Final Section 4960 Executive Compensation Excise Tax

Final Section 4960 Executive Compensation Excise Tax Regulations: Significant Changes for Tax-Exempt OrganizationsGrandfathering, Covered Employees, Timing Rules For Renumeration, Related Group 50 Percent Test, Parachutes, and More

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THURSDAY, MAY 13, 2021

Presenting a live 90-minute webinar with interactive Q&A

Today’s faculty features:

Seth J. Safra, Partner, Proskauer Rose LLP, Washington, D.C.

James R. Huffman, Associate, Proskauer Rose LLP, Washington, D.C.

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Final Regulations Under Section 4960:Excise Tax on Executive Compensation

Seth J. SafraPartner, Proskauer Rose LLP

James R. HuffmanAssociate, Proskauer Rose LLP

May 13, 2021

Key Executive Compensation Rules for Tax-Exempts

• Anti-inurement: Compensation < fair market value ‒ Section 4958 intermediate sanctions regime (tax on executive)

• Disclosure: Form 990 (organization must report)

• Deferred compensation is included in income at vesting (no deferral)

• Code Section 4960: Excise tax for organization on:‒ Remuneration > $1 million ‒ Excess parachute payments (compensation and benefits > “base amount”)

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May 13, 2021Final Regulations Under Section 4960: Excise Tax on Executive Compensation

Overview of Section 4960

• Who:‒ Applicable tax exempt organizations (“ATEOs”) and related organizations

• What:‒ (1) Remuneration > $1 million (excess compensation); not indexed for inflation‒ (2) Separation pay and benefits (excess parachute payments)

• Rate:‒ The corporate tax rate (currently 21%, proposed increase to 28%)

• Who pays:‒ The ATEO (allocated among related organizations)

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Underlying Policy: Economic Effect of Excise Tax

• Comparable to:

‒ Losing a deduction for compensation > $1 million (Section 162(m))

‒ Losing a deduction for excess parachute payments (Section 280G)

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Who is subject to Section 4960?

ATEO (Applicable Tax-Exempt Organization):

• Exempt under Section 501(a), including:‒ All Section 501(c) (not just § 501(c)(3))‒ VEBA (§ 501(c)(9))‒ Benefit plans (§ 501(a))‒ Exclude certain foreign organization under § 4948(b)

(substantially all support from outside the US)

• Exempt under Section 115(1) (income from public utility or exercise of essential government function)‒ But not state and local governments claiming sovereign immunity‒ Public university vs. private university

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Covered Employees

• Every organization has them--even if compensation << $1 million‒ Separate list for each related ATEO‒ Dual-employee can be on >1 list

• Must track, because once covered, always covered‒ Even after employment ends‒ E.g., executive of foundation later becomes CFO of affiliated for-profit

• Top five highest-paid employees for the applicable tax year‒ All tax years starting after December 31, 2016‒ Count remuneration from related organizations, including for-profits, foreign entities‒ Officer status not relevant (unlike § 162(m))

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What is a “Related Organization”?

• Controls or controlled by the ATEO (greater than 50%)‒ Voting or value of stock corporation‒ Capital or profits interest of partnership‒ Beneficial ownership of a trust‒ Board of nonstock organization

• Brother-sister: 2 organizations controlled by same persons (greater than 50%)

• Supported organization (§509(f)(3)) or supporting organization (§509(a)(3))

• VEBA: establish, maintain, or contribute to the VEBA

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Related Organizations Example #1Entity NotesATEO 1 Nonstock organizationATEO 2 Nonstock organization

ATEO 1 controls appointment of 80% of ATEO 2’s directorsATEO 3 Nonstock organization

Owns 80% of CORP 1ATEO 1 controls appointment of 80% of ATEO 3’s directors

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Conclusions:• ATEO 1 and ATEO 2 are related organizations (ATEO 1 controls appointment of > 50% of directors)

• ATEO 1 and ATEO 3 are related organizations (ATEO 1 controls appointment of > 50% of directors)

• CORP 1 is a related organization of ATEO 3 and ATEO 1• ATEO 3 owns > 50% of CORP 1• ATEO 1 is deemed to own 64% of CORP 1 (i.e., 80% of ATEO 3’s stock in CORP 1)

• ATEO 2 and ATEO 3 are related organizations because both are controlled by ATEO 1 • CORP 1 is a related organization of ATEO 2 because ATEO 1 controls both


Related Organizations Example #2Entity NotesATEO 4 Nonstock organizationATEO 5 Nonstock organization

ATEO 4 controls appointment of 60% of ATEO 5’s directorsATEO 6 Nonstock organization

ATEO 5 controls appointment of 60% of ATEO 6’s directors

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Conclusions:• ATEO 4 and ATEO 5 are related organizations (ATEO 4 controls appointment of > 50% of directors)

• ATEO 5 and ATEO 6 are related organizations (ATEO 5 controls appointment of > 50% of directors)

• ATEO 4 is deemed to control appointment of 36% of ATEO 6’s directors (60% of ATEO 5’s 60% control over ATEO 6)

• So ATEO 4 and ATEO 6 are not related organizations (< 50% control)(Assumes no facts suggesting indirect control)


Covered Employees: Compensation from Related Organizations• Issue: Executives of for-profit serving non-profit

‒ E.g., corporate executives serving foundation

• Count only common law employees of the tax-exempt‒ Exclude non-employee board members‒ But officers of the tax-exempt are presumed to be employees

‒ Even if only part-time to the tax-exempt‒ Even if no separate compensation for tax-exempt work

• Special rules‒ Non-exempt funds exception‒ Limited hours exception‒ Limited services exception

• Exceptions don’t override “once-covered, always-covered” rule(even if service and/or compensation levels drop)

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Covered Employees: Non-Exempt Funds Exception

• < 50% of total time for ATEO (and related ATEO, if any)

‒ Over both applicable year and preceding year

‒ Can measure by hours or days; day with >1 hour for ATEO counts as full day for ATEO

• No compensation from ATEO

‒ No reimbursement or promises of future compensation

• No payment, promises, or reimbursements by for-profit that is controlled by the ATEO

• ATEO doesn’t pay fee for services to any related organization that provides services to the ATEO

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Nonexempt Funds Example• Employee of for-profit corporation is an officer of related ATEO

• The for-profit pays 100% of employee’s compensation‒ ATEO does not pay or reimburse‒ ATEO does not control any other entities

• Allocation of service:

• Not a covered employee for 2023 or 2024

• Don’t forget the once-covered, always-covered rule!

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Year For-Profit ATEO2022 1,950 hours 50 hours2023 1,100 hours 900 hours2024 1,100 hours 900 hours


Covered Employees: Limited Hours Exception

• < 10% of total time for ATEO (and related ATEO, if any)

‒ Over applicable year (don’t look at preceding year)

‒ Automatic pass if < 100 hours in the year for ATEO

‒ Can measure by hours or days; day with >1 hour for ATEO counts as full day for ATEO

• No compensation from ATEO

‒ No reimbursement or promises of future compensation

• No prohibition on payments, promises, or reimbursements from controlled for-profit

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Limited Hours Example

• Employee of for-profit corporation is an officer of related ATEO• Most of employee’s compensation is paid by controlling for-profit• ATEO owns book store that pays remainder of employee’s compensation

‒ Remuneration by downstream for-profit makes ineligible for nonexempt funds exception

• During 2022, Employee has 2,200 hours of service:‒ 2,000 hours to for-profit‒ 200 hours for ATEO

• Not a covered employee for 2022, because 200 hours < 10% of 2,200 hours

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Covered Employees: Limited Services Exception

• Can disregard employee if ATEO paid < 10% of employee’s total remuneration

• Not available unless a related ATEO paid > 10% of total remuneration‒ I.e., individual must be picked up by a related ATEO

• If no related ATEO paid > 10% of total remuneration, count as employee of the ATEO that paid the highest percentage

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Limited Services Example #1

• Employee is an officer of 4 related ATEOs

• Compensation is allocated among the ATEOs as follows:‒ ATEO 1 – 5% ‒ ATEO 2 – 10%‒ ATEO 3 – 25% ‒ ATEO 4 – 60%

• ATEO 1 can disregard the employee (< 10% of total remuneration)

• Employee can be covered employee of ATEO 2, ATEO 3 and ATEO 4(if in the applicable ATEO’s top 5, counting total remuneration paid by all)

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Limited Services Example #2• Employee is an officer of 4 related ATEOs (like Example #1) and a related for-profit

• Compensation is allocated among the ATEOs and for-profit as follows:‒ ATEO 1 – 6% ‒ ATEO 2 – 5%‒ ATEO 3 – 5%‒ ATEO 4 – 5%‒ For-Profit – 79%

• Limited services exception not available (no related ATEO paid > 10%)

• Nonexempt funds and limited hours exceptions not available (because ATEOs pay part of compensation)

• Include in ATEO 1’s covered employee analysis‒ Count total remuneration from all related entities (including for-profit)

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Remuneration > $1 million: What Counts?

• All wages that are subject to federal income tax withholding (§ 3401(a))‒ Exclude Roth contributions to a plan‒ Exclude payments from qualified retirement plans‒ Must count payments from Section 457(b) (nongovernmental) ‒ Must count amounts included under Section 457(f)

• Count over calendar year that ends within tax year(same as Form 990, but compensation calculations are different)‒ E.g., for tax year ended June 30, 2021, count wages for calendar year 2020‒ 2021 wages count for tax year ending June 30, 2022

• No grandfathering (unlike § 162(m))

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Remuneration > $1 million – When counted?

• Count (PV) when no longer subject to substantial risk of forfeiture‒ Even if not paid until later‒ No 2½-month rule‒ Exception for “regular wages,” where pay for last period of year is paid in next year‒ No PV adjustment for nonaccount balance payable within 90 days

• E.g., bonus earned for a year and paid in the next year‒ Counts for year when earned, unless conditioned on working until payment

• Annual adjustments for earnings/losses‒ Losses can offset earnings, but not new wages‒ Unused losses can carry over (if incurred while a covered employee)

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Plan Ahead for Deferred Compensation

CEO receives annual $200,000 deferral, subject to 3-year vest

• Option 1 (cliff vest): Full $600k vests after 3 years

‒ $600,000 counts toward the $1 million limit for year 3

• Option 2 (graded vest): $200,000 vests each year

‒ $200,000 counts toward the $1 million limit for each of year 1, year 2, and year 3

؞ Graded vesting/payment schedule can reduce excise tax

‒ But, consider tradeoff – graded vesting provides less retention incentive

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Spreading Out Deferred Compensation

• No grandfathering!

• Limited ability to spread out deferred compensation that is already in place:‒ Must defer at least 2 additional years‒ Must increase PV of amount deferred by at least 25%

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Exception for Doctors, Nurses, Veterinarians

• Can ignore compensation to licensed medical professionalfor performance of medical services

‒ Includes compensation to veterinarian for veterinary services

• But must count remuneration for teaching, research, administrative duties

• Must bifurcate pay for doctors with administrative responsibility (but, some administrative functions may be integral to providing medical services)

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How to allocate medical vs. non-medical services?

• Good faith, reasonable allocation between medical and non-medical

• For example:‒ Employment agreement setting forth remuneration to be paid for particular services

(unless facts and circumstances indicate allocation is unreasonable)

‒ Representative sample of records (patient, insurance, Medicare/Medicaid billing records)

‒ Internal time reporting mechanisms

‒ Determine medical portion based on compensation for similarly situated professional (non-administrative)

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Example – Chief Surgeon

• Chief Surgeon at a hospital that is an ATEO receives $2.6 million in a year

• Internal time records show split as follows:

• 70% of remuneration ($1,820,000) is for medical services – not subject to Section 4960

• 30% of remuneration ($780,000) is for non-medical services – subject to Section 4960

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Portion of Time Services Performed Characterization35% Surgery, rounds, appointments Medical Services 35% Administrative tasks – Medical notes,

review x-raysMedical Services (integral to providing)

20% Administrative tasks – Scheduling, budgeting, employee review

Not medical services

10% Teaching at medical school Not medical services


“Excess Parachute” Payments

• Separation Pay = amount contingent on involuntary/good reason separation‒ Not limited to taxable compensation‒ Count health insurance, value of stock rights, deferred amounts

• Compare Separation Pay to “Base Amount”‒ Average W-2 wages for prior 5 years (or period of employment, if less)

• Tax triggered if Separation Pay > 3x Base Amount

• Tax = corp tax percentage of (Separation Pay minus 1x Base Amount)‒ Huge consequence for barely hitting trigger‒ Rate is currently 21%; Biden has proposed 28%

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4960 v. 280G

• Similar, but Section 4960 does not require CIC

• Tax consequence under Section 4960 is borne solely by employer‒ ATEO executives have less incentive than executives of for-profit to cooperate

• No chance for “cleansing vote” under Section 4960

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“Excess Parachute” Payments: Sneaky

• Base Amount < Current Compensation (assuming salary increases)

• Base Amount is limited to taxable compensation

• But Separation Pay includes nontaxable amounts

‒ E.g., value of continued health benefits

‒ Exceptions for qualified plan, 403(b) benefits (but not for non-governmental 457(b) or 457(f))

• Watch out for deferred compensation that vests on involuntary termination

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“Excess Parachute” Payments: Base Amount

• Averaged over 5 years (or period of employment, if less)

• If salary increases, base amount < current compensation

• Example –

Base amount = $271,666.67 (< half of current compensation)

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Year W2 Compensation2019 $95,0002020 $120,0002021 $600,000


“Excess Parachute” Example

• Covered employee’s salary for 2021 is $250,000

• Section 457(f) account balance of $400,000, conditioned on working 3 more years

• If terminated without cause, Employee gets severance equal to 2x salary, plus continued health and life insurance for two years and vesting of the 457(f) account

• Employee’s W-2 for 2016 through 2020 is as follows:

‒ 2016: $170,000‒ 2017: $175,000‒ 2018: $200,000‒ 2019: $210,000‒ 2020: $225,000

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“Excess Parachute” Example (cont’d)

• Base Amount = $196,000 (average W-2 over prior five years)

• 3x Base Amount = $588,000

• Severance = $599,800‒ $250,000 times two years = $500,000, plus‒ Two years of health and life insurance costs ~ $80,000, plus‒ Value of accelerated vesting of $400,000 = $19,800

1. Value of paying 3 years early ~ $55,000 (assuming 5% interest)2. 1% of amount in #1, times months to vesting (36) = 36% of $55,000 = $19,800

• Excess Parachute = $403,800 ($599,800 minus $196,000)

• Excise tax = $84,798 (21% of $403,800)

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Reporting the Excise Tax

• Form 4720 (“Return of Certain Excise Taxes Under Chapters 41 and 42 of theInternal Revenue Code”), Schedule N (“Tax on Excess Executive Compensation”)

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Reporting the Excise Tax: When?

• Deadline: 4.5 months after ATEO’s year end (May 15 for calendar-year organization)

• Same deadline as for Form 990

• But compensation calculations for Section 4960/Form 4720 ≠Calculations for Form 990 ‒ E.g., time of vesting vs. time of payment

• Extension available for both Form 4720 and Form 990

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Allocation and Payment of Excise Tax

• If ATEO is related to a for-profit or another ATEO,must allocate excise tax among the related organizations

Each Org’s Share =

• Special rules apply when one organization pays for services performed for a differentorganization

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Questions?

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Biographies

Seth J. Safra

Seth J. Safra is a partner in Proskauer’s Employee Benefits & Executive Compensation Group. He is a member of the Firm’s COVID-19 Task Force, which is helping employers deal with myriad issues related to business disruption.

Described by clients as “extremely knowledgeable, practical, and strategic,” Seth advises clients on compensation and benefit programs.

Seth’s experience covers a broad range of retirement plan designs, from traditional defined benefit to cash balance and floor-offset arrangements, ESOPs and 401(k) plans—often coordinating qualified and non-qualified arrangements. He also advises tax-exempt and governmental employers on 403(b) and 457 arrangements, as well as innovative new plan designs; and he advises on ERISA compliance for investments.

On the health and welfare side, Seth helps employers provide benefits that are cost-effective and competitive. He advises on plan design, including consumer-driven health plans with HSAs, retiree medical, fringe benefits, and severance programs, ERISA preemption, and tax and other compliance issues, such as nondiscrimination and cafeteria plan rules.

Seth also advises for-profit and non-profit employers on executive employment, deferred compensation, change in control, and equity and other incentive arrangements. In addition, he advises on compensation and benefits in corporate transactions.

Seth represents clients before the Department of Labor, IRS and other government agencies.Seth has been recognized by Chambers USA, The Legal 500, Law360, Human Resource Executive, Lawdragon and Super Lawyers.

Education

[email protected]

District of Columbia Bar

Partner+1-202-416-5840

Duke University School of Law (J.D., 2001)

Georgia Institute of Technology (B.C.E., 1998)

Admissions & Qualifications

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Biographies

James R. Huffman

James Huffman is an associate in the Tax Department and a member of the Employee Benefits & Executive Compensation Group.

James counsels public and private companies on their employee benefits plans and executive compensation arrangements. This includes counseling clients on compliance with ERISA, the Internal Revenue Code, and securities laws, both in day-to-day administration and in transactions (including mergers and acquisitions and financing transactions). In the employee benefit plan space, James provides advice on the full lifecycle of a plan, from its inception and administration to its termination. He also represents clients before the IRS and other government agencies in connection with these matters. James’s practice also includes advising clients in connection with distressed multiemployer pension plans.

In the executive compensation space, James works with both companies and executives in negotiating employment and separation agreements. With experience working on both sides, James approaches negotiations with a holistic view of the issues and a focus on reaching an efficient and fair resolution. He also collaborates with companies in designing and implementing annual and long-term cash and equity incentive compensation programs, and in complying with related securities disclosure obligations.

James earned his B.A. and J.D. from the University of Maryland, where he was senior articles editor of the Journal of Health Care Law and Policy, and earned his LL.M. in taxation with a certificate in employee benefits from Georgetown University Law Center.

Education

[email protected]

District of Columbia Bar

Associate+1-202-416-6876

Georgetown University Law Center (LL.M., 2016)

University of Maryland Carey School of Law (J.D., 2015)

University of Maryland (B.A., 2012)Admissions & Qualifications

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Documents

Final Section 4960 Executive Compensation Excise Tax