United States

Proposed regulations address exempt organizations' excess compensation

New rules include favorable volunteer exceptions


On June 5, 2020, the Treasury Department and IRS released proposed regulations (REG-122345-18) under section 4960, providing exempt organizations and their related organizations with guidance on how to calculate the excise tax for remuneration paid in excess of $1 million and for any excess parachute payment to a covered employee. These regulations generally adopt and expand upon the preliminary guidance issued on Dec. 31, 2018 in Notice 2019-09 (the Notice). Read our prior RSM Tax Alert on the Notice.


The 2017 tax law (Pub. L. 115-97) 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. The Notice provided interim guidance on section 4960.


The proposed regulations generally follow the preliminary guidance of the Notice while adding additional clarity and addressing some previously unanswered questions.

The proposed regulations contain five separate parts:

Highlights of the proposed regulations, discussed in further detail below, include:

  • new volunteer exceptions, which serve to exclude remuneration paid by related taxable organizations to certain employees; 
  • a new exception from the definition of a related organization when control exists solely because a majority of lower-level employees serve as directors or trustees of a nonstock organization; and
  • an exclusion from the definition of a parachute payment when paid by a related organization.

Taxpayers may rely upon the proposed regulations in their entirety until promulgation of final regulations. Alternatively, taxpayers may continue to rely on the guidance provided in the Notice until such time. Finally, exempt organizations may rely on a reasonable, good faith interpretation of section 4960, considering all relevant facts and circumstances, and taking note of the specific positions that Treasury and the IRS have concluded are not consistent with a reasonable, good faith interpretation of the statute:

  • Related for-profit or governmental entities are not liable for their share of the excise tax under section 4960;
  • A covered employee ceases to be a covered employee after a period of time;
  • ATEOs include remuneration for medical services when identifying the five-highest compensated employees; and 
  • A group of ATEOs may have only five highest-compensated employees among all related ATEOs.


The first part of the proposed regulations include eight definitions: (1) applicable tax exempt organization (ATEO); (2) applicable year; (3) employee; (4) employer; (5) covered employee; (6) medical services; (7) predecessor; and (8) related organizations. The definitions do not differ significantly from those provided in the Notice but contain some important clarifications and exceptions. The definitions specific to remuneration and excess parachute payments appear in their relevant parts.

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An ATEO generally is a tax-exempt organization described in section 501(a), a farmers’ cooperative under section 521(b)(1), an entity that carries out an essential governmental function and excludes income under section 115(1), or a political organization described in section 527(e)(1). Highlights from the proposed regulations with respect to ATEOs include applicability of section 4960 to government entities and to foreign organizations. 

The proposed regulations confirm that governmental entities may be subject to the excise tax: directly if they excluded their income by reason of section 115(1) or indirectly if they are a related organization with respect to an ATEO. Moreover the proposed regulations suggest that federal instrumentalities described in section 501(c)(1) are subject to section 4960. 

With respect to foreign organizations, the proposed regulations exclude entities described in section 4948(b) from the definition of an ATEO (i.e., a foreign organization that receives substantially all of its support, other than gross investment income, from sources outside the United States). The proposed regulations leave open the issue as to whether such foreign organizations may nevertheless be a “related” organization for purposes of section 4960.

Applicable year

The proposed regulations continue to use the calendar year ending with or within the ATEO’s tax year as the relevant period for purposes of determining remuneration and computing the excise tax. It is important to note, that while it is helpful for the timing to match the Forms W-2 and 990 use of the calendar year, the definition of remuneration for section 4960 purposes is different, which may result in differences between the compensation reported on those forms from the amounts computed for purposes of section 4960. 

In addition, the new guidance clarifies how organizations should treat short tax years, as often occurs with initial or final tax years. Specifically, any short period that ends without a December 31 year-end will typically include the subsequent (in the case of an initial short period) or former (in the case of a final short period) calendar year in applying section 4960.

Employee and employer

As set forth in the Notice, the proposed regulations clarify that the federal income tax withholding definition of employee applies for purposes of section 4960. This definition includes common-law employees, officers or elected or appointed officials of governments, agencies, or instrumentalities, and corporate officers. The proposed regulations also clarify that the “minor services” exception applies, excluding from the definition of employee any officer that provides minor services without compensation.

Similarly, the proposed regulations define an employer to have the same definition as the federal income tax withholding definition of an employer without the benefit of the special rules for third-party payors. In other words, the payor of wages is not relevant for determining the employer under section 4960. Moreover, the sole member of disregarded entities is treated as the employer for purposes of section 4960.

Covered employee

Section 4960 provides that a covered employee is any employee (including any former employee) of an ATEO that is one of the five highest compensated employees for the taxable year, or was a covered employee for any preceding taxable year beginning after Dec. 31, 2016. To determine whether an employee is one of the five highest compensated employees, an ATEO must aggregate the remuneration it pays an individual with that paid by any related organization.

Consistent with the Notice, the proposed regulations provide that each ATEO determines its own group of five covered employees, which may result in a group of related organizations having more than five total covered employees for any given tax year. For these purposes, remuneration does not include amounts paid for the provision of medical services but does include amounts disallowed under section 162(m). 

The proposed regulations add two volunteer exceptions to the definition of covered employee, which will provide substantial relief to the numerous taxable organizations that donate services to related ATEOs. These exceptions exclude certain employees of a related non-ATEO from the definition of a covered employee if they provide services as an employee to a related ATEO and meet certain conditions:

  • Limited hours exception – Neither the ATEO nor any related ATEO pays remuneration to the individual for services rendered to the ATEO. In addition, the individual spends no more than 10% of his/her total work hours for the ATEO and its related ATEOs. The proposed regulations also set forth a safe harbor when the total hours expended for the ATEO and all related ATEOs does not exceed 100 hours.
  • Nonexempt funds exception – Neither the ATEO, any related ATEO, or any taxable organization controlled by the ATEO pays remuneration to the individual for services rendered to the ATEO. In addition, no related organization that pays remuneration to the individual may provide services for a fee to the ATEO, any related ATEO, or any taxable organization controlled by the ATEO. Finally, the individual spends less than 50% of his/her total work hours for the ATEO and its related ATEOs.

For related ATEOs, the proposed regulations also retain the limited services exception from the Notice. It generally provides that an individual is not a covered employee of an ATEO that pays less than 10% of the employee’s total remuneration for services performed as an employee of the ATEO and all related organizations. However, the proposed regulations clarify that this exception does not apply if there are no related ATEOs or if no ATEO pays more than 10% of the employee’s total remuneration.

Medical services

The proposed regulations define medical services as those directly performed by a licensed medical professional (as determined under state or local law) for “the diagnosis, cure, mitigation, treatment, or prevention of disease in humans or animals; services provided for the purpose of affecting any structure or function of the human or animal body; and other services integral to providing such medical services.” Although certain administrative tasks such as creating patient records are integral to providing medical services, managing an organization’s operations, including scheduling, staffing, performance evaluations, and other similar functions are not integral to providing medical services. Moreover, medical services generally do not include teaching or research services except to the extent that they involve direct patient care. 

Consistent with the Notice, the proposed regulations provide that the entity can use a reasonable method of allocating compensation between medical services and other services. A reasonable method may follow an allocation in an employment agreement or proportional time spent on medical vs non-medical services, but other reasonable allocations may exist as well. 


Covered employees also include a covered employee of a predecessor organization. The proposed regulations define a predecessor organization (which the Notice did not) by reference to acquisitions, mergers, reorganizations, and changes in exempt status. There are three rules for predecessor organizations:

  • 80% asset transfer rule – If an ATEO acquires at least 80% of the assets of a target ATEO over a 12-month period (longer if subject to a plan), the target ATEO is a predecessor organization.
  • 24-month services rule – A target ATEO’s covered employees become an acquiror ATEO’s covered employees if they commence services for the acquiror ATEO (or related organization) within a 24-month period (up to 12 months prior to or 12 months after the asset transfer).
  • 36-month limitation – An ATEO can be a predecessor to itself if it ceases to be an ATEO and, within 36 months of the original due date of its final Form 990-series return, becomes an ATEO again. 
Related organizations

In determining covered employees, ATEOs must include remuneration paid by related organizations. Consistent with the Notice, the proposed regulations generally utilize the definition of control set forth in section 512(b)(13) to determine whether an organization controls an ATEO or a non-ATEO. For these purposes, a person controls an organization if it owns more than 50% (by vote or value) of its stock (corporation), more than 50% of its capital or profits interests (partnership), or more than 50% of its beneficial interests (trust).

The removal power or representative test determines control over a nonstock organization:

• Removal power test – The power, directly or indirectly, to remove more than 50% of the nonstock organization’s directors or trustees.

• Representative test – More than 50% of the nonstock organization’s directors or trustees are also directors, trustees, officers, agents, or employees of the controlling person. Note that this test differs from other control tests by including “officers” of the controlling person. Furthermore, the proposed regulations offer an exception to this test if lower-level employee, not acting as a representative of his or her employer, serves as a director or trustee of the nonstock organization. Claiming this exception requires disclosure on the ATEO’s Form 990.


Section 4960 defines remuneration as wages within the meaning of section 3401(a) (federal income tax withholding) and amounts required to be included in income under section 457(f) with the exception of amounts paid with respect to the provision of medical services. The definition also excludes director fees, and retirement benefits such as payments from qualified retirement plans such as 401(k) plans, 403(b) plans and section 457(b) governmental plans. The proposed regulations also include in remuneration any amounts includible in gross income as compensation under section 7872, generally referring to below-market split-dollar loans.

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Under section 4960, remuneration is treated as paid when there is no substantial risk of forfeiture (within the meaning section 457(f)(3)(B)) of the rights to that remuneration. Thus, the section 4960 excise tax can apply to remuneration that is vested, even if it is not yet received. The Notice did not allow for exceptions to this timing, creating disparity among income, payroll, and the section 4960 excise taxes.

Similarly, the proposed regulations generally do not provide exceptions to ease the applicability of this rule, notably declining to adopt the short-term deferral rule for items that are paid within 2 and a half months of the year end of vesting, which are generally excepted from section 457(f) treatment. However, the proposed regulations do carve out “regular wages” as included at actual or constructive payment, which should ease the burden for pay periods that cross calendar years. Treas. Reg. section 31.3402(g)-1(a)(ii) defines “regular wages.”

Previously paid remuneration

Similar to the Notice, the proposed regulations follow a “previously paid remuneration” analysis to determine when to include earnings or losses on amounts previously vested. Once a covered employee has previously paid remuneration, the net earnings (or new accruals) on such amounts are treated as remuneration for section 4960 purposes the year in which they accrue, not the later year when paid. These amounts then become previously paid remuneration. Note that any accrued losses may be carried forward to future years.

This previously paid remuneration mechanism provides a grandfathering effect for amounts vested (but not yet paid) in years prior to the effective date of section 4960 (tax years beginning before Jan. 1, 2018). However, the proposed regulations specifically declined to adopt an overall grandfather rule similar for written binding contracts entered into before a particular date as exists for section 162(m). 

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Parachute payments

The excise tax under section 4960 also applies to excess parachute payments to covered employees even if the amounts are less than $1 million provided that the payments are contingent upon an involuntary separation from service. The proposed regulations utilize the section 409A and 457 definitions of involuntary separation from employment and include a separation from employment for good reason under certain circumstances.

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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 refers to amounts that vest on INVOLUNTARY separation and would not have otherwise vested, including acceleration of vesting. If an employee can voluntarily terminate and receive a benefit, the payment is generally not subject to a substantial risk of forfeiture, but rather the separation solely dictates the timing of that payment. However, the proposed regulations do include the value of accelerated payments plus the value of accelerated vesting as contingent on the separation from employment when the separation causes an acceleration of a payment that would otherwise have vested and been paid in the future.

Following the statute and Notice, the proposed regulations heavily rely on section 280G and its regulations to compute a parachute payment and determine whether there is an excess parachute payment. Specifically, the proposed regulations adopt the 280G calculations for determining base compensation (generally the annualized compensation over the most recent five-year period), three times base compensation, and determining the present value of such amounts. 

The proposed regulations do depart from guidance in the Notice with respect to parachute payments made by related organizations. The proposed regulations include remuneration from related organizations in the base compensation calculation and the total parachute payments, but non-ATEOs are not subject to section 4960 tax for the specific parachute payments they make. Rather, only the ATEO is subject to the tax on payments it makes; however, the Commissioner may reallocate payments if it is determined payments were made by the non-ATEO only to avoid the tax.

Tax liability

The proposed regulations provide that each employer is responsible for reporting and remitting its own portion of the applicable excise tax under section 4960. 

An individual may be an employee of an ATEO and of one or more related organizations during the same applicable year, in which case, remuneration must be aggregated for purposes of determining whether excess remuneration has been paid and computing the tax. To address this situation, the proposed regulations provide guidance for allocating the excise tax liability among the employers.

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With respect to excess parachute payments, the proposed regulations clarify that an employer may elect to prepay the excise tax imposed in the year of separation from employment or any taxable year prior to the year in which the parachute payment is actually paid. 

The proposed regulations also confirm that the excise tax is not subject to quarterly estimated payments. 

Applicability date

The proposed regulations are expected to be effective for taxable years beginning after Dec. 31 of the calendar year in which they are published as final in the Federal Register.

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