Interim guidance issued by the IRS at the end of 2018 (Notice 2019-09) defines how tax-exempt organizations must apply the new excise tax on executive compensation. Nonprofits have known about the tax since the act commonly known as the Tax Cuts and Jobs Act was passed in the waning hours of 2017. Only now has it become clear how it will be implemented.
Internal Revenue Code (IRC) Section 4960 calls for a 21 percent tax on the portion of a covered employee’s income that exceeds $1 million and on excess parachute payments, effective for tax years beginning after December 31, 2017. First filings and payments using Form 4720, Return of Certain Excise Taxes, are due May 15, 2019, for tax years ending December 31, 2018.
It is imperative that applicable tax-exempt organizations (ATEOs) and related organizations take the time to evaluate the impact of Section 4960 and prepare for the first, and subsequent, excise tax liabilities and IRS filings. Following are answers to common questions about the new excise tax to assist in the process.
What is an ATEO and a related organization?
An ATEO includes any organization exempt from tax under IRC Section 501(a). Related organizations include:
- Those that control, or are controlled by, an ATEO
- Those that are controlled by one or more persons who control an ATEO
- Those that are a supported organization
A related organization may include taxable, tax-exempt, and governmental entities.
What is the definition of a covered employee?
For purposes of this law, a covered employee is any employee (or former employee) who is or was one of the five highest-compensated employees of the exempt organization, or a related organization, for any tax year beginning after December 31, 2016.
To identify the five highest compensated employees, an ATEO must consider compensation paid for the taxable year by any related organization, including a related for-profit organization or governmental entity, for services performed as an employee of those organizations. To that end, a group of related organizations could have more than five covered employees.
An employee does not need to be a considered highly compensated (annual salary of $120,000 or more), to be considered a covered employee.
Although the determination of covered employees is made annually, it is important to note that once an individual becomes a covered employee, that person will retain the “covered” status for all subsequent taxable years, even after termination of employment.
What is a parachute payment?
A parachute payment is any payment that is contingent on a covered employee’s separation from employment and the aggregate present value of the parachute payments that exceeds three times the base amount. However, any payment made to an individual who is not a highly compensated employee, as defined in IRC Section 414(q), is excluded. Any excess amount would be subject to the excise tax.
What is considered compensation?
For purposes of Section 4960, compensation is all wages subject to income tax withholding, including amounts that must be included in gross income, but excludes designated Roth IRA or 401(k) contributions. Compensation does not include wages paid to licensed medical professionals (including veterinarians) paid for performance of medical and veterinary services.
The timing of amounts subject to the excise tax is not so well defined. However, the new guidance does say that amounts are treated as paid when there is no substantial risk of forfeiture of the rights to the compensation.
A substantial risk of forfeiture is generally the criteria applied to determine when deferred compensation offered by a tax-exempt, state, or local government organization vests for participants under a nonqualified deferred compensation plan. It should be included as income to the recipient in the first year in which it is not a substantial risk for forfeiture, i.e., at the time of vesting.
When is the excise tax effective?
The amount of the excise tax is determined on wages that are considered paid, or on any excess parachute payment, during any calendar year that ends with or within the taxable year, beginning with the first taxable year of the organization that begins after December 31, 2017.
Does it work differently for fiscal year ATEOs?
As discuss above, the excise tax is based on compensation paid during the calendar year. The tax is effective for compensation paid (or vested) beginning with the first fiscal year beginning after December 31, 2017.
For example: An exempt entity’s fiscal year begins July 1, 2018. Wages paid (or vested) to a covered employee between January 1, 2018, and June 30, 2018, are not included for determining the tax for calendar 2018 because the tax is effective for the first fiscal year beginning after December 31, 2017. Wages paid July 1, 2018, through December 31, 2018, to covered employees are considered in determining whether the excise tax is applicable. If there is an excise tax it is payable 4.5 months after the end of the fiscal year (i.e., November 15, 2019, in this example).
Subsequently, wages paid to covered employees in calendar 2019, reduced by the $1 million exemption, are subject to the excise tax, payable November 15, 2020 (i.e., 4.5 months after the end of the June 30, 2020, fiscal year).
When is Form 4720 due?
An ATEO or related organization is liable for payment of the excise tax and filing of Form 4720, Return of Certain Excise Taxes, with the IRS for any taxable year the tax applies.
The form and tax payment are due by the 15th day of the fifth month after the end of an employer’s taxable year. The first filing due dates are:
- December 31, 2018, tax year end — First filing and tax due May 15, 2019
- June 30, 2019, tax year end — First filing and tax due November 15, 2019
Employers are cautioned against modifying or terminating existing nonqualified or deferred compensation agreements, or the acceleration of deferred compensation benefits, as separate regulations pertaining to those types of arrangement may come into play.
How we can help
CLA’s tax and employee benefit plan professionals are ready to assist nonprofit employers in understanding the application of Section 4960, determining wage components, evaluating deferred compensation plan benefit inclusion, calculating excise tax liability, and preparing and filing the annual Form 4720.