When considering compensation and benefits packages to lure and retain top executives or talent, nonprofit organizations, including universities and hospitals, are often at a disadvantage compared to their for-profit rivals. Their tax-exempt status limits the compensation options available to them and the public reporting requirements imposed by the Internal Revenue Service (IRS) puts their spending on such benefits in the spotlight.
The IRS has added additional considerations to this process as a result of Internal Revenue Code (Code) §4960 and its related regulations finalized in late 2021. Beginning with the 2022 taxable year, most tax-exempt organizations have been subject to an excise tax at the corporate tax rate (21% for 2024) on (1) compensation in excess of $1 million for “covered employees” (as defined in Code §4960) and (2) any excess “parachute payments” paid to a covered employee upon his or her involuntary termination of employment.
Which organizations are subject to Code §4960?
The statute applies to “applicable tax-exempt organizations” (ATEOs) which includes organizations that:
- are exempt from taxation under Code §501(a) (g., organizations described in Code §501(c) such as private universities and hospitals)
- are farmers’ cooperatives organizations described in Code §521(b)(1)
- have income that is excluded under Code §115(1) (e. public utilities and state and local governments), or
- are political organizations described in Code §527(e)(1).
As a result of this definition, there has been confusion as to whether the statute and regulations apply to public universities. Several avenues for federal tax exemption are available to a public university including Code §115(1); Code §§501(a) & (c)(3); or the doctrine of implied statutory immunity. The IRS acknowledges and discusses the multiple ways in which a public university can be exempt from tax in Notice 2019-9. Therefore, a public university exempt from taxation under Code §115(1) or Code §§501(a) & (c)(3) would be an ATEO for purposes of Code §4960, but not one which claims exemption under the implied immunity doctrine.
Who is a covered employee?
A covered employee is any employee (including a former employee) who is one of the five highest paid employees of the ATEO for the taxable year or was a covered employee of the ATEO (or a predecessor) for any preceding year beginning after December 31, 2016. This means that once someone is a covered employee, he or she will always be a covered employee even following termination of employment or death.
To determine who is a covered employee (and for purposes of calculating any excise tax due), an ATEO must consider remuneration paid by the ATEO and any related organization, including taxable organizations or governmental entities, for services performed as an employee of that related organization. Generally speaking, a related organization includes any organization that controls, or is controlled by, the ATEO or is a supporting organization of the ATEO. The regulations provide detailed guidance on what constitutes control for these purposes.
Each ATEO within a group of related organizations must determine its own “covered employees.” The determination is not made for the entire related group as a whole.
What renumeration is taken into account?
For purposes of Code §4960, remuneration includes all wages subject to federal income tax withholding, but excluding Roth contributions and compensation to a licensed medical professional for medical services. It does include 457(f) contributions when included in gross income (i.e. when there is no longer a substantial risk of forfeiture).
What are parachute payments?
Parachute payments are compensation to an employee that is contingent on his or her involuntary separation from employment and the aggregate present value of such payments equals or exceeds three times the “base amount.” An employee’s “base amount” is his or her five-year annual average compensation, including pay for services performed for a predecessor or related organization.
Under a 457(f) plan, if the substantial risk of forfeiture provision lapses on the involuntary termination, the 457(f) payment would be included in the parachute payment calculation. Nontaxable compensation such as the value of health insurance and life insurance would also be included as parachute payments.
Distributions from a qualified plan or 403(b) plan, compensation for medical services, and payments to an individual who is not a highly compensated employee as defined in Code §414(q) (for 2024, a person who earned more than $150,000 in 2023) are not included in the calculation.
Payments upon death disability or voluntary termination for good reason do not trigger the excise tax.
How do I calculate and pay the excise tax?
Amounts paid to a covered employee in excess of $1 million during a taxable year are subject to the tax. In addition, if a covered employee receives a “parachute payment” during the year, the excise tax applies to any excess parachute payment (i.e. the amount received by the employee that exceeds the base amount. So, while an employee must receive three times the base amount before there is a parachute payment, the excise tax is calculated based on any amount above the base amount.
In calculating whether a covered employee had compensation in excess of $1 million, the employee’s annual renumeration calculation includes remuneration from the ATEO and all related organizations. If renumeration is paid by more than one employer, each employer is liable for the excise tax in an amount which bears the same ratio to the total tax determined with respect to such remuneration as the amount of remuneration paid by such employer with respect to such employee, bears to the amount of remuneration paid by all such employers to such employee. Thus, when an employer that is an ATEO or a related organization pays a covered employee either excess remuneration or an excess parachute payment, each employer is liable for the excise tax under section 4960.
Similarly, a covered employee’s base amount calculation includes remuneration from the ATEO and all related organizations, and a covered employee’s parachute payment calculation includes all payments (made by the ATEO and all related organizations) that are contingent on the employee’s involuntary separation from employment.
Report the excise tax on IRS Form 4720, “Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code.” The reporting and payment of any applicable excise taxes are due when payments of chapter 42 taxes are ordinarily due (the 15th day of the 5th month after the end of the taxpayer’s taxable year—May 15 for a calendar year employer), plus extensions.
Considerations for Tax-Exempt Employers
- If you are a public university, determine how you are exempt from federal income taxation. If you are exempt under Code §501(a), consider whether you want to give up that status in order to avoid the application of Code §4960 or would prefer to retain the status for other tax reasons.
- Determine who your covered employees are and note any separation-related payments for which they may be eligible. Do this each year and retain the lists for future reference. Do the same for all related ATEOs.
- If you believe a covered employee will have compensation that exceed $1 million, consider whether to adopt policies to cap annual compensation to $1 million per year and find ways to spread potential excess amounts over future years, through deferred compensation or other arrangements.
- Conversely, if you have concerns about potential excess parachute payments, consider ways to reduce separation payments or increase the five-year average base amount, where possible. If reasonable, you might increase W-2 compensation or qualified plan contributions.
If you would like additional information about the potential applicable of the excise tax to your situation or would like to discuss ways to plan for and reduce the impact of the tax, please contact any of the attorneys in our Employee Benefits group.
