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Excise Taxes on Excess Tax-Exempt Organization Executive Compensation

Excise Taxes on Excess Tax-Exempt Organization Executive Compensation

Background. 

Effective for each tax year beginning after December 31, 2017, an ATEO is generally subject to a special tax (currently 21%) on the amount of any employee's overcompensation covered and any undue payment made to such covered employee.

An ATEO is a section 501(a), tax-exempt organization, which excludes section 115(1) tax revenue, which is a farmer cooperative organization described in section 521(b)(1) or which is a political organization described in subsection 527(e)(1).

An employee covered by ATEO is one of the organization's five highest-paid employees (or a predecessor) for the fiscal year or for any preceding fiscal year beginning after December 31, 2016. Usually, all ATEO compensation paid to a direct or indirect employee should be counted in deciding whether the employee is covered and in determining the salary and parachute payments made to that covered employee. Payments from an organization linked to ATEO should also be considered.

For an applicable year (a calendar year ending in or during the ATEO tax year), compensation generally refers to the salary defined for income tax purposes. It includes amounts to be included in gross income to section 457(f). Compensation is deemed to have been paid in the year in which the employee's entitlement to the sum is no longer subject to a substantial risk of forfeiture, as defined in Section 457 (f)(3)(B), regardless of when it is paid. Section 457(f) governs deferred compensation arrangements for government and tax-exempt organizations.

As a rule of thumb, when the amount of all payments made due to involuntary separation is equal to or greater than 3 times the employee's base amount, the amount that exceeds the base amount is a parachute overpayment.

The TCJA excludes compensation directly related to authorized health professionals (direct payments for medical services) to determine covered employees. The charter also excludes payments for direct health services and payments to employees who are not well-paid from a treatment like parachute payments.

On December 31, 2018, the Treasury and IRS issued Notice 2019-09 to provide initial guidance per Section 4960. The Notice allows taxpayers to rely on their guidance and base their positions on a reasonable and good faith interpretation status (including legislative history, if applicable) until further notice. The notification also describes certain interpretations of Section 4960, which are inconsistent with good faith and a reasonable interpretation of the statute and indicates that the regulations proposed below should cover these interpretations.


The proposed regulation

The Treasury and IRS say the bill's information is generally consistent with the information provided in the 2019-09 notification. Here are some of the proposed rules that add or modify the disclaimer:

  • Definition of employer and employee: The proposed rules define the term "employee" according to the definition of "employee" for federal income tax withholding and related regulations. This definition includes common-law officers, elected or appointed officers or representatives of government or government agencies or bodies, and certain company employees. In particular, the proposed rules confirm Congress's intention that an ATEO employee (including a person acting in that capacity) be a covered employee if the other requirements to be covered are met, and the former employees remain covered employees. Likewise, "employer" is defined per how the term is defined for federal income tax withholding and related regulations. Employer status cannot be avoided by using an external payer, including a management company. Also, the sole owner of an excluded entity is treated as the employer of one of the excluded entity employees.

  • Volunteer services: The proposed regulations determine whether excise duties apply to certain non-ATEO employees who provide limited services for a related ATEO and only receive compensation from non-ATEO. For example, an executive of a for-profit corporation may spend time on the board of directors of a foundation at no associated cost. The proposed regulation includes a "time-limited exception" and an "exception for non-exempt funds." The preamble specifies that to avoid manipulating the rules by deferring the salary, it includes the attribution of a legally binding right to payment acquired by ATEO (or associated with ATEO) to determine whether the worker is one of the five employees the best paid. Any granting of a legally binding right to remuneration that is not invested by ATEO or an associated ATEO automatically excludes ATEO from the corresponding exemption request.

While many other detailed requirements apply to both exceptions, the limited hour exception generally applies if an employee's working hours as an ATEO employee and all associated ATEOs are 10% or less of total hours worked employee service at ATEO and all related organizations during the corresponding year. Suppose an employee works less than 100 hours of work as an ATEO employee and all related ATEOs in an applicable year. In that case, that employee is considered to have worked less than 10% of the total hours of the employee's job for ATEO and all. The non-exempt fund's exception generally applies if an employee's hours of service as an ATEO employee and all related ATEOs represent less than 50% of the total hours worked by the employee for ATEO and all related organizations in the relevant year, and if it is not an affiliated organization that paid remuneration or granted a legally binding right to uninvested remuneration to the person who provided the paid services to the ATEO or any related ATEO.

  • Associated organization: The draft regulation clarifies how to determine the organizations linked to ATEO. An employee's compensation is usually determined based on payments made by any related organization. The proposed regulations indirectly include organizations not related to ATEO (including for-profit entities, not-for-profit entities, and non-ATEO government entities) in a related organization, including those organizations. 

  • Exception for limited services: The 2019-09 notice states that an employee is not among the top five highest-paid employees of an ATEO in a fiscal year if ATEO paid less than 10% of the employee's total salary during the year applicable to the services provided as an employee of ATEO and all related organizations. Also, this requirement in the Notice, the proposed regulation clarifies that this exception does not apply if ATEO has no associated ATEO and only applies if one of the following conditions apply:

  • ATEO will pay at least 10% of the remuneration paid by ATEO and all related organizations. 

  • No affiliated ATEO paid at least 10% of this remuneration, and ATEO paid the employee less remuneration than at least one affiliated ATEO paid to this employee.

  • Organization of the predecessor: A covered employee includes an employee who was a covered employee of an ATEO (or any predecessor) in a previous fiscal year that began after December 31, 2016. The proposed rules provide detailed rules for determining predecessors to that end.

  • Remuneration: Amounts waged per section 3401 (a) are treated as compensation, although such amounts are not subject to withholding tax. This includes, but is not limited to, imputed income from a below-market dollar loan between employer and employee. Also, the salary includes parachute payments.

  • Interaction with Section 162(m) deduction disallowance: The proposed regulation specifies that compensation subject to the section 162 (m) deduction (generally amounts over $ 1 million attributable to an employee covered by some for-profit employers) must be considered in determining which employees are covered by an ATEO. However, these amounts are not subject to Section 4960. The proposed regulations also provide some exemption from coordination where all the circumstances of the applicable law are not known to affect the other.

  • Excessive parachute payments: The concept of parachute overpayments in Section 4960 is generally based on Section 280G, which imposes a special tax on certain directors and an allowable deduction for employers who take advantage of certain overpayments for business transactions. The proposed regulations borrow the rules from section 280G for this purpose and the rules from section 457(f) to determine the separation of labor and related matters. Significantly, the rules state that ATEOs cannot, within the meaning of section 4960, use the exclusion permitted by section 280G for payments made under a non-compete agreement. These non-compete terms are part of many Section 457 (f) tax exemption agreements.

  • Calculation of special taxes: The proposed regulation emphasizes calculating the overpayment tax when a covered employee provides services to one or more related organizations in the same applicable year.


Next steps

The Treasury and IRS propose that the regulations apply to tax periods beginning after December 31 of the calendar year, including their publication date as final. Until then, taxpayers can rely on the 2019-09 Communication Guidelines or proposed regulations. For future tax returns, tax-exempt organizations should consider applying the proposed regulations to any position taken for which no guidance was previously available.


On June 11, the United States Department of the Treasury and the IRS released the proposed IRC Section 4960 regulations. Section 4960 was added to IRC by the 2017 Tax Reform. It imposed a special tax on an organization exempt from tax (ATEO) applicable in the context of certain compensations surplus ATEO management employees.


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