Foundation Legal Perspective: Does the New Section 4960 Excise Tax on Non-Profit Compensation Apply to Uncompensated Private Foundation Officers Based on the Compensation Paid by an Affiliated For-Profit Company?

Originally published in the Wisconsin Philanthropy Network’s blog.

It takes some patience to even understand why this is even a question, but this question is an unintended consequence of the new tax law. The headline here is that the new section 4960 excise tax, under the statutory language, may cause a private company to be subject to a 21% tax on certain compensation paid to company executives who serve as unpaid officers of the private foundation.

The Tax Cuts and Jobs Act of 2017 contained provisions that subject non-profits to rules applicable to for-profits. Among these provisions was the new section 4960 excise tax. The provision is designed so that a non-profit organization is subject to an excise tax (the tax is set at the corporate income tax rate) when certain covered employees of the charitable organization are paid more than $1 million or receive certain excessive parachute payments (a “covered employee” is “any employee . . . of an applicable tax-exempt organization . . . if the employee is one of the five highest-compensated employees of the organization for the taxable year” or was a covered employee of the organization in the past).

The overall intention of the tax is to treat non-profits the same as public companies subject to a provision that disallows a compensation deduction for amounts paid to an executive in excess of $1 million. Non-profits don’t pay income tax, so Section 4960 imposes an excise tax at the income tax rate (equivalent to a taxable company’s loss of the compensation deduction).

In writing the statute, the drafters contemplated large, multi-entity health care systems and included an “anti-avoidance” rule to prevent a health care system avoiding the tax by dividing up an executive’s compensation among many different section 501(c)(3) organizations and for-profit entities in the system. Under the rule, the excise tax applies when a covered employee receives compensation in excess of $1 million from the organization or a related person or entity that controls or is controlled by the tax-exempt organization. When compensation from more than one employer is used to calculate the excise tax, each employer has to pay its portion of the excise tax.

In other words, if there are three section 501(c)(3) hospitals in a hospital system, the tax still applies evens if each hospital pays the CEO $500,000; the total compensation of $1.5 million will be taken into account and the excise tax will apply.

But—the same definition of “related organizations” also captures private foundations controlled by a for-profit company or the owners of a privately held company. In many company / family foundations, the executives of the for-profit company are also the (unpaid) officers of the foundation.

If the unpaid officers of the private foundation are considered “covered employees” of the private foundation, then the “related organization” rule means that the excise tax is triggered if the executives’ total compensation from the company and the private foundation together exceed $1 million (even if the private foundation does not pay the officers). This aggregation rule does not apply to the extent the company is a public company and already subject to the loss of deduction.

Why would unpaid officers be treated as covered employees for purposes of the tax? Because Section 4960 references the employent tax sections of the Internal Revenue Code and “common law employees”, and, the default in this area is that officers of an entity are generally considered employees.

If unpaid officers can be covered employees of the company foundation, then just by having a high paid CEO of a private company serve as an unpaid officer of the company foundation would mean that the excise tax would apply to the CEO’s compensation in excess of $1 million – a heavy tax on the company for the privilege of having the CEO participate in the company foundation as an officer. Many commentators have already detailed how this will chill contributions and involvment with company foundations.

The IRS issued guidance (IRS Notice 2019-19) on the Section 4960 excise tax in April. This guidance didn’t address this specific issue, and instead, in a very small parenthetical, seemed to reinforce that officers should be considered employees. More recently, verbal communications from the IRS confirm that the drafters of Notice 2019-19 didn’t contemplate this issue (And that additional guidance will address it).

Many practitioners are taking the position that an unpaid officer of a private foundation is not a covered employee of the private foundation (and his or her service does not trigger the excise tax). There is some authority for this position in the Treasury Regulations, although the answer remains unclear. Practitioners are also optimistic that the IRS will provide guidance in accordance with Congressional intent (which was not to extend the tax to unpaid officers of company foundations). Updates to follow.