The Tax Cuts and Jobs Act of 2017 added Code Section 4960 to the Internal Revenue Code, which is intended to tax excessive compensation of executives providing services to tax-exempt entities. The limitations apply to tax years beginning on or after January 1, 2018. The Treasury Department previously published proposed regulations and issued interim guidance in the form of an IRS notice (IRS Notice 2019-60). Final regulations were published on January 19, 2021. The final regulations are effective for tax years beginning on or after January 1, 2022. In the interim, taxpayers can rely on guidance set forth in the proposed regulations and interim guidance. This update summarizes the statute and final regulations, which represent the first time that the IRS has attempted to assess penalty taxes on excessive compensation of tax-exempt executives.

Amount of Excise Tax: Code Section 4960 imposes an excise tax of 21% on “excessive remuneration,” which is defined as follows:

• Remuneration over $1 million paid to a “covered employee” (defined below) in any tax year; or

• Remuneration paid to a “covered employee” that exceeds the “parachute payment” limit (defined below) in any tax year.

An employer that pays excess remuneration is responsible for paying the 21% excise tax and must report the excessive compensation on IRS Form 990.

Covered Employee: In general, a “covered employee” is a one of the top five highest-paid employees of an “applicable tax-exempt organization” (referred to as an ATEO). All common-law employees are considered in determining the top five paid employees, but nonemployee directors and independent contractors are excluded. Each ATEO must designate its covered employees each tax year. If an ATEO is affiliated with one or more other ATEOs in the same “related organization” (discussed below), each ATEO within the group must designate its own covered employees each tax year.

The statute has a “once covered, always covered” rule. This means that once an employee is characterized as a “covered employee,” that individual is potentially subject to the excise tax, even after separation from employment. Therefore, if an employee separates from employment with an ATEO to work at a for-profit organization, then any remuneration paid by the ATEO for the employee’s services at the for-profit entity will be considered remuneration potentially subject to the excise tax. This may happen, for example, if an ATEO is affiliated with or “related” to a for-profit organization, such as a tax-exempt foundation tied to a for-profit company.

Compensation for medical and veterinary services is disregarded for purposes of determining compensation potentially subject to the excise tax. Therefore, if a hospital pays an executive for providing both administrative and medical services, payments attributable to medical services are excluded. The final regulations incorporate a “reasonable allocation” rule pursuant to which an employer may specify in an employment agreement the compensation that is attributable to medical and nonmedical services. If the allocation was determined reasonably and in good faith, then the amounts for nonmedical services are not subject to the excise tax.

The final regulations provide several exceptions intended to exclude arrangements where an ATEO (or multiple ATEOs) are “related” to “for-profit” companies and may benefit from the services of a covered employee, but the ATEO does not actually pay any compensation to an employee, or pays limited compensation to a covered employee. These are too detailed to address here, but ATEOs related to “for-profit” companies should seek tax counsel to determine whether these exceptions may apply.

Applicable Tax-Exempt Organization: A threshold issue is that the tax applies to ATEOs. The final regulations define an ATEO as (i) any organization exempt from tax under Code Section 501(a), (ii) farmers’ cooperatives, and (iii) political organizations described in Code Section 521(b)(1). The final regulations exclude governmental organizations (such as public universities), but only if the governmental organization is not also a tax-exempt entity under Code Section 501(a). However, governmental entities that are related to an ATEO (i.e., a public university with a foundation) may be subject to Code Section 4960 under certain circumstances. For instance, if a governmental and a nongovernmental entity are “related organizations,” then all remuneration paid by any organization within the “related” group to a covered employee will count as remuneration paid by an ATEO. This means that compensation paid by a governmental entity may be considered covered compensation. To determine whether organizations are “related,” the “controlled group” rules under Code Section 414(c) are used.

Determining Annual Compensation ($1 Million Annual Compensation): All wages paid to a covered employee in a tax year are considered “remuneration” for purposes of the $1 million limit. This generally means compensation reported in Box 1 of Form W-2. Deferred compensation amounts are included for purposes of the $1 million limit when the amounts become “vested” (i.e., are no longer subject to a substantial risk of forfeiture). The amount includible is the present value of the deferred compensation on the vesting date. Earnings on vested deferred amounts are included in the year the earnings accrue. For bonuses, amounts are includible in the tax year they are earned and vested. For example, if a covered employee provides services for a tax year, becomes vested in the bonus by the end of the tax year, and receives a bonus payable in February of the year following the tax year in which the services were provided, the bonus is includible for purposes of Code Section 4960 in the year that the services were provided.

The final regulations adopt a “grandfathering” rule, but only for amounts that vested prior to the first day of an ATEO’s taxable year beginning after December 31, 2017. Amounts that were promised but did not vest by such date are not considered grandfathered for purposes of the excise tax limits.

Determining Parachute Payments (Separation Pay): In addition to the annual $1 million limit on compensation, any “excess parachute payment” is subject to the excise tax. For this purpose, “parachute payment” means all amounts that become payable as a result of an employee’s involuntary separation (including an employee’s separation for “good reason”).

The excise tax on parachute payments is triggered if the present value of all separation pay (parachute payments) equals or exceeds three times an employee’s “base amount.” The “base amount” is an employee’s average wages (as reported in Box 1 of Form W-2) over the preceding five years, or a lesser period if an employee has not been employed with an ATEO for at least five years.

One important feature of “parachute payments” is that virtually all remuneration that is contingent upon separation is considered. Therefore, “parachute payments” include not just severance pay but also any pay that is subject to accelerated vesting upon separation (i.e., bonuses, long-term incentives, and deferred compensation). In order to calculate the amount includible as a “parachute payment” that results from accelerated vesting, the present value of the vested amount is used. Presumably, taxpayers can use certain models and assumptions similar to those utilized under the “golden parachute” rules contained in Code Section 280G.

The excise tax on “parachute payments” is triggered if all “parachute payments” equal or exceed three times an employee’s “base amount.” However, the excise tax is imposed on a much lower limit — one times an employee’s base amount. Therefore, employers will want to carefully consider the amount of separation pay they intend to pay to covered employees in light of the potential for additional taxes on the employer.

Applicable Tax Year: The excise tax under Code Section 4960 is calculated on a calendar year basis. If an ATEO has to report an excise tax for a calendar year, the ATEO must report the tax by the filing deadline for the fiscal year immediately following the year in which the excise tax is triggered. For example, if an ATEO owes an excise tax for calendar year 2021 and has a fiscal year ending April 30, 2022, then the excise tax must be reported and paid for the fiscal year ending April 30, 2022.

Planning Ahead: Now that final guidance has been issued, ATEOs should plan ahead to mitigate potential adverse tax consequences and should consider adopting the following strategies:

• Maximize retirement income for covered executives. Under the final regulations, payments from tax-qualified retirement plans are exempt from the excise tax. Employers may want to consider enhancing tax-qualified retirement income for covered executives by maximizing contributions to tax-qualified plans. In a similar vein, payments from non-qualified deferred compensation plans are not considered covered payments until the deferred amounts are fully vested. Employers may want to consider implementing or amending deferred compensation arrangements so that vesting occurs in years when other income is likely to be low. In addition, use of a graded vesting schedule over a number of years (i.e., 20% vesting over five years) should result in lower amounts being considered covered payments than full vesting in a single year.
• Consider implementing excise tax cutbacks. Employers may want to adopt “cutbacks” in their compensation arrangements pursuant to which amounts payable to a covered executive are cut back to avoid imposition of the excise tax. These provisions are not popular with executives, but are often utilized by for-profit companies to avoid the imposition of excise taxes under the “golden parachute” rules contained in Code Section 280G.
• Consider adopting split dollar life insurance arrangements. Under a split dollar arrangement, an employer makes annual loans to an employee in order for the employee to pay premiums under a whole life insurance policy, with the cash value of the policy used for retirement income to the employee. Loans are not characterized as “wages” under IRS rules, and therefore the use of these split dollar policies allows an employer to provide a significant benefit to an employee without making payments that are considered covered compensation.
• Review current compensation programs to determine extent of potential liabilities as well as potential exemptions. Employers will want to analyze their current compensation programs to determine if any payments will trigger excise tax liabilities, or have triggered excise tax liabilities in prior tax years. To the extent elements of the program can be amended or recharacterized to avoid adverse tax consequences, employers will want to think about modifying any particular elements of the compensation program. For example, certain fringe benefits that are excludable from income under the tax code could be increased in lieu of traditional compensation that may trigger or increase an excise tax, and employers will want to ensure that proper tax treatment is afforded such benefits.

Remember that legal principles may change and vary widely in their application to specific factual circumstances.