The S Corporation Association sent comments to the Department of Treasury today raising concerns that recent guidance it published has the potential to impose the new, Section 4960 excise tax onto private operating companies.

The tax is supposed to be targeted at big non-profits and universities that pay their executives and coaches salaries in excess of $1 million per year, but due to expansive definitions of “employee” and “related organization” included in the department’s guidance (Notice 2019-09), the tax could be paid by many family businesses with related foundations and other charities instead.

Worse, the new law is written in such a way that, for many of these families, the only way to avoid the tax would be to shut down the tax exempt organization, or roll all its resources into a Donor Advised Fund.

As the letter explains:

How does a tax targeted at tax-exempt organizations hit private operating companies instead?  A typical case is where a successful family business or family stakeholders establish a private foundation (“Foundation”), where the family business and/or family stakeholders or non-family employees of the business contribute financial support to the Foundation and personal time administering the Foundation’s affairs as unpaid directors, officers or staff.  The compensation paid by private operating companies is not impacted by personal services provided by these employees to the Foundation.   Under the broad definition of “employee” included in Notice 2019-09, officers of the Foundation could be considered employees of the Foundation even though they receive no compensation from the Foundation, are full-time employees of the business and provide limited services to the Foundation or otherwise serve the Foundation in a nominal capacity. 

The Notice may also be applied in a manner that a “related person or government entity” could include private operating companies merely because the Foundation is financially dependent on contributions from the company and has overlapping directors, officers and staff.  The result could be that highly-compensated employees of the company could be included in the Foundation’s “top five” compensated individuals for purposes of the $1 million threshold. 

The excise tax is pro-rated to the entity paying the compensation, so in the case posited above where the Foundation pays no compensation, the business could owe an excise tax of 21 percent on compensation exceeding $1 million, even though the relevant business “employees” donated limited personal services to the Foundation.

Finally, private operating companies subject to this unintended excise tax cannot terminate ongoing liability by having the relevant family stakeholders or other business employees end their relationship with the Foundation, as Section 4960 makes clear that once an individual is listed as a “covered employee” of an Applicable Tax Exempt Organization (ATEO), they are always to be listed, even if the individual is no longer associated with the ATEO.  These relevant family stakeholders or other employees of the business could stop volunteering at the Foundation, but their compensation in excess of $1 million from the company would continue to be subject to the 21-percent tax.  The only practical means to end the tax may be for the Foundation to transfer its assets to a Donor Advised Fund.  

The good news in all this is that while Treasury has published guidance on Section 4960, it has yet to release proposed or final rules, so there’s time to work with them and the Hill to prevent this unintended tax from hitting numerous private operating companies.  More to come.