Just in time for the New Year and notwithstanding the government shutdown, on December 31, 2018, the Internal Revenue Service ("IRS") issued Notice 2019-09 (the "Notice"), which provides interim guidance on the new excise tax applicable to certain compensation paid by tax-exempt organizations that was enacted as part of the Tax Cuts and Jobs Acts of 2017.  As enacted, Internal Revenue Code ("Code") Section 4960 imposes a 21% excise tax on tax-exempt organizations that pay "excess" remuneration to covered employees.1 This excise tax functionally levels the playing field with respect to the compensation of tax-exempt executives and for-profit executives.2

First the "good" news: the IRS addressed many questions left open by the rather vague statutory provisions. Now the "bad" news: the IRS narrowly construed many of the statutory provisions, which ultimately will result in additional administrative burden and cost to tax-exempt organizations subject to the rules. In particular, large, multiple-entity tax-exempt organizations (e.g., hospital or university systems) will need to be careful in determining which employees are subject to the excise tax, how much compensation is paid to each such employee, and which employers throughout the system will be liable for the tax.

What is the new excise tax?

The 21% excise tax can be imposed on two types of compensation paid to selected employees of covered organizations.  The first type of compensation subject to the tax is annual "remuneration" paid in excess of $1 million. The second type of compensation subject to the tax are "parachute payments" (i.e., payments made contingent on an employee's separation from employment) in excess of a calculated amount.

When did the excise tax become effective?

The excise tax became effective for taxable years beginning after December 31, 2017, without any grandfathering provisions for compensation arrangements already in place prior to the enactment of the new rule. However, as explained more fully below, the tax will not apply to remuneration that:

  • was paid prior to 2018, 
  • wasn't paid prior to 2018 but was "vested" (and therefore treated as paid) prior to 2018, or
  • is paid to an employee who is not a covered employee as defined by the new rule.

What organizations are subject to the excise tax?

In general, the excise tax applies to organizations exempt from federal income taxes, including Code Section 501(c)(3) charitable or educational organizations. Also covered are farmers' cooperative organizations described in Code  Section 521(b)(1), organizations that exclude income from taxation under Code Section 115(1) (generally a State or political subpision thereof), and political organizations described in Code Section 527(e)(1).

The treatment of a state university or college is specifically addressed in the Notice. Some state universities and colleges rely on the doctrine of "implied statutory immunity" to avoid federal income taxation, rather than seeking tax-exemption under Code Section 501(a) or excluding income under Code Section 115(1). Such state universities and colleges are not subject to the Section 4960 excise tax. The distinction is of particular importance to such organizations that have awarded significant compensation packages to athletic coaches and/or athletic directors.

Further, and of particular relevance to large, multiple-entity tax-exempt organizations (e.g., health systems), covered organizations include "related" organizations, including related for-profit and governmental entities, generally determined using a 50% control threshold (rather than the higher 80% "control group" threshold applicable in the context of tax-qualified and 403(b) retirement plans). This 50% threshold aligns with the definition of a related organization for purposes of tax-exempt organizations' annual reporting requirements under Form 990.

Who is a covered employee?

A "covered employee" for purposes of Code Section 4960 is any inpidual who is one of the organization's 5 highest-compensated common-law employees for the current taxable year, based on remuneration paid in the calendar year ending with or within the employer's fiscal year. Independent contractors are not covered employees, regardless of how much they may be paid.

A few points are particularly noteworthy:

  • Each employer within a related group of tax-exempt organizations must make its own separate determination of who is a covered employee every year (even in years when the excise tax will not be triggered).
  • Once a covered employee, an inpidual remains a covered employee indefinitely, even if he or she falls out of the 5 highest-compensated employees for the employer.
  • To identify its 5 highest-compensated employees, an employer must include remuneration paid by any related organization (as defined above) for services performed as an employee of such related organization. However, there is limited relief in situations where an employer pays less than 10% of the total remuneration paid by all employers in the related organization during the calendar year.
  • There is no minimum dollar threshold for an employee to be a covered employee.

What is considered "remuneration" for these purposes?

For purposes of this excise tax, "remuneration" is defined as wages for purposes of federal income tax withholding, but excluding compensation paid for the performance of medical or veterinary services and designated Roth contributions (e.g., to a 401(k) or 403(b) plan). However, amounts required to be included in gross income under Code Section 457(f), whether or not actually distributed to the plan participant, are considered remuneration for purposes of the excise tax. 

When is remuneration treated as "paid" for purposes of the excise tax? 

  • Deferred remuneration is treated as having been paid for purposes of these excise tax rules when the right to the remuneration is no longer subject to a "substantial risk of forfeiture" (i.e., when the remuneration is vested).3 For purposes of the excise tax, the amount of remuneration treated as paid at vesting is the present value of the vested remuneration, determined using reasonable actuarial assumptions.
  • Net earnings (or net increase in present value) on any "previously paid remuneration" (i.e., an amount treated as paid because it has vested) will be treated as remuneration paid at the end of the year in which the earnings accrue, rather than in the year paid (which is the general rule applicable under Code Section 457(f)).
  • While there is no grandfather rule applicable under Code Section 4960, any vested amount (including vested but unpaid earnings on deferred amounts) that is treated as paid before 2018 (when Code Section 4960 became effective) is not subject to the excise tax. Similarly, vested amounts that would have been treated as remuneration paid (including vested but unpaid earnings) before the year in which an employee first becomes a covered employee are not subject to the excise tax if that employee later becomes a covered employee. However, earnings that accrue after 2017 on previously vested but unpaid amounts are considered remuneration for purposes of the excise tax.

What is considered to be compensation paid for medical or veterinary services?

Compensation paid for the direct performance of medical or veterinary services by a licensed professional are not considered either remuneration or parachute payments for purposes of this excise tax. The Notice generally defines medical or veterinary services narrowly as services for the diagnosis, cure, mitigation, treatment, or prevention of disease, consistent with the definition of "medical care" used in determining deductible medical expenses for federal income tax purposes. Under this definition, administrative, teaching, and research services generally are not medical services, unless such activity involves direct medical care to a patient. If a covered employee is compensated for both the performance of direct medical or veterinary services and other services (e.g., administrative services), the employer must allocate remuneration paid to such employee between the direct medical or veterinary services and any other services. Pursuant to the Notice, the allocation can be made by means of a reasonable allocation set forth in an employment agreement.

How is an employee who works for and is paid by more than one employer within a group of related exempt organizations treated?

If an inpidual performs services as a common-law employee for two or more related tax-exempt employers during the calendar year (e.g., different entities within a single large health system), one or both of which is subject to Code Section 4960, remuneration paid for the taxable year by all related organizations is aggregated for purposes of determining whether excess remuneration has been paid. In these situations, the Notice provides rules for allocating the liability for the excise tax among the different employer entities.

What is considered "excess" remuneration for purposes of the Code Section 4960 excise tax?

If the $1 million annual remuneration cap is exceeded, only remuneration paid to a covered employee in excess of $1 million is subject to the 21% excise tax.

What is a parachute payment under Code Section 4960?

Even if no covered employee receives annual remuneration in excess of $1 million, tax-exempt organizations may still be liable for the excise tax if any covered employee is entitled to "excess parachute payments." For these purposes, a "parachute payment" is any payment contingent upon the employee's "separation from employment."4

The Notice provides technical guidance for identifying parachute payments potentially subject to the excise tax. Specifically, the Notice:

  • clarifies that "separation from employment" refers to a covered employee's involuntary separation from employment, which may include termination of employment without cause, an employer's failure to renew the covered employee's contract upon its expiration, and voluntary separation of employment by the covered employee for "good reason."
  • advises that payments are "contingent" upon separation from employment if the separation from employment results in vesting the covered employee or accelerating the covered employee's right to payment, which includes payments that are conditioned upon restrictive covenants (such as a noncompete) or the execution of a release of claims.
  • generally adopts the definition of "separation from service" under Code Section 409A, but expands this definition to encompass certain changes in employment status, such as from an employee to an independent contractor, even if the inpidual continues to provide services for the applicable tax-exempt organization. Further, the Code Section 409A rules that provide for separation from service upon an anticipated reduction of the level of service to less than 20% of the prior level of service also apply to the Code Section 4960 excise tax.5

When is a parachute payment considered an "excess parachute payment?"

A payment contingent upon separation from employment is only a parachute payment if the aggregate present value of the payment is at least three times the covered employee's "base amount" (generally the average annual compensation of the covered employee over the five most recent taxable years). However, the amount of excess parachute payment subject to the Code Section 4960 excise tax is any amount that exceeds one times the covered employee's base amount.

How is the excise tax paid and reported to the IRS?

The excise tax is paid and reported to the IRS using Form 4720. The Form 4720 is due to be filed by the tax return (generally the Form 990) filing due date, subject to any applicable extensions. The Form 990 is due on the 15th day of the fifth month following the end of the organizations fiscal year, with a 6 month extension available. For calendar year organizations, this means that the Form 4720 is due to be filed no later than May 15th, or as late as November 15th if an extension applies.

A separate Form 4720 must be filed for each employer organization sharing excise tax liability.

May an employer rely on the interim guidance contained in the Notice?

Yes. Employers are required to comply with a good faith interpretation of the excise tax statutory provisions. While the IRS anticipates that the Notice's interim guidance will be incorporated into future proposed regulations, until such further guidance is issued, reliance on the Notice will be considered to be a good faith interpretation of the excise tax statutory provisions.

What to do next?

Tax-exempt organizations, including related tax-exempt and for-profit entities, have to address these new rules for the first time when filing their Form 990 for the first fiscal year that began after 2017. That could be as early as May 15, 2019.  The application of the rules will be particularly challenging to large multiple-entity health and university systems, as each employer within the group is liable for (and must separately file its own Form 4720 for) its allocable share of the excise tax on excess compensation paid to one of its covered employees by all members of the related group of organizations. We encourage tax-exempt and related employers to consult with their tax and executive compensation counsel to determine whether any Code Section 4960 excise tax is due for 2018 and to begin preparing for Code Section 4960's filing and payment deadlines.


1. The excise tax is equal to the new tax rate applicable to corporations under the Tax Cuts and Jobs Acts of 2017.

2. As explained in this Alert, the Code Section 4960 excise tax rules to a large extent mirror the tax deduction rules of Code Sections 162(m) and 280G applicable to for-profit employers.

3. The term "substantial risk of forfeiture" is addressed under proposed Treasury regulations issued in 2016 related to Code Section 457(f) plan benefits, which are beyond the scope of this Alert.

4. This differs from the treatment of "golden parachutes" under Code Section 280G, which are payments contingent on a change of control.

5. However, while the Code Section 409A rules permit an employer to elect that a separation from service may occur upon an anticipated reduction of the level of service between 50% and 80%, the Code Section 4960 reduction in service levels are not elective.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.