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IRS Clarifies Payroll Taxes On Executive Pay of Not-For-Profit Organizations

IRS Clarifies Payroll Taxes On Executive Pay of Not-For-Profit Organizations

On January 19, the Treasury Department and the IRS released a final rule to help tax-exempt nonprofits comply with excise tax which is considered excessive under Section 4960 of the Internal Revenue Code (IRC).

The tax applies to tax-exempt organizations that pay more than $1 million to any "covered employee," who are the five highest-paid employees in the organization, typically CEOs and other executives. The amount of $1 million includes the applicable tax-exempt employer (ATEO) and any related organization defined in the tax legislation.

The excise tax value, which came into effect in 2018, reflects the corporate tax rate, which is currently 21%.

The final regulations remain virtually unchanged from the proposed regulations released in June 2020, providing only minor clarifications and some adjustments to facilitate taxpayer compliance and not respond to wholesale interpretive changes proposed by professionals and tax-exempt organizations.

Much like the proposed regulations, the final regulations provide guidance and examples for calculating excise duties in various scenarios.

The IRS recently said that the filing data's ongoing review shows that there are still a large number of exempt organizations that have paid more than $1 million in compensation to at least one "covered employee" but did not declare IRC section 4960 excise tax of Form 4720 and therefore subject to IRS penalties.


Annual Reporting

Section 4960, added to the IRC by the Tax Cuts and Jobs Act 2017, came into effect in January 2018. The 21% excise tax only applies to the portion of the employee's salary that exceeds $1 million annually.

The general purpose of the new Section 4960 is to subject tax-exempt entities, such as organizations referred to in Section 501(c)(3), to the same types of restrictions as public traded companies [per IRC Section 162 (m)] as part of the compensation paid to directors and high-paid individuals.

Once an employee meets a covered employee's definition, they are still a covered employee, even if the employee fails to meet up with being one of the five highest-paid employees, but remains an employee of the organization.

Tax-exempt organizations with a calendar-based tax year (January 1 to December 31) were required to complete Form 4720 by May 15, 2019, report and pay excise taxes, if applicable, and continue to do so every May 15 after the applicable exercises. An organization with a non-calendar fiscal year must file Form 4720 by the annual return due date.

Without a final rule, the organizations relied on the statutory wording of the Tax Cuts and Jobs Act and interim guidelines published in IRS Notice 2019-09 as well as the year's proposed regulations.

The final precepts came into effect on January 15, 2021, but will only apply to fiscal years beginning after December 31, 2021. Until then, tax-exempt organizations may rely on provisional guidelines in accordance with Notice 2019-09 or a draft regulation or final regulation, but only if the rules apply in full in accordance with relevant guidelines. The IRS will continue to allow a reasonable and good faith interpretation of the law.

Some of the key points clarified in the final rule include the following:

  • Applicable organizations: Per the above guidelines, the final rule states that ATEO includes all organizations exempt from tax under IRC Section 501(a), i.e., most non-profit US organizations.

  • Deferred compensation: For purposes of the $1 million limit, deferred compensation should be included in compensation for the year in which it was purchased and is no longer subject to a substantial risk of loss, rather than when it is paid, specifies the final rule.

  • No grandfathering: Excise applies to remuneration paid or acquired during the financial years from January 1, 2018, or after. The IRS denied requests to grandfather amounts paid under existing agreements before their approval.

  • Payment from related organizations: At the end of the regulation, the Treasury and IRS rejected requests to account for the only compensation paid by an ATEO for services provided to ATEO when calculating the $1 million limits. The Treasury and IRS concluded that weakening the aggregation rule could increase the potential for abuse.


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