The IRS has released proposed regulations that are intended to provide comprehensive guidance on Section 4960 of the Internal Revenue Code. Section 4960 was added by the Tax Cuts and Jobs Act, which we have blogged about previously, and imposes an excise tax at the current 21 percent rate on applicable tax-exempt organizations (ATEOs) for compensation to a covered employee that either exceeds $1 million or is an excess parachute payment.
Under 4960, the amount of compensation or “remuneration” paid by an ATEO includes amounts paid to a covered employee by a related organization. Many practitioners raised concern about this provision and its impact on related for-profit corporations that share employees or officers with a tax-exempt entity. For instance, it is common for a corporation to form a related private foundation, and for employees of the corporation to serve as officers and directors of the nonprofit in a largely volunteer capacity—yet it would appear that compensation by the related corporation would be pulled in for these purposes.
In general, a covered employee is an employee is who is one of the five highest-compensated employees of the ATEO for the taxable year, or was a covered employee of the organization for any preceding taxable year beginning after December 31, 2016. One welcome component of the proposed regulations is several exceptions to the term “covered employee,” which should address some concerns around corporations and related foundations:
- Limited hours exception: This exception disregards an individual for purposes of determining the five highest compensated employees if neither the ATEO nor any related ATEO paid compensation for services performed for the ATEO, and the individual performed services for the ATEO and other related ATEOs for no more than 10 percent of the total hours worked as an employee for the ATEO and all related organizations. There is a safe harbor here for employees that perform no more than 100 hours of service for the ATEO and all related ATEOs during the applicable year. This exception works for situations where an individual provides fairly limited volunteer services to an ATEO.
- Nonexempt funds exception: This exception disregards an individual for purposes of determining the five highest compensated employees if neither the ATEO, nor any related ATEO or taxable related organization controlled by the ATEO, paid remuneration to an individual for services performed as an employee for an ATEO; the individual performed services as a employee of the ATEO and all related ATEOs for less than 50 percent of total hours worked as a employee of the ATEO and all related organizations; and no related organization that paid remuneration to the individual provided services for a fee to the ATEO, any related ATEO or any taxable related organization controlled by the ATEO. This exception would cover situations where an individual provides more substantial services for an ATEO.
There is also a more complex limited services exception, which requires that an ATEO have at least one related ATEO and contains additional requirements around the amount of total remuneration paid by different ATEOs.
The proposed regulations are based largely on Notice 2019-9, with clarifications in response to comments and some changes with respect to excess parachute payment calculation and liability. They are robust, and define a variety of key terms and concepts under the statue, including:
- Organizations considered “applicable tax-exempt organizations” or ATEOs, with attention to the status of governmental entities as ATEOs.
- Clarification that the “applicable tax year” for purposes of the tax is the calendar year ending with or within an ATEO’s tax year, given that ATEOs and related organizations may have different tax years.
- Clarification that granting a legally binding right to remuneration is treated the same as paying out compensation for purposes of determining whether an employee is one of the five highest-compensated employees and thus a covered employee.