The Internal Revenue Service (IRS) and Department of Treasury issued a notice of proposed rule-making regarding an additional tax on nonprofit salaries of more than $1 million, originally included in the Tax Cuts and Jobs Act of 2017 (TJCA).
Proposed regulations under Section 4960 of the Internal Revenue Code impose an excise tax of 21 percent on tax-exempt organizations that pay their highest-paid covered employees more than $1 million, or parachute payments equal to at least three times a covered employee’s average pay.
The IRS issued the 177-page proposal and is scheduled to publish it today in the Federal Register. Written or electronic comments and requests for public hearing must be received 60 days after that.
The law generally applies to the five highest-earning officials and universities, hospitals and other nonprofits, according to the National Council of Nonprofits. It’s likely to impact private and corporate foundations, large nonprofits, like hospitals, healthcare systems and universities, as opposed to most nonprofits that generally spend less than $1 million annually.
The IRS in early 2019 issued interim guidance via Notice 2019-09 which defined application tax-exempt organizations, excess remuneration, covered employee and excess parachute payment, and instructed taxpayers how to report and pay the excise tax. The proposal also would relieve for-profits from having to pay the excise tax on executive compensation earned when volunteering at related nonprofit organizations.
Proposed regulations are a little more definitive than interim guidance issued last year, according to Alexander Reid, a partner at Morgan Lewis. He advises tax-exempt organizations and taxpayers on tax planning, structuring, and transactional matters. Interim guidance gives an indication of where the IRS might take a position but it’s not binding on anyone, he said.
There was “a hue and cry” after interim guidance suggested the definition of a related organization would be so broad that it would pick up relationships between highly compensated employees of a company who serve for free on an affiliate nonprofit, Reid said.
“There was a real thought process on the part of the IRS that this excise tax can and should apply, dragging in compensation from a related organization, and serving for free on the board of a nonprofit wouldn’t be good enough to get out of the rule,” Reid said. “Now there are some parameters around exceptions,” he said.
The proposed regulations are based on Notice 2019-09 with changes in part addressing comments received, according to the notice. The Treasury Department and the IRS received 14 comments in response to the notice, primarily discussing treatment of employees of a related person who also provides services to the tax-exempt organization, suggesting various exceptions for such situations.
“What Congress was trying to do was tax people who make more than $1 million but they didn’t want to create a new tax bracket,” Reid said. “It would be great to get a collective action by the nonprofit sector to really focus these regulations down on just payments that burden the tax-exempt income,” he said.
The regulations apply to all tax-exempt organizations, including 501(c)(4) social welfare and 501(c)(6) business leagues, Reid said, but the way related entities are defined it ends up being a small business tax that drags in affiliated organizations.
An estimated 261,000 tax-exempt organizations would be affected under the regulations, with about 239,000 of those being 501(a) organizations, including 23,000 private foundations, and 2,000 are 527 political organizations, according to the notice. There were about 2,000 company foundations responsible for $5.5 billion in giving in 2015, and about half of the 42,000 family foundations have a related business with an employee to whom the exceptions apply.