Earlier this year, the IRS issued final regulations on IRC Section 4960, which imposed an excise tax on tax-exempt organizations and related organizations that pay over $1 million of compensation or excess parachute payments to a covered employee. The Tax Cuts and Jobs Act added a provision stating that, beginning in 2018, nonprofit organizations could be charged an excise tax if it pays more than $1 million to certain “covered” employees.
These final regulations generally mirror the proposed regulations released in 2020 and guidance provided in Notice 2019-09. The new regulations, which fall short of wholesale changes requested by nonprofits and other members of the tax community, went into effect on January 15, 2021. However, technically, they don’t apply until tax years beginning after 2021. Nonprofit organizations may want to analyze the final regulations with regard to their specific facts to identify any potential tax planning opportunities before 2022.
Who’s Covered, What’s Taxed
Under the law, the definition of “covered” employees includes an organization’s five highest-compensated employees (HCEs) for the current tax year, based on remuneration paid in the calendar year ending with or within the fiscal year. It also includes any individual who was a covered employee for any preceding tax year beginning after 2016. Note: There’s no minimum dollar threshold for covered HCEs for purposes of this calculation.
The excise tax kicks in if a covered employee receives remuneration of more than $1 million in a tax year. The tax applies to the portion above $1 million, not the entire amount, and is equal to the corporate tax rate — currently a flat 21%. For these purposes, “remuneration” includes wages paid that are subject to federal income tax withholding, such as salary and bonuses, plus amounts included in gross income under a nonqualified deferred compensation plan.
Here’s an example of how easily compensation can exceed $1 million. A nonprofit pays its president an annual salary of $800,000 and contributes $50,000 a year to a deferred compensation plan on the president’s behalf for 10 years. If, at the end of 10 years, the cumulative benefits vest all at once, the president’s total remuneration is $1.3 million that year [$800,000 + ($50,000 × 10)]. Thus, the nonprofit is liable for an excise tax on the $300,000 excess compensation, resulting in a tax bill of $63,000 (21% of $300,000).
Several Clarifications
Notice, 2019-09 and the 2021 final regulations provide several clarifications to the law regarding covered individuals. Specifically:
- Each tax-exempt organization operating within a related group of organizations must make a separate determination of which employees are covered each tax year. This applies even if an organization doesn’t trigger the excise tax in a particular year.
- An individual who’s designated as a covered employee remains a covered employee indefinitely, even if the person is no longer one of the organization’s five HCEs.
- When it determines its five HCEs, an organization must include remuneration paid to the employee by any related organizations.
The IRS also provides guidance on reporting. The tax must be reported on Form 4720, “Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code.” However, the IRS has compiled data showing that many nonprofits are failing to meet the reporting requirements when one of its covered employees exceeds the $1 million threshold.
Notably, tax-exempt organizations with a calendar tax year were initially required to start filing Form 4720 by May 15, 2019 and should continue doing so by May 15 for each of the following applicable taxable years. An organization with a non-calendar tax year must file Form 4720 by its tax return due date.
Four Points
The final regulations further clarify the following four key points:
- There’s no “grandfather rule” for deferred compensation plans. The excise tax applies to compensation that’s paid or becomes vested during tax years beginning after 2017. The IRS has rejected requests to grandfather amounts paid under agreements created before the TCJA was enacted.
- As reflected in prior guidance, the final regulations establish that excess compensation rules apply to all organizations that are exempt from tax under Section 501(a). This includes most domestic not-for-profit organizations.
- Deferred compensation counts toward the $1 million threshold for the tax year in which it becomes vested and is no longer subject to a substantial risk of being forfeited. It doesn’t matter when it’s actually paid.
- The IRS has rejected requests to count only remuneration paid by an organization when calculating the $1 million limit. Therefore, the “aggregation rule” remains in place.
Be Prepared
The IRS provided a good faith interpretation provision in the proposed regulations. Beginning in 2022, most of the flexibility available in interpreting this new provision under the good faith interpretation provision is eliminated with the final regulations. Nonprofit organizations should review compensation provisions in regard to when compensation is paid; when it is vested and the involuntary termination provision in employment contracts to avoid excess parachute payments.
