On Jan. 11, 2021, the Department of the Treasury and the Internal Revenue Service issued final regulations pertaining to the implementation of tax code Section 4960, which imposes an excise tax of 21% on salaries exceeding $1 million paid to covered employees of nonprofit organization.
Treasury and the IRS issued the proposed regulations pertaining to Section 4960 on June 11, 2020. In general, the vast majority of the final regulations retain the directional guidance originally provided in the proposed regulations. This article focuses on the changes incorporated in the final regulations based on comments received with respect to the proposed regulations. The following are a summary of those clarifications, changes and/or variations from the original guidance.
Nonexempt Funds Exception
Under the nonexempt funds exception, an individual is disregarded for purposes of determining an ATEO’s five highest-compensated employees for a taxable year if all of the following are satisfied: (a) neither the ATEO, nor any related ATEO, nor any taxable organization controlled by the ATEO (either each such entity alone or together with the ATEO), paid remuneration or granted a legally binding right to nonvested remuneration to the individual for services the individual performed as an employee of an ATEO; (b) the individual performed services as an employee of the ATEO and all related ATEOs for less than 50% of the total hours worked as an employee of the ATEO and all related organizations; and (c) no related organization that paid remuneration or granted a legally binding right to nonvested remuneration to the individual provided services for a fee to the ATEO, to any related ATEO, or to any taxable related organization controlled by the ATEO (either each such entity alone or together with the ATEO). The final regulations in the preamble acknowledge that the drafting in the proposed regulations could lead to inadvertent failures or inability to satisfy each of the three criteria established under the nonexempt funds exception in certain situations. As such, the follow revisions are incorporated:
1. Regulation Sections 53.4960-1(d)(2)(iii)(A)(1) and 53.4960-1(d)(2)(iii)(A)(3) are revised to modify the attribution rules for purposes of determining eligibility for use of the exception by disregarding the application of downward attribution in applying tax code Section 318(a)(3) to taxable corporations and taxable nonstock entities. The final regulations acknowledge that the restrictions in these two criteria as pertains to taxable related entities is really only warranted if the applicable tax-exempt organization (ATEO) actually owns a controlling interest in the taxable entity. Unless the ATEO actually owns a controlling interest, the IRS concluded that the legislative intent of Section 4960 could not be circumvented. Notwithstanding this relaxation, the preamble to the final regulations note that this modification applies only for purposes of applying the nonexempt funds exception and does not apply for purposes of determining whether an organization is a related organization generally.
2. Section 53.4960-1(d)(2)(iii)(A)(2) was revised to expand the measurement period for hours of service determination (one of the criteria used in the nonexempt funds exception) from one applicable year to two applicable years (i.e., the current applicable year and the preceding applicable year are treated as a single measurement period). Consequently, to neutralize one-time anomalies (such as an employee rotating into an ATEO for a period that extends longer than six months), whether an employee provided services to the ATEO and all related ATEOs for not more than 50% of the total hours will be evaluated and determined by looking to hours for the current applicable year and preceding applicable year. Equally, for purposes of remuneration under Regulation Sections 53.4960-1(d)(2)(iii)(A)(1) and 53.4960-1(d)(2)(iii)(A)(3), the period evaluated for payment is expanded from the current applicable year to include the preceding applicable year. Therefore, remuneration equally must not be paid during the applicable two year period to qualify for the nonexempt funds exception.
Definition of Remuneration
The proposed regulations confirmed that Section 4960(c)(3)(A) generally defines “remuneration” as wages under Section 3401(a) (i.e., wages subject to federal income tax withholding), but excluding designated Roth contributions under Section 402A(c) and including amounts required to be included in gross income under Section 457(f). Regulation Section 53.4960-2(a)(1) was amended to state that remuneration does not include amounts which are excepted from taxation under tax code Section 7872(c)(3) (pertaining to compensation-related loans falling under the $10,000 de minimis exception). Additionally, this same regulatory section, at the request of a commentator, expressly confirms that remuneration does not include any amount that vested or was paid by a taxpayer before the start of the taxpayer’s first taxable year that began on or after Jan. 1, 2018.
NOTABLE GOVERNMENT COMMENTARY: An interesting comment was added to the preamble of the final regulations specifically pertaining to split-dollar life insurance but outside of the Section 4960 context. According to the preamble, ATEOs that are private foundations or Section 509(a)(3) supporting organizations should consider, before entering into these arrangements, that loans (including transactions treated as loan for Federal tax purposes, such as split-dollar arrangements) to certain employees may constitute an act of self-dealing under Section 4941 or an excess benefit transaction under Section 4958(c)(3).
Given the significant uptick in the use of split-dollar insurance arrangements by large health systems and educational institutions as a means of minimizing the impact of Section 4960 since its enactment, this statement appears to be indicating that a parent organization that employs key executives and thereby qualifies as a tax-exempt supporting organization could in fact be prohibited from entering into split-dollar arrangements and that potentially doing so is an immediate excess benefit transaction. Any supporting organizations under Section 509(a)(3) that are contemplating the use of a split-dollar arrangement or have recently entered into split-dollar arrangements are advised to discuss this issue with legal counsel.
Definition of ATEO (Applicable Tax-Exempt Organization)
The proposed regulations provided that a foreign organization (defined in Regulation Section 53.4948-1(a)) that receives substantially all of its support (from the date of creation) from sources outside the U.S. is not an ATEO.
The IRS concluded that Section 4948 is concerned with foreign private foundations (including entities treated as private foundations for purposes of tax code Chapter 42) and other tax-exempt organizations that have received sufficient support from U.S. sources to warrant subjection to taxation as well as various prohibitions under Chapter 42 of the tax code. Regulation Section 53.4948-1(b)(1) and (2) now provides that if a related organization, which is a foreign organization, is BOTH described in Section 4948(b) AND is either exempt from tax under Section 501(a) or the entity is a taxable private foundation, then the foreign organization is not an ATEO and thereby is excluded from taxation under Section 4960.
Remuneration Not Deductible Under Section 162
The preamble to the final regulations states that the interplay between Section 162(m) and Section 4960 raises significant issues stemming largely from the difference in timing between the payment of remuneration under Section 4960 (when the right to the amount vests), and the availability of a deduction that may be restricted under Section162(m) (generally when the amount is paid). Because the Treasury and IRS are still determining the appropriate manner of implementation of this interplay between these two tax code sections, they have struck the prior guidance and simply reserve that section of the regulations for future guidance.
Until that future guidance is issued, however, taxpayers may use a reasonable, good faith approach with respect to the coordination of Section 4960 and Section 162(m) 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 (including any extension) of the relevant Form 4720. For this purpose, a reasonable, good faith approach must have a reasonable basis for anticipating that the compensation that a particular employee will be paid in the future may be subject to the deduction limitations of Section 162(m). For example, it is not reasonable for this purpose to anticipate that an ATEO may become a public corporation by the date the compensation will be paid absent facts indicating that is a realistic potentiality. Until future guidance is issued, taxpayers may also continue to use the two approaches regarding deferred compensation described in Section III(F) of the Explanation of Provision of the Proposed Regulations.
Deferred Compensation Plans
The preamble to the final regulations specifically notes that the proposed regulations for Section 457(f) are not yet finalized. Any changes to the tax code Section 457(f) proposed regulations when finalized will be considered for purposes of Section 4960 and consequently, further guidance may need to be issued at that time if appropriate (including any transition guidance that may be needed to take into account periods before and after the applicability date of the definition of substantial risk of forfeiture under those final rules).
Inclusion in Remuneration at the Time of Vesting
The proposed regulations provided that the present value of remuneration under a nonaccount balance that is scheduled to be actually or constructively paid within 90 days of vesting can be treated as paid by the employer on the vesting date. Regulation Section 53.4960-2(e)(2) was amended to provide that any remuneration that is scheduled to be actually or constructively paid within 90 days of vesting can be present valued and treated as paid on the vesting date. Therefore, the limit of this present value early inclusion is no longer limited to non-account balances but instead applies to any vested amount that is scheduled to be paid within 90 days. It is anticipated that these final regulations will be updated with respect to present value determinations after the final regulations under Section 457(f) are issued.
Allocation for Remuneration of Medical Services
An employer is permitted to make a reasonable, good faith allocation between the remuneration for medical services and the remuneration for non-medical services. Regulation Section 53.4960-2(a)(2)(ii) clarifies that the allocation of remuneration pertaining to medical services, regardless of the form of compensation, must be made on a reasonable, good faith basis, and that the employer may apply the same principles of allocation with respect remuneration for medical services to contribution and earnings under a deferred compensation plan.
The final regulations reserve Regulation Sections 53.4960-1(b)(3) and 53.4960-4(a)(5) for future rules to address federal instrumentalities. However, until further guidance is issued, a federal instrumentality for which an enabling act of Congress provides for exemption from all current and future federal taxes may treat itself as not subject to tax under Section 4960 as an ATEO or related organization. However, if the Federal instrumentality is a related organization of an ATEO, the remuneration that it pays MUST be taken into account by the ATEO.
Grandfather Rule Rejected
Although commentators requested that the final regulations provide a grandfather rule for employee remuneration contracts that existed prior to Nov. 2, 2017, the Treasury and IRS concluded it was not necessary or appropriate.
As noted from the summary, the Treasury and IRS “stayed the course” on the majority of the proposed rules. With respect to the changes above, two are “significant” (i.e., the two year applicable measurement period for the nonexempt funds exception) and the commentary on split-dollar insurance being used by supporting organizations). The other changes are more in the arena of nominal expansions and clarifications. Regardless, it is recommended that ATEOs familiarize themselves with these additional revisions when implementing what are now the final rules effective for taxable years beginning after Dec. 31, 2021.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Mary K. Samsa is a partner with Akerman, LLP in their Chicago office. With 25 years of experience, Mary Samsa focuses her practice on executive compensation matters and tax-qualified retirement programs for a wide range of organizations, including Fortune 500 companies, privately held companies, multinational organizations and nonprofit entities, including health systems and educational institutions.