By Norma Sharara, JD and Joan Vines, CPA
On Dec. 31, 2018, the IRS released Notice 2019-09 (the
Notice), providing interim guidance regarding Section 4960 of the Internal
Revenue Code (the Code) that was enacted on Dec. 22, 2017, by the Tax Cuts and
Jobs Act (the Act). The Notice provides the first guidance on new excise
taxes that tax-exempt and governmental entities (and their related for-profit
entities) may need to pay on the amount of remuneration in excess of $1 million
in compensation and any excess parachute payments paid to a covered employee as
early as May 15, 2019 (for calendar year entities). Affected organizations must
report and pay the tax on recently updated IRS Form 4720.
The 2017 Tax Reform and Jobs Act established new Code Section
4960, effective Jan. 1, 2018, which imposes an excise tax on “excess” executive
compensation paid by tax-exempt and certain governmental entities. The excise
tax rate is established in Section 11 of the Code and is currently 21 percent.
For-profit employers related to such entities may also need to pay their pro
rata share of the tax (such as for-profit entities within a tax-exempt hospital
or university’s controlled group).
EMPLOYERS PAY THE TAX
The excise tax is the employer’s responsibility — it is not
withheld from employee compensation. The 21 percent excise tax applies to
employers who pay, after taking into account payments by members of its
controlled group:
- More than $1 million in annual
“remuneration”—wages subject to withholding, including 457(f) income but
excluding Roth contributions, certain retirement plan contributions and
payments, and wages for certain medical services paid to any “covered employee”
(five highest compensated employees for the current or any prior year starting
with 2017)
- “Excess parachute payments”—amounts over three
times the employee’s five-year average wages that are contingent on an
involuntary termination (including a “good reason” termination or non-renewal
of an employment agreement), but only if the employee makes over the IRS’
qualified retirement plan limit for “highly compensated employees” during the
year (currently $125,000)
EVEN SMALL EMPLOYERS
ARE AFFECTED
Notice 2019-09 clarifies that even if an employer never pays
anyone more than $1 million per year, it could still owe the tax on excess
parachute payments. But employers who do not pay anyone over $125,000 for a
year may never have a 4960 tax liability. Nevertheless, employers of all sizes
must track “covered employees.”
COVERED EMPLOYEES
Since there is no minimum dollar test to be a “covered
employee,” tax-exempt employers who do not have a 4960 tax liability for a year
would still need to make a list of covered employees each year. Per the Notice,
once someone is a covered employee, he or she is a covered employee forever
under 4960, even after termination of employment. Since the definition of
“covered employee” is cumulative, the list will likely include more than five
individuals over time.
Note that each applicable tax-exempt employer within a controlled
group must make a cumulative list of its covered employees for 2017, 2018 and
all subsequent years (there isn’t one list for the whole controlled group). The
Notice confirms that even though 4960 took effect Jan. 1, 2018, employers need
to make a covered employees list starting in 2017, because remuneration paid to
those individuals in 2018 or later could trigger the 4960 tax.
REMUNERATION IS A NEW
CONCEPT
Section 4960 created its own concept of “remuneration” that
is different from any other way that employers calculate annual compensation.
To determine 4960 tax liability, employers need to look to when amounts are
vested under 457(f)’s special timing rule (not when the amounts are paid). The
Notice confirms that this analysis is required even if the amount is not
technically subject to 457(f). For example, certain bona fide disability plans
are exempt from 457(f)’s special timing rules because they are not treated as
deferred compensation. But such amounts would be counted for 4960 tax liability
purposes when they are vested (not when they are paid).
The Notice confirms that for 4960 purposes, amounts provided
after an involuntary separation are excluded if all of the benefits vested
before the separation (since the separation affected only the timing of the
payments, not the employee’s right to the payments). But any new increase in
value (such as earnings) that accumulate after the vesting would be treated as
remuneration subject to 4960 testing. Also, if the termination of employment
accelerates vesting, then the value of the acceleration is treated as
remuneration for 4960 purposes.
The Notice also clarifies that certain amounts are excluded
from “remuneration” entirely, such as wages paid for medical services (which
are discussed in detail in the Notice) and amounts paid to independent
contractors (such as director’s fees). The Notice also says that certain other
amounts are included in “remuneration”—such as payments conditioned on a
release of claims, damages for employment agreement breaches, payments under
early retirement or other “window” programs, payments for non-compete and
non-disclosure or similar agreements.
WHO’S THE EMPLOYER
This Notice makes it clear that “common law” employers of
the covered employee owe the 4960 tax. Employers with related entities will
need to determine which entity is the common law employer under applicable IRS
tests. Employers cannot avoid liability by using payroll agents, common
paymasters, professional employer organizations (PEOs), etc.
If a covered employee is also employed by another entity
related to the tax-exempt entity, each employer, including taxable entities, is
separately liable for its pro rata share of the 4960 tax, regardless of any
arrangement between them to bear the cost of the tax liability. So the amount
of 4960 tax owed could change if the related entities restructure their
employment relationships.
RELATED ORGANIZATIONS
The Notice says that for 4960 purposes, an entity is
“related” to an employer if it:
- controls (or is controlled by) the employer
- is controlled by one or more persons which
control the employer
- is a “supported” or “supporting” organization
with respect to the employer
- establishes, maintains or contributes to a
voluntary employees’ beneficiary association
The Notice defines what “control” means for stock
corporations, partnerships, trusts and non-stock organizations. The Notice also
explains how to determine the 4960 tax if the entity becomes or ceases to be
related to the employer during the calendar year.
In addition, the Notice adopts (for 4960 purposes) the broad
definition of “related organization” for annual Form 990 reporting. While using
the Form 990 definition reduces burdens when determining 4960 liability, it is
likely to cause more tax to be paid than if a more narrow definition was
selected.
GOVERNMENTAL
EMPLOYERS
Despite much publicity about highly paid public university
sports team coaches being subject to the tax on annual remuneration over $1
million, some schools may avoid paying the 4960 tax unless Congress enacts a
technical correction. Per the Notice, governmental entities that rely on the
doctrine of “implied sovereign immunity” for their tax-exempt status are not
subject to 4960. The Notice also clarified that a governmental unit (including
a state college or university) that received a favorable IRS determination
letter confirming its 501(a) tax-exempt status may voluntarily relinquish that
status (which may exempt it from 4960 tax).
HOW TO CALCULATE THE
EXCESS PARACHUTE PAYMENT TAX
While calculating the 4960 tax on annual remuneration over
$1 million may be fairly straightforward, calculating the tax on excess
parachute payments is more complicated.
The Notice sets out six steps for determining the excess
parachute tax (which is separate from the $1 million tax). Remember that the
tax applies to the excess over one times the base amount (not the excess over
three times the base amount).
Generally, a covered employee’s base amount is the average
of the employee’s Box 1, Form W-2 annual taxable compensation for services
performed as an employee of an applicable tax-exempt organization (ATEO) (and
any predecessor entity of the ATEO) or a related entity for the five years
prior to the termination year.
Compensation for short taxable years generally must be
annualized before determining the five-year average (but a special rule applies
to covered employees who have a separation from employment during their initial
year of employment). If the covered employee was not employed by the employer
for the entire five-year period, use the portion of the five-year period during
which the employee performed services for the employer, a predecessor entity or
a related entity.
CALENDAR YEAR TAX
LIABILITY
The Notice clarifies that 4960 tax will be based on the
calendar year ending with or within the employer’s taxable year. For example,
assume an employer’s taxable year began on July 1, 2018, and ends on June 30,
2019. The employer may owe 4960 tax on remuneration paid between July 1 and
Dec. 31, 2018 (remuneration paid from January 1, 2018 to June 30, 2018 would
not be subject to 4960 tax, which gives an initial, first-year advantage to
entities that use non-calendar year fiscal years).
To avoid penalties and interest, the employer should remit
any tax owed by filing IRS Form 4720 on or before Dec. 15, 2019 (5 1/2 months
after its fiscal year end). This approach aligns with employers’ Form W-2 and
Form 990 disclosures.
NO TRANSITION RULES
Despite what many had hoped, the IRS declined to provide any
4960 transition rules. The Notice confirms that the Act clearly mandates the
Jan. 1, 2018 effective date. So employers should already be complying.
Nevertheless, the Notice may help employers review and
revise existing employment, deferred compensation, severance and other agreements
or design and implement new arrangements. Employers may also want to consider
whether changing existing management service arrangements among related
entities may reduce 4960 liability exposure.
IRS intends to propose regulations under 4960, but until
further guidance is issued, employers can apply a reasonable, good faith
interpretation, which would include taking the Notice into account.
ACCOUNTING
CONSIDERATIONS
Booking a contingent tax liability. Before reporting and
paying the 4960 tax, employers may need to book a contingent tax liability if
they are reasonably certain that they will incur a 4960 excise tax (for
example, upon an employee’s termination of employment based on existing
employment agreements, deferred compensation agreements, etc.). Adjustments may
need to be made ratably over the number of years between 2018 and when the tax
is expected to be due. Many tax-exempt organizations may not be accustomed to
booking contingent tax liabilities, so this may be uncharted territory for them.
Book/tax difference. The employer may also need to track a
book/tax difference due to the timing of when the liability is accrued for
financial statement purposes and when the amounts are subject to 4960 excise
taxes (i.e., when the amounts are vested).
For further information access the Notice. The Notice has a
detailed frequently asked questions section and examples that clarify certain
scenarios.
For more information, contact Norma Sharara, Managing Director, National Tax – Compensation and Benefits, at nsharara@bdo.com, or Joan Vines, Managing Director, National Tax – Compensation and Benefits, at jvines@bdo.com.