On January 11, 2021, the IRS issued final regulations providing guidance on the federal excise tax on executive compensation in excess of $1,000,000 paid by an applicable tax-exempt organization under Section 4960. The final regulations made minor adjustments to the proposed regulations, adopting the majority of proposed changes. According to the IRS, the final regulations apply to taxable years beginning after December 31, 2021, but exempt organizations (EOs) may choose to apply them sooner.
This alert summarizes the excise tax on executive compensation and offers several key takeaways concerning the final regulations.
Section 4960 was implemented under the “Tax Cuts and Jobs Act” in 2017. Under Section 4960, an applicable tax-exempt organization must pay an excise tax of 21% on:
- Remuneration in excess of $1 million paid to a “covered employee,” plus
- Any excess “parachute payment” paid to a covered employee during the tax year. A parachute payment is any payment in the nature of compensation to a covered employee if the payment is contingent on the employee’s separation from employment with the employer and the aggregate present value of the payment equals or exceeds three times the base amount.
Per the IRS, the excise tax under Section 4960 is reported on Form 4720, “Return of Certain Excise Taxes.” Reporting and payments for applicable taxes are due the 15th day of the fifth month at the end of a taxpayer’s taxable year (May 15 for a calendar year organization). This date is subject to an extension for filing returns. Quarterly payments of estimated excise tax imposed by Section 4960 are not required.
Notice 2019-9 includes initial guidance on the application of Section 4960.
What We Learned From the Proposed & Final Regulations
In June 2020, the IRS released the proposed regulations, which provided comprehensive guidance on excessive compensation paid to covered employees of exempt organizations. Now that the final regulations have been released, here’s what to note:
- There is no major change in the definition of “remuneration” from the proposed regulations.
- The remuneration calculation can exclude a below-market loan between a covered employee and the exempt organization if the loan is of a de minimis amount ($10,000 or less).
- There was no major change in the timing of remuneration paid to the executive. One commenter on the proposed regulations recommended changing the calculation of remuneration to be determined as when it is paid, instead of when it is vested, to better match remuneration with Form W-2. This comment, however, was not adopted in the final regulations by the IRS. Remuneration is vested if it is not subject to a substantial risk of forfeiture, according to the IRS.
- Significant changes were not made to the exclusion of remuneration for medical services. The regulations still state that remuneration does not include the portion of any remuneration paid to a licensed medical professional that is for the performance of medical services by such professional. If, during an applicable year, an employer pays a covered employee remuneration for providing both medical services and non-medical services, the employer must make a reasonable, good faith allocation between the remuneration for medical services and the remuneration for non-medical services. Examples are included in the final regulations.
- These final regulations do not address the relationship of Section 4960 with Section 162(m) but instead reserve a portion of the regulations for future guidance to address the connection between the two Sections. Please note – Section 162(m) is a separate limitation curbing the deduction of excessive compensation in taxable businesses. Until that future guidance is issued, again, it is recommended that taxpayers use a reasonable, good faith approach in circumstances in which it is not known whether a deduction for the remuneration will be disallowed under Section 162(m) by the due date of the relevant Form 4720.