(c)(4)(C), in any case in which an ATEO includes remuneration from one or more related organizations as separate employers of the individual in determining the excise tax, each employer is liable for its proportionate share of the excise tax.
Medical and Veterinary Services
IRC §4960(c)(3)(B) and (c)(5)(C)(iii) exclude from remuneration the portion of any compensation that is paid for the performance of medical or veterinary services by a licensed medical professional. The notice defines “licensed medical professionals” 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.
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 taxpayers to use any reasonable, good faith method to allocate remuneration. For this purpose, taxpayers may rely on a reasonable allocation set forth in an employment agreement that explicitly allocates a portion of the remuneration as for medical services or other services. If some or all of the remuneration is not reasonably allocated in an employment agreement, taxpayers must use a reasonable method of allocation. Additionally, the Notice clarified that medical services do not include administration, teaching or research services.
Excess Parachute Payments
IRC §4960(a)(2) imposes an excise tax on “any excess parachute payment.”, which is further defined as an amount equal to the excess of any parachute payment over the portion of the base amount allocated to such payment. Parachute payments within the context of the TCJA are payments made in the nature of compensation to a covered employee contingent upon voluntary separation from the employer, in which the aggregate present value of the payments equals or exceeds three times the base amount. According to §280G(b)(3), the term “base amount” refers to the average of an individual’s annualized compensation over the previous five taxable periods (or less) prior to separation.
The guidance in the IRS Notice limits the payments treated as contingent on a separation from employment to payments contingent on an involuntary separation from employment because payments that vest upon a separation from employment typically vest only upon an involuntary separation from employment. If an employee may voluntarily separate from service and still be entitled to a payment, then the payment either is not subject to a substantial risk of forfeiture or the forfeiture condition is not related to the separation from employment.
IRC §4960 is effective for the first taxable year beginning after December 31, 2017. Therefore, calendar year entities will be subject to the 21% excise tax for excess remuneration for their covered employees for calendar year 2018. However, organizations with fiscal year-ends will only be subject to the 21% excise tax on remuneration paid in excess of $1 million on covered employees for the period included for their first able year beginning after December 31, 2017. For example, June 30th Fiscal year ends would be subject to the 21% excise tax paid to covered employees over $1 million for the period 7/1/2018 through 6/30/2019. However, wages paid prior to the start of a taxpayer’s fiscal year in 2018 (1/1/2018 through 6/30/18) would be excluded from the calculation. Please note, this would only take place in the taxpayer’s initial year of filing.
Reporting the Liability Under §4960
Employers are to report their liability and applicable payment by completing Federal Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code by the 15th day of the 5th month after the end of the taxpayer’s taxable year (i.e. May 15th for calendar year filers). However, according to the Notice, an employer may file Form 8868, Application for Automatic Extension of Time to File an Exempt Organization Return, to request an automatic extension of time to file the Form 4720. The automatic extension will be granted if Form 8868 is properly completed, and timely filed. Form 8868 does not extend the time to pay tax. To avoid interest and penalties, an employer must pay the tax due by the original due date of the Form 4720.
It is evident that the TCJA has established a precedent with respect to tax-exempt organizations. For-profit and publicly traded organizations are not allowed to deduct compensation over $1 million per executive for tax purposes. Since tax-exempt organizations do not pay federal tax on income, other than unrelated business income, denying this deduction would have no tax impact on the organization. Therefore, the implementation of this excise tax under §IRC §4960 intends to align the tax treatment, between tax-exempt organizations and their for-profit counterparts. However, it is important to emphasize that thus far, the general public has only received interim guidance. The Treasury Department is still working through this legislation and further guidance, proposed and final regulations, will be released in the future. All tax-exempt organizations should begin identifying all related organizations subject to §4960, identify individuals considered to be covered employees and review compensation information for the current taxable period. In connection with other valid business and tax purposes (i.e. acquisition or affiliation of an entity or employee benefits reorganization) organizations may want to consider reviewing and potentially amending deferred compensation agreements with its employees so that each covered employee vest in the same year, therefore, recognizing the same covered employees consistently on an annual basis.