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In General

  • 3519. What are the limits on an employer’s ability to deduct compensation paid to an employee?

    • Editor’s Note: The Tax Cuts & Jobs Act of 2017 (2017 Tax Act) changed the rules governing the deductibility of compensation, including nonqualified deferred compensation,  Under Code Section 162(m) for certain companies as to “performance-based compensation” and the $1 million cap, except as to amounts under narrowly crafted grandfathering provisions. See Q 3520 for details.

      An employer may deduct all ordinary and necessary business expenses including “a reasonable allowance for salaries or other compensation for personal services actually rendered.”1 “Reasonable” compensation is “such amount as would ordinarily be paid for like services by like enterprises under like circumstances.”2 A salary that exceeds what is customarily paid for such services is considered unreasonable or excessive. Items other than wages may be considered in determining whether compensation is excessive. For example, the amount of loans forgiven on key person insurance policies for two top executives when the policies were transferred to them was used in determining whether their compensation was unreasonable.3 Compensation generally is the total amount of compensation paid to an employee, rather than that paid to all employees as a group.4

      The issue of reasonable compensation has been almost exclusively a problem in connection with employee-shareholders of closely-held companies. If the IRS finds compensation to be unreasonable, it may reclassify it as a dividend if it had been paid to an employee-shareholder.5 The fact that the corporation had never declared a dividend was a factor in determining whether amounts paid to an individual who was president, director, and sole shareholder were actually disguised dividends.6 Bonuses that are disproportionately high in relation to salaries actually may be dividends in disguise, especially if the employee receiving the “bonus” is the company’s sole or majority shareholder.7 This even includes the value of qualified and nonqualified pension-like benefits, although valuing them for this purpose is not entirely clear.8

      1. IRC Sec. 162(a)(1) as amended by PL 115-97.

      2. Treas. Reg. §1.162-7(b)(3).

      3Avis Indus. Corp. v. Comm., TC Memo 1995-434.

      4L. Schepp Co., 25 BTA 419 (1932).

      5. See Treas. Reg. §1.162-7(b)(1).

      6Eberl’s Claim Serv., Inc. v. Comm., 249 F.3d 994 (10th Cir. 2001).

      7. Rapco, Inc. v. Comm., 85 F 3d 950 (2nd Cir. 1996),96-1 USTC ¶50,297 (2nd Cir. 1996); Labelgraphics, Inc. v. Comm., TC Memo 1998-343, aff’d 2000-2 USTC ¶50,648 (9th Cir. 2000). But see Exacto Spring Corp. v. Comm., 196 F. 3d 833, 99-2 USTC ¶50,964 (7th Cir. 1999).

      8. See e.g., The Thousand Oaks Residential Care Home v. Comm. TC Memo 2013-10.

  • 3520. Is there an upper limit on the amount of executive compensation that a publicly-traded corporation may deduct? How did the 2017 Tax Act legislation legislation impact this limit?

    • Editor’s Note: Under IRC Section 162(m), publicly traded corporations are not permitted to deduct compensation paid to “covered employees” to the extent the employees’ annual compensation exceeds $1 million. Covered employees generally include the CEO, CFO and next three-highest paid employees. For tax years beginning in 2027 and thereafter, the ARPA will require corporations to include the five next most highly compensated employees, increasing the number of covered employees to at least 10. However, under prior law, employees were counted as covered employees permanently once they became subject to the Section 162(m) limits discussed below. With respect to employees who only become covered under Section 162(m) because of the ARPA changes, the employee will not continue to be subject to Section 162(m) if the employee later ceases to qualify as a covered employee (i.e., covered employee status will not be permanent for employees who are not the CEO, CFO or among the top three most highly paid employees).

      IRC Section 162(m) mandates an upper limit on the amount that a publicly-traded corporation may deduct for compensation paid to certain executives, even though it may well otherwise be reasonable.[1] No deduction is permitted for “applicable employee remuneration” in excess of $1 million paid to any “covered employee” by any “publicly-held corporation.”[2]

      Prior to 2018, a “covered employee” was defined as the corporation’s principal executive officer or any other employee who is one of the corporation’s three highest compensated officers (other than the corporation’s principal financial officer).[3] This determination is made under the executive compensation disclosure rules of the Securities Exchange Act of 1934.[4] The 2017 Tax Act expanded the definition of “covered employee” to include the chief financial officer and the chief executive officer (if the individual holds one of these positions at any time during the tax year). A covered employee now includes the three (rather than four) most highly compensated officers (other than the CEO and CFO) for the tax year who must be reported on the company’s proxy statement for the tax year (or who would be required to be reported if the company is not required to provide a proxy statement).[5]

      Planning Point: The IRS proposed regulations provide that the employee need not have served as an executive officer as of the end of the company’s tax year in order to be treated as a covered employee (adopting the rule set forth in Notice 2018-68). Further, executive officers can be covered employees even if their compensation need not be disclosed. In determining the three most highly compensated employees, employers are entitled to rely on a reasonable, good faith interpretation of the statute until further guidance is released. The guidance also clarified that covered employees identified during a tax year that began in 2017 in accordance with pre-tax reform rules will continue to be covered employees for 2018 and beyond.

      For tax years beginning after 2017, once the employee becomes a covered employee, he or she will stay a covered employee (even if the compensation is eventually paid to a beneficiary after the individual has died, to a beneficiary of a qualified domestic relations order or if the employee is no longer employed by the employer).[6]

      The term “covered employee” also means any employee who was a covered employee of any predecessor of a publicly held corporation of the taxpayer for any preceding taxable year beginning after December 31, 2016. The proposed regulations use the term “predecessor of a publicly held corporation” for clarity. An individual who is a covered employee for one taxable year (including a taxable year of a predecessor of a publicly held corporation) remains a covered employee for subsequent taxable years. Specifically, a predecessor of a publicly held corporation includes a publicly held corporation that, after becoming privately held, again becomes a publicly held corporation for a taxable year ending before the 36-month anniversary of the due date for the corporation’s federal income tax return (excluding any extensions) for the last taxable year for which the corporation was previously publicly held.

      The proposed regulations also provide that the term “predecessor of a publicly held corporation” includes a publicly held corporation that is acquired (as a target corporation), or the assets of which are acquired, by another publicly held corporation (the acquiror corporation) in certain transactions. The covered employees of the target corporation in those transactions are also covered employees of the acquiror corporation. With respect to asset acquisitions, if an acquiror corporation or one or more members of an affiliated group (acquiror group) acquires at least 80 percent of the operating assets (determined by fair market value on the date of acquisition) of a publicly held target corporation, then the target corporation is a predecessor of the acquiror corporation or group. For acquisitions of assets that occur over time, only acquisitions that occur within a twelve-month period are taken into account to determine whether at least 80 percent of the target corporation’s operating assets were acquired.

      The 2017 Tax Act also expanded the category of publicly held companies that are subject to the limit to include any company that is required to file reports with the SEC under Section 15(d) of the Securities Exchange Act of 1934, as well as any company with securities registered under Section 12 of the Act.[7] The proposed regulations clarify that this determination is made as of the last day of the company’s tax year. However, a corporation will not be considered publicly held if its obligation to file reports under Section 15(d) of the Exchange Act is suspended. A publicly held subsidiary is separately subject to Section 162(m) and, therefore, has its own set of covered employees (in other words, a subsidiary is treated separately from its parent company) under the proposed rules.

      Planning Point: Late in 2019, the SEC proposed amendments to the definition that would add new categories of individuals and expand the types of entitles that will qualify as accredited investors. The definition of “accredited investor” is generally important because satisfying those criteria allows taxpayers to participate in certain private investments. Relevant criteria include things like the taxpayer’s net worth, but the new definition would also consider professional knowledge, experience or certifications (for example, a Series 7 license). Entities that meet an “investments test” would also qualify. Importantly, a company may be exempt from SEC registration requirements under Section 12(g) if fewer than 2,000 persons hold their securities, if fewer than 500 of those people are not accredited investors. Exemption from registration can exempt a company from the Section 162(m) requirements.

      If a disregarded entity that is owned by a privately held corporation is an issuer of securities that are required to be registered under Section 12(b) of the Exchange Act or is required to file reports under Section 15(d) of the Exchange Act, these proposed regulations treat the privately held corporation as a publicly held corporation for purposes of Section 162(m). Similarly, a Qualified Subchapter S Subsidiary (QSub)’s S corporation parent will be treated as a publicly held corporation for purposes of section 162(m) if the QSub is an issuer of securities that are required to be registered under Section 12(b) of the Exchange Act, or is required to file reports under Section 15(d) of the Exchange Act.[8]

      See Q 3522 for a discussion of the transition relief that applies with respect to certain executive compensation agreements entered into before the enactment of the 2017 tax reform legislation.

      “Applicable employee remuneration” is the aggregate amount of remuneration paid to an employee for services performed (whether or not during the taxable year) that would be deductible if not for this limitation.[9] Amounts not considered to be wages for FICA purposes under IRC Sections 3121(a)(5)(A) through 3121(a)(5)(D), including payments to or from any qualified plan, SEP, or Section 403(b) tax sheltered annuity, are not included.[10] Pension plan payments received by a chief executive officer who retired and then returned to work within the same tax year were not considered applicable employee remuneration.[11] Also excluded are any benefits provided to an employee that are reasonably believed to be excludable from his or her gross income and salary reduction contributions described in IRC Section 3121(v)(1) (Q 3940).[12]

      Questions also arose as to how a company should identify its most highly compensated employees if their tax year was not also a fiscal year. The proposed regulations provide that the amount of compensation used to identify the three most highly compensated executive officers is determined pursuant to the executive compensation disclosure rules under the Exchange Act using the taxable year as the fiscal year for purposes of making the determination. For example, if a publicly held corporation uses a calendar year fiscal year for SEC reporting purposes, but has a taxable year beginning July 1, 2019, and ending June 30, 2020, then the three most highly compensated executive officers are determined for the taxable year ending June 30, 2020, by applying the executive compensation disclosure rules under the Exchange Act as if the fiscal year ran from July 1, 2019 to June 30, 2020. The same rule applies to short taxable years.

      The 2017 Tax Act provided for only limited grandfathering of existing remuneration payable under a written binding contract that was in effect on November 2, 2017 (not the date of enactment or later date) and not thereafter modified in any material respect on or after that date.[13] Notice 2018-68 narrowed the grandfathering even further by requiring the contract to be binding under applicable law (i.e., primarily applicable state contract law) if the employee performs services or satisfies any vesting requirements. The Notice also ends grandfathering as soon as the written contract is unilaterally terminable or cancelable by the employer, or is renewable. However, amounts under the contract remain grandfathered if: (a) the written binding contract is terminated or cancelable only by terminating the employee’s employment relationship; (b) employee consent is require; or (c) the amount is required to be paid under an arrangement in place as of November 2, 2017, even though the employee was not eligible on that date to participate, as long as that employee had the right to participate in the arrangement under a written binding contract on November 2, 2017.[14] Grandfathering is complicated since it not only requires that the administrator identify the covered and noncovered employees in a plan but maintain the grandfathered and nongrandfathered amounts separately for each group, based upon the transition rule (using the November 2, 2017 or other date as determined appropriate).  See Q 3522 for more detail.

      [1].     IRC Sec. 162(m).

      [2].     IRC Sec. 162(m)(1).

      [3].     IRC Sec. 162(m)(3); Notice 2007-49, 2007-25 IRB 1429.

      [4].     Treas. Reg. §1.162-27(c)(2)(ii).

      [5].     IRC Sec. 162(m)(3).

      [6].     IRC Sec. 162(m)(4)(F).

      [7].     IRC Sec. 162(m)(2).

      [8].     Prop. Treas. Reg. §1.162-33(c)(1)(iv).

      [9].     IRC Sec. 162(m)(4).

      [10].   Treas. Reg. §1.162-27(c)(3)(ii)(A).

      [11].   Let. Rul. 9745002.

      [12].   Treas. Reg. §1.162-27(c)(3)(ii)(B).

      [13].      162(m) as amended by PL 115-97.

      [14].      Notice 2018-68.


  • 3521. What was the pre-2018 exception for performance-based compensation to the rules for deduction executive compensation?

    • Prior to 2018, specifically excluded from the definition of applicable employee remuneration were commission payments, which generally were defined as any remuneration paid on a commission basis solely due to income generated directly by the employee’s performance.[1] The 2017 Tax Act repealed the exception that allows a corporation to deduct compensation in excess of $1 million to the top executive employees of a public company if that compensation is performance based. As a result, public companies are now only entitled to deduct $1 million in compensation.[2]

      Planning Point: Companies that offer a deferred compensation program should be advised that the Section 409A performance-based compensation definition has not changed. However, deferred compensation is subject to the new rules, except to the extent accrued accounts/amounts and nonforfeitable benefits are grandfathered under the transition rules. See below.

      Planning Point: State law implications should also be examined by companies in light of the now firm $1 million cap on the deductibility of compensation. Most states calculate state taxable income based upon the company’s federal taxable income at some point (either before or after NOL and other special federal-level deductions). The impact will vary based on how closely a state conforms its tax rules to the IRC. Some states may conform to the IRC on a rolling basis (i.e., the new changes will immediately flow through to the state level), while others may conform at a fixed date. If the state uses the IRC as in effect at a fixed date (before the passage of tax reform), corporations in these states may have to separately track their starting point (for measurement of the amount of compensation paid during the one-year period) for state tax purposes.

      Certain other performance-based compensation (e.g., stock options and stock appreciation rights) payable solely on the attainment of at least one performance goal also was excluded, but only if (1) the goals were set by a compensation committee of the corporation’s board of directors, made up solely of at least two outside directors, (2) the terms under which the compensation would be paid were disclosed to the corporation’s shareholders and approved by a majority vote prior to the time of payment, and (3) the compensation committee certified that the performance goals had been attained before payment was made.[3]

      A plan would not be considered performance-based compensation, however, if payment would be made when the employee was terminated or retired regardless of whether or not the goal was met.[4]

      Amounts paid under a binding contract in effect on February 17, 1993, and not modified before the remuneration is paid, also are excluded.[5] If a contract entered into on or before February 17, 1993 is renewed after this date, it becomes subject to the deduction limitation.[6]

      The IRS has concluded that a proposed supplemental executive retirement plan (“SERP”) (Q 3538) affecting employees subject to pre-1993 employment contracts did not provide for increased compensation or the payment of additional compensation under substantially the same elements and conditions covered under the employment agreements and thus was not considered a material modification of those agreements pursuant to Treasury Regulation Section 1.162-27(h)(1)(iii)(C).[7]

      The IRS has released guidance clarifying that the CFO of a smaller reporting company will be treated as a covered employee for purposes of Section 162(m) if the CFO is one of the business’ two most highly compensated employees. In a notice released in 2007, the IRS had stated that a covered employee does not include an employee for whom disclosure is required because the employee is the company’s CFO. A 2015 CCA, however, clarified this rule in the case of smaller reporting companies. The new guidance provides that, in the case of a smaller reporting company, the principal financial officer is a covered employee if he or she is also one of the two most highly compensated employees (other than the CEO) at the end of the tax year. Disclosure is not required only because of the individual’s status as CFO, however.[8] Under the 2017 Tax Act, however, the CFO of a company is now generally treated as a covered employee.

      Revenue Ruling 2008-13

      In Revenue Ruling 2008-13, the IRS took the new position that agreements providing for vesting acceleration on performance-based equity or cash awards following an executive’s termination without cause, without good reason, or due to retirement, or if the plan or agreement does not pay remuneration solely on account of the attainment of one or more performance goals and regardless of actual performance, will cause the plan to fail the requirements of Section 162(m), even if the accelerated vesting and payout is never triggered under the plan.

      In effect, the IRS said that provisions in a plan for vesting and payment accelerations upon terminations without cause, for good reason, or due to involuntary retirement are not permissible payment events under Section 162(m) regulations. The provisions alone thereby cause loss of the compensation deduction, even if the acceleration of vesting and payment never occurs. Under the ruling, the IRS gave employers until January 1, 2009, to modify performance-based plans and agreements with “covered employees” to comply for years after 2009.


      [1].     IRC Sec. 162(m)(4)(B).

      [2].     IRC Sec. 162(m).

      [3].     IRC Sec. 162(m)(4)(C).

      [4].     Rev. Rul. 2008-13, 2008-10 IRB 518.

      [5].     IRC Sec. 162(m)(4)(D); Treas. Reg. §1.162-27(h)(1)(iii).

      [6].     Treas. Reg. §1.162-27(h)(1)(i).

      [7].     Let. Rul. 9619046.

      [8].     IRS CCA 201543003.

  • 3522. What is the grandfathering rule that provides transition relief with respect to executive compensation agreements entered into before the 2017 Tax Act was enacted?

    • A transition rule applies to exempt compensation paid pursuant to a written binding contract in effect on November 2, 2017 and which was not materially modified on or after that date.  If the contract is renewed after November 2, 2017, it does not qualify for the transition relief (i.e., it is treated as a new contract). The IRS has provided guidance with respect to this transition relief, and has clarified that the grandfathering provision applies only with respect to amounts that the employer is obligated to pay under applicable law (i.e., state contract law) if the employee provides the relevant services or satisfies applicable vesting conditions.  If the employer pays more than this amount, those excess amounts are subject to the 2017 Tax Act amendments to Section 162(m).

      Contracts that can be terminated unconditionally by either party without the other party’s consent, or by both parties, are treated as new contracts entered into on the date the termination would be effective if it was made (contracts that can only be terminated by terminating the employment relationship are not treated as new contracts under this provision).1 For example, if the terms of a contract provide that the contract will be automatically renewed unless one party provides notice of termination at least 30 days prior to the renewal date, the contract is treated as though it was renewed as of the date the termination would have been effective if the notice was given.

      If the employer remains legally obligated to perform under the contract beyond a certain date at the sole discretion of the employee, the contract will not be treated as renewed as of that date if the employee exercises the discretion to keep the corporation bound to the contract.  A contract will not be treated as though it was renewed if, upon termination or cancellation of the contract, the employment relationship continues but is no longer covered by the contract. If the employment relationship continues, payments with respect to the employment are not made pursuant to the contract, so they are no longer grandfathered.2

      If a compensation arrangement is binding, amounts required to be paid as of November 2, 2017 pursuant to the plan are not subject to the Section 162(m) amendments even if the employee was not eligible to participate in the plan as of that date.  The amendments do apply if the employee was not employed by the employer as of November 2, 2017, or if the employee had the right to participate in the plan under a binding written contract.

      The Section 162(m) amendments apply to plans that are materially modified after November 2, 2017.  Amounts received pursuant to the agreement before the material modification occurs are not subject to the Section 162(m) amendments, but amounts received after the material modification occurs are subject to the Section 162(m) amendments.  The IRS has provided examples of when a material modification will occur:

      • The contract is amended to increase the amount of compensation payable to the employee,
      • The contract is amended to accelerate payment of compensation, unless the amount paid is discounted to reasonably reflect the time value of money,
      • A supplemental contract or agreement that provides for increased compensation, or the payment of additional compensation, if the facts and circumstances demonstrate that the additional compensation is paid on the basis of substantially the same elements or conditions of the compensation that is otherwise paid pursuant to the written binding agreement (although supplemental plans that provide for reasonable cost of living increases do not result in material modification).

      Failure to exercise negative discretion under a contract does not result in material modification.  Additionally,  if the contract is modified to defer the payment of compensation, any compensation paid (or to be paid) in excess of the original amount payable to the employee under the contract is not a material modification if the additional amount is based on either a reasonable rate of interest or a predetermined actual investment (whether or not assets associated with the amount originally owed are actually invested as such) so that the amount payable by the employer at the later date will be based on the actual rate of return on the predetermined actual investment (including any decrease, as well as any increase, in the value of the investment).3

      Planning Point:  Pre-reform, companies could deduct certain compensation in excess of the $1 million limit so long as the compensation was based on performance goals certified by the company’s compensation committee.  Tax reform eliminated that exception so that companies cannot deduct this excess compensation even if it is performance based–therefore, many companies may decide there is no tangible tax benefit to having a compensation committee certify that those goals were met.  Despite this, in order to qualify under the grandfathering provisions, performance-based compensation must continue to satisfy all of the standards that existed prior to the reform, so it is important to continue the certification practice if the compensation otherwise qualifies for grandfathering treatment.

      1.     Pub. Law. No. 115-97, Sec. 13601.

      2.     Notice 2018-68.

      3.     Notice 2018-68.

  • 3523. Did the TARP program place any limitations on the deductibility of executive compensation of program recipients?

    • The Emergency Economic Stabilization Act of 2008 added new rules to limit the deductibility of compensation paid to certain executives of companies participating in the federal government’s Troubled Assets Relief Program (“TARP”).1 These companies generally may not deduct more than $500,000 in compensation, including deferred compensation.2

      In effect, the compensation in excess of the limit is taxed twice. It is taxed once when the employee pays tax on the compensation, and it is taxed again to the extent the employer cannot deduct the compensation in excess of the limitation. Most large recipients under the program have sought to make their reimbursement of advances under the program to remove these special deduction limitations.

      1. As of 2020, there were 984 recipient organizations under the TARP program originally, See “Bailout Recipients” on ProPublica website at for a list and current status of the recipients under the program.
      2. IRC Sec. 162(m)(5), as added by EESA 2008.

  • 3524. Do the health care reform laws place any limitations on the deductibility of executive compensation?

    • Yes. The Affordable Care Act (“ACA”) has added rules to limit the deductibility of compensation paid to certain executives of certain “health care insurers” as defined under the law (and applying the controlled group rules). The definition of “health care insurers” includes insurance companies, health maintenance organizations, and any other entity that receives premiums for providing “health insurance coverage.” The ACA places a $500,000 limit on the deduction of compensation that otherwise would be deductible to each employee during an applicable tax year. This limit includes any deferred compensation amounts earned in that tax year, even if it will not be paid until a later year. The deduction then would not be available when the deferred compensation is later paid if it is used up.

      In effect, the compensation in excess of the limit is taxed twice. It is taxed once when the employee pays tax on the compensation, and it is taxed again to the extent the employer cannot deduct the compensation in excess of the limit.

      This limit is effective for compensation earned in 2013 and later tax years, but includes compensation earned in 2010 or later tax years and deferred until later than 2012.

  • 3525. Did the Dodd-Frank Act place any limitations on the deductibility of executive compensation?

    • The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (DFA) added new law to prohibit any covered financial institution (those not already covered by TARP restrictions) from offering any type of incentive-based compensation arrangement that encourages inappropriate risk by providing “excessive compensation, fees or benefits,” or would lead to “material loss” to the covered financial institution.

      A “covered financial institution” is one that has assets greater than $1 billion and is:

      (1) a depository institution or depository holding institution;

      (2) a broker-dealer;

      (3) a credit union;

      (4) an investment advisor;

      (5) the Federal National Mortgage Association;

      (6) the Federal Loan Mortgage Corporation; or

      (7) any other financial institution that federal regulators determine should be treated as a covered financial institution.

      Many of these new prohibition rules could look very much like those already in place for TARP-covered financial institutions. It is important to see the final regulations for the details of the operation of this broad and vague compensation limiting prohibition. However, in 2017, the President ordered a review of all of Dodd Frank with regard to regulations, existing or yet to be issued.1 As of the date of this publication, most of the focus has been on current regulations already issued, like the CEO pay ratio regulations.


      1. Executive Order 13772 (Feb. 3, 2017).

  • 3526. Did the Temporary Pension Contribution Relief Act place any limitations on the deductibility of executive compensation?

    • Editor’s Note: The 2017 Tax Act changed the rules governing the deductibility of compensation, including deferred compensation, for certain companies, except to the extent amounts are grandfathered. See Q 3520 for details.

      Although not a deduction limitation, the Preservation of Access to Care for Medicare Beneficiaries and Pension Relief Act of 2010 (“BPRA”) indirectly affects an employer’s compensation deductions (and it affects the employer’s cash and accounting in other ways).

      The law added new rules to permit employers to amortize any qualified pension contribution shortfalls – from the required amount – over a longer time period. A public or private company must give up portions of its annual pension contribution relief permitted under the BPRA, based on “excess compensation” paid to employees (not just executives) of companies. Under the BPRA, there is a formula for calculating the permitted relief reduction in the annual pension contribution; the formula requires the employer to offset certain amounts (i.e., to make an add-back adjustment), primarily stock redemptions, dividends, and so-called “excess compensation.” Under the BPRA, “excess compensation” is defined as all taxable compensation of an employee from the employer during a year exceeding $1 million, including all nonqualified deferred compensation as defined by Section 409A, which includes a broad segment of an employee’s compensation under current law.

      The definition of “excess compensation” also includes certain amounts that are not currently taxable to an employee. The BPRA requires an employer to include in “excess compensation” employer contributions made to any trust (or similar arrangement) to fund any nonqualified deferred compensation plan, even though these employer contribution amounts are not currently taxable. Although it is not yet clear, this requirement could include premium payments made to EOLI/COLI or annuities acquired in connection with an employer’s nonqualified deferred compensation plan. Although excess compensation cannot ever exceed the permitted  temporary reduction, it could cancel the benefit of the reduction for a year. Moreover, there is some concern that, subject to getting the IRS interpretation from further guidance on the statutory language, the formula and its operation with regard to excess compensation actually could cost the employer a $2 increase in pension contribution for each $1 of excess compensation.

      In summary, a public or private employer seeking to take advantage of the temporary qualified pension contribution relief law will need to evaluate both the alternative schedules of pension contribution relief offered by the BPRA, and also then consider the potential impact of various scenarios of excess compensation, taking account of both taxable compensation and non-taxable employer contributions to nonqualified plans on that schedule.

  • 3527. Did the 2017 Tax Act place any limitations on the deductibility of executive compensation in the tax-exempt entity context?

    • For tax years beginning after 2017, the 2017 Tax Act imposed a 21 percent excise penalty tax on remuneration that exceeds $1 million or an excess parachute payment (see below) that is paid by an applicable tax-exempt organization (ATEO, or related organization) to a covered employee.[1] This excise tax is imposed on the ATEO and not the employee. Covered employees include any of the ATEO’s five most highly compensated employees. This penalty also applies to remuneration paid to an employee who was a covered employee for any tax year beginning after December 31, 2016.[2]

      “Compensation” for purposes of the tax is determined based on a calendar year, not on the taxable year of the tax-exempt employer. Further, compensation is counted when there is no substantial risk of forfeiture (i.e., when it is vested), rather than when it is paid. If compensation vested before 2018, it is not counted toward the $1 million threshold.[3]  In determining the five most highly paid employees for the year (and when calculating the tax itself), all compensation paid by the ATEO and related organizations is counted.[4]

      Planning Point: Once an employee is a covered employee, the employee remains a covered employee indefinitely, even as compensation and services change in future years. Because of this, tax-exempt employers must maintain a record of all covered employees indefinitely.

      Further, the 21 percent penalty also applies to excess parachute payments made by tax-exempt employers to any of its five most highly compensated employees even if their compensation does not exceed $1 million.  Excess parachute payments are those contingent on the employee’s leaving employment with the employer and that exceed three times the employee’s five-year average annual compensation.[5] Parachute payments do not include payments under a qualified retirement plan, a simplified employee pension plan, a simple retirement account, a tax-deferred annuity, or an eligible deferred compensation plan of a state or local government employer. The excess parachute payment need not exceed $1 million in order to trigger the excise tax.

      Under the IRS guidance, a parachute payment must be conditioned upon an involuntary separation from employment, and generally means any payment that the employer would not make absent an involuntary separation from employment. If the amount is vested before separation from employment, it should not be treated as a parachute payment. Further, payment that vests early because of a separation from employment, but would have vested at a later date absent that separation, also will not be treated as a parachute payment because it would have been paid to the employee eventually. However, the value of receiving the payment early can be treated as a parachute payment if the accelerated payment is due to an involuntary separation from employment.  Under the proposed regulations, the value of parachute payment is the present value calculated using reasonable actuarial assumptions and using the applicable discount rate for the present value calculation.  In other words, even deferred payments are counted in determining whether an excess parachute payment has been made.[6]

      Planning Point: Under the proposed regulations, excess parachute payments paid by the employer, a predecessor or a related organization are counted.  Payments made by related organizations to the employee are also counted in determining the employee’s base compensation amount.  However, only excess parachute payments made by the ATEO (not the related entity) are subject to the tax.

      However, the regulations contain an anti-abuse rule that allows reallocation of payments if the excess parachute payment was only made by the non-employer to avoid application of the excise tax.

      An employee “separates from employment” if the level of services provided by that employee is reduced to no more than 20 percent of the level of services provided in the prior thirty-six-month period. If the employee is willing and able to continue providing services, and does not request or control the separation, the separation will be considered involuntary.[7]

      Planning Point: The 21 percent tax is imposed on the tax-exempt organization (the employer), not the employee receiving the compensation. Therefore, the tax is a plan design and/or budgeting problem for the ATEO.

      Planning Point: Whether or not an employee is a covered employee must be determined separately for each tax-exempt employer within a group of tax-exempt employers. This means that larger groups of tax-exempt entities could have many employees that trigger the new tax. In some cases, payment of the tax must be allocated among multiple tax-exempt employers within a group of entities.[8]

      “Remuneration” is defined to include wages for income tax withholding purposes.  Designated Roth contributions are excluded.  Remuneration also includes amounts included in income as compensation for services as an employee pursuant to a below-market loan.[9]   Remuneration paid (or a grant of a legally binding right to non-vested remuneration) by a third-party payor for services performed as an employee of an employer is deemed paid (or payable) by the employer.  Third-party payors may include related organizations, payroll agents or other entities.[10]

      Planning Point: Remuneration that is regular wages for employment is counted when it is actually or constructively paid.[11]  Hence, historically popular nonqualified 457(f) supplemental executive benefit plans (SERPs) that become taxable on the entire discounted present value of the future benefit payments upon the lapse or termination of the necessary 457(f) substantial risk of forfeiture present a special problem for ATEOs under this law. Moreover, if the pay period spans two calendar years, the same rules for determining “counting” wages for Form W-2 purposes apply (i.e., the wages are counted in the year they are paid).

      Any payments made with respect to the employment of the covered employee by a person or governmental entity that is related to the ATEO are included in the definition of remuneration. A person or governmental entity is treated as related to the tax-exempt organization if the person or governmental entity (1) controls, or is controlled by, the organization, (2) is controlled by one or more persons that control the organization, (3) is a supported organization during the taxable year with respect to the organization, (4) is a supporting organization during the taxable year with respect to the organization, or (5) in the case of a voluntary employees’ beneficiary association (“VEBA”), establishes, maintains, or makes contributions to the VEBA.[12]

      Under proposed regulations that generally follow Notice 2019-09, remuneration includes compensation paid by the ATEO, and also remuneration paid for services rendered as an employee of a related organization. Related organizations are any entity (regardless of tax-exempt status), using a 50 percent control test. An individual can be an employee of more than ATEO.[13]

      Compensation paid to employees who are not highly compensated employees (under IRC Section 414(q)) is exempt from the definition of parachute payment.

      Further, compensation attributable to medical services of certain qualified medical professionals is exempt from the definitions of remuneration and parachute payment.[14] To qualify, the payment must be directly related to the performance of medical or veterinary services by the professional, while payments to the professional in any other capacity is not exempt. A medical professional for this purpose means a doctor, nurse, or veterinarian.[15]

      Remuneration is treated as paid when there is no substantial risk of forfeiture (the IRC Section 457(f)(3)(B) definition applies in determining when there is a substantial risk of forfeiture).[16]

      [1].     IRC Sec. 4960(a)(1).  “Employee” generally means common law employee, although a facts and circumstances analysis may apply.  See. Prop. Treas. Reg. § 53.4960-1(e).

      [2].     P.L. 115-97, IRC Sec. 4960(c)(2).

      [3].     Notice 2019-09.

      [4]      Prop. Treas. Reg. § 53.4960-1(d)(2)(i).

      [5].     IRC Secs. 4960(a)(2), 4960(c)(5).

      [6]      See Prop. Treas. Reg. § 53.4960-3(h).

      [7].     Notice 2019-09.

      [8].     Notice 2019-09.

      [9]      Prop. Treas. Reg. § 53.4960-2(a)(1).

      [10]      Prop. Treas. Reg. § 53.4960-2(b)(1).

      [11]      See Prop. Treas. Reg. § 53.4960-2(d)(1).

      [12].    IRC Sec. 4960(c)(3).

      [13].    Notice 2019-09.

      [14]      Prop. Treas. Reg. § 53.4960-2(a)(2).

      [15].    IRC Sec. 4960(c)(5)(C).  See also Prop. Treas. Reg. § 53.4960-1(g), which contains several examples designed to illustrate application of this rule.

      [16].    IRC Sec. 4960(a)(flush language).

  • 3528. Are there any exceptions to the application of the 21 percent excise tax on certain individuals who provide services for tax-exempt organizations?

    • In order to be covered by the new regulations, the individual receiving remuneration from the ATEO must be an employee, not an independent contractor.  The typical facts-and-circumstances analysis is used to determine whether independent contractor status is appropriate.

      The proposed regulations also contain exceptions designed to exempt certain individuals who provide minimal services for the ATEO.  This new rule is meant to exclude “employees” who donate services to tax-exempt organizations.

      Under the exceptions, (1) a director is not an employee in the capacity as a director and (2) an officer performing minor or no services and not receiving any remuneration for those services is not an employee.  Employees of a related non-ATEO are not considered for purposes of determining the five highest-compensated employees if they are never employees of the ATEO. In addition, individuals who receive no remuneration (or a legally binding right to remuneration) from the ATEO or a related organization cannot be among the ATEO’s five highest-compensated employees.[1]

      Under the limited hours exception, an ATEO’s five highest-compensated employees also exclude an employee of the ATEO who receives no remuneration from the ATEO and performs only limited services for the ATEO, which means that no more than 10 percent of total annual hours worked for the ATEO and related organizations are for services performed for the ATEO.[2] An employee who performs fewer than 100 hours of services as an employee of an ATEO and its related ATEOs is treated as having worked less than 10 percent of total hours for the ATEO and related ATEOs.[3]

      Under the non-exempt funds exception, an employee who is not compensated by an ATEO, related ATEO, or any taxable related organization controlled by the ATEO and who primarily (more than 50 percent of total hours worked) provides services to a related non-ATEO is also disregarded.

      Similarly, an employee is disregarded if an ATEO paid less than 10 percent of the employee’s total remuneration for services performed for the ATEO and all related organizations. However, in the case of related ATEOs, if neither the ATEO nor any related ATEO paid more than 10 percent of the employee’s total remuneration, then the ATEO that paid the highest percent of remuneration does not meet this exception.  Basically, this exception only applies in the case of multiple ATEOs paying compensation to the same employee.

      An employee is disregarded for purposes of determining an ATEO’s five highest-compensated employees for a taxable year even though the ATEO paid remuneration to the employee if, for the applicable year, all of the following requirements are met:

      • Remuneration requirement. The ATEO did not pay 10 percent or more of the employee’s total remuneration for services performed as an employee of the ATEO and all related organizations; and
      • Related organization requirement. The ATEO had at least one related ATEO and one of the following conditions apply:
        1. Ten percent remuneration condition. A related ATEO paid at least 10 percent of the remuneration paid by the ATEO and all related organizations; or
        2. Less remuneration condition. No related ATEO paid at least 10 percent of the total remuneration paid by the ATEO and all related organizations and the ATEO paid less remuneration to the employee than at least one related ATEO.[4]


      [1]      Prop. Treas. Reg. § 53.4960-1(d)(2)(i).

      [2]      Prop. Treas. Reg. § 53.4960-1(d)(2)(ii)(A)(2).

      [3]      Prop. Treas. Reg. § 53.4960-1(d)(2)(ii)(C).

      [4]      Prop. Treas. Reg. § 53.4960-1(d)(iv).

  • 3529. Did the 2017 Tax Act make any changes to the rules for calculating unrelated business taxable income (UBTI) in the tax-exempt entity context?

    • Editor’s Note: The Taxpayer Certainty and Disaster Relief Act of 2019[1] repealed the expansion of the UBTI definition. The repeal was made retroactive to the date of enactment, so it is essentially as though the new provision never existed. However, organizations can file an amended Form 990-T to claim a refund for taxes paid under the repealed provision. The rules discussed below reflect the rule as it would have stood had the repeal not happened.

      The 2017 Tax Act created a new IRC Section 512(a)(6) requirement that tax-exempt entities now separately compute unrelated business taxable income (UBTI) for each trade or business, so that losses from one business can no longer be used to offset gains in another business. In interpreting this new rule, several questions arose that the IRS began to address in Notice 2018-67.

      Notice 2018-67 makes clear that the IRS will not penalize entities for using any reasonable good faith interpretation of the statute in calculating UBTI, and requests comments on implementation of the new rules. The Notice proposes that entities distinguish between their trades and businesses by using the codes provided by the North American Industry Classification System (NAICS) in order to aggregate certain business lines.

      The notice also requests comments on the IRS’ proposal to create a separate category of “business” for gains and losses generated from partnership investments. Notice 2018-67 contains a safe harbor for organizations to rely upon in the meantime. Under the safe harbor rule, organizations can aggregate income from a single partnership that conducts multiple trades or businesses if the holdings are qualified partnership interests. Gains and losses from all qualifying partnership interests can also be aggregated under the safe harbor. A “qualifying partnership interest” for this purpose is an investment that satisfies one of the following tests:

      • De minimis test where the organization has no more than a 2 percent interest in the profits and capital of the partnership, or
      • Control test, where the organization has no more than a 20 percent interest in the partnership and does not exert any control or influence over the partnership.

      A transition rule allows aggregation of all income from a single partnership as one trade or business if the interest was acquired before August 21, 2018 (although aggregation across partnerships is not addressed).

      Planning Point: After enactment of the 2020 law, UBTI now will not include amounts paid for (1) qualified transportation fringe benefits, (2) parking facilities used in connection with qualified parking or (3) on-premise athletic facilities, if the amounts are not paid in direct connection with an unrelated trade or business regularly conducted by the organization.

      With respect to other fringe benefits, an IRS official has commented on the link between the IRC Section 274 expensing rules and the Section 512 UBTI. The official noted that tax-exempts should look to the Section 274 allowances to determine whether they are offering a fringe benefit that would become subject to the UBTI.

      [1] Part of PL 116-94,

  • 3530. What are “excess parachute payments” and how are they taxed?

    • Editor’s Note: The 2017 Tax Act changed the rules governing the taxability of certain compensation amounts pay by the employer (not the employee), including certain “excess parachute payments”, for certain tax-exempt entities. See Q 3527 for details of coverage for purposes of the 21 percent excise tax penalty.

      Agreements providing a generous package of severance and benefits to top executives and key personnel in the event of a takeover or merger are commonly referred to as “golden parachutes.” “Excess parachute payments,” as defined in IRC Section 280G, are subject to the following two tax sanctions: (1) no employer deduction is allowed; and (2) the recipient is subject to a 20 percent penalty tax.1 Note that this tax penalty is not the same 20 percent penalty imposed by plans covered by and failing IRC Section 409A requirements (Q 3540).

      A “parachute payment” is defined in the IRC as any payment in the nature of compensation to a disqualified individual that is (1) contingent on a change in the ownership or effective control of the corporation or a substantial portion of its assets and the present value of the payments contingent on such change equals or exceeds three times the individual’s average annual compensation from the corporation in the five taxable years ending before the date of the change, or (2) pursuant to an agreement that violates any generally enforced securities laws or regulations.2 The present value of the payments contingent on the change in ownership or control is to be determined as of the date of the change, using a discount rate equal to 120 percent of the applicable federal rate.3 A transfer of property will be treated as a payment and taken into account at its fair market value.4

      A “disqualified individual” is any employee, independent contractor, or other person specified in the regulations who performs personal services for a corporation and who is an officer, shareholder, or highly compensated individual of the corporation. For this purpose, “highly compensated individual” only includes an individual who is a member of the group consisting of the highest paid 1 percent of the employees of the corporation or, if less, the highest paid 250 employees of the corporation.

      A payment generally will not be considered contingent if it is substantially certain at the time of the change that the payment would have been made whether or not the change occurred. If a payment is made under a contract entered into or amended within one year of a change in ownership or control, it is presumed to be a parachute payment, unless it can be shown “by clear and convincing evidence” that the payment was not contingent on the change in ownership or control.5

      The term “parachute payment” does not include:

      (1) any payment to a disqualified individual with respect to a “small business corporation” as defined in IRC Section 1361(b) (which does not have more than one class of stock and not more than 100 stockholders, all of whom are generally individuals but none of whom are nonresident aliens),

      (2) any payment to a disqualified individual with respect to a corporation if, immediately before the change, no stock was readily tradable on an established securities market or otherwise and shareholder approval of the payment was obtained after adequate and informed disclosure by a vote of persons, who, immediately before the change, owned more than 75 percent of the voting power of all outstanding stock of the corporation, or

      (3) any payment to or from a qualified pension, profit sharing or stock bonus plan, a tax sheltered annuity plan, or a simplified employee pension plan.6

      IRC Section 280G applies to agreements entered into or amended after June 14, 1984.7

      See Q 3531 for a discussion of how to calculate the nondeductible portion of a parachute payment.

      Section 409A Impact

      Because Section 280G and Section 409A both can cover a plan providing severance/separation benefits in the case of a change in control, and Section 280G and Section 409A have separate definitions of what constitutes a change in control (Section 409A imposing a narrower definition), it is necessary to carefully coordinate the plan provisions when both IRC sections might apply (Q 537).

      1. IRC Secs. 280G, 4999.

      2. IRC Sec. 280G(b)(2).

      3. IRC Sec. 280G(d)(4).

      4. IRC Sec. 280G(d)(3).

      5. IRC Sec. 280G(b)(2)(C).

      6. IRC Secs. 280G(b)(5) and (6). Based upon the Conference Report to the Tax Reform Act of 1984 that enacted the 280G tax, true nonqualified deferral plans are probably excluded since they are compensation earned prior to the change of control. Nonqualified supplemental plans would generally be included, except for one case, supplemental plans installed to replace an executive’s qualified plan benefits lost under a prior employer’s qualified plan since they were also deemed as earned prior to change of control in the report.

      7. Treas. Reg. §1.280G-1, Q&A 47.

  • 3531. How is the nondeductible amount of a parachute payment calculated?

    • Editor’s Note: The 2017 Tax Act changed the rules governing taxability to the employer (not the employee) of certain compensation, including certain “excess parachute payments”, for certain tax-exempt entities. See Q 3527 for details.

      The amount of a parachute payment that is nondeductible and subject to the excise tax (i.e., the “excess parachute payment,” see Q 3530) is the amount of the payment in excess of the portion of the base amount allocable to that payment.

      The “base amount” is the average of the individual’s annual compensation paid by the corporation undergoing the change in ownership and includable in the gross income of the individual in the most recent five taxable years ending before the date on which the change in ownership or control occurs. If the individual has been employed by the corporation for fewer than five years, then base amount is figured using the annual compensation for the years actually employed. Compensation of individuals employed for a portion of a taxable year should be annualized (i.e., $30,000 in compensation for four months of employment with the corporation would be $90,000 on an annual basis).

      To determine the “excess parachute payment,”the base amount is multiplied by the ratio of the present value of the parachute payment to the present value of all parachute payments expected; the result is then subtracted from the amount of the parachute payment.

      excess parachute payment


      parachute payment

      present value of the parachute payment


      base amount

      present value of all parachute payments expected

      The present value is to be determined at the time the contingency occurs, using a discount rate of 120 percent of the applicable federal rate.

      Any amount the taxpayer can prove is “reasonable compensation” will not be treated as a parachute payment.1 See Q 3519 for a general discussion on standards for “reasonable compensation.”

      Planning Point: The original documentation should allow the sponsor the option to pay the maximum amount payable (2.99 x average annual compensation) without equaling or exceeding the total amount that would make some portion “excess compensation,” which would cause loss of a portion of the deduction. This option often may result in the participant ultimately receiving a larger dollar amount than if the participant had received “excessive compensation,” after consideration for income taxes in both cases. In addition, the sponsor will have retained its compensation deduction for the payment.

      1. IRC Sec. 280G(b)(4); Treas. Reg. §1.280G-1, Q&A 40-44.