The Tax Cuts and Jobs Act, which was adopted in December 2017, added new Code Section 4960. This new code section imposes a 21% excise tax on annual compensation of more than $1,000,000 to certain employees of tax-exempt organizations, including nonprofit corporations, private foundations and company foundations. Internal Revenue Service (IRS) officials have indicated that the intention behind Code Section 4960 is to bring the rules applicable to tax-exempt entities in line with those applicable to for-profit entities.
Why is Code Section 4960 an Issue for Tax-Exempt Organizations?
In Notice 2019-9, the IRS defines compensation to include compensation from the tax-exempt organization and any related organization. A related organization means not only related tax-exempt organizations but also related taxable entities and governmental entities. Because the IRS has taken a broad view of related organizations and the common law employee test is complex, many tax-exempt organizations have become concerned that they may be subject to Code Section 4960. The concern generally arises in the context of company foundations or family foundations where the foundation is controlled by the same people controlling a company and the control persons receive compensation in amounts greater than $1,000,000 from the taxable entity.
Whose Compensation Matters?
Any person, including an officer or director, performing work for a tax-exempt entity can be considered an employee, even if such person’s compensation, which includes deferred compensation, is coming from a related taxable entity only. The five highest compensated employees for the taxable year are covered employees, as are any persons who were covered employees for any preceding taxable year beginning on or after Jan. 1, 2017. Once an employee is a covered employee, the person is always a covered employee.
What is the Common Law Employee Test?
Covered employee status only applies to persons who are considered common law employees of the tax-exempt organization. Determining common law employee status turns on whether an employer exercises the right to control the scope of the person’s work and the circumstances under which it will be performed. It is not required that a common law employee receive compensation from the tax-exempt organization, and the person’s title is not determinative.
What Happens Next?
The IRS has received many comments to Notice 2019-9 about a variety of concerns, including whether directors and officers of a tax-exempt entity are intended to be covered by Section 4960. The IRS has announced that it plans to issue proposed regulations in 2020 to provide greater clarity about the application of Code Section 4960. In the meantime, please consider contacting your tax advisor to determine if Code Section 4960 applies to you or your organization.