NOTICE 2019-09

Excise Tax onExecutiveCompensationPAYABLE BY TAX-EXEMPTEMPLOYERS

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This article identifies the pertinent issuesin section 4960 and summarizes theextent to which the Notice addressesthem, while also providing specificactions that employers should take toaddress the immediate implications ofthe excise tax.

In December 2017, Congress, as part of broadertax legislation, enacted a new excise tax on annualcompensation paid by all tax-exemptorganizations in excess of $1 million and on excessparachute payments. On December 31, 2018, theInternal Revenue Service issued Notice 2019-09(the “Notice”), to provide interim guidance toassist in applying section 49601, which containsthe excise tax provisions.

Background

Section 4960 imposes an excise tax on tax-exempt organization executive compensationequal to 21%2 of: (1) remuneration (other than anyexcess parachute payment) in excess of $1 millionpaid to a covered employee by an applicable tax-exempt organization for a tax year, plus (2) anyexcess parachute payment paid by an applicabletax-exempt organization to a covered employeeother than an employee who is not highlycompensated. This provision imposes the21% .excise tax on an excess parachute payment,even if the covered employee’s total remunerationdoes not exceed the $1 million threshold amount.The $1 million threshold is not adjusted forinflation.

1. All “section” references are to a section of the Internal Revenue Code of 1986, as

amended.

2. 21% is the current rate for the corporate income tax. If that rate is increased in the

future, the rate imposed by section 4960 would increase as well.

Who is a covered employee?

The Notice did not expand or change the keyelements regarding covered employees, despitereceiving numerous requests to do so.Consequently,

A “covered employee” means an employee(including any former employee) of anapplicable tax-exempt organization if (a) theemployee is one of the five highestcompensated employees of the organization forthe taxable year or (b) was a covered employeeof the organization (or any predecessor) for anypreceding taxable year beginning afterDecember 31, 2016.

Determining who is a covered employee ismade each year.

Once a person is a covered employee, they arealways a covered employee – this is the caseeven if the employee’s remuneration does notexceed $1M in a particular year.

Determining who is a covered employee is doneorganization-by-organization, even if a group oforganizations considers themselves part of alarger enterprise; e.g., individual hospitals, eachof which is a separate section 501(c)(3)corporation, and a parent corporation, whichcontrols all of the hospital corporations andwhich also is a section 501(c)(3) corporation,must determine their covered employeesseparately, even if they are part of a singlehealthcare system.

NOTICE 2019-09

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What is remuneration?

The Notice reinforced and expanded on what isincluded and not included in “remuneration.” Anorganization needs to identify the following whendetermining an employee’s remuneration:

Remuneration includes all cash andcompensation in any medium other than cash(this is the starting point for determiningremuneration: the definition of “wages” asdefined in section 3401(a)).

Remuneration also includes amounts that arevested (i.e., the employee does not have toprovide any future services to receive theamount), even if the vested amount is not paiduntil a later date.

Remuneration also includes earnings onpreviously paid remuneration (i.e., amounts thatwere treated as remuneration in a previous yearbut have not been actually paid to theemployee).

Remuneration does not include payments to orfrom a tax-qualified pension or profit-sharingplan.

Remuneration does not include amounts paidfor medical services provided by the employeewho is a licensed medical professional:

Services for diagnosing, curing, mitigating,treating or preventing disease, or servicesfor the purpose of affecting any structuresor function of the body (section 213(d)(1)(A)).

In general, teaching and research, peerreview, and medical director services arenot considered medical services.

Employee must be a licensed medicalprofessional – physician, nurse orveterinarian are specified in the Notice.

Also, remuneration may come from more than oneemployer or organization, even if only oneorganization is treated as the common-lawemployer for federal tax purposes.

All remuneration paid by related organizations to acovered employee for the services rendered bythat employee must be treated as remuneration. Inaddition, all remuneration paid to a coveredemployee for services rendered to an applicabletax-exempt organization (i.e., an organization

subject to the excise tax provisions), must betreated as remuneration, even if one of the payingorganizations is not related to the employer of thecovered employee.

When is remuneration determinedfor purposes of identifying coveredemployees?

The Notice clarified the timing for determiningremuneration in order to identify the coveredemployees: remuneration for an employee is to bethe remuneration paid for the calendar yearending with or within the employer’s tax year. Forexample, if the employer’s tax year is June 30,then remuneration paid to employees for thecalendar year that ends the previous December 31is the remuneration that should be used todetermine the covered employee group for thatyear (and do not forget that any employee whohad been determined to be a covered employee ina prior year continues to be one for this year,regardless of their remuneration for the year beingreviewed).

Which organizations are subject tothe tax?

To start, the statute applies to virtually all tax-exempt organizations: the term “applicable tax-exempt organization” is broadly defined, with afew exceptions.

The Notice provides guidance that expanded onthe law’s description of how organizations arerelated to each other for purposes of determiningboth remuneration to a covered employee and anyshared excise tax liability:

Makes clear governmental entities and for-profitorganizations are not excluded from thesedeterminations.

Uses the concepts in section 512(b)(13)(D) todefine how one organization “controls” another—this can be through stock ownership,partnership interests, trust interest, or boardmembership appointment, depending on thestructure of the organization—and requires onlymore than 50% of ownership or boardmembership appointment to be consideredcontrolled.

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How is the excise tax liabilityaddressed if more than oneorganization has paidremuneration to a coveredemployee?

The Notice provides detailed guidance on how toapportion excise tax liability among relatedorganizations when:

A covered employee’s remuneration is paid bytwo or more organizations for services providedto one organization.

A covered employee’s remuneration is paid bytwo or more organizations for services providedto two or more organizations.

The Notice expands on the guidance contained inthe statute, and without going into the detail ofthis guidance, is intended to avoid a duplication ofexcise tax liability when it is to be apportionedamong organizations.

Excess parachute payments.

As noted above, the 21% excise tax also applies toany excess parachute payment paid to a coveredemployee. An excess parachute payment is anamount (1) paid to a covered employee, (2)contingent on the employee’s separation fromemployment, and (3) in an amount with a presentvalue that equals or exceeds three times theemployee’s “base amount.”

An employee’s base amount is in general theaverage of the employee’s “wages” from theemployer for the five years prior to the year ofseparation from employment. Payments underqualified plans, or any payment under or to anannuity contact described in section 403(b) or aneligible plan described in section 457(b), are notincluded in the definition of excess parachutepayment.

The Notice provides guidance in applying thedetails of how to calculate parachute payments,relying extensively on the structure (and in somecases, the wording and examples) of theregulations under sections 280G and 4999 (the“golden parachute” rules).

The Notice, however, points out that while theterminology (“parachute payments”) in section4960 and in the Notice are similar to the goldenparachute rules applicable to public companies,the definition of a parachute payment is muchbroader than in those rules: section 4960 and the

Notice address payments that occur because of aseparation from employment (and identify thatthe separation must be involuntary) and which donot have to be made in the context of a change incontrol of the organization.

In applying the detailed rules for determiningwhether an excess parachute payment exists, theNotice makes clear that even if payments upon aseparation of employment do not result in anexcess parachute payment, the amounts thecovered employee receives upon a separation ofemployment must still be included in thecalculation of whether remuneration exceeds $1million in the year in which these payments arereceived.

If an excise tax is assessed, is thecompensation subject to the excisetax considered unreasonablecompensation?

The Notice makes clear that there is nocoordination between the excise tax oncompensation in section 4960 with the excise taxon unreasonable compensation imposed bysection 4958 or 4941. This simply means that tax-exempt organizations must still take steps todetermine the reasonableness of all cash andother compensation and benefits as they havebeen doing for many years: there is nopresumption that simply because the section4960 tax applies, that compensation in excess of$1 million is in any way excessive or unreasonable.

Effective date.

The provision is effective for a tax-exemptemployer’s tax years beginning after December 31,2017. Thus, for tax-exempt organizations with fiscalyear-ends, the tax applies to compensation paidbeginning with the first tax year beginning afterDecember 31, 2017. For example, if anorganization’s fiscal year ends September 30,these provisions are effective for the year thatbegins October 1, 2018, and remuneration fordetermining who is a covered employee wouldtake into account remuneration for calendar year2017 (for purposes of that “look-back”requirement) and calendar year 2018.

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Steps a Board of Directors of a tax-exempt organization should take

Identify the employer/identify applicable tax-exempt organizations.

Identify all of the separate organizationsthat are considered to be part of a largerenterprise (e.g., all organizations that areseparate corporations or entities andconsidered to be part of the ABC HealthCare System).

Identify the common law employer ofemployees that provide services in the largerenterprise (NOTE that there may be morethan one common law employer).

Identify which of these organizations is anapplicable tax-exempt organization undersection 4960.

Confirm for each employee.

Remuneration for the 2017 calendar year.

Remuneration for the 2018 calendar year.

Identify whether any of the employees ispaid by more than their common lawemployer, and if so, by which organizationsand the amount paid by each one.

Identify each organization’s five highest-compensated employees for 2018 and for 2017.

Include all remuneration paid by relatedorganizations to a covered employee for theservices rendered by that employee.

Include all remuneration paid for servicesrendered to an applicable tax-exemptorganization (i.e., an organization subject tothe excise tax provisions), even if one of thepaying organizations is not related to theemployer of the covered employee.

Calculate the excise tax liability.

Apply the proportionality rules if a coveredemployee is paid remuneration for servicesfrom two or more related organizations.

Identify any severance amounts paid in 2017 or2018.

Apply the parachute payment rules todetermine whether an excess parachutepayment was made, unless the amount thatis paid is within one of the exceptions to thedefinition of a parachute payment (such asretirement plan benefits).

Calculate excise tax liability if any excessparachute payments were made.

Include any parachute payments inremuneration for any employee whendetermining whether remunerationexceeded $1 million in 2017 or 2018: excludeany excess parachute payment from thisstep (i.e., no double-counting of severanceamounts subject to the excise tax).

Planning for 2019 and beyond.

Consider consolidating all highlycompensated employees into one employersuch as the parent corporation or amanagement company. This would simplifythe reporting of compensation and helpimprove board oversight of the executivecompensation program. (The implications toMedicare reimbursement and other issuesmust be taken into account whenconsidering this approach for tax-exempthospitals.)

Confirm that the current governanceprocess for overseeing executivecompensation is consistent with andadequately addresses the new requirementsunder 4960.

Is the appropriate “authorized body” fromthe governing board—typically thecompensation committee and articulatedthrough a board-adopted “compensationcommittee charter”—overseeing all of theappropriate executive compensationarrangements and coordinating with the taxfunction within the organization?

Is the compensation philosophy up to date?Should it reflect how the organization willaddress the implications of section 4960?

Steps to take now

IdentifyConfirmCalculateAnd plan

NOTICE 2019-09

5 © Korn Ferry 2019. All Rights Reserved.

About Korn Ferry

Korn Ferry is a global organizationalconsulting firm. We help clientssynchronize strategy and talent to drivesuperior performance. We work withorganizations to design their structures,roles, and responsibilities. We help themhire the right people to bring theirstrategy to life. And we advise them onhow to reward, develop, and motivatetheir people.

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Is the appropriate market data used forcontext when making compensationdecisions being developed and provided tothe authorized body? This should includenot only cash compensation data but dataon severance and change-in-controlarrangements, relocation practices, andemployer-provided housing.

Adopt the practice of annually reviewing“tally sheets” for all executives, whichquantify all elements of compensation,identify those elements included in thedefinition of “wages,” and include anestimate of the potential excise tax liabilityresulting from the compensation (both forthe current year and in any future year inwhich a material increase in compensation isanticipated to occur, e.g., when a section457(f) arrangement vests and is paid). Atally sheet would include all supplementalexecutive retirement arrangements(regardless of how the benefit is delivered)and all severance terms that would apply tothe employee – either via an employmentagreement or severance policy.

Maintain information on all compensationnear or above the $1 million level. Thisincludes physician compensation and allcompensation of individuals in relatedentities.

Conclusion

The excise tax on compensation in excess of $1million represents both a challenge as well as anopportunity for tax-exempt organizations. It is achallenge because it will add to the compensationexpense of the organization and even if it is notapplicable today, it may become applicable in thefuture because the $1 million-dollar threshold isnot indexed to inflation. In addition, for largerorganizations the number of covered employeeswill likely increase to more than five over time.

It is an opportunity in the sense that it shouldprompt all tax-exempt organizations to explorecompensation strategies—such as split dollararrangements—as alternatives to traditionalarrangements such as ineligible section 457(f)deferred compensation plans.

Tom Flannery, Ph.D.Senior Client PartnerKorn Ferry(781) 608-7031

Tom.Flannery@kornferry.com

Douglas MancinoPartnerSeyfarth Shaw LLP(310) 201-5241

dmancino@seyfarth.com

James M. OttoAssociate Client PartnerKorn Ferry(404) 575-8740

James.Otto@kornferry.com

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