Historically and still today, the IRS requires that compensation paid to nonprofit executives be reasonable and not excessive. Up until now, tax-exempt organizations have not been subject to compensation limits on executive compensation; they have, however, been subject to the private inurement doctrine, intermediate sanctions, and excess benefit rules that impose an excise tax on nonprofit executives and managers who benefit from and knowingly participate in assigning compensation that exceeds the value of services performed.
Tax-exempt organizations have long relied on Treasury Regulation section 53.4958-6 as a safe harbor when setting executive compensation that provides a rebuttable presumption of reasonableness if (1) the compensation arrangement is approved in advance by an authorized body of the tax-exempt organization composed of individuals who do not have a conflict of interest with respect to the arrangement, (2) the authorized body obtains and relies upon appropriate comparable data prior to making the determination, and (3) the authorized body contemporaneously documents the basis for the determination at the time the decision is made. The three-prong requirement for the rebuttable presumption should be the minimum standard a tax-exempt organization incorporates into a compensation policy that is followed for setting compensation of employees, officers or directors.
Now—notwithstanding a determination that compensation is reasonable—an excise tax on remuneration in excess of $1 million and on parachute payments paid by an applicable tax-exempt organization (ATEO) to a covered employee is imposed. The Treasury Department and the Internal Revenue Service issued the Final Regulations (T.D. 9938) under Code section 4960, added to the Code by section 13602 of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97.
From a tax policy perspective, Congress imposed limitations on executive compensation with the objective to create parity between tax-exempt and taxable organizations. Under Code section 162(m), publicly held corporations generally cannot deduct compensation in excess of $1 million per year paid to senior executive officers. Essentially, the disallowed deduction increases the tax owed by publicly held corporations; specifically, the provisions in Code section 4960 are very similar to and modeled after the disallowed deduction under Code section 162(m) and the parachute payment provisions of Code section 280G.
Excise Tax on Excess Compensation
Code section 4960 imposes a 21% excise tax on an ATEO that pays more than $1 million in remuneration to any covered employee defined as one of the five highest-compensated employees of the ATEO in any tax year beginning after December 31, 2016. The compensation, for purposes of determining the covered employees of an ATEO, includes the remuneration provided by the ATEO and by any related organization with respect to the ATEO. An individual who becomes a covered employee of an ATEO in a given tax year remains a covered employee of that ATEO indefinitely, even after the employment relationship has ended; hence, careful tracking of covered employees is necessary.
An ATEO is an organization that (1) is exempt from tax under Code section 501(a); (2) is a farmers' cooperative organization under Code section 521(b)(1); (3) has income excluded from taxation under Code section 115(1); or (4) is a political organization described in Code section 527(e)(1). A related organization is defined as a person or governmental entity that (1) controls, or is controlled by, the ATEO; (2) is controlled by one or more persons that control the ATEO; (3) is a supported organization of the ATEO, as defined in Code section 509(f)(3); or (4) is a supporting organization described in IRC section 509(a)(3) with respect to the ATEO. The final regulations aligned the definition of “control” with the definition in the Form 990 instructions that is based on the standards prescribed in Code section 512(b)(13).
Governmental entities, such as state colleges or universities, are excluded from the ATEO definition. A governmental entity is an ATEO, however, if it has a Code section 501(a) tax exemption letter from the IRS or income excluded from taxation under Code section 115(1). Even if it is not an ATEO, a governmental entity may still be subject to the excise tax if it is a related organization to, and employs a covered employee of, an ATEO. A government entity that qualifies as an ATEO by virtue of Code section 501(a) may relinquish its tax-exempt status and thereby avoid ATEO status under IRC section 4960. These institutions may remain tax exempt under the doctrine of implied governmental immunity despite no longer being tax exempt under Code section 501(a).
Foreign organizations are excluded from the excise tax if they are either: (1) exempt from tax under Code section 501(a); or (2) a taxable foundation described in Code section 4948(b) that receives substantially all of its support (other than gross investment income) from sources outside the United States (determined at the end of the organization’s tax year). However, the ATEO and any other related organizations must take remuneration paid by these foreign entities into account for purposes of determining both the ATEO's five most highly compensated employees for one year and any applicable excise tax.
Remuneration is defined as Code section 3401(a) wages for federal income tax withholding purposes and Box 1 of Form W-2 typically is the starting point—with some important modifications. Some exclusions from remuneration include designated Roth contributions to a tax-qualified retirement plan or individual retirement account, costs of group-term life insurance in excess of $50,000, the portion of any payment to a licensed medical professional for the performance of medical care services, and certain de minimis amounts of foregone interest. On the other hand, taxable fringe benefits and amounts required to be included in income under Code section 457(f) plans, when vested, are included in remuneration even if the vested amount is not paid until a later date. Remuneration also includes compensation paid under a below-market split-dollar loan.
Important to note, the final regulations adopt a general timing rule that treats remuneration as paid when it has vested (not subject to a substantial risk of forfeiture) without including an exception for short-term deferrals. The amount included as remuneration is the present value of the remuneration on the date the amount vests, and employers can treat the entire amount to be paid on a future date as the present value on the vesting date (i.e., without making a present value calculation) and apply to any vested amount scheduled to be paid within 90 days, including amounts under account balance plans to ease the administrative burden. In addition, annual earnings on previously vested Code section 457(f) amounts are included in remuneration, even though such earnings are not reported on Form 990 Schedule J until paid. Specific rules for the treatment of earnings and losses on previously paid remuneration apply and are also intended to minimize administrative burdens.
There are three volunteer exceptions to the definition of a covered employee as stipulated in the final regulations: limited hours, limited services, and nonexempt funds. These exceptions serve to exclude certain remuneration paid by a related organization if certain conditions are met, including the employee not receiving remuneration for services rendered to the ATEO.
Under the limited-hours exception, the hours (or days) the individual works at the ATEO and related ATEOs can only make up 10% or less of the total hours (or days) the individual works for the ATEO and all related organizations during the year. An individual is deemed to have satisfied this requirement under the safe harbor rule, if the individual works no more than 100 hours for the ATEO and all related ATEOs during the year.
Under the limited services exception, an ATEO can pay remuneration to the employee, but it must be less than 10% of the employee’s total remuneration for services performed as an employee of members of the ATEO group during the applicable year.
Under the nonexempt funds exception, individuals may be disregarded if they have not received remuneration from the ATEO, any related ATEOs, or any taxable related organizations controlled by the ATEO and/or related ATEOs for services provided to the ATEO; and did not perform services for the ATEO and related ATEOs in excess of 50% of the individual’s total hours worked for the ATEO and all of its related organizations. This exception also requires that any related organization that paid remuneration to the individual must not have provided services for a fee to the ATEO, to any related ATEOs or to any taxable related organizations controlled by the ATEO and/or related ATEOs. The measurement period for the 50%-of-total-hours test is two years. In determining whether a taxable related organization is controlled by the ATEO for purposes of this exception, ATEOs may disregard “downward attribution” in applying the principals set forth in Code section 318.
Tax on Excess Parachute Payments
The Code section 4960 excise tax also applies to excess parachute payments. Parachute payments are payments in the nature of compensation that are contingent on an involuntary termination of employment that equal or exceed three times the employees base amount calculated as the employee’s five-year annual average compensation. If there is a parachute payment, the excise tax is imposed on the excess parachute payment that exceeds one times the base amount.
A termination of employment is involuntary if the termination is due to the independent exercise of the employer’s unilateral authority to terminate the employee’s services; more than 80% reduction in services is considered a termination of employment. Furthermore, an ATEO cannot simply avoid the tax by recharacterizing separation payments as damages payments, or payment for a noncompetition covenant, or payment for services that the IRS would consider not to be bona fide services involving payment of no more than reasonable compensation.
Looking Ahead and Planning
Nonprofit executive compensation is on top of the list of issues that are highly scrutinized by the IRS. Compensation data provides valuable insight into the development of equitable standards. All nonprofit organizations that file Form 990 or 990-PF are required to disclose individual-level compensation data for all paid executives and board members; these amounts are reported in Part V of Form 990 and Part VIII of Form 990-PF for each board member or trustee, foundation manager or organization director, executive, or officer who was paid by the nonprofit organization during the tax year.
Recent statistical data released by the IRS shows that 516 tax-exempt organizations exempt under IRC section 501(a) filed and paid excise taxes of approximately $210 million cumulatively during the calendar year 2021. As compared to 2020, 302 tax-exempt organizations filed and paid excise tax of approximately $96 million.
The IRS states that there continues to be a high volume of exempt organizations that paid compensation of over $1 million to at least one covered employee but did not report an excise tax on Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code. The IRS’s Tax Exempt & Government Entities (TE/GE) Division released their compliance and priorities for fiscal year 2022 and supporting examinations of exempt organization executive compensation was among them. Tax Exempt & Government Entities – Compliance Program and Priorities. In fiscal year 2022, the IRS commenced 842 compliance checks with respect to compliance with the excise tax; of those checks, approximately 100 of those cases were referred for examination.
Tax-exempt organizations are urged to review the final regulations with regard to their specific facts and circumstances or consult with their attorneys or tax advisors to identify tax-planning opportunities to reduce its excise tax liability. The form in which compensation is paid and the time at which it vests are among the primary drivers of the excise tax, and several alternatives may be available.
Split-dollar life insurance arrangements, structured as loans, have become an increasingly popular if structured properly. Restructuring compensation arrangement to be paid by an affiliate that is not a related organization for this purpose, such as an unrelated management company, may be another option. Independent contractors of the tax-exempt organization do not trigger the excise tax—for example, consultants, outside fundraisers, and similar independent service-providers. Nonprofit organizations may also want to consider adding clauses to covered employees' employment contracts or other governing documents to cap payments upon involuntary termination of employment, so no excess parachute payment arises.
Last, for tax-exempt organizations that become subject to the excise tax, establishing the rebuttable presumption of reasonableness with respect to the payment of more than $1 million in annual remuneration will be even more important. Establishing the rebuttable presumption of reasonableness can significantly help protect against IRS findings of private inurement and the imposition of intermediate sanctions and should be a best practice to be followed for all tax-exempt entities.
Eva Mruk, CPA, is a partner in the PKF O’Connor Davies Exempt Organization Tax & Advisory Services Group. She has 25 years of experience providing tax compliance and advisory services to the not-for-profit and tax-exempt sectors assisting with a broad range of tax issues such as: federal, state, and local tax compliance; establishing and protecting tax-exempt status; governance, executive compensation; lobbying and political activities, public support testing and planning; fundraising and state solicitation laws; grant-making; international activities, strategic tax planning; unrelated business income (UBI); and alternative investments and their subjectivity to UBI tax and foreign reporting.