Effective for taxable years beginning after December 31, 2017, section 4960 of the Internal Revenue Code imposes a tax at the corporate income tax rate (currently 21 percent) on two types of compensation paid by applicable tax-exempt organizations (ATEOs) to their covered employees.  An ATEO’s covered employees generally include its five highest paid employees for a year plus all individuals determined to be covered employees for a preceding year.

  • The two types of compensation are—
    • Remuneration (generally, wages for purposes of federal income tax withholding) in excess of $1,000,000 paid by an ATEO or its related organizations for a year with respect to employment of any covered employee.
    • Any “excess parachute payment” paid by an ATEO or related organization to any covered employee.
  • Granting a legally binding right to nonvested remuneration counts as “paying remuneration.”
  • See here for our previous blog post on the basics of the statute.

Treasury and the IRS published interim guidance on December 31, 2018 (Notice 2019-9), proposed regulations in June 2020, and final regulations in January 2021. In reponse to the interim guidance, several comments raised concerns about the treatment of an employee of a taxable employer who spends some of his or her time providing services to a related ATEO. Under one reading of the statute and interim guidance, such an employee might be treated as a “covered employee” whose compensation is subject to the excise tax under § 4960 even if the employee receives no compensation from the ATEO. The IRS and Treasury responded by including several helpful exceptions in the proposed regulations. The exceptions remain largely unchanged in the final regulations.

  1. Who are an ATEO’s employees under the final regulations?

Under the final regulations, an ATEO’s employees generally include its common-law employees and its officers. Whether an individual providing services to an ATEO is a common-law employee of the ATEO depends on the facts and circumstances, most significantly the type and degree of control the ATEO has over the individual’s performance of services. An officer of an ATEO is treated as its employee regardless of the common-law standard. This definition generally would pick up any employee of a taxable employer who serves as an officer of a related ATEO or who performs services for the ATEO as a common-law employee.

  1. Who are an ATEO’s covered employees under the final regulations?

Subject to certain exceptions, described below, the “covered employees” of an applicable tax-exempt organization are the organization’s five highest compensated employees for the taxable year and any employees who were covered employees for any preceding taxable year beginning after December 31, 2016. This means that if an employee is a covered employee for one year, the employee will be a covered employee for all future years. This is sometimes referred to as the “once a covered employee, always a covered employee” rule. Compensation paid to an ATEO’s employee by related organizations is aggregated with any compensation paid by the ATEO for purposes of determining whether an individual is a covered employee of an ATEO.

  1. What exceptions do the final regulations provide for determining an ATEO’s covered employees that might apply to an employee of a related taxable entity?

The final regulations allow certain employees to be disregarded in determining an ATEO’s five highest-compensated employees for a year. These exceptions apply only to the current-year prong of the definition of “covered employee.” They do not preclude an individual from being a covered employee under the “once a covered employee, always a covered employee” rule.

  • Limited hours exception. This exception applies to an individual in determining an ATEO’s five highest compensated employees for a year if all of the following remuneration and service requirements are met:
    • Neither the ATEO nor any related ATEO paid remuneration to the individual for services the individual performed as an employee of the ATEO during the applicable year. (For this purpose, a payment from a related organization that is not an ATEO would be treated as a payment from an ATEO if the non-ATEO is entitled to reimbursement or other consideration from the ATEO for the payment.)
    • The individual performed services as an employee of the ATEO and all related ATEOs for no more than 10 percent of the total hours the individual worked as an employee of the ATEO and any related organizations during the applicable year. This determination can be based on days worked instead of total hours worked. This requirement is deemed to be satisfied if the individual performs no more than 100 hours of service as an employee of the ATEO and all related ATEOs during the applicable year.
  • Nonexempt funds exception. This exception applies to an individual in determining an ATEO’s five highest compensated employees for a year if all of the following requirements are met:
    • Neither the ATEO , nor any of certain related organizations, paid remuneration to the individual for services the individual performed as an employee of an ATEO during the applicable year and the preceding applicable year. (For this purpose, a payment from a related organization that is not an ATEO would be treated as a payment from an ATEO if the non-ATEO is entitled to reimbursement or other consideration from the ATEO for the payment.)
    • The individual performed services as an employee of the ATEO and any related ATEOs for 50 percent or fewer of the total hours worked as an employee of the ATEO and any related organizations during the applicable year and the preceding applicable year (i.e., a rolling two-year measurement period). This determination can also be based on days worked instead of total hours.
    • No related organization that paid remuneration to the individual during the applicable year and the preceding applicable year provided services for a fee to the ATEO, to any related ATEO, or to any taxable related organization controlled by the ATEO or by one or more related ATEOs, either alone or together with the ATEO, during the applicable year and the preceding applicable year.
  • Limited services exception. This exception applies to an individual in determining an ATEO’s five highest compensated employees for a year, even though the ATEO paid remuneration to the individual, if all of the following requirements are met:
    • The ATEO did not pay 10 percent or more of the individual’s total remuneration for services performed as an employee of the ATEO and all related organizations during the applicable year.
    • Either (1) a related ATEO paid at least 10 percent of the remuneration paid by the ATEO and any related organizations during the applicable year, or (2) no related ATEO paid at least 10 percent of the total remuneration paid by the ATEO and any related organizations and the ATEO paid less remuneration to the individual than at least one related ATEO during the applicable year.
  1. For which taxable years do the final regulations apply?

The final regulations apply to taxable years beginning after December 31, 2021. Taxpayers are permitted to apply the final regulations for earlier taxable years if they apply them in their entirety and in a consistent manner.

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Photo of Julie Edmond Julie Edmond

Julie Edmond has extensive experience counseling and litigating in the employee benefits area, including traditional defined benefit, cash balance, 401(k), profit-sharing and money purchase pension plans; executive compensation and § 409A; § 403(b) plans, § 457 plans and other plans for tax-exempt organizations…

Julie Edmond has extensive experience counseling and litigating in the employee benefits area, including traditional defined benefit, cash balance, 401(k), profit-sharing and money purchase pension plans; executive compensation and § 409A; § 403(b) plans, § 457 plans and other plans for tax-exempt organizations; ESOPs; cafeteria plans; VEBAs and self-insured medical plans and other welfare plans.  Her experience includes plan selection, formulation and drafting, regulatory compliance, audits, voluntary compliance, prohibited transactions and fiduciary duty requirements, separate line of business issues, use and handling of employee benefits and benefit plans in corporate transactions, and ERISA litigation.