Executive Compensation and the Excise Tax – What You Need to Know
This blog post was contributed by Alexander L. Reid and Chelsea R. Rubin of Morgan, Lewis & Bockius LLP.
The Tax Cuts and Jobs Act of 2017 imposed significant new taxes on nonprofit organizations, including colleges and universities. Specifically, section 4960 of the Internal Revenue Code imposes a 21 percent excise tax on applicable tax-exempt organizations that pay a covered employee in excess of $1 million or an excess parachute payment.
On December 31, 2018, the IRS and the Treasury Department released Notice 2019-09, providing interim guidance that taxpayers may rely on while further guidance is being developed. While the Notice addresses some of the significant issues raised by the excise tax, numerous questions remain unanswered, leaving colleges and universities to base their decisions on a “reasonable, good-faith interpretation” of the statute.
Applicability to Public Colleges and Universities
One of the early issues introduced by the new excise tax was that it did not appear to apply to all public colleges and universities. Section 4960(c)(1) lists the types of organizations classified as applicable tax-exempt organization (ATEO)s to include organizations that exclude income from taxation under section 115(1) and organizations that are exempt from taxation under section 501(a).
However, there are many public colleges and universities that are not eligible to exclude income from gross income under section 115(1) because these institutions are a state or political subdivision, or an integral part of a state or political subdivision (referred to as a governmental unit). These institutions are not taxed by the federal government under the doctrine of implied statutory immunity, which requires specific statutory authority for the federal government to tax a state instrumentality.
Notice 2019-09 clarifies that a state, political subdivision, or integral part of a state or political subdivision is not an ATEO within the meaning of section 4960. However, there are a number of ways that a governmental unit — including a state college or university — may nonetheless be liable for tax under section 4960.
Liability as an ATEO
If an organization applied for and received recognition of tax exemption under section 501(a), then it is an ATEO even if it would otherwise be considered a governmental unit. Institutions seek recognition as section 501(c)(3) organizations for a number of reasons, including that section 501(c)(3) status is more easily recognizable to donors for purposes of making deductible contributions.
However, as provided in the Notice, an institution may voluntarily relinquish its section 501(c)(3) tax-exempt status under the procedures described in the EO Determination Letter revenue procedure (Rev. Proc. 2019-5, updated annually). Under the revenue procedure, an institution must show that it is not subject to income tax under some basis other than exempt status under section 501(a).
Section 115(1) is an income exclusion, rather than a tax-exempt status. A governmental entity — again, including a state college or university — may exclude income under section 115(1) with or without a private letter ruling issued by the IRS Office of Chief Counsel under Rev. Proc. 2019-1 (or a predecessor revenue procedure). Although there is no procedure for voluntarily relinquishing a private letter ruling on section 115(1), the IRS may revoke a letter ruling based on a material change to the facts after the ruling was issued.
Liability as a Related Organization
A governmental unit may be liable for excise tax as an organization that is related to an ATEO and pays remuneration to one of the ATEO’s covered employees. Section 4960(c)(4)(A) provides that remuneration of a covered employee by an ATEO includes “any remuneration paid with respect to employment of such employee by any related person or governmental entity.”
In Notice 2019-09, the IRS has interpreted the provision to impose the excise tax not only on remuneration paid by any related person or governmental entity for services provided to the ATEO, but also to any remuneration paid for services provided to a related person or governmental entity. The Notice requires an ATEO to determine its five highest-compensated employees and calculate any applicable excise tax including remuneration from a related organization, even if the related organization is not an ATEO.
Since the Notice was published, practitioners have raised the issue that the related organization rules in the Notice do not sufficiently address non-abusive arrangements between ATEOs and related organizations under which employees of the related organization provide services, or agree to serve as officers, on a volunteer basis. In a commonly raised fact pattern, a highly paid company executive volunteers his or her services as an officer of a related company foundation and provides services that utilize his or her particular skills and expertise in furtherance of the foundation’s exempt purpose.
Under an expansive interpretation of section 4960, the executive would be considered one of the ATEO’s five highest-compensated employees solely because of the executive’s remuneration as an executive of the company, and an excise tax would be imposed on the executive’s remuneration solely based on remuneration paid by the company for his or her services as an executive.
The consequences for future years may be equally severe. Because an employee is always a covered employee, the employee’s remuneration from the company would continue to be subject to tax even if the employee no longer provided any services to the foundation as long as the company were considered a related organization.
Similarly, a highly paid employee of a public college or university that is not an ATEO may trigger the excise tax by providing services to a related ATEO, such as a booster club, even if the employee is paid little, if anything, for those services. However, a more common example of public university excise tax liability would be a coach that is compensated by the university for coaching services and by a related ATEO for public appearances, speaking engagements and other services.
The Notice provides that the ATEO and the public university would each be liable for a share of the excise tax on remuneration over $1 million in proportion to the remuneration paid by each employer, assuming that the coach is a covered employee of the ATEO, including remuneration from the university and any other related organization.
Colleges and universities should consult with their advisors to identify the basis under which their income is or is not subject to federal income tax. If the institution is a state or political subdivision or an integral part of a state or political subdivision that also holds a section 501(c)(3) determination letter, the institution should carefully weigh any impact on donors, outstanding bond financing, existing benefit plans, and other tax and public relations aspects before voluntarily relinquishing exempt status under section 501(a).
In addition, colleges and universities should examine any shared employment arrangements with related organizations and obtain information on any volunteer offices held by its highly compensated employees at related organizations to identify risks for excise tax liability.
Furthermore, Section 4960 may be amended by technical correction, or otherwise, to specifically impose the excise tax on public colleges and universities in keeping with the supposed intent to address significant compensation packages for coaches and others at some large public universities.
Notice 2019-09 provides that the IRS and Treasury intend to issue proposed regulations under Section 4960. The proposed regulations are expected to propose rules similar to the provisions in Notice 2019-09 and to address issues raised since the notice was published.
The content in this blog post is for general information purposes only and should not be considered tax or legal advice.