Nonprofits Should Be Wary of Excise Tax Complexity
As part of 2017’s Tax Cuts and Jobs Act, Congress added new Section 4960 to the Internal Revenue Code. Section 4960 imposes an excise tax — currently set at 21 percent — on “applicable tax-exempt organizations” that pay annual remuneration to an employee in excess of $1 million or that make one or more “parachute payments” to an individual upon an involuntary separation from service, which equal or exceed three times the individual’s five-year average annual pay. The Internal Revenue Service issued guidance on many of the key aspects of Section 4960 at the end of 2018.
Section 4960 is not only complex, but like many tax provisions, it is a minefield populated with traps for the unwary. Below is an overview of some, but not all, of the more significant Section 4960 features that tax-exempt employers need to be aware of.
Which Organizations Are Impacted by Section 4960?
Section 4960 defines “applicable tax-exempt organizations,” or ATEOs, which are required to comply with Section 4960, as all organizations that are exempt from tax under Section 501(a) of the code. This definition encompasses any organization that has a tax exemption under Section 501(c) of the code. This means that all Section 501(c)(3) charitable organizations, all tax-exempt trade associations, social clubs and labor unions, without regard to their size or number of employees, are subject to the rules of Section 4960.
Section 4960’s reach also extends to certain governmental employers that are tax exempt under Section 115(1) of the code, political organizations described in Section 527(e)(1) and farmers’ cooperative organizations described in Section 521(b)(1).
Who are Covered Employees for Purposes of Section 4960?
Section 4960 only applies to amounts paid to “covered employees,” who are defined as the five highest paid employees of an ATEO in any year beginning after Dec. 31, 2016. Importantly, the definition of covered employee does not have a minimum dollar amount of annual compensation that an individual must earn to be included as a covered employee, and once a person is a covered employee of an ATEO, they never cease to be a covered employee of that organization.
How are Groups of Related Organizations Impacted by Section 4960?
Special rules govern the operation of Section 4960 in the case of ATEOs that are part of a group of related organizations. An organization, including entities that are not ATEOs — such as for-profit companies — generally are treated as “related” to an ATEO if the organization controls or is controlled by the ATEO, or if the organization is controlled by one or more persons that control the ATEO.
Under the IRS guidance, each ATEO within a group of related organizations must separately determine who is a covered employee; in other words, the determination is not made on a group or consolidated basis. However, an ATEO must include the compensation paid to employees of the ATEO by both the ATEO and any related organization for purposes of identifying its covered employees.
When is Remuneration Considered Paid for Purposes of the $1 Million Excess Compensation Excise Tax?
The general rule under Section 4960 is that remuneration is considered paid at the time it is included in income withholding tax wages. But an important exception applies to deferred compensation payable in a year after the year in which the compensation vests. This exception creates a potentially challenging administrative burden for ATEOs.
Under Section 457(f) of the code, deferred compensation paid to an individual by a tax-exempt organization is included in the individual’s income at the time the deferred compensation vests, subject to a number of significant exceptions, one of which is for short-term deferrals, defined as amounts payable no later than 2 1/2 months after the end of the year in which vesting of the amount occurs, and another of which is for severance payments that fit within specified parameters as to amount and timing of payment. Short-term deferrals and qualifying severance payments are included in the recipient’s income at the time of payment.
By way of comparison, all deferred compensation is included in Section 4960 remuneration at the time of vesting, without regard to the short-term deferral, severance payment or other Section 457(f) exceptions that apply to the individual’s income tax treatment. To appreciate the practical significance of this difference between Section 4960 and Section 457(f), consider the case of an executive of an ATEO who has an annual salary of $600,000 — $50,000 per month — and is involuntarily terminated by the ATEO on Nov. 30, having earned $550,000 in the year of termination. Assume the executive is entitled to receive a severance benefit of one year’s salary, payable over 12 months, and that after signing a standard release agreement, severance payments begin in January of the year following the year of termination and are made entirely in the following year.
In this example, the executive would have $550,000 of income withholding tax wages in year one and $600,000 of income withholding tax wages in year two. But for purposes of the Section 4960, $1,150,000 would be included in year one. This results in the ATEO having to pay an excise tax of $31,500 — $150,000 x 21 percent. This analysis puts aside the yet unclarified uncertainty as to whether accrued unused vacation payable upon a termination of employment is included under Section 4960 at the time of termination or at the time it is paid, which, with a year-end termination, could produce differing outcomes.
An ATEO that provides benefits to an executive under a nonqualified deferred compensation plan, which is subject to Section 457(f) of the code, may face another pitfall. Under Section 4960 and Section 457(f), amounts deferred on behalf of an executive under the plan, plus earning under the plan, are included in the executive’s income and the executive’s Section 4960 remuneration at the time of vesting.
The following example illustrates the application of what can happen when an ATEO provides deferred compensation benefits to an executive.
An executive of an ATEO has an annual salary of $500,000 and is entitled to a deferred compensation benefit of $150,000 per year, payable with earnings at the end of the fifth year, if the executive is employed by the ATEO at that time. Assume that the deferred compensation earns $10,000 per year, such that at the end of the fifth year, when the deferred compensation vests, the executive is entitled to a benefit of $800,000. For that fifth year, the amount includable in the executive’s income and in the executive’s Section 4960 remuneration would be $1.3 million, comprised of $500,000 salary and an $800,000 vested deferred compensation benefit, with the ATEO being subject to a Section 4960 excise tax of $63,000 — $300,000 x 21 percent.
What Is a Section 4960 Parachute Payment?
The Section 4960 parachute payment rules are modeled after the rules in Section 280G of the code. Section 280G defines parachute payments as payments made to an employee by a for-profit corporation, which are contingent on a change of control, that equal or exceed three times the employee’s five-year average annual pay.
Section 4960 uses a similar definition of parachute payments. A key distinction, however, between Section 280G and Section 4960 is that there is no change of control prerequisite applicable to Section 4960 parachute payments. Instead, Section 4960 parachute payments include payments made by an ATEO, which are contingent on any involuntary termination of employment.
The Section 4960 excise tax applies to parachute payments made to an individual who is a highly compensated employee, based upon the individual’s compensation in the prior year. For 2019, that would include employees, subject to certain exceptions, who earned more than $120,000 in 2018. Although ATEOs that maintain Section 401(k) or other tax-qualified retirement plans typically determine which of their employees are highly compensated employees, many ATEOs — particularly smaller ones — do not have tax-qualified plans and would not as a matter of course collect such information.
What is the Effective Date of Section 4960?
Section 4960 is effective for taxable years of an ATEO beginning after Dec. 31, 2017. The IRS has stated that, under a transition rule, remuneration paid before the first taxable year beginning after Dec. 31, 2017, is not subject to Section 4960.
Pursuant to the remuneration timing rule described above, which treats deferred compensation as includable in Section 4960 remuneration at the time of vesting, the transition rule is helpful in the case of a deferred compensation plan where the benefit vested before the Section 4960 effective date. The IRS, however, gave no relief to deferred compensation that had not vested prior to the effective date, even though the deferred compensation may have accrued over a long period of time.
The foregoing is by no means an exhaustive discussion of the complexities of Section 4960. Omitted, for example, are hair-splitting determinations that may need to be made in deciding whether certain governmental entities are ATEOs, special rules applicable to individuals who perform medical services for ATEOs and conventions for calculating and allocating Section 4960 tax liability with respect to individuals who work for multiple related ATEOs.
The broad sweep, complexity and burdens associated with Section 4960, including an ATEO’s need to keep track of covered employees throughout the employees’ entire post-2016 employment with the ATEO, and the disconnect between the deferred compensation timing rules of Section 457(f) and Section 4960, are likely to create administrative headaches and problems for many tax-exempt organizations. Nevertheless, as burdensome as in many instances it is likely to be, ATEOs need to give serious thought to putting in place policies and practices to comply with Section 4960 and avoid the difficulties and costs that would result from a failure to comply.
“Nonprofits Should Be Wary of Excise Tax Complexity,” by Daniel L. Morgan was published in Law360 on January 31, 2019. Reprinted with permission.