The Treasury Department and IRS recently released an advance copy of final regulations (T.D. 9938) under section 4960, providing exempt organizations and their related entities with definitive guidance addressing the computation of excise tax on remuneration paid in excess of $1 million and excess parachute payments to covered employees. The final regulations will apply to tax years beginning after December 31, 2021.
If the final regulations are not published by the Federal Register ahead of Jan. 20, 2021, they may be further delayed and require additional approval by the incoming administration before being published.
The 2017 tax law (Pub. L. 115-97), commonly referred to as the Tax Cuts and Jobs Act (TCJA), added section 4960, which imposes an excise tax on exempt organizations (and certain related entities) that provide “excessive executive compensation.” Congress indicated its intent to create parity between tax-exempt employers and taxable employers by imposing limitations on executive compensation paid by tax-exempt employers that are similar to those imposed on taxable employers. Specifically, the provisions in section 4960 are similar to and modeled after the disallowed deduction under section 162(m) and the parachute payment provisions of section 280G.
These regulations generally adopt and clarify the guidance provided in the proposed regulations released in June 2020. Read our prior RSM Tax Alert. The substantive changes contained in the final regulations generally are limited to expanding the nonexempt funds exception to the definition of covered employees. In addition, the final regulations add a number of examples to clarify provisions originally included in the proposed regulations.
The final regulations retain the three volunteer exceptions to the definition of a covered employee as set forth in the proposed regulations: limited services, limited hours, and nonexempt funds. These exceptions serve to exclude certain remuneration paid by a related organization if certain conditions are met, including the employee not receiving remuneration for services rendered to the applicable tax exempt organization (ATEO). The final regulations adopt without change the limited services and limited hours exceptions and provide two taxpayer favorable modifications to the nonexempt funds exception.
The final regulations expand the application of the nonexempt funds exception by establishing a two year testing period (rather than the one year period originally proposed) and narrowing the scope of what entities are related organizations for this purpose. The nonexempt funds exception generally provides relief for an employee of a related non-ATEO that performs a significant portion of his/her services as an employee of the ATEO if the following criteria are met:
- None of the ATEO, any related ATEO, or any taxable organization controlled by the ATEO pays remuneration to the employee for services rendered to the ATEO;
- No related organization that pays remuneration to the employee provides services for a fee to the ATEO, any related ATEO, or any taxable organization controlled by the ATEO; and
- The employee spends less than 50% of his/her total work hours during the applicable year and the preceding applicable year for the ATEO and its related ATEOs.
Solely for purposes of this exception, the final regulations narrow the definition of a related organization by providing that the section 318(a)(3) downward attribution rules do not apply. The definition of a related organization for other purposes of section 4960 does not change. The preamble explains that without this modification, the definition of a related organization would be unduly restrictive and not permit the exception to apply in situations where it was intended to function. The preamble illustrates this concern as follows: assume a single person controls two taxable corporations and an ATEO. Section 318 attribution results in the ATEO controlling both taxable corporations even though there is no actual control or ownership by the ATEO of either taxable entity. As a result, no shared employee of both the taxable corporation and the ATEO could qualify for the nonexempt funds exception. By eliminating the downward attribution, the final regulations permit a shared employee that otherwise meets the criteria discussed above to satisfy the nonexempt funds exception.
Timing of remuneration
The final regulations adopt the general timing rule that treats remuneration as paid when it has vested (i.e., is not subject to a substantial risk of forfeiture) without including an exception for short-term deferrals. Despite commenters continuing to request the inclusion of a short-term deferral rule, Treasury and the IRS stated that doing so would be inconsistent with the statutory language. Therefore, the complexity in differentiating W-2 wages from section 4960 remuneration related to year-end payments and bonuses continues to apply as there is no matching between the year of inclusion for the excise tax and the income tax.
Although comprehensive, the final regulations leave open a few items to be addressed in future guidance. First, a federal instrumentality (e.g., described in section 501(c)(1)(A)(i)) with an enabling statute that specifically provides exemption from all current and future federal taxes may treat itself as not subject to section 4960 either as an ATEO or a related organization. However, if it is related to an ATEO, the ATEO must include remuneration paid by the instrumentality in determining its covered employees and the amount of remuneration subject to tax. The final regulations reserve paragraphs to resolve this issue in further guidance
Second, the final regulations do not address the coordination between sections 162(m) and 4960, acknowledging that the timing differences between the two sections make it a complex analysis to ensure that remuneration disallowed as a deduction under section 162(m) is not subject to an excise tax under section 4960. Therefore, the preamble permits taxpayers to use a reasonable, good faith approach to coordinate these provisions in circumstances where it is not known whether section 162(m) will result in a disallowed deduction by the due date of the Form 4720 (for payment of the section 4960 excise tax).
The final regulations will be effective for tax years beginning on or after the date they are published in the Federal Register; however, the regulations will be applicable to tax years beginning after December 31, 2021. Until the applicability date, taxpayers may rely on a reasonable good-faith interpretation of section 4960, including guidance provided in Notice 2019-09 or the proposed regulations. Alternatively, taxpayers may choose to apply the final regulations to tax years beginning after December 31, 2017.