Exempt Organizations: IRS Issues Final Rules on 21% Excise Tax on Excess Compensation

The IRS has issued final regulations under Internal Revenue Code Section 4960 regarding the 21% excise tax on excess executive compensation paid by certain tax-exempt organizations, such as nonprofit hospitals.

The excise tax applies to an applicable tax-exempt organization (ATEO) that pays a covered employee more than $1 million in remuneration during a year or an “excess parachute payment.” A parachute payment, which is a payment contingent on the employee’s separation from the organization, is considered excessive if it is at least three times the employee’s base salary. The excess amounts are taxed to the ATEO at the corporate tax rate, currently 21%. However, no excise tax is due for any amounts paid for medical or veterinary services.

Enacted by the Tax Cuts and Jobs Act, Code Section 4960 defines an ATEO as any organization that is exempt from tax under Section 501(a); is a farmers’ cooperative organization described in Section 521(b)(1); is a governmental entity with income excluded from taxation under Section 115(1); or is a political organization described in Section 527(e)(1). The final regulations affect an estimated 261,000 ATEOs and 77,000 non-ATEO related organizations.

Following initial guidance provided in Notice 2019-09 and proposed regulations issued in June 2020, the Treasury Department and IRS published final regulations in January 2021 that provide rules for determining:

• The amount of remuneration paid for a taxable year for purposes of identifying covered employees and calculating the excise tax
• Whether excess remuneration has been paid, and in what amount
• Whether a parachute payment has been paid, and in what amount
• The allocation of liability for the excise tax among related organizations

Clarity on Covered Employees

The final regulations also define and clarify certain terms used in the statute, including who is considered a covered employee. As defined by statute, a covered employee is any of the five highest-compensated employees of the ATEO for a taxable year (or any preceding taxable year beginning after December 31, 2016).

Whether an individual is one of the highest-paid employees is determined separately for each ATEO in a related group, which means that one individual could wind up being a covered employee for more than one ATEO in a group of related organizations. A group of related ATEOs could also have more than five covered employees for a taxable year. The final regulations retained the limited hours, nonexempt funds, and limited services exceptions found in the proposed regulations.

Applicable Date

The final regulations are applicable in tax years beginning after December 31, 2021. In the meantime, taxpayers may choose to rely on guidance provided in Notice 2019-09, or on the proposed regulations, or they can choose to adopt the final regulations early, as long as the rules are applied in their entirety and consistently.

If your organization may be affected by these regulations, please contact your CRI advisor for more information.