On June 5, 2020, the Internal Revenue Service issued proposed regulations providing extensive guidance on a recently enacted excise tax imposed on nonprofits and their related entities that pay compensation in excess of $1 million to "covered employees."1 These proposed regulations offer much-awaited clarity on how the excise tax is likely to apply to companies and their related foundations. The proposed regulations also provide rules for determining: a nonprofit's covered employees; what gets counted in compensation potentially subject to the excise tax; what constitutes a related entity; and the allocation of liability for the excise tax among related organizations.
Background on Proposed Regulations and Application to Company Foundations
Section 4960 of the Internal Revenue Code, included as part of the 2017 Tax Cuts and Jobs Act, imposes an excise tax equal to the corporate income tax rate (currently 21%) on compensation in excess of $1 million paid by a nonprofit organization to any of its five highest-compensated employees. By its terms, Section 4960 applies not only to compensation paid by a nonprofit organization directly but also to compensation paid by a "related organization" of such nonprofit. Thus, this excise tax could potentially apply in instances where a company executive devotes a meaningful part of his or her work hours to the company's affiliated nonprofit organization, even if the nonprofit does not actually pay any portion of the compensation. Following the enactment of Section 4960, many commentators expressed concern that the application of the excise tax to a nonprofit's related entities would expand the scope of the tax beyond the scenarios intended by Congress. The proposed regulations provide clarity and relief for certain for-profit entities whose employees provide limited services to a related nonprofit organization and do not receive compensation from the nonprofit organization for such services. That said, in other instances, the IRS and Treasury Department declined to provide certain relief from Section 4960 that was suggested by taxpayers and commentators.
Relief Provided by the Proposed Regulations for Company Foundations
The proposed regulations provide two important exceptions permitting a nonprofit and its related for-profit entity to exclude certain employees when identifying a nonprofit's five highest- compensated employees (i.e., the "covered employees" whose compensation is potentially subject to the excise tax). Generally, these exceptions require that an employee (a) not receive any compensation from the nonprofit and (b) spend no more than a certain percentage of her or his time working for the nonprofit.
Limited Hours" Exception
Under the "limited hours" exception, an individual is not considered a covered employee and is thus disregarded for purposes of determining a nonprofit's five highest-compensated employees if each of the following requirements is satisfied:
- Neither the nonprofit nor any related nonprofit pays compensation to the individual for services that such individual performed as an employee of the nonprofit. To satisfy this requirement, the nonprofit may not reimburse a related for-profit for the time that the individual in question devotes to providing services to the nonprofit. Thus, if a nonprofit and its related for-profit have entered into a management services agreement or other shared-services arrangement that requires the nonprofit to cover the costs associated for employees who render services thereunder, the organizations will not qualify for the limited hours exception.
- The individual performed services as an employee of the nonprofit and all related nonprofits for no more than the greater of (a) 10% of the total hours or days the individual worked for the nonprofit and all related organizations (including for‑profit organizations), or (b) 100 hours.
Nonexempt Funds" Exception
The proposed regulations also provide a "nonexempt funds" exception for employees who spend more than 10%, but less than 50%, of their time (measured by hours or days) providing services to a nonprofit organization. The requirements of the nonexempt funds exception are substantially similar to those of the limited hours exception. However, insofar as the nonexempt funds exception permits an employee to devote a larger portion of her time to the nonprofit, the exception imposes two additional requirements not present in the limited hours exception: (1) the individual may not receive any compensation from a for‑profit entity that is controlled by the nonprofit (i.e., a for-profit subsidiary of the nonprofit), and (2) the nonprofit may not pay a fee for services to the for-profit entity or any other related entity that provides compensation to the individual. Thus, to prevent the indirect payment of compensation from the nonprofit, the nonexempt funds exception does not permit arrangements whereby the nonprofit pays a management fee to a related for-profit entity that employs the individual.
The proposed regulations also reiterate that a member of the board of directors is not an employee in the capacity as a director. Thus, if an individual provides services to a nonprofit as a director, and not in any other capacity, that individual is not an employee of the nonprofit and thus is not considered one of the nonprofit's covered employees.
Examples
To illustrate the foregoing exceptions, consider the following examples:
Public Company and Related Charitable Foundation – Donated Services
The chief accounting officer (CAO) of a publicly traded corporation receives compensation of more than $1 million from the corporation but is not one of its three most highly compensated executives other than the CEO or CFO, such that a deduction for the CAO's compensation is not disallowed under Section 162(m).2 The corporation previously established a related charitable foundation to carry out the corporation's charitable initiatives, and the CAO serves as the treasurer of the foundation. In her capacity as such, the CAO spends approximately five hours per month on foundation matters. The CAO is not compensated directly by the foundation, nor does the foundation reimburse or otherwise compensate the company for the portion of the CAO's time devoted to foundation matters. Pursuant to the limited hours exception, the CAO does not constitute a covered employee of the foundation and is therefore disregarded for purposes of determining the foundation's five highest-compensated employees because the CAO performs fewer than 100 hours per year providing services to the foundation. Thus, the compensation the CAO receives from the corporation is not subject to excise tax under Section 4960.
Family-Held Business and Related Family Foundation – Substantial Services Provided
The CEO and majority owner of a privately held, family-owned corporation established a related charitable foundation. The CEO's daughter is an executive employee of the corporation and receives compensation of more than $1 million from the corporation. The CEO's daughter also serves as the president of the charitable foundation and spends substantial time working on foundation matters. She does not receive compensation from the foundation; the foundation does not reimburse the corporation for her services; and the corporation does not pay a management fee or other administrative charge to the corporation for services. If the daughter spends less than 50% of her time providing services to the foundation, the nonexempt funds exception would apply, and she would be disregarded for purposes of determining the foundation's five highest-compensated employees. Conversely, if the daughter spends at least 50% (or more) of her time providing services to the foundation, the nonexempt funds exception does not apply, and she may be one of the foundation's five highest-compensated employees based on the salary paid by the corporation.
Related Organizations – Shared Services and Reimbursement Arrangement
A nonprofit organization leases three employees from a related for-profit entity, and each employee receives more than $1 million of compensation from the for-profit entity. The employees maintain timesheets to track their time devoted to the nonprofit and the related for‑profit, and pursuant to a shared services agreement, the nonprofit reimburses the for-profit entity for the portion of the leased employees' salaries attributable to the time spent on providing services to the nonprofit. Neither the limited hours nor the nonexempt funds exceptions apply in this instance, because the nonprofit entity reimburses the for-profit entity for the leased employees' time. Thus, each of the employees may be treated as one of the nonprofit's five highest- compensated employees and the portion of the compensation the employees receive from the related for-profit entity in excess of $1 million may be subject to the 21% excise tax.
Conclusions
The limited hours and nonexempt funds exceptions in the proposed regulations should provide welcome relief to many for-profit entities that donate the services of their highly compensated employees to a related nonprofit. However, in situations where the for-profit charges the related nonprofit for services provided by the for-profit's highly compensated employees, or if some of the for-profit's highly compensated employees spend the bulk of their time providing services to the related nonprofit, the Section 4960 excise tax may apply. Thus, for‑profit entities with related nonprofit organizations should carefully review their shared services arrangements to determine whether those agreements and transactions qualify for an exception or potentially subject the nonprofit and/or for-profit to excise tax liability.
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Until the proposed regulations are finalized, nonprofits have the option of relying on either the proposed regulations or any other reasonable, good-faith interpretation of Section 4960 – although certain positions are expressly identified in the proposed regulations as per se unreasonable. The IRS has invited comments on several aspects of the proposed regulations, and thus the final regulations, upon adoption, may differ from the proposed regulations.
[1] Section 4960 also imposes an excise tax on "excess parachute payments" paid by nonprofit organizations. The proposed regulations provide rules for determining whether an excess parachute payment is paid and in what amount.
[2] Section 162(m) is applicable to publicly traded companies and certain health insurance providers. Section 162(m) disallows a business deduction for compensation over $1 million paid to a covered employee and thus operates in an analogous manner to Section 4960.