The 21% tax on compensation over $1 million could apply to more organizations than one would think. This tax applies not only to compensation over $1 million but also to excess parachute payments. And those parachute payments need not even be over a million dollars to be subject to the tax. It could also apply with respect to volunteers or low wage employees.
Clarification, provided in the recently published proposed regulations [Reg-122345-18], helps explain how this could be true and provides exceptions which give some relief in these situations.
About the Tax
First, the tax is imposed on remuneration over $1 million paid by an applicable tax-exempt organization (ATEO) or its related organizations to a covered employee. Remuneration is defined by Code Section 3401, which is an employment tax concept, but basically, it’s any compensation under an employment relationship, with a few exceptions. One exception is that it does not include the portion of any remuneration paid to a licensed medical professional (including a veterinarian) for medical or veterinary services.
The tax, imposed by Internal Revenue Code Section 4960, was intended to equalize tax-exempt and taxable employers regarding the deduction limits in Code sections 162(m) and 280G. These code sections disallow deductions by publicly held corporations of the compensation over $1 million of certain key employees and by payors of certain excess parachute payments to certain persons.
Excess parachute payments are payments to a covered employee by an ATEO and its related entities that equal at least three times the employee’s annual compensation (averaged over five years). The payment must be contingent on the employee’s involuntary separation from employment.
ATEOs include:
- Organizations exempt under Internal Revenue Code Section 501(a), which includes organizations exempt under 501(c);
- Organizations that exclude income under Section 115(1), such as some state colleges and universities;
- Political organizations exempt under Section 527(e)(1); and
- Farmers’ cooperatives described in Section 521(b)(1).
When Congress enacted the tax, presumably intending to include colleges and universities, they did not consider that, rather than excluding income under section 115, some state colleges and universities may have income excluded under sovereign immunity and being a state entity. We expect more guidance from the IRS on this issue.
What is Considered a Related Organization?
A related organization controls or is controlled by the ATEO, or it is controlled by one or more persons that control the ATEO. We will refer to related ATEOs as RATEOs, and taxable organizations controlled by the ATEO as a Taxable Subsidiary.
How is Control Defined?
Control is more than 50% of:
- Vote or value of stock in a corporation;
- Profits or capital interest in a partnership;
- Beneficial interest in a trust; or
- Board control of a nonstock corporation, defined as:
- More than 50% of the nonstock organization’s directors or trustees are also trustees, directors, officers, agents, or employees of the person or governmental entity. This is known as the representative test; or
- The power to remove more than 50% of the trustees or directors of the nonstock organization and designate new trustees or directors. This is known as the removal power test.
Controlled entities also include supported or supporting organizations of the ATEO.
Who is Considered a Covered Employee?
An ATEO worker is considered to be a covered employee if they were one of the five highest compensated employees for the taxable year or were a covered employee in a prior year beginning in 2017, even if the employee is currently a volunteer, low paid, or earns much less than $1 million.
How can a volunteer be a highest compensated employee? The person may be paid by a related entity to work for the ATEO, and thus be swept into this category. But see the exceptions below. If the volunteer is not paid by the ATEO or any related organization for services to the ATEO, then the volunteer is not a covered employee. Board members are not employees, but officers are.
Once a person is identified as a covered employee, he or she remains a covered employee forever. Thus, if a person was a covered employee in a prior year and is paid by a related entity to work for the ATEO, the compensation from the related entity may be subject to this tax. Tracking covered employees each year will be important, particularly if in the future, someone advances his or her career to earn more than $1 million or inflation makes $1 million a standard salary.
Exceptions for Covered Employees
Exceptions designed to save a volunteer or similar employee from being swept into this section include:
Limited Hours Exception
This exception applies if:
- No remuneration is paid to the employee by the ATEO or any RATEO, and
- The person works as an employee of the ATEO or RATEOs no more than 10% of the time worked for the ATEO and all related organizations or 100 hours of service, whichever is greater.
Not Paid with Exempt Funds
For this exception to apply, all remuneration to the employee is paid by an unrelated or controlling taxable entity (not an ATEO, RATEO, or Taxable Subsidiary of the ATEO or RATEOs), and the person works as an employee of the ATEO or RATEOs for less than 50% of the total hours worked for the ATEO and all related organizations. Also, the related organization that paid the employee must not have provided services for a fee to the ATEO, RATEO, or Taxable Subsidiary.
This means that a non-ATEO can donate up to 50% of an employee’s time to an ATEO it controls, so long as the ATEO does not pay for any of those services. The idea is to make sure that tax-exempt funds were not used to over-compensate employees.
Limited Services
Even if the ATEO pays the employee, the employee may be disregarded (as a covered employee) if:
- A RATEO paid at least 10% of the total remuneration paid by the ATEO and all RATEOs; or
- No RATEO paid at least 10% of the total remuneration paid by the ATEO and all RATEOs, and at least one RATEO paid more than the ATEO.
Thus, a group of RATEOs will not spread out the compensation among themselves in such a way that no one pays at least 10% of the compensation. Here, if no one pays 10%, then whoever pays the person the most must consider the employee for determining the covered employees.
For the limited hours and nonexempt funds exceptions, payments by an employer organization related to the ATEO but not reimbursed by the AETO may be disregarded in determining if there is remuneration.
Effective Date
Until the final regulations are published in the Federal Register, taxpayers may rely on the guidance provided in the proposed regulations or Notice 2019-09, including for periods before June 5, 2020. Taxpayers may also base their positions upon a reasonable, good-faith interpretation of the statute.
The rules are very complicated, and there are many questions that we hope will be answered in the final regulations. For help navigating these rules, see your tax advisor or contact a Clark Nuber professional. It will be important to start tracking covered employees for possible future liability under this section.
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