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In proposed regulations (REG-122345-18), the IRS answers many of the questions concerning IRC Section 4960, which imposes an excise tax on "applicable tax-exempt organizations" (ATEOs) based on remuneration that is (1) paid in a tax year to a "covered employee" and (2) either exceeds $1 million (excess compensation) or is an excess parachute payment.

The excise tax imposed on ATEOs is at the IRC Section 11 rate on corporations, which is currently 21%. The proposed regulations help clarify when taxable organizations that are related to tax-exempt organizations may also be liable for the excise taxes. This situation can occur in health care systems, universities and other groups comprised of multiple entities, including related tax-exempt, governmental and for-profit entities.

The proposed regulations define relevant terms as well as provide rules for determining:

• The amount of remuneration paid for a tax year (including for purposes of identifying covered employees)
• Whether excess remuneration is paid and in what amount
• Whether an excess parachute payment is paid and in what amount
• The allocation of liability for the excise tax among related organizations

The proposed regulations also answer some questions that were not fully addressed in Notice 2019-09, such as whether people who volunteer at a tax-exempt organization while working at a related corporation, or who work a limited number of hours at an ATEO, must be counted as employees of the ATEO for purposes of determining the top five most highly compensated employees of the ATEO, and therefore covered employees, for a given tax year.

Background

IRC Section 4960 was enacted by the Tax Cuts and Jobs Act of 2017 (TCJA). The IRS released Notice 2019-09 on December 31, 2018, as interim guidance on IRC Section 4960 (see Tax Alert 2019-0145). The proposed regulations are based principally on Notice 2019-09, with more guidance on additional issues raised by IRC Section 4960, such as how to define a predecessor organization for the purpose of determining who is a covered employee. The proposed regulations would apply to covered employees who work for an ATEO for a calendar year and either receive remuneration of more than $1 million or an excess parachute payment (even if it is less than $1 million).

ATEOs, related organizations and governmental entities

An ATEO is an organization that (1) is exempt from tax under IRC Section 501(a), (2) is a farmers' cooperative organization under IRC Section 521(b)(1), (3) has income excluded from taxation under IRC Section 115(1) or (4) is a political organization described in IRC Section 527(e)(1). A "related organization" generally is a person or governmental entity if that person or entity: (1) controls, or is controlled by, the ATEO; (2) is controlled by one or more persons that control the ATEO; (3) is a supported organization of the ATEO, as defined in IRC Section 509(f)(3); or (4) is a supporting organization described in IRC Section 509(a)(3) with respect to the ATEO.

Normally, governmental entities, such as state colleges or universities, are excluded from the ATEO definition. A governmental unit is an ATEO, however, if it has an IRC Section 501(a) tax exemption letter from the IRS or income excluded from taxation under IRC Section 115(1). Even if it is not an ATEO, a governmental entity may still be subject to the IRC Section 4960 excise tax if it is a related organization to an ATEO and employs a covered employee. Like Notice 2019-09, the proposed regulations would permit a government entity that qualifies as an ATEO by virtue of IRC Section 501(a) to relinquish tax-exempt status and thereby avoid ATEO status under IRC Section 4960.

Under the proposed regulations, federal instrumentalities that are not states, political subdivisions, or integral parts thereof generally would be subject to IRC Section 4960. The Preamble to the proposed regulations requests further comments on this subject.

A foreign organization that otherwise qualifies as an ATEO would avoid ATEO status if, under IRC Section 4948(b), it receives substantially all support (other than gross investment income) from the date of its creation from sources outside of the United States. The Preamble requests comments on whether a similar exception should apply to exempt foreign organizations from the definition of a related organization, for purposes of IRC Section 4960.

Implications

As expected, the proposed regulations continue to treat most governmental entities that rely on IRC Sections 501(a) or 115(1) for federal tax exemption, such as federal instrumentalities, as being subject to IRC Section 4960. The IRS and Treasury request comments on how IRC Section 4960 applies to such instrumentalities.

Employees and employers

A covered employee is any individual who is one of the five highest-compensated employees of the ATEO for a tax year or was a covered employee of the ATEO (or any predecessor) for any preceding tax year beginning after December 31, 2016. The proposed regulations define "employer" and "employee" consistent with the definitions of "employer" and "employee" for purposes of federal income tax withholding under IRC Section 3401. These definitions include common-law employees and certain officers of corporations, whether or not those officers receive compensation.

In a group of related organizations, the five highest-compensated employees are determined separately for each ATEO. As a result, a group of related ATEOs can have more than five covered employees for a tax year. In addition, an employee can be a covered employee for more than one ATEO in a group.

Consistent with Notice 2019-09, for purposes of determining whether an employee is one of an ATEO's five highest-compensated employees for a tax year, remuneration paid by the ATEO during the applicable year is aggregated with remuneration paid by any related organization during the applicable year, including remuneration paid by a related for-profit organization or governmental entity, for services performed as an employee of that related organization.

Under the statutory text, an individual who is a covered employee of an ATEO (or its predecessor) for one tax year remains a covered employee of that ATEO (and any successor ATEOs) for subsequent tax years of that ATEO. Consistent with Notice 2019-09, the proposed regulations confirm that covered employees retain that status indefinitely.

Definition of predecessor. The proposed regulations for the first time define "predecessor" under IRC Section 4960 by referencing several categories of organizational changes, including acquisitions, mergers, other reorganizations and changes in tax-exempt status. The Preamble explains that these rules are generally intended to be consistent with analogous rules in recently proposed regulations under IRC Section 162(m), but with modifications to reflect the tax-exempt context in which IRC Section 4960 arises. For example, if an acquiror ATEO were to acquire at least 80% of the operating assets or total assets of a target ATEO, then the target ATEO would be a predecessor of the acquiror ATEO. Only the target ATEO's covered employees who provided services for the acquiror ATEO (or a related organization) during the period beginning 12 months before and ending 12 months after the date on which all events necessary for the acquisition to have occurred would become the acquiror ATEO's covered employees. The acquisition may be by gift or for bona fide consideration. Additionally, an ATEO would be treated as its own successor if its ATEO status lapses and subsequently resumes in a tax year that ends within 36 months of the lapse.

Implications

The proposed regulations generally follow Notice 2019-09 by reiterating that a covered employee is determined on an ATEO-by-ATEO basis and that no controlled group rules apply to a group of tax-exempt organizations for IRC Section 4960 purposes. The parent of a group of tax-exempt organizations, however, can structure its employee control and compensation arrangements to limit the group's number of covered employees and affiliates subject to the IRC Section 4960 excise tax. For instance, the parent may employ all employees in the group and clarify in management/service agreements with affiliates that employees of the parent who provide services to an affiliate do so as agents of the parent, under its control and not as employees of the affiliate.

The proposed regulations also maintain that covered employee status applies indefinitely, which underscores the importance of tracking covered employees because they remain covered employees of the ATEO even if they are no longer employed by that ATEO.

Even though government organizations and taxable organizations are not ATEOs for IRC Section 4960 purposes, they are liable for reporting (on Form 4720) and paying the compensation excise tax on their portion of any excess compensation paid to a covered employee of any related ATEOs. Accordingly, an ATEO's related organizations need to be aware of their potential IRC Section 4960 payment and reporting obligations. Similarly, acquisitive tax-exempt organizations may want to analyze the target organization's (and any related organization's) compliance with IRC Section 4960 in order to avoid any unexpected excise tax liabilities.

Corporate foundations and volunteers

There was concern that the excise tax would apply to people who volunteer at a corporate foundation or other ATEO (e.g., as an officer of the ATEO) while working at a related taxable corporation, or who work a limited number of hours at an ATEO. The IRS noted in the Preamble to the proposed regulations that it received many comments about this issue and invited further comments.

The proposed regulations provide two exceptions under which "volunteers" would not be treated as covered employees: (1) the "limited-hours" exception and (2) the "nonexempt funds" exception. Both exceptions would require that neither the ATEO nor any related ATEO pay remuneration or grant a legally binding right to nonvested remuneration to the employee for services performed as an ATEO employee.

Under the limited-hours exception, the hours (or days) the individual works at the ATEO and related ATEOs can only make up 10% or less of the total hours (or days) the individual works for the ATEO and all related organizations during the year. An individual would be deemed as having satisfied this requirement if the individual works no more than 100 hours for the ATEO and all related ATEOs during the year.

Under the nonexempt funds exception, the threshold for hours (or days) worked for the ATEO and related ATEOs is less than 50% of the total hours (or days) the individual works for the ATEO and all related organizations (including both ATEOs and taxable organizations) for the year. In addition, no related organization may provide paid services to the ATEO, any related ATEO(s), or taxable related organization(s) controlled by the ATEO and/or related ATEOs.

Implications

The breadth of these exemptions, as well as the discussion of the underlying issues in the Preamble to the proposed regulations, suggest that Treasury and the IRS tried to thoroughly cover and exempt from covered employee treatment those employees of taxable organizations who provide volunteer services to related ATEOs. Taxpayers that have similar employee-sharing arrangements and believe these exceptions would not cover their arrangements should consider commenting on the proposed regulations. As the IRS and Treasury have been willing to consider comments and provide reasonable exceptions to make IRC Section 4960 more administrable, they would likely consider additional comments on how to apply the regulations to taxpayers' specific facts and circumstances and how to interpret IRC Section 4960 to both honor congressional intent and limit taxpayer burden.

Definition of remuneration

Remuneration for purposes of identifying who is a covered employee includes remuneration paid by an ATEO and a related organization. IRC Section 4960 defines "remuneration" as including wages paid under IRC Section 3401(a), related to federal income tax withholding, with some modifications. For instance, remuneration generally includes amounts required to be included in income under IRC Section 457(f) plans but does not include designated Roth contributions to tax-favored employer-sponsored retirement plans or amounts paid to a licensed medical professional (including a veterinarian) that is directly related to the performance of medical or veterinary services by that professional. Consistent with Notice 2019-09, the proposed regulations narrowly define amounts that may be excluded from application of the excise tax rules by limiting excluded remuneration to remuneration for "medical care" services (i.e., services for the diagnosis, cure, mitigation, treatment or prevention of disease, including services affecting any bodily structure or function, and services that are integral to providing these medical services, such as creating patient records). Remuneration for teaching or research is not excluded, unless the services meet the "medical care" definition.

The proposed regulations clarify that certain nontaxable benefits are not considered remuneration, including: (1) expense allowances and reimbursements under an accountable plan and (2) most insurance for liability arising from service with an ATEO, such as directors' and officers' liability insurance.

The Preamble requests comments on whether certain taxable benefits, such as employer-provided parking that exceeds the value excluded under IRC Section 132, should be disregarded for purposes of determining whether an individual receives remuneration for services for this purpose and, if so, what standards should apply to identify those benefits.

In addition, the proposed regulations clarify that remuneration includes any amounts includible in gross income as compensation under IRC Section 7872 and related regulations (such as a below-market split-dollar loan between an employer and employee).

Applicable year. IRC Section 4960 refers to remuneration paid in the tax year but does not specify whether the remuneration is measured in the employer's tax year or the covered employee's tax year (e.g., the calendar year). Consistent with Notice 2019-09, the proposed regulations identify the applicable year as the calendar year ending with or within an ATEO's tax year. For the tax year in which an organization becomes an ATEO, the applicable year would begin on the date the organization becomes an ATEO and end on December 31 of that calendar year (short applicable year). If an ATEO's exempt status ceased on or before December 31, then the applicable year for that tax year would start January 1 and end on the date of termination of status. If the termination of exempt status occurred after December 31 of the calendar year ending within the tax year of the termination, then the ATEO would have two applicable years for the tax year: (1) the full calendar year ending within the tax year in which the termination of ATEO status occurs and (2) the period starting on January 1 of the calendar year in which termination of ATEO status occurs and ending on the date of termination.

Pay periods straddling calendar years. Consistent with Notice 2019-09, the proposed regulations would generally treat the present value of all remuneration as paid when it is no longer subject to a "substantial risk of forfeiture" (i.e., upon vesting) under IRC Section 457(f)(3)(B) and make clear that this rule applies to all remuneration, not just deferred compensation. In response to commenters' requests for an exception for pay periods straddling calendar years, the proposed regulations would allow "regular wages" under Treas. Reg. Section 31.3402(g)-1(a)(1)(ii) to be treated as paid when actually or constructively paid rather than upon vesting. Thus, for example, salary paid early in 2022 for services performed in the last week of 2021 would be treated as paid in 2022, whereas a bonus (or any other amount treated as supplemental wages) that vested in 2021 but was paid in 2022 would be treated as paid in 2021. The proposed regulations would permit, for administrative convenience, employers to treat the present value of the remuneration as the amount ultimately paid if remuneration were paid within 90 days of vesting.

Remuneration disallowed under IRC Section 162. The proposed regulations would prohibit remuneration for which a deduction is disallowed under IRC Section 162(m) from being treated as remuneration paid to a covered employee. Thus, remuneration for purposes of IRC Section 4960 generally would not include remuneration paid to an ATEO covered employee who is also a covered employee of a related "publicly held corporation." It also would not include renumeration that is paid to an applicable individual of a related "covered health insurance provider" (as defined in IRC Sections 162(m)(2) and (m)(6)(C), respectively), and for which a deduction is disallowed under IRC Section 162(m). That remuneration is, however, considered for purposes of determining the ATEO's five highest-compensated employees. In the proposed regulations, the IRS and Treasury suggested some alternative approaches and requested comments on how to account for the timing mismatch between when an amount is included in remuneration under IRC Section 4960 and when the deduction is disallowed under IRC Section 162(m), recognizing that the two may be many years apart, and that whether disallowance will occur may not be clear until the later year.

Implications

The proposed regulations' rules for remuneration are mostly consistent with Notice 2019-09, with some helpful clarifications and limited administrative relief. Some taxpayers that have not been applying IRC Section 4960 consistent with Notice 2019-09 may wish to comment on the proposed regulations in hopes of attaining a different rule in the final regulations. In some cases, taxpayers may reasonably interpret the consistency between Notice 2019-09 and the proposed regulations as an indication that the Treasury Department and the IRS are not inclined to reverse course. On some issues, however, the Treasury Department and the IRS have specifically invited comments, suggesting that they may be open to input from the public. These issues include (1) whether to disregard certain taxable benefits to individuals when determining whether those individuals receive remuneration, (2) how to design a short-term deferral rule that (a) treats remuneration as paid at the time of actual payment, (b) reduces burden, and (c) prevents tax avoidance, and (3) reasonable methods of allocating remuneration between medical services and other services.

Excess parachute payments

A parachute payment is the aggregate present value of all payments in the nature of compensation to a covered employee that are contingent on the employee's separation from service and exceed three times the individual's base amount (generally the individual's average annual compensation over the preceding five years). An "excess parachute payment" on which an ATEO would pay the IRC Section 4960 excise tax is the amount of the payment that exceeds the individual's base amount — not the amount that exceeds three times the base amount.

Consistent with Notice 2019-09, the proposed regulations would limit parachute payments to amounts paid solely due to an involuntary termination of employment and generally adopt the standards under Treas. Reg. Section 1.409A-1(h)(1)(ii) to determine when a reduction in services results in separation from employment.

Contrary to Notice 2019-09, the proposed regulations would not impose the IRC Section 4960 excise tax on excess parachute payments made by related organizations.

Implications

In practice, the excess parachute payment rules are only relevant when the individual's remuneration does not exceed $1 million. Where the excess parachute payment rules are relevant, however, an ATEO could reduce its risk of incurring excise tax from excess parachute payments by structuring its compensation and severance arrangements with employees to cap any severance payments at three times or less than the employee's base compensation amount for the prior five tax years.

Conclusion

The proposed regulations would apply to tax years beginning on or after the date the final regulations are published in the Federal Register. Comments on the proposed regulations must be received by August 10, 2020. The Preamble states that the Treasury Department and the IRS will take into account the time of year the final regulations are published when deciding the final applicability date, understanding that taxpayers will need time to familiarize themselves with the final regulations and make the necessary adjustments.

Pending final regulations, taxpayers may still rely on (1) a reasonable, good-faith interpretation of the statute, (2) Notice 2019-09, (3) the proposed regulations or (4) any combination of the three.

If you have any additional questions, please contact your EY representative.

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