The IRS recently issued Notice 2019-09 (Notice), which provides guidance with respect to the 21 percent excise tax on remuneration in excess of $1 million and excess parachute payments by “applicable tax exempt organizations” (ATEOs) applies under Code Section 4960. In general Code Section 4960 and the Notice apply concepts from Code Sections 162(m) (which denies a deduction to publicly traded corporations with respect to payments of compensation in excess of $1 million to certain covered employees) and 280G (which, along with Code Section 4999, imposes an excise tax and disallows a deduction with respect to excess parachute payments). Code 4960 was added to the Internal Revenue Code as part of the tax reform legislation enacted in December 2017. While the IRS and Treasury Department intend to issue more detailed guidance in future proposed regulations, the Notice shows that Code Section 4960 will have a significant impact on compensation practices – particularly with respect to severance and deferred compensation – that ATEOs pay to key employers. 

ATEOs must address these new rules for the first time when filing their Form 990 for the first fiscal year that began after 2017. That could be as early as May 15, 2019. The application of the rules could be particularly challenging to large multiple-entity health and university systems. To address these issues, we recommend that tax-exempt organizations and public universities and community colleges immediately take the following steps:

Determine whether they are an ATEO subject to the potential excise tax.

In general, the excise tax applies to organizations exempt from federal income taxes, including Code Section 501(c)(3) charitable or educational organizations. Also covered are farmers’ cooperative organizations described in Code  Section 521(b)(1), organizations that exclude income from taxation under Code Section 115(1) (generally a State or political subdivision thereof), and political organizations described in Code Section 527(e)(1).

Public universities and community colleges should determine the authority for its tax-exempt status.

The issue is particularly tricky for public universities and community colleges. A public university or community college could fit into one of three categories. One is that the entity, despite being an instrumentality of a state, received a determination letter from the IRS in which the IRS certified that the entity qualified as a tax-exempt organization under Code Section 501 (probably 501(c)(3), although some may have qualified under 501(c)(1)). Those entities would be subject to the Code Section 4960. Second, an entity separately organized from a state or political subdivision of a state would have its income exempt under Code Section 115(1). That entity also would be subject to Code Section 4960. Some entities, however, rely on the doctrine of “implied statutory immunity” to avoid federal income taxation, rather than seeking tax-exemption under Code Section 501(a) or excluding income under Code Section 115(1). The Notice explains that such entities are not subject to the Section 4960 excise tax.

Public universities and community colleges need to determine how they have provided authority for their tax-exempt status. Some public universities, for example, provide copies of IRS determination letters certifying 501(c)(3) status on their web sites. Those entities probably are subject to the new rules unless they relinquish their determination letters. Other universities have statements from their general counsels stating that they are exempt from tax under Code Section 115(1). Those entities may have a more difficult time arguing that they should be exempt from tax under the doctrine of implied statutory immunity.

Identify covered employees whose compensation may be subject to excise taxes.

The excise tax applies annual “remuneration” paid in excess of $1 million to covered employees.  A “covered employee” for purposes of Code Section 4960 is any individual who is one of the organization’s five highest-compensated common-law employees for the current taxable year, based on remuneration paid in the calendar year ending with or within the employer’s fiscal year. Independent contractors are not covered employees, regardless of how much they may be paid. Each ATEO and its related entities must determine its own covered employees, raising the possibility that there may be more than 5 covered employees within a controlled group.  Once a covered employee, an individual remains a covered employee indefinitely, even if he or she falls out of the five highest-compensated employees for the employer.

Identify compensation – particularly severance and Code Section 457(f) deferred compensation arrangements – that may trigger the tax.

For purposes of this excise tax, “remuneration” is defined as wages for purposes of federal income tax withholding, but excluding compensation paid for the performance of medical or veterinary services and designated Roth contributions (e.g., to a 401(k) or 403(b) plan). Remuneration paid to an employee for medical (or veterinary) services is excluded from this calculation, but the Notice defines such services narrowly. Amounts required to be included in gross income under Code Section 457(f), however, whether or not actually distributed to the plan participant, are considered remuneration for purposes of the excise tax.  Many 457(f) deferred compensation arrangements pay an executive upon an involuntary or “good reason” termination. The result is that terminated executives often receive a much larger amount of compensation in the year of termination than in any prior year. ATEOs will need to determine whether such payments are greater than or equal to 3 times prior average annual compensation and trigger excise tax.  Alternatively, if an agreement pays a large amount at vesting – even if the employee remains employed – it could trigger excise tax if the total compensation for the year exceeds $1 million.

Consider alternative compensation arrangements.

ATEOs should consider alternative compensation strategies that may alleviate some of the excise tax consequences. As one example, split dollar life insurance under the loan regime, where the employer essentially lends money to an executive to finance the executive’s purchase of a life insurance policy, could be a compensation strategy that largely is exempt from the excise tax rules while still providing a valuable benefit to the executives. Of course, an ATEO should consider whether any strategy is consistent with its compensation philosophy. It also is important that any arrangement be designed properly to fit within the ATEO’s compensation philosophy and to comply with applicable law.