IRS Issues Notice 2019-09 Providing Interim Guidance Under Code Section 4960

Practical Law Legal Update w-018-3458 (Approx. 8 pages)

IRS Issues Notice 2019-09 Providing Interim Guidance Under Code Section 4960

by Practical Law Employee Benefits & Executive Compensation

Year Used for Calculating Excise Tax

Section 4960 refers to remuneration paid for the "taxable year" but does not specify:

Which taxpayer's year is used.
What it means for remuneration to be paid "for a taxable year."
How to measure remuneration if an ATEO and related organization have different taxable years.

The Notice provides that the excise tax is calculated based on excess remuneration paid and excess parachute payments made during the calendar year ending with or within the employer's taxable year.

Liability for Excise Tax

The common-law employer, as generally determined for federal tax purposes, is liable for the excise tax imposed under Section 4960 and cannot avoid liability by using a third-party payor arrangement. Also, a payment to the employee from a related entity for services rendered to the common-law employer is considered paid to the employee from the common-law employer. If a covered employee is an employee of both an ATEO and a related organization, each employer is liable for the excise tax under Section 4960.

Each ATEO calculates liability for the excise tax for a covered employee by:

Including remuneration paid by the ATEO and any related organization that employs the covered employee.
Allocating the excise tax among each employer.

The Notice provides rules for allocating liability for the excise tax among the employers, with each employer being liable for its proportionate share of the excise tax.

Applicable Tax-Exempt Organizations and Related Organizations

Section 4960(c)(1) provides that an ATEO is any organization that for the taxable year:

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).
Is a political organization described in Section 527(e).

This definition picks up certain government entities, such as federal instrumentalities exempt from tax under Section 501(c)(1) and public universities with IRS determination letters recognizing their tax-exempt status under Section 501(c)(3).

A person or governmental entity is "related to" an ATEO if the person or governmental entity:

Controls, or is controlled by, the ATEO.
Is controlled by one or more persons which control the ATEO.
Is a supported organization (as defined in Section 509(f)(3)) with respect to the ATEO.
Is a supporting organization described in Section 509(a)(3) with respect to the ATEO.
In the case of an ATEO which is a voluntary employees' beneficiary association (VEBA) described in Section 501(c)(9), establishes, maintains, or makes contributions to the VEBA.

Covered Employees

The excise tax applies to certain remuneration paid to "covered employees." A covered employee is any employee (including a former employee) of an ATEO if the employee either:

Is one of the five highest-compensated employees of the organization for the taxable year of the ATEO (see Determining the Five Highest-Compensated Employees).
Was a covered employee of the ATEO (or any predecessor) for any of the ATEO's preceding taxable years beginning after December 31, 2016. (Like new Section 162(m), once an individual is a covered employee for purposes of Section 4960, he or she continues to be a covered employee for all subsequent taxable years.)

There is no minimum dollar threshold for an employee to be a covered employee.

Determining the Five Highest-Compensated Employees

Section 4960 does not include rules for determining the five highest-compensated employees. The Notice provides that, in general, the determination of whether an employee is among the five highest-compensated employees of an ATEO is made based on his or her remuneration for services performed as an employee of the ATEO, including remuneration for services performed as an employee of a related organization with respect to the ATEO.

Applicable remuneration for purposes of making this determination is the remuneration paid to an employee during the calendar year ending with or within the ATEO's or related organization's taxable year, excluding remuneration paid for medical or veterinary services.

A limited services exception applies if, during the calendar year ending with or within the taxable year, the ATEO paid less than 10% of the employee's total remuneration for services performed as an employee of the ATEO and all related organizations. If no ATEO in the group paid at least 10% of the total remuneration paid by the group during the calendar year, then the exception does not apply to the ATEO that paid the employee the most remuneration during that year.

Whether an employee is one of the five highest-compensated employees is determined separately for each ATEO and not for the entire group of related organizations. Therefore, in many cases, a group of related organizations will have more than five covered employees.

Excess Remuneration

For each covered employee, excess remuneration is the excess for a taxable year of the remuneration that is paid (other than any excess parachute payment) by an ATEO, including remuneration paid by a related organization, over $1 million for the taxable year. The $1 million amount corresponds to the maximum amount of compensation a public company can deduct each year for compensation paid to each of its covered employees pursuant to Section 162(m).

The term remuneration has the same meaning as "wages" as defined in Section 3401(a), excluding certain retirement benefits and directors' fees and including amounts required to be included in income under Section 457(f). Remuneration includes parachute payments; however, a parachute payment is not subject to tax as excess remuneration if it is also subject to tax as an excess parachute payment. Remuneration does not include the portion of any remuneration paid to a licensed medical professional that is directly related to the performance of medical or veterinary services.

Remuneration includes remuneration paid to a covered employee by any related organization with respect to the employee's employment by that related organization. The Notice includes rules for allocating liability for the excise tax when remuneration from more than one employer is taken into account in determining liability for the excise tax.

Remuneration is treated as paid for purposes of Section 4960 when there is no substantial risk of forfeiture of the rights to the remuneration, as defined by Section 457(f)(3)(b) (26 U.S.C. § 457(f)(3)(b)). Therefore, an amount of compensation is subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on either:

The future performance of substantial services.
The occurrence of a condition related to the purpose of the transfer if the possibility of forfeiture is substantial.

The amount of remuneration treated as paid at vesting is the "present value" of the remuneration in which the employee vests, determined using reasonable actuarial assumptions regarding the time and likelihood of actual or constructive payment.

Excess Parachute Payments

The excess parachute rules are modeled after Section 280G (26 U.S.C. § 280G). However, Section 4960 defines "parachute payment" differently. There are also other differences between Section 280G and Section 4960.

For purposes of Section 4960, "excess parachute payment" means an amount equal to the excess (if any) of the total amount of any parachute payment over the portion of the base amount allocated to the payment. (This is the excess over one times the base amount, and not the excess over three times the base amount.)

For purposes of Section 4960, the term "parachute payment" means any payment in the nature of compensation made by an ATEO or a related organization to or for the benefit of a covered employee if:

The payment is contingent on the employee's separation from employment with the employer. (Note the distinction between parachute payments for Section 280G purposes which are contingent on a change in control and for Section 4960 purposes which are contingent on a separation from employment.)
The aggregate present value of the payments in the nature of compensation to or for the benefit of an individual that are contingent on the separation equals or exceeds an amount equal to three times the base amount.

Certain exclusions apply, for example, for payments to or from a qualified retirement plan that includes a trust exempt from tax under Section 501(a), payments to licensed medical professionals, and payments to non-highly compensated employees.

Separation from Employment

For purposes of Section 4960, separation from employment generally has the same meaning as separation from service under Section 409A, except that a change from employee to independent contractor status is treated as a separation from employment. In addition, an employer may not set the level of anticipated reduction in future services that will give rise to a separation from employment. Rather, Section 409A's default rules apply. For information on Section 409A, see Practice Note, Section 409A: Deferred Compensation Tax Rules: Overview.

A payment is considered contingent on a separation from employment if the facts and circumstances indicate that the employer would not make the payment in the absence of an involuntary separation from employment.

Payment in the Nature of Compensation

A payment in the nature of compensation includes, but is not limited to:

Wages and salary.
Bonuses.
Severance pay.
Fringe benefits.
Life insurance.
Pension benefits and other deferred compensation.
Cash when paid.
The value of the right to receive cash, including the value of accelerated vesting or a transfer of property.

The Notice includes guidance regarding when a payment in the nature of compensation is considered to be made.

Three-Times Base Amount Test for Parachute Payments

To determine whether payments in the nature of compensation made to a covered employee contingent on the covered employee's separation from employment are parachute payments, they must be compared to the covered employee's base amount.

First, the aggregate present value of all payments in the nature of compensation that are made or to be made to or for the benefit of a covered employee by an ATEO (or predecessor) or related organization that are contingent on the separation from employment must be determined.

If this aggregate present value equals or exceeds three times the individual's base amount, the payments are parachute payments. If this aggregate present value is less than three times the individual's base amount, then no portion of the payments are parachute payments.

Base Amount

In general, a covered employee's base amount is the average annual compensation for services performed as an employee of the ATEO or a related organization with respect to which there has been a separation from employment, if the compensation was includible in the gross income of the individual for taxable years in the "base period" which is generally the covered employee's five most recent taxable years ending before the date on which the separation from employment occurs.

Computing Excess Parachute Payments

The amount of an excess parachute payment is the excess of the amount of any parachute payment made by an ATEO (or related organization) over the portion of the covered employee's base amount that is allocated to the payment. The portion of the base amount allocated to any parachute payment is determined by multiplying the base amount by a fraction, the numerator of which is the present value of the parachute payment and the denominator of which is the aggregate present value of all parachute payments.

Reporting Liability Under Section 4960

Taxes imposed under Section 4960 are reported and paid using Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code. If remuneration from a related organization is included to determine the excise tax, each ATEO and related organization must file a separate Form 4720 to report its share of the liability. The Form 4720 must be filed and the excise tax paid by the 15th day of the fifth month after the end of the employer's taxable year. Employers generally have the option of prepaying the excise tax. There is no requirement to pay estimated taxes on excise taxes imposed under Section 4960.

Relationship Between Section 4960 and Section 162(m)

Remuneration paid by a publicly held corporation within the meaning of Section 162(m) to a covered employee within the meaning of Section 162(m)(2) generally is taken into account for purposes of Section 4960. However, any amount for which a deduction is not allowed by reason of Section 162(m) is not taken into account for purposes of Section 4960.

Effective Date

Section 4960 applies to taxable years of an employer beginning after December 31, 2017. Remuneration paid before the beginning of the first taxable year that begins after December 31, 2017 is not subject to the excise tax under Section 4960.

Practical Implications and Comment Period

The Notice provides a good deal of information to assist taxpayers in complying with Section 4960. Ultimately, according to the IRS, the Q&As will be incorporated into proposed regulations addressing Section 4960. Further guidance will be prospective and will not apply to taxable years beginning before the issuance of the guidance. Until further guidance is issued, taxpayers may base their positions on a good faith, reasonable interpretation of the statute. The Notice's preamble describes certain positions that the Treasury Department and IRS have concluded are not consistent with a good faith, reasonable interpretation of the statutory language. Comments concerning the Notice should be submitted no later than April 2, 2019.

IRS Issues Notice 2019-09 Providing Interim Guidance Under Code Section 4960 | Practical Law