Proposed 4960 Excise Tax Regulations Issued
On June 5, 2020, the Internal Revenue Service (“IRS”) issued proposed regulations on the excise tax on excess tax-exempt organization executive compensation under Section 4960 of the Internal Revenue Code (the “Excise Tax”). This tax, which was enacted as part of tax reform in 2017, applies to certain tax-exempt organizations (or related organizations) that pay annual remuneration in excess of $1 million or so-called “excess parachute payments” to certain “covered employees” (generally, employees who were among the five highest-compensated employees of the organization for a given taxable year or any prior taxable year in 2017 or later).
The proposed regulations expand upon and modify guidance that the Treasury Department and the IRS published on December 31, 2018 in Notice 2019-09 (the “Notice”). They contain a number of helpful new provisions, including a series of exemptions from “covered employee” status in certain situations where employees of for-profit entities serve as officers of, or provide services to, affiliated tax-exempt organizations. That fact pattern had raised significant concerns for many taxpayers under Section 4960 and the Notice. This summary focuses on two key issues: the determination of whether an entity is a “related organization” of a tax-exempt organization, and the identification of an organization’s “covered employees.”
In determining whether an applicable tax-exempt organization (“ATEO”) pays remuneration in excess of $1 million, any remuneration paid by a “related organization” must be taken into account. As a result, even if an ATEO pays no compensation to a “covered employee,” the Excise Tax may apply.
For purposes of Section 4960, a person or governmental entity is treated as 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;
- is a supported organization during the taxable year with respect to the ATEO;
- is a supporting organization during the taxable year with respect to the ATEO; or,
- in the case of an ATEO which is a voluntary employees’ beneficiary association (“VEBA”) under section 501(c)(9), establishes, maintains, or makes contributions to the VEBA.
For purposes of the first and second prong, the proposed regulations define “control” as ownership of more than 50% of stock by vote or value (in the case of a corporation), 50% of profits or capital interests (in the case of a partnership) or 50% of beneficial interests (in the case of a trust), after the application of certain attribution rules. If the organization in question is a nonstock organization (as is the case with most ATEOs), the Proposed Regulations provide two tests for determining whether another person has control. First, under the “removal power” test, an individual or entity controls a nonstock organization if she or it has the power, directly or indirectly, to remove more than 50 percent of its trustees or directors and designate new trustees or directors. Second, under the “representative” test, a person generally controls a nonstock organization if more than 50 percent of the nonstock organization’s directors or trustees are also trustees, directors, officers, agents, or employees of the person or governmental entity. Under a limited exception to this test, if a director or trustee of the nonstock organization is a lower-level employee of a would-be controlling entity, the nonstock organization may claim that the employee is not a representative of the other entity.
This second test may lead to surprising consequences, as illustrated by the following simple example. Imagine that a for-profit corporation establishes an ATEO as a partner for its charitable endeavors. The ATEO’s organizational documents give the corporation no formal control powers over the ATEO—for example, the corporation has no power to appoint members to the ATEO’s three-member board, which is “self-perpetuating” (i.e. board members elect their successors). Nonetheless, by chance, two individuals are elected to the board who happen to be employees of the corporation. Under the “representative” test, since two thirds of the ATEO’s board are representatives of the corporation, the two entities are treated as related (unless one or both of the employees are lower-level employees who qualify under the limited exception described above). As a result, many employees of the corporation that do work for the ATEO may inadvertently become covered employees.
Only remuneration that is paid to a “covered employee” may be subject to the Excise Tax. In this regard, two determinations must be made—whether an individual is an employee of the ATEO in question, and, if so, whether the employee is a “covered employee.”
The determination of whether an individual is an employee of an ATEO is made under common law principles, which ultimately have a broad reach (although directors would not be employees). One issue that the Notice left unresolved was the treatment of officers of an ATEO. In the context of wage withholding and reporting, officers are generally considered employees, but there is an exception for those who perform only “minor services” (i.e. occasional, routine signing of documents, presiding over or attendance at infrequent meetings, and similar isolated or noncontinuous acts) and receive no compensation in their officer capacity. It was unclear under the Notice whether these rules applied in the context of the Excise Tax, but the proposed regulations clarify that they do—officers are employees unless they qualify for the minor services exception. Accordingly, if an employee of a for-profit entity serves as an officer of a related ATEO and provides only minor services in that capacity, she is not treated as an employee of the ATEO for purposes of the Excise Tax.
The implications of this “minor services” exception may be illustrated with our example above, which involved a for-profit corporation and a related ATEO. Imagine that an employee of the for-profit corporation volunteers to serve as vice-president of the ATEO (and receives no additional compensation in that capacity from any entity). The role of vice-president is limited to occasional signing of documents and very limited public appearances as a representative of the ATEO. In these circumstances, the ATEO may be able to claim that she performs only minor services and is therefore not an employee. As a result, even though the ATEO and the non-profit corporation are related, the ATEO would not need to consider whether she is a “covered employee.” Therefore, even if the for-profit organization pays her well in excess of $1 million, her compensation is not subject to the Excise Tax.
Although this “minor services” exception is helpful, it can apply only to officers and relies on a facts and circumstances analysis, which can lead to continuing uncertainty. The proposed regulations create two new, helpful exceptions (and clarify a third from the Notice) that may remove individuals from designation as “covered employees.” In order for these exceptions to apply, it is critical that the ATEO not reimburse or otherwise provide any consideration to a related organization with respect an individual performing services for the ATEO, in addition to the other requirements set out below.
The first exception—the “limited hours” exception—applies if (a) neither the ATEO nor any related ATEO pays remuneration or grants a legally binding right to nonvested remuneration to the employee for services performed for the ATEO and (b) the employee performs only limited services for the ATEO. For purposes of prong (a), the ATEO is not generally deemed to pay remuneration paid by a related organization (unless the ATEO reimburses the remuneration). With respect to prong (b), an employee qualifies only if the hours of service performed for the ATEO comprise 10 percent or less of the employee’s total hours of service for the ATEO and all related organizations during the applicable year. Furthermore, under a safe harbor, an employee will be deemed satisfy prong (b) if she performs fewer than 100 hours of service as an employee of an ATEO and all related ATEOs.
The second exception—the “nonexempt funds” exception—applies if neither the ATEO, nor any related ATEO, nor any taxable related organization controlled by the ATEO pays the employee of the ATEO any remuneration for services performed for the ATEO or grants a legally binding right to nonvested remuneration to the employee. As under the limited hours exception, the ATEO is not generally deemed to pay remuneration that is paid by a related organization (absent a reimbursement arrangement). That said, there are a couple of additional requirements that may prevent application of this exception to certain service arrangements. First, the related taxable organization paying the remuneration must not provide services for a fee to the ATEO, related ATEOs, or their controlled taxable related organizations. Second, the employee must have provided services primarily to the related taxable organization or other non-ATEO (other than a taxable subsidiary of the ATEO) during the applicable year. To satisfy this requirement, an employee must have provided services to the ATEO and all related ATEOs for less than 50 percent of her total hours worked for the ATEO and all related organizations during the applicable year.
Thus, if a related for-profit organization of an ATEO contributes the services of the ATEO’s full-time Executive Director, the “nonexempt funds” exception will not apply because the Executive Director is spending 100% of her work hours on services to the ATEO. In contrast, if the related-for profit contributes the services of one of its employees to act as a part-time Executive Director of an ATEO, and (1) that employee spends 40% of her time on her work for the ATEO and 60% of her time on her work at the related for-profit organization, (2) none of the ATEO, any related ATEO, and any taxable related organization controlled by the ATEO reimburses or otherwise compensates the for-profit for the Executive Director’s services, and (3) neither the for-profit, nor any other related organization that paid the Executive Director) provided services for a fee to the ATEO, then the Executive Director will not be one of the ATEOs five highest compensated employees irrespective of how much she is paid by the related for-profit organization.
Finally, the proposed regulations clarified a “limited services” exception from the Notice, which applies if an ATEO pays less than 10 percent of an employee’s remuneration for a given taxable year and other conditions are met. In general, the exception is available to an ATEO only if another, related ATEO already treats the employee in question as a covered employee. Therefore, it is only of use in situations where an employee would otherwise be a covered employee of multiple, related ATEOs.
These various exceptions will provide comfort to many for-profit affiliates whose employees serve as officers or otherwise provide services to ATEOs. Nonetheless, they do not help all organizations. For example, for-profit entities whose employees spend more than 10% of their time on ATEO work and receive fees from an ATEO under a servicing agreement will not qualify for either exception. As a result, highly compensated employees in such arrangements may continue to trigger the Excise Tax.
Reliance on the Proposed Regulations and Related Issues
Taxpayers are entitled to rely on either the proposed regulations or the Notice until final regulations are published under Section 4960. Furthermore, as was the case with the Notice, the preamble to the proposed regulations permits Taxpayers to adopt any “reasonable, good faith” interpretation of Section 4960, although they enumerate a list of positions that the IRS does not consider to be reasonable. Accordingly, although the proposed regulations provide a number of helpful bright-line rules and additional clarity, there is still leeway for differing interpretations in the highly factual determinations that the Excise Tax often requires.