New Rules on Excise Tax on Highly Compensated Employees

IRC Sec. 4960 was enacted as part of the Tax Cuts and Jobs Act (“TCJA”) and imposed an excise tax on remuneration in excess of $1 million and any excess parachute payment paid by an applicable tax-exempt organization (“ATEO”) to any covered employee.

• Under IRC Sec. 4960, “remuneration” is definedas wages for federal income tax purposes, except that it excludes Roth contributions and certain retirement benefits and, generally, includes amounts as they vest.
• An ATEO is defined in the Code as any organization which is exempt from taxation under IRC Sec. 501(a) (which includes IRC Sec. 501(c) organizations), is a farmers’ cooperative organization described in IRC Sec. 521(b)(1) , has income excluded from taxation under IRC Sec. 115(1) , or is a political organization described in IRC Sec. 527(e)(1).
• A “covered employee” is any individual who is one of the five highest compensated employees (including former employees) of the ATEO for a taxable year or any individual who was a covered employee in any preceding taxable year beginning after December 31, 2016. 

On June 5, 2020, the IRS issued proposed regulations under IRC Sec. 4960. The proposed regulations affect certain tax-exempt organizations and certain entities that are treated as related to those organizations.

The proposed regulations follow Notice 2019-09, which was issued on December 31, 2018 and provided initial guidance on the application of IRC Sec. 4960. It defines what is considered an ATEO, what is included in remuneration and who are considered covered employees of an ATEO. It also focused on the allocation of liability for the excise tax among related organizations.

One major concern that arose when Notice 2019-09 was issued was regarding employees of for-profit entities that provide services to ATEOs. According to the Notice, the liability for the tax on excess remuneration would have to be allocated among all related entities. Would the for-profit entities be subject to this excise tax because of their relationship with a tax-exempt organization? Would the closely-held business of the founder of a private foundation be subject to the tax because of the relationship? These issues have been addressed by the proposed regulations which provide exceptions for certain employees of for-profit entities who will not be treated as “covered employees” of the ATEO.

One exception is for an employee that provides “limited hours” to the ATEO. The proposed regulations state that a shared employee of an ATEO and a related organization will not be considered for the purposes of determining an ATEO’s five highest compensated employees if that employee does not spend more than 10% of her time, or more than 100 hours annually, providing services to the ATEO. Another exception, referred to in the proposed regulations as the “nonexempt funds exception,” is for employees who are not paid by the ATEO itself, any taxable related organization controlled by the ATEO, or any related ATEO. Further, to qualify for this exception, the employee’s services must have been primarily provided to the for-profit entity or other non-ATEO during the applicable year. For purposes of this exception, an employee is treated as having provided services primarily to the related taxable organization or other non-ATEO only if the employee provided services to the related non-ATEO for more than 50% of the employee’s total hours worked for the ATEO and all related organizations during the applicable year.

Some other notable clarifications in these proposed regulations are as follows:

• A foreign organization that, for its taxable year, receives substantially all of its support (other than gross investment income) from the date of its creation from sources outside of the United States is not an ATEO.
• Amounts includible in gross income as compensation under IRC Sec. 7872 and related regulations are included in remuneration for purposes of computing the excess compensation. For example, under Reg. Sec. 1.7872-15(e)(1)(i), a below-market split-dollar loan between an employer and employee generally is a compensation-related loan and any imputed transfer from the employer to the employee generally is a payment of compensation. The proposed regulations clarify that although there are no withholding requirements on those amounts, they are “remuneration … for services performed by an employee for his employer” as defined in IRC Sec. 4960(c)(3)(A).

These regulations are proposed to apply to taxable years beginning on or after the date the final regulations are published in the Federal Register. Until the applicability date of the final regulations, taxpayers may rely on these proposed regulations or on the guidance provided in Notice 2019-09. Taxpayers may also base their positions upon a reasonable, good faith interpretation of the statute.