Executive Compensation Excise Tax: Challenges and Strategies

Insight
As a result of the final regulations, some employers may be able to request refunds for overpaid taxes in past years using the relief provided. The publication of final regulations limits interpretive flexibility. Therefore beginning in 2022, increased consideration should be given to these requirements as the IRS began 4960 compliance checks in 2021 that will continue in 2022. Failure to respond to a compliance check may be referred to examination.

Section 4960 of the Internal Revenue Code (IRC) imposes a 21% excise tax on remuneration in excess of $1 million and any excess parachute payment paid by an applicable tax-exempt organization (ATEO) or its affiliates to any covered employee. On Jan. 19, 2021, the IRS released final regulations that affect ATEOs and related entities. While the 2021 final regulations generally follow the proposed regulations released on June 11, 2020, the final regulations include several important changes. Of particular significance, the final regulations expand the exceptions where employees of a for-profit entity related to an ATEO will not be treated as covered employees. Although the final regulations are effective for taxable years beginning after Dec. 31, 2021, taxpayers can apply them retroactively to 2018, when Section 4960 first became effective.  

Insight
Entities that can claim tax-exempt status under the doctrine of implied sovereign immunity may be subject to Section 4960 if they also obtained tax-exempt status under Section 501. These entities may choose to give up their Section 501 tax-exempt status in order to avoid ATEO status.

Key Concepts

Who is subject to 4960?

An ATEO that is subject to 4960 is any organization that:

• Is exempt from taxation under Section 501(a);
• Is a farmers' cooperative organization described in Section 521(b)(1);
• Has income excluded from taxation under Section 115(1); or
• Is a political organization described in Section 527(e)(1).

Entities related to the ATEO could also be subject to 4960, even if the affiliate is not a tax-exempt organization. An ATEO’s related organizations are generally any person or governmental entity that:

• Controls, or is controlled by, the ATEO;
• Is controlled by one or more persons who control the ATEO;
• Is a supported organization of the ATEO, as defined in Section 509(f)(3); or
• Is a supporting organization described in Section 509(a)(3) with respect to the ATEO.

Section 4960 is sometimes referred to as the “Nick Saban rule,” which is ironic because 4960 does not apply to the famed University of Alabama football coach or to many other highly paid state college employees. Some state colleges are not applying 4960 because they do not derive tax exemption for any reason enumerated above. While the IRC does not explicitly exempt states and instrumentalities from federal income tax, the IRS views them as exempt from federal tax because nothing in the IRC taxes them. Therefore, the doctrine of “implied sovereign immunity” is applied.

The exclusion of state colleges and universities from the 4960 definition based on the doctrine of implied sovereign immunity appears to have been a drafting error in the Tax Cuts and Jobs Act of 2017. In the preamble to the final regulations the IRS confirms the statutory disparity, resulting in inequity between public and private collegiate athletic departments.[2] Congress appears frustrated with that result and may revisit the definition. For example, in January 2022, the House Ways and Means Subcommittee on Oversight demanded answers to a long list of questions aimed at discerning how large compensation packages for athletic coaches further the public university’s educational mission.

What is the 4960 excise tax rate?

The 21% excise tax rate for 4960 is based on the current federal corporate income tax rate set forth in IRC Section 11.³ Therefore, if the federal corporate income tax rate goes up or down, the 4960 excise tax rate will automatically adjust to that new rate.  

Insight
Watch for changes to the 4960 excise tax rate based on potential increases in the federal corporate income tax rate, as Congress and the Biden Administration consider scaling back “Build Back Better” legislation that would possibly include tax increases as revenue raisers.

What are Excess Parachute Payments?

To have a 4960 “excess parachute payment,” there must first be a “parachute payment.”⁴ Parachute payments are payments in the nature of compensation ⁵ that are contingent on an “involuntary termination of employment” that equals or exceeds three times the employee’s “base amount” (i.e., the employee’s five-year annual average compensation, including pay for services performed for a predecessor or related organization). ⁶ Parachute payments exclude amounts paid from tax-qualified retirement plans, payments for medical services, and “substantially certain” amounts that would have been paid even without the involuntary termination of employment. Parachute payments include payments for a release of claims, damages for employment agreement breaches, window program payments, payments for noncompete or similar agreements, and the value of accelerated vesting of benefits. ⁷

A termination of employment is involuntary for the 4960 excess parachute payment rules if the termination is due to “the independent exercise of the employer’s unilateral authority to terminate the employee’s services” if the employee was willing and able to continue the services and did not request termination.⁸ Also, for the 4960 rules, a more than 80% reduction in services is considered a termination of employment, but a less than 50% reduction in services is not considered a termination of employment. Whether a reduction of services between 50% and 80% would be a termination of employment for 4960 purposes depends on the specific facts and circumstances.

Once there is a parachute payment, Section 4960 imposes an excise tax on “excess parachute payments.” Excess parachute payments are parachute payments that exceed one times the base amount.⁹ If there is a 4960 parachute payment, the 4960 excise tax applies to any “excess” parachute payment.

Insight
Keep in mind that the 4960 excise tax on excess parachute payments is relevant only where the fair market value of all payments contingent on an involuntary separation (as specifically defined in the 4960 final regulations) equals or exceeds three times the base amount. Then, if the tax applies, it applies only to “excess” amounts – i.e., amounts that exceed one times the base amount.

 
What is remuneration? - “Remuneration” ¹⁰ for 4960 purposes means Section 3401(a) wages (i.e., Box 1 of W-2), but:

• Excluding designated Roth contributions to a tax-qualified retirement plan or individual retirement account and amounts paid for performing medical services (which include deferred compensation attributed to performing medical services)
• Including taxable fringe benefits and amounts required to be included in income under Section 457(f) — i.e., when vested — even if the vested amount is not paid until later.

Insight
For purposes of Section 4960, annual earnings on previously vested Section 457(f) amounts are included in remuneration, even though such earnings are not reported on Form 990 Schedule J until paid. See Treas. Reg. §53.4960-2(d). This is a disconnect between Form 990 reporting and the 4960 excise tax calculation that could be a trap for the unwary.

Who are covered employees?

For 4960, “covered employee” means an employee (including any former employee) of an ATEO if the employee is one of the five highest compensated employees (HCEs) for the taxable year or was a covered employee of the organization (or a predecessor) for any preceding taxable year beginning after Dec. 31, 2016.¹¹ Thus, even though Section 4960 first became effective for taxable years beginning on or after Jan. 1, 2018, ATEOs and related entities must look back to the 2017 taxable year to determine who is a 4960 covered employee for 2017, and apply the covered employee rules to those individuals for 2018 and beyond. ATEOs and related entities should make a new, cumulative covered employee list every taxable year. Once an employee is covered, the individual retains that status indefinitely, even after termination of employment or death (i.e., a cumulative covered employee list is needed). So, over time, it is likely that ATEOs and related entities will have a covered employee list that exceeds five individuals. ATEOs and related entities that do not have a 4960 liability for a taxable year would still need to make a list of covered employees each year. A separate covered employee list is required for each ATEO and for each related entity. In other words, the ATEO cannot maintain a single covered employee list for itself and all of its related entities.

 
Section 4960 excise taxes are not just for employers who pay over $1 million.

ATEOs of all sizes (and their related entities) may owe a 4960 excise tax if (i) they paid any employee $125,000 or more on or after Jan. 1, 2018 (or $125,000 for 2019; $130,000 for 2020 and 2021; $135,000 for 2022) (i.e., HCEs)¹² and (ii) the HCE is paid an amount equal to or exceeding three times the HCE’s five-year average annual compensation from the ATEO, any predecessor or related organization due to HCE’s involuntary termination of employment. So even if the ATEO never pays any employee more than $1 million, it could still owe the tax on excess parachute payments. Keep in mind, however, that death, disability, retirement, or a voluntary resignation (other than for “good reason” which is treated as an involuntary termination) do not trigger excess parachute payment excise tax under Section 4960.

 
Who owes the 4960 excise tax?

The common law employer of the employee (not the employee) must pay the tax.¹³ For-profit employers related to the ATEO could also owe their share of the tax. A 100% penalty for failure to pay the excise tax could apply unless the failure was due to reasonable cause.

 
What does “taxable year” mean for determining 4960 excise tax liability?

Remuneration is determined for 4960 purposes based on the calendar year beginning with or within the employer’s fiscal year.¹⁴ This is the same way compensation is determined for annual Form 990 reporting. Note that “taxable year” does not mean the employer’s fiscal year.

 
How to report and pay the tax?

The employer must timely file IRS Form 4720 to report and pay the excise tax.¹⁵ Form 4720 is due by the 15th day of the fifth month after an employer’s taxable year-end (i.e., May 15 for calendar year employers). For-profit-related entities file their own Form 4720. The IRS has rejected joint filings of a single Form 4720 for a related group. Although estimated tax payments are not required for 4960 excise tax, employers can elect to prepay the tax.¹⁶
 

Key Points in the Final Regulations

No grandfathering.

In the preamble to the final regulations, the IRS rejected comments asking for a grandfather rule that would exempt agreements entered into before Dec. 31, 2017, from the 4960 excise tax. The IRS noted that the statute did not give the IRS authority to adopt a grandfather rule and does not include such relief. The final regulations clarify that the excise tax applies to remuneration paid or vested during taxable years after Dec. 31, 2017. So, generally, 4960 does not apply to amounts that vested before 2018, but does apply to earnings on those vested amounts that accrue or vest in 2018 or later.¹⁷

Aggregated compensation.

Covered employees may receive compensation from multiple entities of the ATEO or related organizations. The final regulations clarify that all compensation received by a covered employee must be aggregated.¹⁸

Special timing rule for remuneration.

Under the final regulations, any deferred compensation must be included in a covered employee’s remuneration calculation for the taxable year that it becomes vested, rather than the taxable year in which it is paid (i.e., there is no short-term deferral rule).¹⁹

Pay for medical services excluded from remuneration.

Payments for medical and veterinary services are disregarded when determining an ATEO’s covered employees. But the final regulations clarify that amounts paid for administrative services provided by medical and veterinary employees is included in the remuneration calculation.[20]

Covered employee rules.

Once an ATEO employee (or employee of an entity related to the ATEO) has been designated as a covered employee, that designation remains indefinitely. The individual is still considered a covered employee after retirement and after death (for payments to beneficiaries). Thus, any deferred compensation that would be paid to the covered employee after retirement would be subject to the $1 million cap, including compensation paid by a related organization.²¹

The final regulations also confirm that the ATEO and each related entity must have its own list of covered employees. In other words, there cannot be one aggregated list of covered employees for the entire related group of employers. Further, an employee can be a covered employee of more than one ATEO in a related group of organizations for a tax year.

When determining covered employees, the final regulations confirm that remuneration paid by the ATEO is aggregated with remuneration paid by any related organization during the ATEO’s applicable year, including remuneration that a related organization or governmental entity pays for services that someone performs as an employee of the related organization.

Exceptions to covered employee rules.

Three exceptions allow taxpayers to exclude certain remuneration paid by an ATEO’s related organizations if certain conditions are met, including the employee not receiving remuneration for services rendered to the ATEO itself. This often comes up when a for-profit company creates a tax-exempt foundation, and executives of the for-profit company perform services for the foundation on a volunteer basis.

The final regulations adopt without change the limited hours and limited services exceptions and make two taxpayer-favorable changes to the nonexempt funds' exception.

• Limited hours exception - An employee’s time working at an ATEO during the applicable year must be less than 10% of the total time the employee worked for any related organizations during the same time period. The final regulations include a safe harbor for employees who work no more than 100 hours for the ATEO and all related entities during the applicable year.²²
• Limited services exception - An ATEO can pay remuneration to the employee, but it must be less than 10% of the employee's total remuneration for services performed as an employee of members of the ATEO group during the applicable year.²³
• Nonexempt funds exception - Individuals may be disregarded if they have not received remuneration (or any legally binding right to nonvested remuneration) from the ATEO, any related ATEOs, or any taxable related organizations controlled by the ATEO and/or related ATEOs for services provided to the ATEO; and did not perform services for the ATEO and related ATEOs in excess of 50% of the individual’s total hours worked for the ATEO and all of its related organizations. This exception also requires that any related organization that paid remuneration to the individual must not have provided services for a fee to the ATEO, to any related ATEOs or to any taxable related organizations controlled by the ATEO and/or related ATEOs.²⁴ 
• The measurement period for the 50%-of-total-hours test is two years instead of one year (i.e., the current year and the preceding year are a single measurement period). This allows flexibility for employees who rotate to an ATEO for more than six months or unexpectedly provide services for more than six months.
• In determining whether a taxable related organization is “controlled” by the ATEO for purposes of this exception, ATEOs may disregard “downward attribution” in applying IRC Section 318(a)(3) to corporations and other entities and in applying Section 318 principles to nonstock organizations. This modification is only for the nonexempt funds' exception and not for determining whether an organization is related generally.²⁵

The final regulations do not prescribe how to determine present value, other than saying that present value is determined using reasonable actuarial assumptions about the amount, time and probability that the payment will be made. The final regulations say that rules for determining 4960 present values will likely be issued when final Section 457(f) regulations are issued. Until further guidance is issued, 4960 present values can be calculated using proposed Treas. Reg. § 1.457-12(c).

Determining Present Value.

The final regulations retain the concept that the amount included as 4960 remunerations is the present value of the remuneration on the date the amount vests.²⁵ The final regulations do not prescribe how to determine present value, other than saying that present value is determined using reasonable actuarial assumptions about the amount, time and probability that the payment will be made. The final regulations say that rules for determining 4960 present values will likely be issued when final Section 457(f) regulations are issued. Until further guidance is issued, 4960 present values can be calculated using proposed Treas. Reg. § 1.457-12(c).

Also, to reduce administrative burdens of determining present values that would involve minimal discounting, the final regulations continue to allow employers to treat the entire amount to be paid on a future date as the present value on the vesting date (i.e., without making a present value calculation). The proposed regulations limited this special rule to non-account balance plans, but the final regulations expand it to apply to any vested amount scheduled to be paid within 90 days, including amounts under account balance plans.

Split-dollar Life Insurance Arrangements.

The preamble to the final regulations cautions ATEOs, especially private foundations and 509(a)(3) entities, from entering into split-dollar life insurance arrangements with covered employees since this “may constitute an act of self-dealing under Section 4941 or an excess benefit transaction under Section 4958(c)(3).”²⁶

To minimize the impact of Section 4960, many large health systems, educational institutions and other tax-exempt organizations have turned to collateral assignment split-dollar life insurance arrangements. The IRS statement seems to say that a parent organization that employs key executives (i.e., that is a supporting organization) may be prohibited from entering into split-dollar arrangements, since (in the IRS’ view), doing so may result in an immediate excess benefit transaction. Any supporting organizations under Section 509(a)(3) that are considering split-dollar arrangements or that entered into split-dollar arrangements after Jan. 19, 2021 (when the final regulations were issued) may want to discuss this issue with legal counsel.

Below-Market Employer Loans.

The final regulations also provide that 4960 remuneration includes amounts treated as compensation under Section 7872 (for example, amounts includible as compensation under a below-market split-dollar loan).²⁷ This clarification was needed because 4960 remuneration is generally defined as Section 3401(a) wages for federal income tax withholding purposes, but Section 7872(f)(9) excludes such compensation from federal income tax withholding. The IRS takes the position that such compensation is 4960 remuneration because it falls within the broad definition of 3401(a) wages and is not excluded under that section. The final regulations clarify that 4960 remuneration does not include amounts that are not treated as compensation under Section 7872(c)(3), which excludes from compensation forgone interest attributable to any day on which the aggregate outstanding amount of loans between the employee and the employer does not exceed $10,000.

Federal Instrumentalities are not Subject to the Tax.

The final regulations say that until further guidance is provided, a federal instrumentality for which an enabling act provides for exemption from all current and future federal taxes under Section 501(c)(1)(A)(i) may treat itself as not subject to Section 4960 as an ATEO or related organization.[28] But, if the federal instrumentality is a related organization of an ATEO, remuneration it pays must be taken into account by that ATEO.

Coordinating 4960 with 162(m).

IRC Section 162(m) disallows deductions for public company annual compensation over $1 million for certain “covered employees” as defined under that section. Taxpayers may use a reasonable, good faith approach with respect to the coordination of Sections 4960 and 162(m) where it is not known whether a deduction will be disallowed under 162(m) by the due date (including any extension) of the relevant Form 4720. Taxpayers can also rely on the two proposed approaches described in the preamble to the proposed regulations.²⁹

Exclusion of Certain Foreign Organizations.

The final regulations exclude from 4960 any foreign organization that is both described in Section 4948(b) and is either (i) exempt from tax under Section 501(a) or (ii) a taxable private foundation (“4948(b) related organization”).³⁰ Section 4948(b) generally applies to foreign organizations that receive substantially all of their support (other than gross investment income) from sources outside the United States (determined at the end of the organization’s tax year).

Nevertheless, any remuneration paid to a covered employee of an ATEO by a 4948(b) related organization must be taken into account by the ATEO (and any related organizations subject to 4960) for purposes of determining an ATEO’s (and related organizations’) 4960 liability and the ATEO’s covered employees.
 

Mitigation and Planning Strategies

Executive Compensation in Excess of $1 Million – Who are they?

The taxpayers most likely to be impacted are large and complex organizations, with positions such as senior executives in health systems/hospitals, leadership positions in higher education (including, e.g., private university athletic coaches), senior executives in large professional and industry trade associations, as well as those in large philanthropic/charitable foundations.  The size of this group is very small in relation to the large numbers of leadership positions in tax-exempt organizations making less than $1 million, but these highly paid positions draw a great deal of attention from the public.

Highly paid executives in the publicly traded, for-profit world are regularly targets for outcries over excessive compensation.  But pay for any non-profit executive at or above $1 million is simply unimaginable for most of the public. These people are assumed to not warrant this type of compensation in the “charitable” sphere. The highly paid are regularly highlighted in the media in annual listings of local executives, or the compensation of executives which finds its way into reporting on some controversy involving the organization.

Yet, the market for executive talent is blind to the tax status of the organization. The talent demands on executives in a large health system or sprawling higher education institution are no less rigorous than those facing executives in the for-profit sector. Competitive market forces exercise great influence on the price of executive talent.

Executive Compensation in Excess of $1 Million – What can be done?

Where executive compensation is projected to be $1 million or more, there are a few planning ideas:

• Make the entire payment and pay the excise tax on the excess over $1 million - Some organizations are doing this based on contractual commitments and/or competitive necessity.
• Cap remuneration at $1 million per year – In instances where remuneration is approaching $1 million, the organization can institute policies that will prevent remuneration from exceeding the $1 million threshold.
• Shift compensation over $1 million into other compensation arrangements – If a $1 million cap on remuneration is not possible, then avoid or minimize the excise tax by spreading the excess compensation to various tax years. This can be accomplished by:
• Using a Section 457(f) plan to defer amounts to a later year with lower compensation
• Entering into a split-dollar life insurance policy between the employer and the executive. Under a collateral assignment arrangement, the executive owns the policy and the employer makes the policy premium payments as loans to the executive. These premiums are recouped when the policy benefit is paid.  As the policy owner, the executive can enjoy many of the attractive advantages associated with a life insurance policy (e.g., death benefit, cash value build-up and other tax-favorable benefits).  However, these are complex arrangements and involve extensive administrative and reporting requirements. Experienced advisors must be consulted to properly structure these policies.
  
  

“Parachute” Payments to Covered Employees – Who are they?

Large payments to executives leaving organizations, especially in any involuntary situation, attract as much or more public ire as the highly paid executive, regardless of the organization’s tax status.  Affectionately known by some as the “golden boot,” these payments are included in the 4960 excise tax. 

Unlike the $1 million executives, there are numerous organizations that may encounter scenarios prone to the excise tax on a “parachute” payment. The simple fact that a much lower compensation level (i.e., the HCE amount for 2022 is $135,000) and being (or ever have been) one of the organization’s five highest-paid executives – a covered employee) raises the prospect of exposure to the excise tax.

In any number of different situations, the provisions of a substantial separation-related payment(s) (e.g., significant 457(f) plan vesting, special bonus, etc.), with the intent to provide something “nice” or extra under the circumstances could produce an award that triggers the excise tax. Without careful attention to the organization’s covered employee group and understanding all the elements conferred in a separation arrangement, there could be an unpleasant surprise when the excise tax is triggered.

“Parachute” Payments to Covered Employees – What can be done?

As suggested above, organizations should begin by carefully identifying and then tracking their covered employee group. Organizations must remember: Once a covered employee, always a covered employee. The next step is to carefully identify any separation-related payments for which a covered employee may be eligible. The types of payments and current levels should also be kept up to date with any changes that impact the payment amounts (e.g., salary or bonus-based separation payments).

With an updated inventory of covered employees and separation-related payments, it should be very easy to determine any individual potentially representing an excise tax exposure. Review actual or projected W-2 earnings for the five years preceding the potential separation event.  Compute the actual or estimated base amount (average of those five years). If the estimated total of all payments triggered by the separation from service exceeds three times the five-year average W-2 earnings, there is exposure to the excise tax. The exposure is the difference between the total payment minus one times the five-year W-2 average.

Organizations can explore strategies to lower separation-related compensation. If possible, start the planning early as there may be an option to shift some separation-related amounts into compensation during one or more years prior to the separation event — for example, by maximizing qualified plan contributions, especially additional amounts when nearing retirement age, or increasing W-2 compensation. This could lower the separation amount and increase the five-year average base amount.

IRC Section 4960 does offer a few alternatives that can avoid or lower the organization’s exposure to the 21% tax. The amount due in 4960 taxes represents funds that might otherwise be used for the organization’s overall mission.  Organizations must be alert to the 4960 issue and, whenever possible, plan ahead.

Copyright © 2022 BDO USA, LLP. All rights reserved. www.bdo.com 

[1] Regs Section 53.4960-1(i).
[2] Federal Register, Jan. 19, 2021, page 6197.
[3] IRC Section 4960(a).
[4] Regs Section 53.4960-3(a).
[5] Regs Section 53.4960-3(b).
[6] Regs Section 53.4960-3(g).
[7] Regs Section 53.4960-3(f).
[8] Regs Section 53.4960-3(d) and (e).
[9] Regs Section 53.4960-5(b)(2) and (d).
[10] Regs Section 53.4960-2(a).
[11] Regs Section 53.4960-1(d).
[12] The definition of HCE for tax-qualified retirement plans in IRC Section 414(q) is used for determining covered employees for 4960 excise taxes. The IRS adjusts HCE dollar limits annually in $5,000 increments based on cost-of-living increases.
[13] Regs Section 53.4960-4(a).
[14] Regs Section 53.4960-1(c).
[15] Regs Section 53.4960-4(a).
[16] Regs Section 53.4960-4(d)(4).
[17] Regs Section 53.4960-6(a).
[18] Regs Section 53.4960-2(b).
[19] Regs Section 53.4960-2(c).
[20] Regs Section 53.4960-2(a)(ii).
[21] Regs Section 53.4960-1(d).
[22] Regs Section 53.4960-1(d)(2)(ii).
[23] Regs Section 53.4960-1(d)(2)(iv).
[24] Regs Section 53.4960-1(d)(2)(iii).
[25] Regs Section 53.4960-3(h).
[26] Federal Register, Jan. 19, 2021, page 6205.
[27] Regs Section 53.4960-2(a).
[28] Federal Register, Jan. 19, 2021, page 6197.
[29] Federal Register, Jan. 19, 2021, page 6198.
[30] Regs. Section 53.4960-1(b)(2).