When Treasury released its initial Section 4960 guidance last year (Notice 2019-09), S-Corp warned the rules would force many family businesses to dissolve their related charities and/or private foundations to avoid the new tax. Those concerns remain under the proposed rules published last week, but they are dramatically reduced, so that’s progress. Here’s the good and the bad on Section 4960.
To recap, tax reform created a new excise tax on million-plus salaries earned by executives at non-profits, or applicable tax-exempt entities (ATEOs). The targets were the high salaries earned by CEOs at charity hospitals and football coaches at large universities. Congress wanted to make certain tax-free dollars intended for non-profit purposes weren’t used for personal enrichment instead. As House Report 115-409 stated:
The Committee believes that tax-exempt organizations enjoy a tax subsidy from the Federal government because contributions to such organizations generally are deductible and such organizations generally are not subject to tax (except on unrelated business income). As a result, such organizations are subject to the requirement that they use their resources for specific purposes, and the Committee believes that excessive compensation (including excessive severance packages) paid to senior executives of such organizations diverts resources from those particular purposes.
The guidance issued by Treasury turned that goal on its head, however. Through a broad interpretation of the “related” entity and “covered employee” provisions in the statute, Treasury applied the tax to private operating companies who share directors, officers, and staff with an ATEO. Under the Treasury guidance, for example, the salary of a CEO at a large family-owned business would be subject to the tax if he or she also volunteered as the director of the family’s private foundation.
Worse, the statute would prevent avoiding the tax by having the CEO resign as the director of the foundation. Under Section 4960, once an individual is listed as a “covered employee,” they are always listed, even if they stop working or volunteering at the ATEO. The only way to avoid the tax is to dissolve the ATEO.
That’s the background. Under the old Treasury guidance, thousands of companies were forced to pay the excise tax last fall simply because their leadership volunteered at the company’s non-profit. The good news is the new rules out of Treasury provide relief to many of these companies. For workers at private companies considered covered employees under the prior guidance, the proposed rules provide the following exceptions:
- Director’s Exemption: Excludes employees who also serve as directors and officers of an ATEO, but perform only minor or no services for the ATEO and receiving no renumeration from the ATEO;
- Limited Hours Exception: Excludes an employee who receives no remuneration from an ATEO and works at the ATEO for no more than 10 percent of their total working hours at all the related entities. A safe harbor excludes all employees who perform fewer than 100 hours of service as an employee of an ATEO or related ATEOs; and
- Nonexempt Funds Exception: In cases where employees of business donate their time at a related ATEO, they are excluded from being a covered employee if 1) neither the ATEO, nor any related ATEO, nor any taxable related organization controlled by the ATEO pays the employee remuneration, 2) the ATEO does not reimburse the business, 3) the business does not provide services to the ATEO for a fee, and 4) the employee primarily (more than 50 percent of their total hours worked) provides services to the business, not the ATEO.
Here’s an example from the proposed rules:
Consider, for example, a corporate employee making $2 million per year who spends 5 percent of her time (roughly one day each month) working for the corporation’s foundation, a related ATEO, without receiving compensation from the ATEO and who would be a covered employee of the ATEO absent the exceptions. The value of the employee’s services provided to the ATEO is roughly five percent of her salary, or $100,000. Without the exceptions, her compensation in excess of $1 million from the corporation, which is a related party of the foundation, is subject to a 21 percent excise tax, or $210,000 in excise tax liability. The exceptions remove that liability and the incentive it provides to stop providing such services or to dissolve the relationship between the ATEO and the related organization.
That’s the good news. The bad news is the rules don’t appear to address the broader “control” issue raised by S-Corp in our earlier comments. As we noted last year:
Merely because a for-profit business is a primary financial sponsor of an ATEO, has overlapping directors and officers with an ATEO, or whose employees provide limited personal services to the ATEO, such factors alone should not be determinative of “control” by a for-profit business and relatedness to an ATEO for purposes of applying the excise tax. Rather, “control” and relatedness should be evaluated and determined in the context of circumstances and criteria which demonstrate a joint-operational relationship between the for-profit business and the ATEO facilitating direct or indirect compensation of relevant key employees attributable to services provided to or on-behalf of the ATEO – thereby diverting resources that would otherwise be available to the ATEO for charitable purposes.
Finally, the once listed, always listed mandate remains. This rule is in the statute, but it is unclear whether Congress fully understood its implications when it was adopted. It forces ATEOs to endlessly track current and past employees, regardless of whether they provide ongoing services, and will prove to be a trap for the unwary. Congress needs to fix this by repealing the mandate. Treasury should support this effort.
These are proposed rules and there is a 60-day comment period, so S-Corp intends to work with other stakeholders to identify areas where Treasury can make improvements. The rules released last week are a good start and would provide meaningful relief to many private companies blindsided by the new tax. Hopefully, we can make them better.