IRS answers questions on tax-exempt executive compensation
TAX ALERT |
The IRS issued Notice 2019-09 (Notice), providing extensive guidance regarding section 4960 that applies to excess executive compensation for tax-exempt entities. The Notice provides a number of definitions and clarifies a number of items. An IRS notice is not enforceable guidance, but this Notice can be relied upon until further guidance is issued. Taxpayers are also permitted to use other reasonable methods for satisfying section 4960, but should note a few positions that the Notice highlights the IRS does not believe are reasonable methods.
Before the Notice was issued, practitioners and taxpayers had numerous open issues, especially regarding the proper definition of various terms provided in section 4960. Where possible in the Notice, the IRS used concepts and definitions already available in related tax areas (especially using already established tax exempt and compensation and benefit rules such as sections 162(m) and 280G, as well as indicating when these rules do not match with section 4960).
The IRS uses an abbreviation in the guidance: “Applicable Tax Exempt Organization” (ATEO). Section 4960 applies to Excess Remuneration (payments in excess of $1 million to a covered employee of an ATEO and its related entities) and to Excess Parachute Payments (compensation payments contingent on separation from service from an ATEO and its related entities). The Notice clarifies that section 4960 can include remuneration paid by a for-profit entity related to an ATEO.
Certain governmental entities, including state colleges and universities, that are not recognized under section 501(c) are not subject to section 4960. State entities that also have section 501(c) letters can relinquish the section 501(c) letters in order to become exempt from section 4960. However, if an entity excludes income under section 115(1), it is an ATEO and subject to section 4960.
Control organization or Control group
The Notice uses the same definition that is used in Form 990. The Notice specifically provides that Control is not determined under the section 414(b), (c) or (m) definitions. Under section 4960 a person or governmental entity is related to an ATEO if it:
- Controls or is controlled by the ATEO
- Is controlled by a person that controls the ATEO
- Is a supported organization (section 509(f)(3) or section 509(a)(3) OR
- For a VEBA – establishes or makes contributions to the VEBA
Control is generally more than 50 percent ownership, interest, or control of trustees.
One of the five highest-compensated employees on the basis of remuneration for services as an employee of the ATEO, including remuneration for services of a related entity.
Section 4960 remuneration uses the section 3401(a) (federal income tax withholding) definition but also includes Designated Roth contributions (to a 401(k) or 403(b) plan, for example) and includes section 457(f) amounts vesting in the year (whether or not paid in the year). Importantly, as well, the definition excludes director fees and retirement benefits (payments from qualified retirement plans such as 401(k) plans, 403(b) plans, and section 457(b) governmental plans).
Likewise, payments for medical services are not counted as covered employee remuneration. Q-15 defines direct medical or veterinary services so that an entity can allocate and exclude the portion of the compensation of doctors, nurses, nurse practitioners, dentists and veterinarians that is directly related to providing medical services. Medical services include diagnosis, treatment, mitigation or preventive care, including services affecting the structure or function of the body. Interestingly, generally medical services do not include administration, teaching or research services unless the medical processional is medical services as part of the above (presumably clinical research could fall within medical services even though there is a research component).
The Notice provides that the entity can use a reasonable method of allocating compensation between medical services and other services. An entity may be able to calculate the medical services time allocation by using billing or other medical service records.
Q 10 addresses several covered employee remuneration calculation timing issues. Importantly, the calculation focuses on remuneration paid in the calendar year ending with or within in employer’s taxable year. However, compensation for medical services is not counted in determining which employees are covered employees.
Q 10 also addresses more general ATEO Covered Employees rules. Under the Notice, each ATEO has its own group of 5 covered employees. There may be overlap between the various related organizations, but each must identify its own 5 covered for the year. As with section 162(m), an organization needs to keep a list of every employee who has been a covered employee (once the rules are effective for the entity) regardless of whether the excise tax may apply for that year, because it may apply in the future.
Remuneration must be appropriately allocated among the related entities. In Q-14 the Notice provides some discussion of general allocation rules for ATEOs that share employees. If same employee is a covered employee and provides services for the ATEO and related entities, the entities add together the remuneration from all entities and then allocate based on the service to each common law employee.
Common law employee rules apply for this purpose. The fact that a separate entity or related entity does the payroll reporting does not change the common law employment relationship and thus the ATEO that is a common law employer (or one of the common law employers) of an employee must generally count that individual’s compensation in determining the five most highly paid employees of the ATEO.
Where a given ATEO only pays less than 10 percent of an employee’s total remuneration, the ATEO does not usually count that person as a covered employee. However, if no ATEO in the group pays the individual more than 10 percent of the total remuneration, then the ATEO paying the highest amount may have to count the individual as a covered employee.
Under Q-13, section 457(f) deferred compensation amounts are “treated as paid” when no longer subject to a substantial risk of forfeiture. The Notice suggests use of section 457(f) proposed regulations definition of substantial risk of forfeiture. For a payment that will be made over time or at a later date, the calculation for the year of vesting includes the present value (PV) of the deferred compensation in which the covered employee vests, using reasonable actuarial methods. However, if an amount will actually be paid within 90 days of vesting, the company can use the PV on the vesting date.
It is not uncommon for a tax exempt entity to provide for deferred compensation. Some such arrangements are taxed and immediately paid as soon as vested. Other arrangements vest over time but are not paid until a later date. Under section 457(f), deferred compensation amounts are typically included in taxable income as soon as vested (other than section 457(b) limited savings arrangements, which may allow vested amounts to be included in taxable compensation at a later payment date).
Under the Notice, where arrangements provide for payments at a later date, any amount treated as paid because it has vested (generally under section 457(f)) is called, “Previously Paid Remuneration,” until actually or constructively paid. Once a covered employee has Previously Paid Remuneration, the earnings (or new accruals) on such Previously Paid Remuneration are counted as remuneration for section 4960 in year accrued, not the later year when paid. Once accrued and counted for section 4960, the earnings for the year become part of the Previously Paid Remuneration.
This Previously Paid Remuneration mechanism also essentially provides a grandfathering effect for amounts already vested in pre-section 4960 years but not yet paid (including any earnings before the section 4960 effective date). Such amounts are not subject to excise tax to the extent they were included (or, for earnings amounts after vesting, were accrued) in earlier years.
The Notice provides that the “treated as paid” language may apply to other types of compensation, not just section 457(f) deferred compensation. This might include annual bonuses, depending on how the bonuses are structured and paid.
Excess parachute payments
The Notice uses a calculation structure akin to the section 280G excess parachute payment structure, but the calculation only applies to payments contingent on separation from service rather than a change in control. The Notice borrows extensively from section 280G regulations, including the section 280G calculations for base compensation and three times base compensation and determining the present value calculations.
The Notice describes the following overall steps for calculating the excess parachute payments.
- Calculate total aggregate PV of separation payments (from ATEO and all related entities), using the special section 280G Q 24 valuation rules for acceleration of vesting on separation.
- Calculate base compensation
- Calculate the three times base threshold
If the aggregate payments are over the three times base compensation threshold, the parachute payments over one times base compensation are excess parachute payments. The excise tax is 21 percent of the excess parachute payments.
Payments considered, “contingent on a separation from service,” are generally payments that would not have been made but for the separation from service. This generally means amounts that are vesting on INVOLUNTARY separation. If an employee can voluntarily terminate and receive a benefit, the payment is generally not subject to a substantial risk of forfeiture.
Also, amounts included in taxable income in previous years (e.g. on vesting) and “excess remuneration,” discussed above, are not included as excess parachute payments.
Q-24, which focuses on the calculation of value for acceleration of amounts at an involuntary separation from service, borrows most of section 280G Q 24(b) and (c) for the acceleration calculations. Thus, where payments that would be made otherwise but where the vesting or availability is accelerated because of a separation from service, the guidance permits the entity to determine the acceleration value rather than using the full value of the amount paid. However, the Notice specifically provides that if acceleration seems to be tied to involuntary separation (discretionary acceleration “shortly” before an involuntary separation), the whole amount may have to be included as a parachute payment. The same is likely true of increased salary or other payments just before an involuntary separation.
Overall, the Notice appears to answer most of the outstanding section 4960 questions and uses familiar concepts from other related areas as often as possible. This will make section 4960 determinations easier, but, as with section 162(m) and section 280G calculations, ATEOs and their related entities will have to determine the related entities, choose a reasonable method for allocating compensation among the entities, and determine the appropriate remuneration for each calculation. Exempt organization professionals and compensation and benefits professionals will likely have to work together on some of the issues to address overlapping concepts.