The IRS recently issued Notice 2019-9 to provide interim guidance on the excise tax on certain executive compensation paid by applicable tax-exempt organizations (“ATEOs”). Under Section 4960 of the new tax law, an ATEO is generally subject to a 21% tax for compensation paid to a covered employee in excess of $1 million per year. Covered employees are the five highest compensated employees of the organization for the year plus anyone who is a covered employee of the organization in any year after 2016. The tax also applies to excess parachute payments, which are severance-type compensation equal to more than three times the covered employee’s average annual compensation over a specified look-back. The tax generally applies to deferred compensation when it vests, whether or not paid. The tax does not apply to compensation to licensed medical professionals for medical services.
The excise tax produces surprising results in some situations, as illustrated in the examples below. In each case assume a university pays annual compensation to its president, football coach, or prominent research professor of $5 million.
1. The tax applies to all private 501(c)(3) universities but does not apply to all state universities. If a private 501(c)(3) university pays its football coach $5 million per year, it will generally be subject to a Section 4960 excise tax of $840,000. If a state university pays its football coach $5 million, it may or may not be subject to the tax, as described in the following paragraph. It is strange for one university or team in a conference to be subject to the tax while another is not.
2. Some state universities are subject to the tax while others are not. If a state university obtains a determination of exemption under Section 501(c)(3) or bases the exemption of its income on Section 115 because it does not have sovereign powers and is not an integral part of a state or political subdivision, the university is subject to the excise tax. See Notice 2019-9, Q&A-5. In contrast, if a state university has sovereign powers or is an integral part of a state or political subdivision and has not obtained a determination of exemption under Section 501(c)(3), its exemption is generally based on the doctrine of implied statutory immunity. Such a university is not subject to the excise tax. It is strange for one state university to be subject to the tax as to compensation paid to its president while another is not.
3. Some state universities can avoid the tax by relinquishing their 501(c)(3) status. A governmental entity may voluntarily relinquish its Section 501(c)(3) status pursuant to Rev. Proc. 2018-5, Section 3.01(12). If the exemption of the university’s income is then based on its being a governmental unit with sovereign powers or an integral part of a state or political subdivision, it will no longer be subject to the tax It is strange some universities initially subject to the tax can avoid it by relinquishing their Section 501(c)(3) status while others cannot.
4. A state university not otherwise subject to the tax may be liable for it as to compensation to a person who is employed by both the university and a foundation controlled by the university. Although a governmental entity is not subject to the tax solely as a result of its compensation to its employees, it can have liability where it pays compensation to an employee who is also an employee of a related ATEO. See Notice 2019-9, Q&A-14. If, for example, a state university not otherwise subject to the tax controls a 501(c)(3) foundation, and both employ a prominent research professor at an annual salary of $2.5 million, both the university and the foundation will incur an excise tax of $420,000 (i.e., each is subject to tax on one-half of the total compensation above $1 million). In contrast, if the university does not control the foundation and is not otherwise related to it within the meaning of Section 4960(c)(4)(B), the university will not owe any tax as to the professor’s compensation. See Notice 2019-9, Q&A-7 and 8.
In some cases where a governmental entity and a 501(c)(3) entity both employ a highly compensated employee, it may be possible to adjust the relationship between the entities so they are not related within the meaning of Section 4960. In that case, a governmental entity that has not obtained a determination of exemption under Section 501(c) and does not rely on Section 115 for exemption would not be subject to the tax as to its compensation to the employee. The foundation would be subject to the tax only to the extent its compensation of the employee exceeds $1 million.
5. Supplemental payments from booster clubs will generally not cause a state university to be subject to the tax. If a state university is generally not subject to the excise tax, a payment to the university’s football coach from a related or unrelated 501(c)(3) foundation or booster club should not cause the university to be subject to the tax so long as the foundation or booster club is not a common-law employer of the coach. Where the foundation or booster club is not an employer, the payment should be treated as made by the university.
Only the common-law employer, under general tax principles, is liable for the Section 4960 excise tax. Whether an entity is the common-law employer generally depends on all the facts and circumstances. A common-law employer may not avoid liability under Section 4960 by using a third-party payor arrangement. A payment to an employee on behalf of the common-law employer (such as from a related organization for which the individual is not providing services as an employee) is treated as paid by the common-law employer. See Notice 2019-9, Q&A-3.
6. Where a university is subject to the tax, supplemental compensation paid by a foundation or booster club will generally be subject to the tax. When a booster club supplements the compensation of a coach, and the university is subject to the tax, the payments will generally be taken into account in determining the university’s excise tax. The booster club or foundation will almost never be a common-law employer of the coach. The payment should certainly be treated as made by the university where the coach’s contract provides for the payment or the university controls the foundation or booster club. The issue may be uncertain if the foundation or booster club is not a common-law employer, the university and the foundation or booster club are not related within the meaning of Section 4960, and the payments are made voluntarily by the foundation or booster club.
The surprising results described above provide opportunities for some governmental and exempt entities to plan around the excise tax.
Herman Spence III is an attorney with Robinson Bradshaw in Charlotte.