The Department of the Treasury and the IRS published a final rule on Jan. 19 to help tax-exempt not-for-profit organizations comply with the excise tax on pay considered to be excessive under Section 4960 of the Internal Revenue Code (IRC).
The tax is levied on tax-exempt organizations that pay over $1 million to any "covered employee," meaning the five highest-paid employees at the organization, often the CEO and other C-suite executives. The $1 million figure includes pay from the applicable tax-exempt employer (ATEO) and any related organizations, as defined under tax law.
The amount of the excise tax, which took effect in 2018, mirrors the corporate tax rate, which is currently 21 percent.
"The final regulations are largely unchanged from the proposed regulations issued in June 2020 … providing only minor clarifications and some adjustments intended to ease compliance by taxpayers and falling short of wholesale interpretive changes that had been proposed by practitioners and tax-exempt organizations," according to an alert by Boston law firm Ropes & Gray.
"Like the proposed regulations, the final regulations provide guidance and examples for calculating the excise tax under a variety of scenarios," Ropes & Gray noted.
The IRS recently said that "ongoing review of filing data shows there continues to be a high volume of exempt organizations that paid compensation of over $1 million to at least one 'covered employee' but did not report IRC Section 4960 excise tax on Form 4720," and thus are liable for IRS penalties.
Section 4960, added to the IRC by the Tax Cuts and Jobs Act of 2017, took effect in January 2018. The 21 percent excise tax applies only to the portion of covered employees' compensation that exceeds $1 million a year.
"The overall purpose of new section 4960 is to subject tax-exempt entities such as Section 501(c)(3) organizations to the same types of constraints that publicly traded corporations are subject to [under IRC Section 162(m)] with respect to compensation paid to officers and highly compensated individuals," an alert from the Wager Law Group in Boston explained when the excise tax was enacted.
Once an employee meets the definition of a covered employee, he or she is always a covered employee—even if the employee ceases to be one of the top-five highest compensated employees but stays employed with the organization.
Tax-exempt organizations with a calendar-based tax year (Jan. 1 through Dec. 31) were required to start filing a Form 4720 by May 15, 2019, to report and pay the excise tax, if owed, and to continue doing so by each May 15 following the applicable taxable years. An organization with a non-calendar tax year must file Form 4720 by the due date of its annual return.
Without a final rule, organizations have relied on the statutory language of the Tax Cuts and Jobs Act and on interim guidance issued under IRS Notice 2019-09, as well as the last year's proposed regulations.
"The final regulations became effective Jan. 15, 2021, but they will apply only for tax years that start after Dec. 31, 2021," according to attorneys at Proskauer in New York City. Until then, tax-exempt organizations "may rely on the interim guidance under Notice 2019-09 or the proposed regulations, or the final regulations, but only if they apply the rules in their entirety" under the relevant guidance, Proskauer noted. "The IRS will continue to allow a reasonable, good faith interpretation of the statute," the firm advised.
Among the key points clarified in the final rule, Proskauer explained, are the following:
- No grandfathering. The excise tax applies to compensation that is paid or becomes vested during taxable years that started as of Jan. 1, 2018. The IRS has rejected requests to grandfather amounts paid under agreements that were in effect before Section 4960 was passed.
- Applicable organizations. Consistent with earlier guidance, the final rule provides that ATEOs include all organizations that are exempt from taxation under IRC Section 501(a), meaning most U.S. nonprofit organizations.
- Deferred compensation. For purposes of the $1 million cap, deferred compensation must be included in remuneration for the year in which it becomes vested and is no longer subject to a substantial risk of being forfeited, rather than when it's paid, the final rule clarifies.
- Pay from related organizations. In finalizing the regulations, "the Treasury and IRS rejected requests to count only remuneration paid by an ATEO for services provided to the ATEO" when calculating the $1 million cap, Proskauer noted. "The Treasury and the IRS concluded that loosening the aggregation rule could increase the potential for abuse."
Related SHRM Articles:
IRS Proposal Clarifies Tax on Excess Pay at Tax-Exempt Organizations, SHRM Online, June 2020
IRS Provides Guidance on Excess Executive Pay at Tax-Exempt Organizations, SHRM Online, February 2019