The IRS has proposed regs regarding the tax on excessive compensation paid to tax-exempt organization executives.
Background.
Under Code Sec. 4960(a), an “applicable tax-exempt organization (ATEO)” must pay a 21% excise tax on (1) remuneration in excess of $1 million paid to a “covered employee” (“excess remuneration”) plus (2) any “excess parachute payment” paid to a covered employee during the tax year.
An ATEO is any organization that is exempt from taxation under Code Sec. 501(a), is a farmers’ cooperative organization under Code Sec. 521(b)(1), has income excluded from taxation under Code Sec. 115(1), or is a political organization described in Code Sec. 527(e)(1). (Code Sec. 4960(c)(1))
Generally, a parachute payment is any payment in the nature of compensation to (or for the benefit of) a covered employee if the payment is contingent on the employee’s separation from employment with the employer and the aggregate present value of the payment equals or exceeds 3 times the “base amount.” (Code Sec. 4960(c)(5)(B))
An excess parachute payment generally is an amount equal to the excess of any parachute payment over the portion of the “base amount” allocated to such payment. (Code Sec. 4960(c)(5)(A))
The base amount is an individual’s annualized compensation over the “base period,” which is the individual’s last five tax years. (Code Sec. 4960(c)(5)(D))
In Notice 2019-9, 2019-4 IRB 403, the IRS provided initial guidance on the application of Code Sec. 4960. See IRS issues interim guidance on excess remuneration paid by exempt orgs.
Proposed regs. These proposed regs would provide comprehensive guidance on the application of Code Sec. 4960 to excessive compensation paid to tax-exempt organization executives. (Preamble to Prop Reg REG-122345-18)
The guidance in the proposed regs generally is consistent with the guidance provided in Notice 2019-9. However, the IRS made certain modifications in response to comments it received after Notice 2019-9 was published.
The proposed regs also differ from the guidance provided in Notice 2019-9 regarding the calculation of, and liability for, the tax on excess parachute payments.
Notice 2019-9 provided that an ATEO or related organization may be liable for the tax on an excess parachute payment based on the aggregate parachute payments made by the ATEO and its related organizations, including parachute payments based on separation from employment from a related organization. The proposed regs provide that only an excess parachute payment paid by an ATEO is subject to the excise tax on excess parachute payments. (Prop Reg §53.4960-4(a)(1))
However, the proposed regs also provide that payments from related non-ATEO organizations are considered for purposes of determining the base amount and total “payments in the nature of compensation” that are contingent on the covered employee’s separation from employment with the employer. Generally, this means that a covered employee’s base amount calculation includes remuneration from all ATEOs and related organizations, and that a covered employee’s parachute payment calculation includes all payments (made from all ATEOs and related organizations) that are contingent on the employee’s involuntary separation from employment. (Prop Reg §53.4960-4(d)(1))
The proposed regs further provide that, based on the facts and circumstances, the IRS may reallocate excess parachute payments to an ATEO if it is determined that excess parachute payments were made by a non-ATEO for the purpose of avoiding the tax under Code Sec. 4960. (Prop Reg §53.4960-4(d)(4))
Who is a “covered employee?” A covered employee is any individual who is one of the ATEO’s five highest-compensated employees for the tax year or was a covered employee of the ATEO (or any predecessor) for any preceding tax year beginning after December 31, 2016. (Prop Reg §53.4960-1(d)(1))
Based on comments the IRS received in response to Notice 2019-9, the proposed regs include exceptions to the definition of “employee” and “covered employee” (Prop Reg §53.4960-1(d)(1)) and modify the rules for identifying the five highest-compensated employees. (Prop Reg §53.4960-1(d)(2))
These exceptions to the definition of “employee” and “covered employee” are intended to ensure that certain employees of a related non-ATEO providing services as an employee of an ATEO are not treated as one of the five highest-compensated employees of the ATEO, provided that certain conditions related to the individuals’ remuneration or hours of service are met. (Preamble to Prop Reg REG-122345-18)
In addition, to prevent manipulation of the rules for determining whether an employee is one of the five highest-compensated employees, through the use of deferred compensation, the proposed regs also provide that a grant of a legally binding right to vested remuneration is considered to be remuneration paid, and any grant of a legally binding right to non-vested remuneration by the ATEO (or a related ATEO)—for example, under a deferred compensation plan or arrangement—disqualifies the ATEO from claiming a relevant exception. (Prop Reg §53.4960-2(c)(2))
The “limited services” exception in Notice 2019-9 provides that an employee is not one of an ATEO’s five highest-compensated employees for a tax year if, during the applicable year, the ATEO paid less than 10% of the employee’s total remuneration during the applicable year for services performed as an employee of the ATEO and all related organizations.
However, if an employee would not be treated as one of the five highest-compensated employees of any ATEO in an ATEO’s group of related organizations because no ATEO in the group paid at least 10% of the total remuneration paid by the group during the applicable year, then this exception does not apply to the ATEO that paid the employee the most remuneration during that applicable year. The proposed regs adopt a substantially similar rule that has been modified to simplify the structure of the exception and to clarify that the exception does not apply if the ATEO has no related ATEOs. (Prop Reg §53.4960-2(d)(2)(ii)(A))
Under the proposed regs, whether an employee is one of the five highest-compensated employees of an ATEO is determined separately for each ATEO. Accordingly, a group of related ATEOs can have more than five highest-compensated employees for a tax year. Similarly, an employee may be a covered employee of more than one ATEO in a related group of organizations for a tax year. Once an employee is a covered employee of an ATEO, the employee continues to be a covered employee for all subsequent tax years of that ATEO. (Prop Reg §53.4960-1(d)(2))
The proposed regs do not set a minimum dollar threshold for an employee to be a covered employee because there is no minimum threshold provided in the statute. Thus, an employee need not be paid excess remuneration or an excess parachute payment or be a highly compensated employee under Code Sec. 414(q) to be a covered employee of an ATEO for a tax year and all future tax years. However, if an ATEO never pays a covered employee excess remuneration or an excess parachute payment, then there would be no Code Sec. 4960 excise tax with respect to the covered employee. (Preamble to Prop Reg REG-122345-18)
Also, the “limited hours” and “nonexempt funds” exceptions provided in the proposed regs exclude certain employees that may be viewed as “volunteers” from five highest-compensated employee status. This includes certain “volunteer” officers. (Prop Reg §53.4960-1(d)(2)(iv))
Excess remuneration paid in an applicable year. Generally, Code Sec. 4960(a)(1) imposes an excise tax when an ATEO pays remuneration during the applicable year in excess of $1 million to any covered employee (“excess remuneration.”)
The “applicable year,” is the calendar year ending with or within an ATEO’s tax year. (Prop Reg §53.4960-1(b)(1))
Under the proposed regs, remuneration would be considered paid when there is no “substantial risk of forfeiture” of the employee’s right to the remuneration (i.e., when the employee’s right to the remuneration is “vested”). (Prop Reg §53.4960-2(c))
For purposes of determining whether the ATEO paid excess remuneration, the amount of remuneration paid to an employee during the applicable year would be the sum of regular wages (as defined under Reg §31.3402(g)-1(a)(1)(ii)) actually or constructively paid and the “present value” of all other remuneration that vested during that year. The amount of remuneration that vests during an applicable year would be determined on an employer-by-employer basis with respect to each covered employee. (Prop Reg §53.4960-2(c))
Under the proposed regs, the ATEO would need to determine “present value” using reasonable actuarial assumptions regarding the amount, time, and probability that a payment will be made. (Prop Reg §53.4960-2(e)(1))
The proposed regs would provide that any vested remuneration, including vested but unpaid earnings accrued on deferred amounts, that is treated as paid before January 1, 2018 (for a calendar year employer) is not subject to the excise tax imposed under Code Sec. 4960(a)(1). However, all earnings on that remuneration that accrue or vest after that date would be treated under the proposed regs as remuneration paid for purposes of the excise tax under Code Sec. 4960(a)(1). (Prop Reg §53.4960-2(d)(2))
Under Code Sec. 4960(c)(4)(C), when an individual performs services as an employee for two or more related organizations during the applicable year, one or more of which is an ATEO, each employer would be liable for its proportional share of the excise tax.
The proposed regs would provide rules for allocating liability for the excise tax among the employers. For this purpose, remuneration that is paid by a separate organization (whether related to the ATEO or not) for services performed as an employee of the ATEO would be treated as remuneration paid by the ATEO. (Preamble to Prop Reg REG-122345-18)
Whether an excess parachute payment is paid and in what amount. The proposed regs, would define a “parachute payment” as any “payment in the nature of compensation” made by an ATEO to a covered employee that is “contingent on the employee’s separation from employment” and that equals or exceeds 3 times the individual’s base amount. (Prop Reg §53.4960-3(a)(1))
Under the proposed regs, a “payment in the nature of compensation” generally would be defined as any payment arising out of an employment relationship. (Prop Reg §53.4960-3(a)(2))
Code Sec. 4960(c)(5)(A) provides that “excess parachute payment” means an amount equal to the excess of any parachute payment over the portion of the base amount allocated to such payment. Under the proposed regs, a parachute payment would be an “excess parachute payment” when it exceeds one-times the individual’s base amount allocated to the payment.
The proposed regs would treat a payment as “contingent on an employee’s separation from employment” only if there was an “involuntary separation from employment.” (Prop Reg §53.4960-3(d)(1)) The proposed regs generally adopt the standards in the Code Sec. 409A regs for determining whether there has been a “separation from employment.” (Preamble to Prop Reg REG-122345-18)
In defining when a payment is “contingent on separation from employment,” the proposed regs do not focus solely on whether the payment would not have been made but for a separation from employment, but instead also take into consideration whether the separation from employment accelerates the lapse of the substantial risk of forfeiture with respect to the right to payment or accelerates the right to payment. (Preamble to Prop Reg REG-122345-18)
Applicability date.
These regs are proposed to apply to tax years beginning after December 31 of the calendar year in which the Treasury Decision adopting these rules as final regulations is published in the Federal Register. (Prop Reg §53.4960-5)
To continue your research on the tax on excess tax-exempt organization executive compensation, See FTC 2d/FIN ¶D-4046; United States Tax Reporter ¶49,604.
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