IRS Issues Proposed Excess Compensation and Parachute Payment Rules
On June 5, 2020, the Internal Revenue Service (“IRS”) issued proposed rules under Section 4960 of the Internal Revenue Code (the “Code”), as added by the Tax Cuts and Jobs Act (Pub. L. 115-97). While there may be significant press about these rules, the good news is that they will not have any effect on most 501(c)(3) organizations and governmental bodies.
Section 4960 imposes an excise tax on the organization at the rate of 21% on compensation paid to certain employees in excess of $1 million and on any parachute payments in excess of three times the base amount.
Note that the tax applies to exempt organizations and includes nonprofit organizations exempt under Section 501(c)(3) of the Code (and other nonprofits exempt under 501(a) and governmental organizations exempt under Section 115 of the Code (the typical basis for exemption of public hospitals)).
Excess Compensation Rules
- The excess compensation rules apply only to amounts paid to the 5 highest paid employees, but that is a decision that gets made on an annual basis, and once a person falls in this category, he or she stays in it for all future years.
- The rule does not apply to remuneration paid to a medical professional for the performance of medical services. Importantly, the rules do apply for executive and administrative services of medical professionals as well as teaching and research. The rules provide several examples of administrative, teaching, and research duties that are not medical services. Where a medical professional performs both medical and non-medical services, the organization is to make a reasonable, good-faith allocation between the remuneration for medical services and for non-medical services. Only the compensation for non-medical services is counted for purposes of determining whether compensation is subject to the tax.
- Compensation includes all compensation that vests in the year. That includes regular compensation and the present value of all other compensation that vested during the year. Remuneration is vested when it is no longer subject to a substantial risk of forfeiture under the Code. The regulations provide that an amount is subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on the future performance of substantial services or upon the occurrence of a condition that is relation to a purpose of the remuneration. Thus, compensation can include payments under deferred compensation plans. Generally, this means that the amount in such plan is treated as compensation when it vests and any subsequent earnings in such account (while still held by the employer) are treated as vested in the year such earnings occur. These rules are complicated and include several examples.
Parachute Payments Rules
- A parachute payment is any payment contingent of the employee’s separation from employment. The rules apply if the present value of payments exceeds 3-times the base amount (generally the average annual compensation for services prior to separation).
- The rules only apply to “a highly compensated individual,” which currently means an employee with compensation in excess of $130,000. Thus, for example, the rules would be triggered if the total parachute payment for a $130,000 employee is $390,000 or greater.
- All payments in the nature of compensation are included, regardless of whether they are characterized as payments for a non-compete or similar restrictive covenant. Payments include compensation as well as bonuses and benefits.
- The rules can be triggered even if there is not a complete separation from employment. The rules adopt a test that looks at the percentage reduction in level of services, where 80% or more is treated as a separation, 50% or less is not treated as a separation, and anywhere in the middle is evaluated on a facts and circumstances basis.
The comment period on these proposed rules is open until August 10, 2020.