In IRS Notice 2019-09 (the “Notice”), the Internal Revenue Service (“IRS”) has provided guidance on the excise tax imposed on a tax-exempt entity under Code section 4960 that pays excess remuneration (or an excess parachute payment) to an employee. Here are the highlights of the Notice.
The General Rule of Code Section 4960. Under Code section 4960, an applicable tax-exempt organization (an “ATEO”) that pays excess remuneration or makes an excess parachute payment to a covered employee during a taxable year is subject to an excise tax on this excess. The rate of this excise tax is equal to the rate of tax under Code section 11. For taxable years beginning after December 31, 2017, this rate of tax is 21 percent.
What is An ATEO? As provided in Code section 4960(c)(1), an ATEO is any organization which, for its taxable year:
— is exempt from taxation under Code section 501(a);
— is a farmers’ cooperative organization described in Code section 521(b)(1);
— has income excluded from taxation under Code section 115(1) (income from a state exercising an essential government function); or
— is a political organization described in Code section 527(e)(1).
A governmental entity may also be an ATEO.
Who is a Covered Employee? A “covered employee” is any employee (including any former employee) of an ATEO, if the employee: (1) is one of the five highest-compensated employees of the organization for the taxable year of the ATEO, or (2) was a covered employee of the ATEO for any of the ATEO’s preceding taxable years beginning after December 31, 2016. Generally, the determination of whether an employee is included in clause (1) is made on the basis of his or her remuneration for services performed as an employee of the ATEO. The remuneration used for this purpose are amounts paid to the employee during the calendar year ending with or within the ATEO’s taxable year.
What is Remuneration? The term “remuneration” has the same meaning as the term “wages,” as defined in Code section 3401(a), except that it excludes any designated Roth contribution (as defined in Code section 402A(c)), and includes amounts required to be included in gross income under Code section 457(f). Remuneration includes an amount that is a parachute payment; however, a parachute payment is not subject to tax as excess remuneration if it is also subject to tax as an excess parachute payment. Remuneration paid by another organization, whether or not a related organization (see below), with respect to an employee’s employment by an ATEO, is treated as remuneration paid by that ATEO for purposes of section 4960. The amount of remuneration treated as paid upon vesting is the present value (on the vesting date) of the future payments to which the participant has a legally binding right.
What are Section 3401(a) Wages? Code section 3401(a) wages are generally all pay for services performed by an employee for his employer (with certain exceptions provided under section 3401(a)(1) through (a)(23)), including the cash value of all remuneration (including benefits) paid in any medium other than cash. Among the more broadly applicable exclusions, section 3401(a)(12) provides that wages do not include remuneration paid to, or on behalf of, an employee or his beneficiary:
— as a payment of benefits from or to a trust described in Code section 401(a) which is exempt from tax under Code section 501(a);
— under or to an annuity plan described in Code section 403(a);
— as a payment described in Code section 402(h)(1) and (2) (that is, a payment from a simple pension plan), if it is reasonable to believe that the payment will be excludible from tax under section 402;
— under an arrangement to which Code section 408(p) applies; or
— under or to an eligible deferred compensation plan which is described in Code section 457(b) and which is maintained by a governmental employer.
What is Excess Remuneration? For each covered employee, “excess remuneration” is the excess (if any) for a taxable year of the remuneration that is paid (other than any excess parachute payment) by an ATEO over $1 million for the calendar year ending with or within the taxable year.
What is an Excess Parachute Payment? An “excess parachute payment”, for a taxable year, is the excess of the amount of any parachute payment made by an ATEO to a covered employee over the portion of his or her base amount that is allocated to the payment, for the calendar year ending in the taxable year. Allocation is made in accordance with the Notice. The “base amount” is the average annual compensation for services performed as an employee of the ATEO, if the compensation was includible in the gross income of the individual, with respect to whom there has been a separation from employment, for taxable years in the base period. The “base period” is generally the covered employee’s five most recent taxable years ending before the date on which he or she separates from employment.
What is a Parachute Payment? A “parachute payment” is any payment in the nature of compensation made by an ATEO to (or for the benefit of) a covered employee if:
— the payment is contingent on the employee’s separation from employment with the employer; and
— the aggregate present value of the payments in the nature of compensation to (or for the benefit of) the individual that are contingent on the separation equals or exceeds an amount equal to three times the base amount.
The term “parachute payment” does not include any payment: (1) to or from a plan described in Code section 401(a) that includes a trust exempt from tax under Code section 501(a), an annuity plan described in Code section 403(a), a simplified employee pension (as defined in Code section 408(k)), or a simple retirement account described in Code section 408(p), (2) made under or to an annuity contract described in Code section 403(b) or a plan described in Code section 457(b), or (3) made to an individual who is not a highly compensated employee as defined in Code section 414(q) (an “HCE”). If an employee is an HCE at the time of the separation from employment, then any parachute payment made as a consequence of the separation from employment is treated as paid to an HCE, even if the payments occur during one or more later taxable years (that is, taxable years after the taxable year during which the employee separated from employment).
What is Payment In The Nature Of Compensation? A payment is generally “in the nature of compensation” if the payment arises out of an employment relationship, including holding oneself out as available to perform services and refraining from performing services. Thus, for example, payments made under a covenant not to compete or a similar arrangement are payments in the nature of compensation. A payment in the nature of compensation includes (but is not limited to) wages and salary, bonuses, severance pay, fringe benefits, life insurance, pension benefits, and other deferred compensation (including any amount characterized by the parties as interest or earnings thereon). A payment in the nature of compensation also includes cash when paid, the value of the right to receive cash, including the value of accelerated vesting, or a transfer of property. In general, a payment in the nature of compensation is considered made in the taxable year in which it is includible in the covered employee’s gross income (in the case of taxable non-cash fringe benefits, consistent with IRS Announcement 85-113) or, in the case of fringe benefits and other benefits that are excludible from income, in the taxable year the benefits are received. Special rules apply to stock compensation.
NOTE: A “related organization” could also be liable for the excise tax on amounts it pays to a covered employee, and the payments it makes to a covered employee may have to be taken into account in determining the remuneration, excess remuneration and excess parachute payments made by the ATEO to a covered employee for a taxable year.
What is a Related Organization? As provided in Code section 4960(c)(4)(B), a person or governmental entity is related to an ATEO if such person or governmental entity:
— controls, or is controlled by, the ATEO;
— is controlled by one or more persons which control the ATEO;
— an organization which is supported by the ATEO within the meaning of Code section 509(f)(3);
— an organization which supports the ATEO within the meaning of Code section 509(a)(3); or
— in the case of an ATEO which is a voluntary employees’ beneficiary association described in Code section 501(c)(9) (a “VEBA”), establishes, maintains, or makes contributions to such VEBA.
What is the effective Date? Section 4960 applies to taxable years of an employer beginning after December 31, 2017. Remuneration paid before the beginning of the first taxable year that begins after December 31, 2017, is not subject to the excise tax under section 4960.
See the Notice for reporting requirements, liability for paying the excise tax and other details.