IRS Announces “Compliance Strategy” for Excess Executive Compensation Paid by Tax Exempt Entities

The Tax Cuts and Jobs Act (TCJA) enacted in December 2017 created a 21% excise tax on executive compensation in excess of $1 million paid by tax-exempt organizations to certain employees (IRC Section 4960). Covered employees include the five highest-compensated employees of an organization or an individual who qualified as a covered employee in a preceding taxable year.

On November 5, 2020, the IRS’s Tax Exempt & Government Entities Division (TE/GE) issued its annual program letter outlining the areas of focus for TE/GE in 2021 and released a new compliance website featuring the Division’s compliance strategies, which includes the following:

Exempt Organizations: Excise Tax on Excess Compensation. This strategy is to review the impact of the new Internal Revenue Code Section 4960 excise tax on excess compensation. IRC Section 4960 imposes a 21% excise tax on tax-exempt organizations that pay over $1 million in compensation to any “covered employee.” On-going review of filing data shows there continues to be a high volume of exempt organizations that paid compensation of over $1 million to at least one “covered employee” but did not report IRC Section 4960 excise tax on Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code. The approved workstreams for this strategy are compliance checks and examinations of Form 4720.

Typically limited in scope and less burdensome than an examination or audit, an IRS compliance check is a review process the IRS uses to determine whether an organization is in compliance with IRS reporting requirements. 

IRS Guidance on Calculating the Excise Tax

IRS Notice 2019-09 states that the following steps should be taken to calculate how much excise tax is owed, if any, on a parachute payment:

  • Is the covered employee entitled to compensation due to an involuntary termination that is not subject to any exclusions? If yes, then continue.
  • Determine the total aggregate present value of the expected contingent payments. Watch for pertinent special valuation rules that affect payment or the vesting of a right to payment.
  • Calculate the covered employee’s base amount of compensation.
  • Are the contingent payments considered parachute payments?
  • If so, then calculate the amount of excess parachute payments, if any.
  • Finally, use Code Section 4960(a)(2) to calculate the amount of excise tax owed.

Other factors affect this calculation, including whether a separation of employment is voluntary or involuntary. Remuneration paid for medical and veterinary services should not be included when calculating the five highest-paid individuals.

HBL helps our clients stay on top of the legislative and regulatory changes that apply to their employee benefit plans, and our team ensures that plans and processes are updated to stay in compliance. To learn more, call our team today at 678-439-6236.

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Hall Benefits Law, LLC

HBL offers employers comprehensive legal guidance on benefits in mergers and acquisitions, Employee Stock Ownership Plans (ESOPs), executive compensation, health and welfare benefits, healthcare reform, and retirement plans. We counsel a wide spectrum of clients including small, mid-sized, and large companies, 401(k) investment advisors, health insurance brokers, accountants, attorneys, and HR consultants, just to name a few. HBL is passionate about advising clients, and we are dedicated to our mission: to provide comprehensive, personalized, and practical ERISA and benefits legal solutions that exceed client expectations.

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