The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, enacted changes to the tax law that have proved costly to some tax-exempt organizations. The TCJA amended Sec. 512 to provide less-favorable rules for computing tax on unrelated business income, added a tax on the investment income of larger private colleges and universities (Sec. 4968), and added an excise tax on excess compensation paid to certain executives and other highly paid employees (Sec. 4960).
Of these new provisions, for many organizations, the Sec. 4960 excise tax on excess compensation, effective for organizations' tax years beginning after Dec. 31, 2017, has had or has the potential to have the most pronounced impact. Sec. 4960 imposes an excise tax at the corporate tax rate (currently 21%) on remuneration paid by an applicable tax-exempt organization (ATEO) for the tax year with respect to employment of any covered employee in excess of $1 million (not adjusted for inflation) and on any "excess parachute payment" by an ATEO to a covered employee (Sec. 4960(a)).
There was little warning that the new tax was coming, although it might be seen as a natural development of Congress's long-standing concern over highly paid employees of entities that serve the public good (see the sidebar, "How Did We Get Here?"). The tax went into full effect immediately and provided no transition relief or exclusions for compensation contracts in existence prior to the law change.
Final regulations under Sec. 4960 were issued in January 2021 and are applicable to tax years beginning after Dec. 31, 2021 (T.D. 9938). Until the applicability date, taxpayers may choose to base their positions on either a reasonable, good-faith interpretation of the statute that includes consideration of any relevant legislative history, Notice 2019-9, or the proposed regulations. Alternatively, for tax years beginning in 2018 through 2021, taxpayers may apply the final regulations.
ORGANIZATIONS SUBJECT TO THE TAX
Under Sec. 4960(c)(1), the term "applicable tax-exempt organization" includes:
- An organization exempt from taxation under Sec. 501(a);
- A farmers' cooperative organization described in Sec. 521(b)(1);
- An organization that has income excluded from taxation under Sec. 115(1) (i.e., income from a public utility or the exercise of an essential governmental function that accrues to the states, the federal government and its possessions, or the political subdivisions of any of them); and
- A political organization described in Sec. 527(e)(1) (a party, committee, association, fund, etc., organized and operated primarily to directly or indirectly accept contributions or make expenditures to influence the selection, nomination, election, or appointment of an individual to a public federal, state, or local public office or office in a political organization, or the election of presidential or vice presidential electors).
What about public hospitals, colleges, and universities? Some have recognition of exempt status under Sec. 501(c)(3) and so would fall under No. 1 above. A few others might have status under No. 3 by virtue of their relationship to a state government. However, a fair number of such organizations fall outside either designation because they are considered to be governmental entities in their own right. While it seems certain that the intention of the new law was to include such entities (since Congress had the compensation of athletic coaches in its sights, and many highly paid coaches are at state universities), the Code as it is written does not do so (confirmed by Notice 2019-9, II.B. Q/A-5). Sec. 4960 could have easily mirrored the unrelated business income tax provisions, which explicitly refer to "state colleges and universities" (Sec. 511(a)(2)(B)), but perhaps this was overlooked in the haste to get the law enacted. Many have predicted that there would be a technical correction to this effect passed at some point, but that still has not materialized (see, e.g., Joint Committee on Taxation, General Explanation of Public Law 115-97 (JCS-1-18) (Dec. 20, 2018), page 264: "Applicable tax-exempt organizations are intended to include State colleges and universities," and footnote 1251: "A technical correction may be necessary to reflect this intent").
Additionally, a "related organization" of an ATEO may also be subject to the tax in certain situations (Sec. 4960(c)(4)). An organization is considered to be related to an ATEO if it:
- Controls, or is controlled by, the ATEO;
- Is controlled by one or more persons that control the organization;
- Is a supported organization (as defined in Sec. 509(f)(3)) during the tax year with respect to the ATEO;
- Is a supporting organization described in Sec. 509(a)(3) during the tax year with respect to the ATEO; or
- In the case of a voluntary employees' beneficiary association (VEBA) described in Sec. 501(c)(9), establishes, maintains, or makes contributions to the VEBA.
COVERED EMPLOYEES
The term "covered employee" under Sec. 4960(c)(2) means any employee of an ATEO who:
- Is one of the five highest-compensated employees of the organization for the tax year; or
- Was a covered employee of the organization for any preceding tax year beginning after Dec. 31, 2016.
The five highest-compensated employees of an ATEO are identified on the basis of the total remuneration paid during the year to the employee for services performed as an employee of the ATEO or any related organization. An employee is disregarded for purposes of determining an ATEO's five highest-compensated employees if neither the ATEO nor any related organization paid remuneration or granted a legally binding right to nonvested remuneration (hereinafter referred to as "provided remuneration") to the individual for services performed as an employee of the ATEO or any related organization.
The regulations (Regs. Sec. 53.4960-1(d)) also provide three exceptions intended to alleviate concerns regarding the unintended inclusion of individuals paid by taxable related organizations who provide services to an ATEO on a volunteer or minimal basis. These are a "limited hours" exception, a "nonexempt funds" exception, and a "limited services" exception. An individual meeting one of the exceptions is disregarded for purposes of determining an ATEO's five highest-compensated employees for the year. Generally, the "limited hours" and "nonexempt funds" exceptions are similar to the "volunteer" exception for purposes of reporting employee compensation on Form 990, Return of Organization Exempt From Income Tax. A "limited services" exception may apply if the ATEO paid less than 10% of an employee's total remuneration during the year for services performed as an employee of the ATEO and all related organizations.
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. Therefore, it is possible for a group of related organizations to have more than five highest-compensated employees in any given year. Lastly, it is important to note that once an individual becomes a covered employee, he or she will always be a covered employee. An organization subject to these provisions will need to track its covered employees in perpetuity.
REMUNERATION
For purposes of Sec. 4960, remuneration means any amount that is wages as defined in Sec. 3401(a), excluding any designated Roth contribution, and including any amount required to be included in gross income under Sec. 457(f) (amounts not subject to a substantial risk of forfeiture in the case of an eligibility failure of certain deferred compensation plans; see Sec. 4960(c)(3)(A) and Regs. Sec. 53.4960-2(a)(1)). However, remuneration does not include reasonable fees paid by a corporation to a director of the corporation or amounts paid to a licensed medical (or veterinary) professional for the performance of medical services by such professional. If a medical professional receives compensation for both medical and nonmedical services, the employer must make a reasonable, good-faith allocation to determine the amount of remuneration for nonmedical services.
Remuneration of a covered employee by an ATEO includes any remuneration paid with respect to employment of the employee by any related person or governmental entity. Universities commonly have supporting organizations that provide supplemental compensation to certain employees. For purposes of Sec. 4960, all such payments would be considered to be made by the university (assuming the supporting organizations meet the definition of a related organization discussed previously).
While the liability for the tax must be apportioned between or among employers (Sec. 4960(c)(4)(C)), only one entity might be considered an individual's employer (in this example, the university), even though multiple entities may be paying the individual's compensation. In that case, the employer would file Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code, and pay the tax liability, although it could certainly make arrangements with its related organizations to reimburse it for a portion or all of the tax should it so desire.
EXCESS PARACHUTE PAYMENTS
A parachute payment means any payment in the nature of compensation to (or for the benefit of) a covered employee that is contingent on the employee's separation from employment with the employer when the aggregate present value of the payment(s) equals or exceeds three times a "base amount" (Sec. 4960(c)(5)(B)). The base amount is generally equal to the average annual compensation for services performed by the employee for the five most recent tax years ending before the date of separation from employment. An excess parachute payment is the excess of any parachute payment over the portion of the base amount allocated to the payment.
Parachute payments do not include payments:
- To or from a plan described in Sec. 401(a), which includes a trust exempt from tax under Sec. 501(a);
- To or from an annuity plan described in Sec. 403(a);
- To or from a simplified employee pension as defined in Sec. 408(k);
- To or from a simple retirement account described in Sec. 408(p);
- Made under or to an annuity contract described in Sec. 403(b) or a plan described in Sec. 457(b);
- To a licensed medical professional to the extent that the payment is for the performance of medical services by the professional; or
- To an individual who is not a highly compensated employee as defined in Sec. 414(q).
CALCULATING THE TAX
Remuneration is calculated based on the calendar year ending with or within the ATEO's tax year. So, for example, an ATEO with a June 30 year end would calculate remuneration for its fiscal year ending June 30, 2021, based on calendar year 2020. The amount of remuneration treated as paid by the employer to a covered employee is the sum of regular wages actually or constructively paid during the applicable year and the present value of all other remuneration that vested during the applicable year.
For employees receiving compensation outside normal wages (e.g., deferred compensation vesting over time), this calculation can be very tricky. The regulations (Regs. Sec. 53.4960-2) provide a wealth of guidance and examples for such situations. For parachute payments, the regulations (Regs. Sec. 53.4960-3) clarify when a parachute payment has been made and how to calculate its present value. It is important to remember that the amount of an excess parachute payment does not have to exceed $1 million to be subject to the tax — it could in fact be much less.
REPORTING THE TAX
The tax is reported on Form 4720 (Schedule N, "Tax on Excess Executive Compensation"), which is due 4½ months after the organization's year end (e.g., May 15 for calendar-year organizations). A six-month automatic extension is available. If the organization also files Form 990, the extension filed for the Form 990 does not automatically extend the Form 4720; a separate extension must be filed. Estimated tax payments are not required to be made for the Sec. 4960 tax. Although payment of the tax by check does not appear to be prohibited, use of the Electronic Federal Tax Payment System is strongly recommended.
HOW TO REDUCE THE TAX
Split-dollar loan arrangements have become more popular in recent years as an alternative to traditional nonqualified deferred compensation arrangements described in Sec. 457(f). Under a split-dollar loan arrangement, the employer agrees to make loans to the employee to pay the premiums for a universal life insurance policy that is owned by the employee and that has a high death benefit. The employee agrees to assign a portion of the death benefit to the employer in the amount sufficient to repay the loan and any accrued interest. Upon retirement, the employee is allowed to borrow against the policy within agreed-upon limits — based on the accumulated cash value of the policy and the amount needed to eventually repay the employer.
Since a loan is not considered remuneration for purposes of Sec. 4960, any benefits received in connection with this type of arrangement would not be subject to that tax. Sec. 4960 aside, such an arrangement is attractive to the employer because it essentially recovers the amount it initially provided as a benefit (unlike other plans), and it is attractive to the employee because he or she is typically not taxed on the amount borrowed from the plan. If the loan terms do not provide for the regular payment of interest on the amount borrowed at the applicable federal rate, then the forgone interest will be imputed and considered remuneration for Sec. 4960 purposes and taxable compensation under Sec. 7872. Practitioners choosing to recommend this arrangement should consider all potential tax implications.
Another option would be to structure an employee's compensation package such that a portion of it is paid by an affiliated, but not related, organization so that it wouldn't be combined with remuneration paid by the ATEO and related organizations. This would necessitate that such compensation be paid for services rendered as an employee to the affiliated organization, because if the compensation was for services provided to the ATEO, then it would be considered to be paid by the ATEO, unless either the limited-hours or nonexempt-funds exception discussed previously applies (Regs. Sec. 53.4960-2(b)(1)). Similarly, the use of a professional employer organization would likely not be sufficient to eliminate attribution of remuneration to an ATEO.
Lastly, while organizations classified as a political subdivision or integral part of a state or local government would not normally be eligible for Sec. 501(c)(3) status, an organization falling in that category may wish to consider voluntarily relinquishing its Sec. 501(c)(3) status to avoid the Sec. 4960 tax. It should continue to be exempt from income tax by virtue of its governmental status.
IMPACT ALREADY SEEN
The statistics available for filings of Forms 4720 (calendar year 2019) for this tax are mind-boggling. While the number of returns reporting Sec. 4960 tax represented only approximately 20% of the total number of returns filed, the tax reported (over $125 million) was almost 90% of the total tax paid on all Forms 4720 filed (IRS Tax Statistics, Domestic Private Foundation and Charitable Trust Statistics, Excise Taxes Reported by Charities, Private Foundations, and Split-Interest Trusts on Form 4720).
The increase in all excise taxes reported on Form 4720 over the prior-year data (which did not report any Sec. 4960 tax) was 677%, so the provision clearly adds considerably to aggregate revenues from exempt organizations overall. Also, according to a recent comment by Margaret Von Lienen, director of the IRS's Exempt Organizations and Government Entities Division, the IRS has received Forms 4720 from only approximately 14% of the organizations officials believe could be subject to the Sec. 4960 tax, so the IRS will likely plan to conduct compliance checks and/or examinations to ensure complete reporting (Stokeld, "Processing of 'Parking Tax' Refund Claims for EOs Could Be Delayed," 169 Federal Tax Notes 1683 (Dec. 7, 2020)).
COORDINATION WITH TAX ON SELF-DEALING OR EXCESS BENEFIT
Even though Sec. 4960 is labeled as a tax on excess compensation, it does not pass judgment on whether such compensation is truly excessive within the meaning of Secs. 4941 and 4958. Sec. 4941 imposes a 10% tax on a disqualified person that has engaged in an act of self-dealing (such as paying unreasonable compensation) with a private foundation, and Sec. 4958 imposes a 25% tax on a disqualified person that has engaged in an excess benefit transaction (also such as paying unreasonable compensation) with a Sec. 501(c)(3) or (4) organization. Both sections require repayment of the excess amounts to the exempt organization in addition to payment of the tax.
Notice 2019-9 clarified that just because compensation was subject to tax under Sec. 4960 did not automatically mean that it was considered to be unreasonable compensation for purposes of Secs. 4941 and 4958. However, it would be prudent to be sure that all of the steps enumerated in Regs. Sec. 53.4958-6(a) to provide a "rebuttable presumption of reasonableness" for purposes of Sec. 4958 are completed and documented for those individuals whose compensation was reported on Form 4720.
ATEOs UNAWARE
Unlike the somewhat similar Sec. 162(m) regime applicable to public corporations that denies a deduction of applicable remuneration over $1 million to covered employees, Sec. 4960 did not provide an exception for amounts paid under a contract in place before its enactment and not subsequently materially modified (also, Sec. 162(m), before amendment by the TCJA, excepted certain commissions and other performance-based compensation). Consequently, ATEOs tracking remuneration to their suddenly (and perpetually) covered employees may hardly have gotten over the suddenness of the tax liability and compliance burdens entailed. For many more organizations, IRS statistics seem to indicate, that unpleasant surprise still awaits.
How did we get here?
One of the central tenets for qualification as an exempt organization under most subparagraphs of Sec. 501(c) is that the organization be operated such that "no part of the net earnings ... inures to the benefit of any private shareholder or individual." While the payment of reasonable compensation by exempt organizations is certainly anticipated and permissible under existing tax law, the potential for private inurement or benefit has long been a concern of the IRS, Congress, and charity watchdogs.
The addition of Sec. 4958 in 1996 to provide for "intermediate sanctions" against those receiving excess benefits from Sec. 501(c)(3) or (4) organizations emphasized the desire for a tool other than revocation of exempt status to deter the payment of excessive compensation by exempt organizations. The redesign of the annual information return filed by most exempt organizations (Form 990, Return of Organization Exempt From Income Tax) beginning with the 2008 tax year astronomically increased the amount of information required to be disclosed about the compensation of top officials, thereby creating a tool for the IRS and the public to monitor compensation levels on a regular basis.
Also around that time, the IRS began a compliance project focused on colleges and universities that sought out specific information about compensation as well as other topics of interest. In 2013, the IRS issued its final report on the project, noting that investment managers and sports coaches received the highest compensation of any of the positions studied, averaging almost $900,000 annually. Interestingly, an early proposed provision of the TCJA that didn't make it into the final law sought to add investment advisers and athletic coaches to the category of individuals subject to penalties for excess compensation under Sec. 4958. Given that history, it is easy to see how the groundwork was laid for the creation of this new tax on "excess compensation."
About the author
Amanda M. Adams, CPA, is managing director and national leader, Nonprofit Tax Services, with Cherry Bekaert LLP in Atlanta.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.
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