The Tax Cuts and Jobs Act of 2017 created Section 4960 of the Internal Revenue Code ("Section 4960"), which imposes a 21% excise tax on excess compensation paid by an applicable tax-exempt organization to its five highest-paid employees ("covered employees"). Pending the issuance of proposed regulations, the IRS issued interim guidance, Notice 2019-09 (the "Notice"), to assist taxpayers in applying Section 4960. The Notice provides numerous Q&As that address issues surrounding the application of Section 4960.
Which Employers Are Affected?
Section 4960 applies to organizations exempt from taxation under Section 501(a) and "related organizations." Related organizations with respect to an applicable tax-exempt organization ("ATEO") include entities that control or are controlled by the ATEO.
Who Are Covered Employees?
An ATEO's covered employees are its five highest-compensated employees for the taxable year plus any employees who were covered employees for any of the ATEO's prior tax years beginning after December 31, 2016. Accordingly, an individual who is a covered employee at any point beginning in 2017 or later will always retain that status, even after retirement. The determination of the highest-compensated employees is based on the employee's compensation for services performed for both the ATEO and related organizations.
What Payments are Subject to the Excise Tax?
The 21% excise tax applies to (a) remuneration over $1 million paid during the taxable year to a covered employee, and (b) any excess parachute payments paid to a covered employee. "Remuneration" includes wages paid to the employee and nonqualified deferred compensation included in the employee's gross income under Section 457(f). An "excess parachute payment" means the portion of a payment to a covered employee contingent on separation from employment, which exceeds three times the employee's average annual compensation for the ATEO or a related organization for the five years preceding such separation.
Who is Taxed?
The excise tax is imposed on the common-law employer of the covered employee. Generally, when a covered employee has more than one common-law employer, and each such employer is an ATEO or related organization, each employer is liable for the share of the Section 4960 excise tax allocable to the remuneration paid by such employer.
What Should Tax-Exempt Entities Do Next?
ATEOs should review their existing compensation arrangements for highly compensated employees to identify opportunities that may avoid or minimize the Section 4960 excise tax. For example, the vesting of deferred compensation could be staggered over several years (as opposed to cliff vesting) to avoid the excess remuneration tax. Similarly, severance payments could be reduced to avoid the parachute payment tax.
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