On Friday, June 5, Treasury and the IRS issued proposed regulations under section 4960. Section 4960, enacted as part of the Tax Cuts and Jobs Act (TCJA), imposes 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. The excise tax, and the proposed rules, can affect not only ATEOs but also certain entities that are treated as related to those organizations.
In general, an ATEO includes any organization exempt from tax under section 501(a), any farmer's cooperative organization described in section 521(b)(1), any organization that has income excluded under section 115(1), and any political organization described in section 527(e)(1). Covered employee generally means any employee (including any former employee) of an ATEO if the employee is one of the five highest compensated employees of the organization for the taxable year, or was a covered employee of the organization (or any predecessor) for any preceding taxable year beginning after December 31, 2016. The excise tax generally applies to remuneration paid to a covered employee in excess of $1 million (including remuneration paid by related organizations) and certain parachute payments.
The proposed regulations are intended to provide comprehensive guidance with regard to the section 4960 excise tax. These rules are based in large part on earlier guidance provided in Notice 2019-09, with changes as appropriate based on comments received. The proposed regulations include definitions of key statutory terms and rules for determining: (i) the amount of remuneration paid for a taxable year (including for purposes of identifying covered employees); (ii) whether a parachute payment is paid; (iii) whether excess remuneration is paid and in what amount; (iv) whether an excess parachute payment is paid and in what amount; and (v) the allocation of liability for the excise tax among related organizations.
Some of the key new rules in the proposed regulations include:
- Volunteer Services and Similar Exceptions: Many commenters expressed concern that the rules for identifying an ATEO's five highest-compensated employees provided in Notice 2019-09 would subject a non-ATEO (such as a corporation or family office with a related charitable foundation) to the excise tax on remuneration it pays to an employee who performs limited or temporary services for a related ATEO and who typically receives remuneration only from the non-ATEO. To address these comments, the proposed rules provide for certain exceptions that permit an employee to be disregarded for purposes of determining an ATEO's five highest-compensated employees if the employee performs only limited volunteer services or services that are entirely compensated for using nonexempt funds. Because the adverse consequences of failing to meet one of these detailed and strict exceptions can be severe, entities with related tax-exempt organizations should carefully review their compensation arrangements with highly-compensated employees to determine whether any changes are required.
- Governmental Entities: The proposed regulations include rules regarding which governmental entities will be treated as ATEOs. In general, under these proposed rules, a governmental entity that is separately organized from a state or political subdivision of a state and excludes income from gross income under section 115(1) will be treated as an ATEO. In addition, a governmental entity (including a state college or university) that sought and received a determination letter recognizing its exemption from taxation will be treated as an ATEO. However, such organizations may be able to avoid the section 4960 excise tax by affirmatively relinquishing this status. Finally, federal instrumentalities that are described in section 501(c)(1) will be treated as ATEOs.
- Limited Grandfathering: Because Treasury and the IRS decided it was inconsistent with the statute, the proposed regulations expressly decline to adopt a "grandfather" rule for section 4960 similar to the grandfather rule for section 162(m) (applicable to compensation paid by publicly-traded corporations) that was included in the TCJA. However, the proposed regulations provide rules that have the effect of grandfathering certain compensation in limited circumstances. In particular, nonqualified deferred compensation that is vested prior to the first day of the first taxable year of the ATEO beginning after December 31, 2017, will not be considered remuneration. The proposed regulations do not provide any relief for so-called "cliff vesting" arrangements where amounts accrue based on services performed over a long period of time but the right to the entire amount vests only at the end of that period. These kinds of arrangements, which can expose additional income to the excise tax by bunching it into a single year, may need to be modified.
ATEOs and related organizations should consider how the proposed rules will apply to their existing compensation arrangements and if any planning opportunities exist before the regulations become applicable. The 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 either on the earlier guidance provided in Notice 2019-09 or, alternatively, on the guidance provided in the proposed regulations. In some circumstances, taxpayers may also rely on a reasonable, good faith interpretation of the statute that includes consideration of any relevant legislative history, even when that interpretation differs from the rules in Notice 2019-09 or the proposed regulations.
Written or electronic comments on the proposed rules are due within 60 days of the date the proposed regulations are published in the Federal Register, which is currently scheduled for June 11.