The Tax Cuts and Jobs Act imposes a 21 percent excise tax on charitable hospitals and other tax-exempt organizations that pay excess remuneration or excess parachute payments to certain highly-compensated employees. On December 31, 2018, the Internal Revenue Service (IRS) issued interim guidance (the Guidance) to assist tax-exempt employers in understanding how this excise tax will apply. The IRS requests comments on the Guidance to be submitted no later than April 2, 2019.

Section 4960 of the Internal Revenue Code (the Code), enacted December 22, 2017, pursuant to section 13602 of the Tax Cuts and Jobs Act, imposes a tax equal to the corporate tax rate (currently at 21 percent) to be paid by applicable tax-exempt organizations (ATEOs) for:  (i) remuneration paid by such organizations in excess of $1 million to any covered employee; and (ii) any excess parachute payments paid by such organizations to any covered employee.  

Applicable Tax-Exempt Organizations and Related Organizations

ATEOs include many different types of nonprofit organizations, including charitable hospitals and health systems. Additionally, the excise tax applies to organizations related to the ATEO. An organization is related to an ATEO if such organization:  (i) controls, or is controlled by, the ATEO; (ii) is controlled by one or more persons which control the ATEO; (iii) is a supported organization (as defined in section 509(f)(3) of the Code); (iv) is a supporting organization as described in section 509(a)(3) of the Code with respect to the ATEO; or (v) in the case of an ATEO which is a voluntary employees’ beneficiary association described in section 501(c)(9) of the Code, establishes, maintains, or makes contributions to such voluntary employees’ beneficiary association. The Guidance also clarifies that the excise tax applies to remuneration paid by a separate organization on behalf of the ATEO, such as a payroll agent or professional employer organization.

Covered Employees

The Code defines a “covered employee” to mean the top 5 highest compensated employees for the organization for the taxable year or any preceding taxable year beginning after December 31, 2016. To reduce administrative burdens that would arise due to varying taxable years for ATEOs and related organizations, the Guidance explains that the excise tax is determined on a calendar-year basis.

Unfortunately, other aspects of Section 4960 and the Guidance create administrative burdens for tax-exempt organizations. For example, the IRS specifies that there is no minimum dollar threshold for an employee to be a covered employee. This means that even if the ATEO has no liability under Section 4960 for one year, those employees that are among the top five highest paid employees in any year beginning after December 31, 2016, will continue to possess the status of a “covered employee” in all future years and may be paid excess remuneration or excess parachute payments in a future year.

Additionally, tax-exempt systems will have to gather compensation data from the ATEO and all related organizations to accurately identify the covered employees and any excise tax owed. The Guidance states that “[t]o identify its five highest-compensated employees, the ATEO must include remuneration paid for the taxable year by any related organization, including remuneration paid by a related for-profit organization or governmental entity, for services performed as an employee of such related organization.” Each employer of a covered employee, ATEOs and related organizations, is liable for their allocated portion of the excise tax. This poses an additional hurdle for tax-exempt systems in which covered employees are employed by both an ATEO and a related organization. The Guidance includes rules for allocating the excise tax among related employers and rules regarding a change in related status during a calendar year.

Remuneration and the Exclusion of Medical Services

 “Remuneration” is defined as “wages,” but Section 4960 specifically exempts compensation paid to licensed medical professionals in exchange for their professional services. This exemption excludes only compensation for the “direct performance of medical services.” The Guidance states that administrative, teaching, and research services are generally not medical services, and the tax would apply to remuneration for these services. When a covered employee is compensated for both medical services and other services, the employer must allocate remuneration paid to such employee between medical services and such other services. If the employee’s compensation is not reasonably allocated in an employment agreement, ATEOs must use a reasonable method to allocate the compensation for medical services versus non-medical services. The Guidance suggests allocating the compensation by using records such as patient, insurance, and Medicare/Medicaid billing records or internal time reporting mechanisms to determine the time spent providing medical services, and then allocate remuneration to medical services in the proportion such time bears to the total hours the covered employee worked for the ATEO.

Excess Parachute Payments

An “excess parachute payment” is an amount equal to the excess of any parachute payment over the portion of the base amount allocated to such payment. A “parachute payment” is defined as any payment in the nature of compensation to (or for the benefit of) a covered employee if:  (i) such payment is contingent on such employee’s separation from employment with the employer; and (ii) the aggregate present value of the payments in the nature of compensation to (or for the benefit of) such individual which are contingent on such separation equals or exceeds an amount equal to three times the base amount. The Guidance explains that a payment is “contingent on an employee’s separation from employment” if the facts and circumstances indicate that the employer would not make the payment in the absence of an involuntary separation from employment. This includes circumstances under which the separation from employment results in the employee becoming vested or otherwise accelerates the right to payment.

The Guidance can be found here. The IRS states that it, along with the Department of Treasury, intends to incorporate the Guidance into forthcoming proposed regulations.