IRS Releases Final Regulation on Tax-Exempt Organizations Excise Tax

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). On January 19, 2021, the IRS published the final regulations to help applicable tax-exempt organizations (ATEOs) comply with the excise tax on excessive pay under Section 4960.

The following summarizes the key takeaways from the final regulations, which take effect starting after December 31, 2021:

No grandfathering. When the IRS published its proposed regulations in June 2020 for comment, it received feedback requesting the grandfathering of contracts prior to December 31, 2017, the year in which Section 4960 became law. The IRS has rejected those proposals; in the final regulations, the 21% excise tax under Section 4960 applies to compensation paid or vested during the taxable years following December 31, 2017.

Aggregated compensation. Covered ATEO employees may receive compensation via multiple entities of the organization or “related” organizations where the threshold for relatedness is 50%.  All compensation received by a covered ATEO employee must be aggregated under the final regulations. If the aggregated amount exceeds $1 million, the ATEO must pay the 21% excise tax.

Once covered, always covered rule. Once an ATEO employee has been designated as a “covered” employee for purposes of Section 4960, that designation stays in place indefinitely – including after retirement. Therefore, any deferred compensation arrangements that would go to the covered employee after retirement would be subject to the $1 million cap, including compensation from a related organization. There are two exceptions to this rule:

  1. Nonexempt funds exception, where a covered employee’s time working at an ATEO over the applicable and preceding year cannot exceed 50% of that employee’s total service time to any related organizations during the same time period.
  2. Limited hours exception, where 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.

Special timing rule for remuneration. Under the final regulations, any deferred compensation must be included in a covered employee’s remuneration calculation the year it is vested rather than the year in which it is paid. 

Pay for medical services excluded from remuneration. Under Section 4960, the excise tax does not apply to compensation paid for medical and veterinary services; therefore, payments for medical veterinary services are to be disregarded when determining an ATEO’s five highest paid employees. However, compensation paid for administrative services from medical and veterinary employees is included in the remuneration calculation.

Split-dollar life insurance arrangements. The final regulations caution ATEOs – especially private foundations and Section 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).” This type of compensation is considered part of the remuneration calculation. Loans under $10,000 (de minimus loans) are an exception.

HBL has experience in all areas of benefits and employment law, offering a comprehensive solution to all your business benefits and HR/employment needs. We help ensure you are in compliance with the complex requirements of ERISA and the IRS code, as well as those laws that impact you and your employees. Together, we reduce your exposure to potential legal or financial penalties. Learn more by calling 678-439-6236.

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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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