Consider the following hypothetical: Bill and his wife, Melinda, are the sole owners of Microfix, Inc., a successful computer repair business. They are also the sole directors of the business, and Bill receives from the business an annual salary of $1.5 million. Bill and Melinda donate substantial amounts to charity, and in 2018 they decided to form a private foundation to further their charitable giving. They serve as the foundation’s directors and officers on a volunteer basis. As a result of being volunteers, Bill and Melinda receive no compensation from the foundation.
This hypothetical is not uncommon and does not suggest any abusive behavior. And yet, under new excise tax rules intended to deter certain tax-exempt organizations from paying excessive compensation to their employees, Microfix is subject to an excise tax of $105,000 for 2018 (and annually for future years if nothing changes). How can Microfix be subject to such a harsh result?
Overview of Section 4960
The answer is section 4960, which was added to the Internal Revenue Code as part of the Tax Cuts and Jobs Act in late 2017 and became effective for tax years beginning after December 31, 2017. In general, if a tax-exempt organization (EO) and one or more of its related organizations pay excess compensation to certain employees of the EO, then a penalty tax equal to 21 percent of the excess compensation is shared among the EO and its related organizations based on the amount of compensation paid by each organization. If the EO paid no compensation, all of the excise tax is due from its related organization(s). May 15, 2019 is the first deadline for calendar year EOs and their related organizations to report and pay the excise tax on excess compensation paid during calendar year 2018.
Congress’s intent behind section 4960 was, in part, to create parity between large EOs and public companies that are not permitted to deduct compensation of greater than $1 million paid to certain employees. Unfortunately, as the above example shows, section 4960, as interpreted by the IRS, could create surprising results and ensnare EOs that pay no compensation at all to their officers or other employees. The IRS recently issued Notice 2019-09 to provide interim guidance under section 4960, pending the release of proposed regulations. The Notice introduced some harsh and unexpected interpretations of section 4960. Comments from the public have been critical, and it is possible that the upcoming regulations will deviate from the Notice. Until further guidance is issued — which is expected to apply only prospectively — taxpayers may base their positions on a good faith, reasonable interpretation of section 4960, including the positions reflected in the Notice.
What Organizations Are Affected?
Section 4960 applies to “applicable tax-exempt organizations” and their “related” organizations. The most significant category is organizations exempt from tax under section 501(a), such as section 501(c)(3) charitable organizations.
An EO is related to another organization if the EO controls, or is controlled by, the other organization or if the EO is controlled by one or more persons that control the other organization. In the case of a stock corporation, control means actual or constructive ownership (by vote or value) of more than 50 percent of the stock in the corporation. The stock owned by certain relatives of an individual is deemed to be owned by that individual. Similar rules apply for partnerships and trusts.
An EO is controlled by another entity if more than 50 percent of the directors or trustees of the EO are either “representatives” of, or are directly or indirectly controlled by, the other entity. A representative means a trustee, director, agent or employee. In the above example, Microfix and the foundation are related because Microfix’s representatives (Bill and Melinda) represent more than 50 percent of the foundation’s board. Although not entirely clear, we think that a related entity’s lawyer, accountant or banker would not be considered an agent of the related entity for this purpose.
The excise tax applies only if a “covered employee” of an EO receives excess compensation from the EO and its related organizations. A “covered employee” is any current or former employee of the EO that is one of the five highest-compensated employees of the EO for the tax year.
Hidden in this seemingly benign definition are several important points that will surprise unsuspecting EOs. First, under Notice 2019-09, an unpaid officer of an EO is treated as an employee of the EO. Because compensation from an EO’s related organizations is taken into account in determining whether an employee of the EO is among its five highest-compensated employees, even a volunteer officer of an EO could be a covered employee. (A director, on the other hand, is not considered an employee.) Second, a covered employee will always remain a covered employee. In other words, an EO cannot avoid the section 4960 excise tax merely by having the covered employee resign.
There is a limited exception whereby an employee of an EO would not be considered one of the five highest-compensated employees if the EO paid less than 10 percent of the employee’s total remuneration for services performed as an employee of the EO and all related organizations. However, if no EO pays at least 10 percent of the employee’s total remuneration during a calendar year, then this exception does not apply to the EO that paid the most remuneration to the employee during the calendar year. This exception has been interpreted by commentators to mean that, if there is only one EO in the group of related organizations and it pays no compensation to employees, then this exception does not apply and the excise tax is due. The tax community hopes that the IRS will expand this exception in future regulations.
The excise tax is imposed on two forms of excess compensation: (1) annual “remuneration” in excess of $1 million received from the EO and its related organizations and (2) compensatory payments received from the EO and its related organizations that are contingent on, and paid in connection with, the employee’s involuntary separation from employment and that exceed certain limits.
Remuneration means wages and amounts included in income relating to ineligible deferred compensation plans. Compensation paid to a member of the board of directors, who is not otherwise an employee, is not remuneration because the fees received by the director for performing these services constitute self-employment income, rather than wages. Distributions from a partnership are not considered wages (even if classified as “guaranteed payments”), and distributions from an S corporation are not considered wages unless recharacterized as such by the IRS.
Because Congress wanted to create parity between large EOs and taxable entities, the excise tax does not apply to amounts already subject to disallowance under section 162(m). However, section 162(m) applies only to public companies and only to a specific subset of their employees that differs from section 4960. Moreover, sections 162(m) and 4960 use different measures of compensation.
For example, suppose Yearbook, Inc., a large public corporation, decided in 2015 to form a private foundation to further its charitable giving. The top executives of Yearbook serve as the foundation’s directors and officers, making the two organizations related. One of these executives, Sheryl, receives an annual salary of $1.5 million from Yearbook. Part of Sheryl’s compensation includes a $500,000 performance-based bonus that was grandfathered under section 162(m) and, therefore, is deductible by Yearbook even though the bonus otherwise would have exceeded the deductibility limit under section 162(m). Nevertheless, because a deduction is not disallowed under section 162(m), Yearbook will be subject to an annual excise tax of $105,000 (21 percent of $500,000) if nothing changes.
What Could Have Fixed the Issue for Microfix and Yearbook?
What could Microfix or Yearbook have done to avoid this excise tax? When forming their foundations, they could have appointed a sufficient number of independent directors to the foundations’ boards to avoid being related to the foundation. Microfix alternatively could have paid Bill no more than $1 million in salary and distributed any additional profits as dividends (assuming this lower salary is otherwise reasonable). However, this solution may not be viable for a company that has other shareholders, such as employees, minority investors or trusts, that would be entitled to their pro rata shares of profit distributions.
If the IRS does not provide an exception for volunteer officers, many private foundations — both large and small — will find themselves ensnared in a rule that they had no idea would catch them. The IRS is aware of this issue and has signaled informally that it may provide relief in the future. However, no action is expected before the May 15 deadline for calendar year organizations. Those organizations must determine whether to file returns and pay the tax, or to not take any action and hope that future guidance will exempt them from this rule.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.