IRS Issues Final Regulations Under Code Section 4960 | Practical Law

IRS Issues Final Regulations Under Code Section 4960 | Practical Law

The Internal Revenue Service (IRS) has issued final regulations under Internal Revenue Code Section 4960, which imposes an excise tax on the amount of remuneration in excess of $1 million and any excess parachute payment paid by an applicable tax-exempt organization (ATEO) to a covered employee. Section 4960 was added to the Internal Revenue Code by the Tax Cuts and Jobs Act (TCJA).

IRS Issues Final Regulations Under Code Section 4960

Practical Law Legal Update w-029-2247 (Approx. 7 pages)

IRS Issues Final Regulations Under Code Section 4960

by Practical Law Employee Benefits & Executive Compensation
Published on 15 Jan 2021 • USA (National/Federal)
The Internal Revenue Service (IRS) has issued final regulations under Internal Revenue Code Section 4960, which imposes an excise tax on the amount of remuneration in excess of $1 million and any excess parachute payment paid by an applicable tax-exempt organization (ATEO) to a covered employee. Section 4960 was added to the Internal Revenue Code by the Tax Cuts and Jobs Act (TCJA).
The Treasury Department and the IRS have issued final regulations (86 Fed. Reg. 6196 (Jan. 19, 2021)) under Section 4960 of the Internal Revenue Code (Section 4960), which imposes an excise tax equal to the rate of tax imposed on corporations under Code Section 11 (26 U.S.C. § 11) (currently 21%) on the amount of remuneration in excess of $1 million and any excess parachute (severance) payment paid by an applicable tax-exempt organization (ATEO) or a related organization to a covered employee (26 U.S.C. § 4960).
Section 4960 was added to the Code by the Tax Cuts and Jobs Act (TCJA), which is generally effective for taxable years beginning after December 31, 2017. On December 31, 2018, the Treasury Department and the IRS issued Notice 2019-09 (the Notice) providing interim guidance on Section 4960. On June 5, 2020, they issued proposed regulations. The final regulations, which were issued on January 11, 2021, retain the basic approach and structure of the proposed regulations, with certain revisions, which are discussed below.
The final regulations:
  • Restate certain statutory definitions.
  • Define various terms.
  • Provide rules for determining:
    • the amount of remuneration paid for a taxable year for purposes of determining covered employees and calculating the excise tax;
    • whether excess remuneration has been paid and in what amount;
    • whether a parachute payment has been paid and in what amount;
    • the allocation of liability for the excise tax among related organizations; and
    • the applicability date of the final regulations.
This Legal Update addresses the modifications made by the final regulations. For a discussion of the proposed regulations, see Legal Update, IRS Issues Proposed Regulations Under Code Section 4960. For a discussion of the Notice, see Legal Update, IRS Issues Notice 2019-09 Providing Interim Guidance Under Code Section 4960. For information on executive compensation for tax-exempt organizations generally, see Practice Note, Executive Compensation for Tax-Exempt Organizations (which is currently being updated to reflect the final regulations).

Nonexempt Funds Exception: Expansion of Measurement Period and Modification of Attribution Rules

The proposed regulations set out certain exceptions to the definition of covered employee and the rules for identifying the five highest-compensated employees of an applicable tax-exempt organization (ATEO). One of these exceptions is for "nonexempt funds" which covers employees of a related non-ATEO organization who may, under certain circumstances, perform a large portion of their overall services as employees of the ATEO. To qualify for the exception, the employee must have provided services "primarily" (more than 50% of the employee's total hours worked for the ATEO and all related organizations) to the taxable related organization or other non-ATEO.
The final regulations adopt the exceptions set out in the proposed regulations, however, to provide more flexibility in cases where an employee may unexpectedly fail to meet the 50% threshold in an applicable year, they expand the measurement period for the non-exempt funds exception from one applicable year to two applicable years (the current year and the immediately preceding year are combined and treated as one measurement period).
The final regulations also make clarifying changes to two examples illustrating the application of the nonexempt funds exception and modify the attribution rules (by disregarding downward attribution) that are used to determine eligibility for the nonexempt funds exception.

Foreign Organizations as ATEOs

The proposed regulations excluded foreign organizations described in Code Section 4948(b) (26 U.S.C. § 4948(b)) (those that have not received substantial support from United States sources) from ATEO status and requested comments on:
  • Whether a foreign related organization that meets the requirements of Code Section 4948(b) should be exempt from the Section 4960 excise tax.
  • If so, whether compensation paid by the foreign related organization should be taken into account for purposes of determining excess compensation and allocating liability among the ATEO and related organizations that are subject to the Section 4960 excise tax.
While the Treasury Department and the IRS received no comments, the final regulations exclude from the Section 4960 excise tax as a related organization any foreign organization that both:
  • Meets the requirements of Code Section 4948(b) (determined at the end of the organization's taxable year).
  • Is either:
    • exempt from tax under Code Section 501(a) (26 U.S.C. § 501(a)); or
    • a taxable private foundation.

Applicable Tax-Exempt Organization: Applicability of Excise Tax to Certain Federal Instrumentalities

The final regulations adopt the definition of ATEO set forth in the proposed regulations. However, they reserve on the question of whether Section 4960 should apply to Federal instrumentalities for which enabling acts provide for an exemption from all current and future Federal taxes. Until further guidance is issued, a Federal instrumentality for which an enabling act provides for an exemption from taxes may treat itself as not subject to tax under Section 4960 as an ATEO or related organization.

Compensation

Section 4960 and the proposed regulations defined "remuneration" (compensation) as wages under Code Section 3401(a) (26 U.S.C. § 3401(a)):
  • Excluding designated Roth contributions under Code Section 402A(c) (26 U.S.C. § 402A(c)).
  • Including amounts required to be included in gross income under Code Section 457(f) (26 U.S.C. § 457(f)).

De Minimis Exception

In response to one commenter, the final regulations clarify that compensation for purposes of Section 4960 does not include amounts that are not includible in gross income pursuant to Code Section 7872's $10,000 de minimis exception (26 U.S.C. § 7872).

Compensation Related to Medical Services

Compensation that is paid to a licensed medical professional for medical services is excluded from the definition of compensation for purposes of Section 4960. The final regulations permit taxpayers to use a reasonable, good faith method to allocate compensation between compensation for medical verses nonmedical services (for example, making allocations based on the portion of the total number of hours worked for the medical service provider).

Payment Timing

Section 4960 provides that all compensation except "regular wages" (which are treated as paid at the time of actual or constructive payment) is treated as paid for purposes of Section 4960 when there is no substantial risk of forfeiture (SRF) of the rights to the compensation within the meaning of Code Section 457(f)(3)(B) (26 U.S.C. § 457(f)(3)(B)). The amount treated as paid is generally the present value of the compensation on the vesting date. The final regulations do not provide rules for determining present value. However, for ease of administration, the final regulations provide that where there is a short delay between vesting and payment, the employer may treat the full amount to be paid on a future date (without making a present value determination) as the present value on the vesting date.

Earnings and Losses

In determining the amount of earnings and losses treated as paid for an applicable year, the final regulations generally adopt the proposed regulations, providing specific rules for the treatment of earnings and losses on previously paid compensation. These rules are designed to minimize administrative burdens in determining the amount of earnings and losses:
  • Treated as paid for an applicable year.
  • Across multiple compensation arrangements.
The final regulations include examples that illustrate the operation of these rules.

Grandfathering

While the IRS rejected one commenter's request for a grandfathering rule for employee compensation contracts executed on or before November 2, 2017, the Treasury Department and the IRS highlight that because compensation is treated as paid at the time of vesting, any compensation vested before the first day of the first taxable year of the ATEO beginning after December 31, 2017, is not considered compensation under Section 4960.
In response to a commenter's request to make this explicit, the final regulations provide that any vested compensation, including vested but unpaid earnings accrued on deferred amounts, that is treated as paid before the effective date of Section 4960 (January 1, 2018, for a calendar year employer) is not subject to the excise tax.

Coordination of Section 4960 and Code Section 162(m)

Under Section 4960, compensation for which a deduction is disallowed under Code Section 162(m) (26 U.S.C. § 162(m)) is not taken into account for purposes of Section 4960. However, this compensation is taken into account for purposes of determining an ATEO's five highest-compensated employees.
The difference in timing between the payment of compensation for purposes of Section 4960 (at vesting) versus the availability of a deduction that may be disallowed by Code Section 162(m) (generally when the amount is paid) raises significant coordination issues. For example, there may be circumstances where it is not known whether a deduction will be disallowed under Code Section 162(m) by the due date of the relevant Form 4720 (the form for reporting the Section 4960 excise tax).
Because the Treasury Department and IRS have not yet determined the most appropriate way to implement this provision, the final regulations reserve for future guidance. Until that guidance is issued, taxpayers may use a reasonable, good faith approach in coordinating these provisions. The final regulations describe two approaches that will be considered reasonable, good faith approaches.

Applicability Date

The final regulations were proposed to apply to taxable years beginning after December 31 of the calendar year in which the decision to adopt the final regulations was published in the Federal Register. In response to comments, and to provide ample time for ATEOs and related organizations to understand and be able to implement the final regulations, the final regulations modify this applicability date.
The final regulations will apply to taxable years beginning after December 31, 2021 (with the first applicable year generally being the 2022 calendar year). Until the applicability date of the final regulations, taxpayers may rely on the guidance in the Notice in its entirety or the guidance in the proposed regulations in its entirety. Alternatively, taxpayers may elect to apply the final regulations to taxable years beginning after December 31, 2017, and on or before December 31, 2021, provided they apply the final regulations consistently and in their entirety. Until the applicability date, taxpayers may also base their positions on a good faith, reasonable interpretation of the statute, including relevant legislative history.

Practical Implications and Effective Date

The final regulations provide guidance to assist taxpayers in complying with Section 4960. This guidance is generally consistent with the guidance provided in the proposed regulations. However, in certain instances the final regulations modify the guidance in the proposed regulations to address issues raised by commenters. ATEOs and related organizations should review the final regulations and be prepared to implement them before the scheduled applicability date.
The final regulations became effective as of January 15, 2021.