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The IRS has issued final regulations (TD 9938) under Internal Revenue Code (IRC) Section 4960, which imposes an excise tax on applicable tax-exempt organizations (ATEOs) and related organizations that pay remuneration over $1 million (excess compensation) or an excess parachute payment to a covered employee.

The final regulations retain the basic principles of the proposed regulations, making relatively minor clarifications and modifications. The final regulations will apply to tax-exempt organizations' tax years beginning in 2022. Until then, tax-exempt organizations can rely on the interim guidance in Notice 2019-09 (see Tax Alert 2019-0145), the proposed regulations (see Tax Alert 2020-1559), the final regulations, or a reasonable, good-faith interpretation of the statute that includes consideration of any relevant legislative history.

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 that (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. The final regulations generally align the definition of "control" with the definition in the Form 990 instructions, with some modifications; including:

• For Section 4960 purposes, an individual’s control of a nonstock corporation is attributed to the individual’s family members, whereas no such family member attribution is required for Form 990 purposes.
• For Form 990 purposes, an entity is deemed to control a nonstock organization if the entity’s board members, officers, employees or agents comprise a majority of the nonstock organization’s board, even if overlap is accidental, because such persons are deemed to be representatives of the entity.  The Section 4960 final regulations contain a similar rule, but add an exception.  The final regulations provide that an entity’s employees (other than (i) officers, (ii) directors, or (iii) employees who have officer or director powers) who happen to be on the board of a nonstock organization can be excluded from the “representative” definition if certain requirements are met. 

Normally, governmental entities, such as state colleges or universities, are excluded from the ATEO definition. A governmental entity 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, and employs a covered employee of, an ATEO. A government entity that qualifies as an ATEO by virtue of IRC Section 501(a) may relinquish its tax-exempt status and thereby avoid ATEO status under IRC Section 4960.

The proposed regulations do not resolve the question of whether federal instrumentalities are ATEOs. In the Preamble to the final regulations (Preamble), the IRS stated that it is still considering this issue for further guidance. In the meantime, a federal instrumentality for which an enabling act provides for exemption from all current and future federal taxes may treat itself as not subject to tax under IRC Section 4960 as an ATEO or related organization. If a federal instrumentality is a related organization of an ATEO, however, the Preamble also stated that the ATEO must take into account any remuneration the federal instrumentality pays for IRC Section 4960 purposes.

Corporate foundations and volunteers

The interim guidance in Notice 2019-09 raised concerns that the excise tax would apply if employees of a taxable organization volunteered at a related corporate foundation or other ATEO (e.g., as an officer of the ATEO), or worked a limited number of hours at a related ATEO.

The proposed regulations created two exceptions under which individuals would not be treated as covered employees: (1) the "limited-hours" exception and (2) the "non-exempt funds" exception. Both exceptions require that neither the ATEO nor any related ATEO pay remuneration or grant a legally binding right to non-vested remuneration to the employee for services performed as an ATEO employee. The "non-exempt funds" exception also extends this requirement to taxable related organizations controlled by the ATEO or any related ATEOs.

The final regulations adopt the limited-hours exception without substantive modifications. Under this 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 is deemed to have satisfied this requirement, and is treated as having worked no more than 10% of the employee's total hours, if the individual works no more than 100 hours for the ATEO and all related ATEOs during the year.

The final regulations also adopt the non-exempt funds exception, but with two substantive modifications. Under this 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 for the current year and the preceding year (the proposed regulations considered only the current 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.

The final regulations revise the attribution rules for control, for purposes of the non-exempt funds exception, to disregard the application of downward attribution in applying IRC Section 318(a)(3) principles to stock and nonstock corporations and trusts. For example, if an individual commonly controls Taxable Corporation 1, Taxable Corporation 2 and an ATEO, the ATEO is not deemed to control either Taxable Corporation 1 or 2 for purposes of the non-exempt funds exception.

Foreign organizations

The proposed regulations excluded foreign organizations described in IRC Section 4948(b)¹ from ATEO status and requested comments on their status as related organizations. The final regulations retain the proposed rule and exclude these organizations from tax if they are either exempt from tax under IRC Section 501(a) or are taxable foundations described in IRC Section 4948(b). However, the ATEO and any other related organizations must take remuneration paid by these entities into account for purposes of determining both the ATEO's five most highly compensated employees for a year and any applicable excise tax under IRC Section 4960. The final regulations clarify that the determination of whether an organization meets the requirements of IRC Section 4948(b) is made at the end of its tax year.

Remuneration

The final regulations adopt the proposed regulations' definition of remuneration, with some minor modifications. IRC Section 4960(c)(3)(B) excludes from remuneration the portion of any payment to a licensed medical professional for the performance of medical services. The proposed regulations limited this exclusion 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 certain administrative services that are integral to providing these medical services, such as creating patient records). The final regulations retain the proposed rule but clarify that an employer may make a reasonable, good-faith allocation between remuneration for medical and non-medical services, regardless of the form of compensation, and that an employer may apply the same principles to contributions and earnings under a deferred compensation plan.

The proposed regulations generally treated 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 made clear that this rule applies to all remuneration, not just deferred compensation. The proposed regulations allowed an employer to treat the entire amount to be paid on a future date within 90 days of vesting as the present value on the date of vesting but limited that rule to non-account balance plans. The final regulations expand this rule to any vested amount that is scheduled to be paid within 90 days. Thus, for example, an employer is not required to calculate the present value of a bonus that vests on December 31, 2022, and is scheduled to be paid on February 15, 2023, to reflect the delay in payment; instead, the employer may treat the full amount paid in 2023 as remuneration in 2022. Alternatively, the employer may treat the present value of the payment on December 31, 2022, as 2022 remuneration and the increase in value in 2023 as 2023 remuneration. However, the employer may not simply treat the full value of the payment as 2023 remuneration.

Coordination with IRC Section 162(m)

The excess-compensation component of IRC Section 4960 is loosely based on the $1 million deduction limit under IRC Section 162(m), which applies to compensation a publicly held corporation pays to certain officers. IRC Section 4960(c)(6) coordinates the two provisions by excluding from IRC Section 4960 any amount of compensation paid by a publicly held corporation that is non-deductible because of IRC Section 162(m). Coordination of IRC Section 162(m) and IRC Section 4960 is complicated by the fact that they are based on different timing rules. The excess-compensation component of IRC Section 4960 is generally based on vesting, whereas IRC Section 162(m) may not disallow the employer's deduction until payment occurs. It would not be uncommon for an employer to need to calculate its IRC Section 4960 tax without knowing whether or how IRC Section 162(m) might apply in a later year.

Recognizing these practical challenges, the IRS suggested two possible approaches in the Preamble to the proposed regulations and requested comments on those suggested approaches. Under one of the suggested approaches, an employer would reduce remuneration for the current year if it reasonably expected (based on certain assumptions) that IRC Section 162(m) would apply to that remuneration in a later year. Under the other approach, an employer would wait until the year in which IRC Section 162(m) limited its compensation deduction and offset remuneration in that later year by the amount erroneously treated as remuneration in a prior year. In the final regulations' Preamble, the IRS states that it is still considering this issue for further guidance. Pending this further guidance, taxpayers may use a reasonable, good-faith approach, including either of the two approaches described in the proposed regulations.

Like the proposed regulations, the final regulations do not allow the IRC Section 162(m) coordination rule to apply when identifying covered employees.

Covered employees

The final regulations confirm that an individual who becomes a covered employee of an ATEO in a given tax year remains a covered employee of that ATEO for all subsequent tax years, even after the employment relationship has ended.

Implications

Tax-exempt entities, and the related organizations with which they share common employees, should review the final regulations carefully to confirm that they will be prepared to apply them beginning in 2022. Because IRC Section 4960 generally applied beginning in 2018, many employers will have four years of experience applying IRC Section 4960 by the time compliance with the final regulations is required in 2022. The IRS has been rather lenient in the positions it has allowed taxpayers to take pending the applicability of final regulations. Beginning in 2022, however, most of the interpretive flexibility available to taxpayers will be eliminated. Given the unusually long delay between the publication date and the applicability date of the final regulations, it would be reasonable to assume that the IRS will expect taxpayers to be fully compliant with the final regulations once they apply.

One counter-intuitive effect of IRC Section 4960 and the final regulations is that a related organization (including a taxable organization) of an ATEO may be liable for excise tax on compensation the related organization pays to an ATEO's covered employee even when the covered employee is no longer employed by or associated with the ATEO. Accordingly, ATEOs and their related organizations should carefully track compensation paid to all the ATEO's covered employees, whether or not still employed by the ATEO, as long as the ATEO and related organizations remain related to one another.

The IRC Section 4960 excise tax also applies to excess parachute payments (see Tax Alert 2020-1559). In practice, the excess parachute payment rules are only relevant when a covered employee's remuneration does not exceed $1 million. 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 of the employee's base compensation amount for the prior five tax years.

Tax-exempt organizations may want to analyze the final regulations with regard to their specific facts and circumstances to identify tax-planning opportunities to reduce an employer's IRC Section 4960 liability. The form in which compensation is paid and the time at which it vests are among the key drivers of the excise tax, and alternatives may be available. Some employers may want to consider adding clauses to covered employees' employment contracts or other governing documents to cap payments upon involuntary termination of employment so no excess parachute payment arises. As with any tax-planning opportunity, however, it is important to understand the broader context and the ways in which actions that might reduce exposure to tax could conflict with other objectives.

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

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ENDNOTES

¹ IRC Section 4948(b) describes certain foreign organizations that have received substantially all of their support (other than gross investment income) from sources outside the United States.