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Firms Suggest Guidance Clarifying Executive Compensation Excise Tax

SEP. 17, 2018

Firms Suggest Guidance Clarifying Executive Compensation Excise Tax

DATED SEP. 17, 2018
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September 17, 2018

Honorable David Kautter
Assistant Secretary
Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20020

Victoria A. Judson, Esq.
Associate Chief Counsel (Tax Exempt & Government Entities) (CC:TEGE)
Internal Revenue Service
1111 Constitution Avenue, N.W.
4302 IR
Washington, D.C. 20224

Re: Request for Guidance on the Application of § 4960 of the Internal Revenue Code

Dear Assistant Secretary Kautter and Ms. Judson:

We are writing to offer recommendations for consideration by the Department of the Treasury (“Treasury”) and the Internal Revenue Service (the “Service”) as they develop guidance under § 4960 of the Internal Revenue Code (the “Code”) as enacted by § 13602 of Public Law Number 115-97 (the “Act”). We appreciate the time and resources that Treasury and the Service have dedicated to reviewing the issues, and we further appreciate the opportunity to provide these written comments.

We specifically recommend that Treasury and the Service provide guidance clarifying the following issues:

1. All forms of deferred compensation, including amounts deferred under a “Pre-457(f) Plan,1” should be taken into account for purposes of calculating the excise tax liability under § 4960(a) in the year such accruals and any attributable earnings are (or were) no longer subject to a substantial risk of forfeiture;

2. That remuneration taken into account under the Timing Rule (as defined below) in a taxable year beginning before January 1, 2018 is not subject to the excise tax;

3. That the term “remuneration” for purposes of determining amounts taken into account under the Timing Rule in a taxable year beginning before January 1, 2018 includes earnings under any arrangement and also specifically includes amounts accrued under a Pre-§ 457(f) Plan;

4. That earnings under a deferred compensation arrangement accrued in a year following the year in which the underlying remuneration was taken into account under the Timing Rule are taken into account at the end of each year in which they accrue; and

5. That the term “parachute payment” excludes a payment under a nonqualified deferred compensation plan that: (i) is attributable to benefits that vested before the employee's separation from employment or (ii) is made for reasons that are beyond the control of the applicable tax-exempt employer or the employee (such as the employee's death or disability) or pursuant to a prior employee election or the terms of the plan on or after retirement.

Background and Overview

The Act includes new taxes and provisions aimed at executive compensation payable by certain tax-exempt entities. In particular, § 4960(a) imposes an excise tax on remuneration paid by certain tax-exempt organizations to their highest paid employees in excess of $1,000,000 in a year. Our recommendations below are intended to clarify how the tax will be applied and the treatment of amounts accrued and vested before § 4960's effective date.

This letter focuses on the treatment of long-held balances under Pre-457(f) Plans. A Pre-457(f) Plan is a deferred compensation arrangement maintained by a tax-exempt entity that is not subject to the § 457(f) early inclusion rules. These plans have been in place since before 1987. In many cases, employees have had vested rights under these arrangements for decades and have accumulated earnings (and losses) over that lengthy period. We recommend clarifying that amounts accrued and vested under a Pre-457(f) Plan during a taxable year beginning before January 1, 2018 will not be subject to the excise tax. As outlined below, the plain language of the statute would treat vested benefits and earnings accrued prior to January 1, 2018 (for a calendar year taxpayer) as taken into account before the excise tax became effective and therefore not subject to the excise tax.

Our comments outline the statutory support for this position and request for clarification. Section 1 below discusses when remuneration should be taken into account for purposes of calculating whether the $1,000,000 threshold is exceeded. The general rule is that the tax applies to “paid” remuneration over $1,000,000. However, there is a special rule (referred to below as the “Timing Rule”) that treats deferred compensation as “paid” when the employee vests in the right to the amount even though the employee may not receive payment for a number of years.2 For example, assume a deferred compensation plan requires an employee to work full time until December 1, 2019 to earn a cash bonus of $50,000 that will be paid when the employee separates from employment. The Timing Rule would require the taxpayer to treat the $50,000 as having been paid in 2019 because the employee's right to the $50,000 bonus vests in 2019, even though the employee will not receive the bonus until the executive separates from employment in a later year. Thus, the $50,000 bonus is included in the 2019 excise tax calculations (assuming a calendar tax year).3

As it concerns amounts accrued and vested in prior years, the Timing Rule treats amounts accrued and vested under a long-standing arrangement, such as a Pre-457(f) Plan, as having been “paid” in tax years before § 4960 became effective. The Act provides that the enactment of the excise tax applies to taxable years beginning after December 31, 2017. As described in Section 2, we request clarification that amounts treated as “paid” under the Timing Rule before 2018 (assuming a calendar tax year) are not be subject to the excise tax. As described in Section 3, we also recommend guidance that clarifies that the amount treated as having been “paid” also includes any earnings that accrued prior to January 1, 2018, and would also include any vested benefits and earnings that accrued under a Pre-457(f) Plan prior to January 1, 2018 (assuming a calendar tax year). Indeed, we see no reason to treat a Pre-457(f) Plan any differently than any other arrangement providing vested deferred compensation.

On a going forward basis — for accruals and earnings after § 4960 becomes effective — Section 4 recommends guidance that clarifies that earnings after the year the deferral is initially treated as “paid” and taken into account are treated as paid in the year such earnings are accrued. This treatment is consistent with the position that an amount is treated as “paid” at the time it is earned and vests. Finally, our last comment (Section 5) focuses on the term “parachute payment” and requests clarification that such term would not include deferred compensation or other similar amounts.

Comments

1. All “remuneration” is paid when no longer subject to a substantial risk of forfeiture

Section 4960(a) imposes an excise tax on remuneration paid by an applicable tax-exempt organization for the taxable year with respect to the employment of any covered employee in excess of $1,000,000. We recommend that Treasury and the Service provide guidance clarifying that all forms of deferred compensation, including amounts deferred under a Pre-457(f) Plan, should be taken into account for purposes of calculating excise tax liability under § 4960(a) in the year such accruals and any attributable earnings are (or were) no longer subject to a substantial risk of forfeiture.

Section 4960(c)(3) defines “remuneration” to mean “wages (as defined in section 3401(a))” plus amounts required to be included in gross income under § 457(f).4 The definition of “wages” under § 3401(a) is quite broad and includes “all remuneration for services performed by an employee for his employer” unless excepted under § 3401(a) or § 3401(e). The term “wages” under § 3401(a) therefore would include amounts that will be paid under various benefit plans including arrangements subject to § 457(b), § 457(f), and a Pre-457(f) Plan. As described below, the term “remuneration” should not be read to include only amounts that have actually been subject to withholding under § 3402 (plus amounts includible under § 457(f)).

As to when such amounts are taken into account for purposes of calculating the excise tax, the flush language at the end of § 4960(a) provides that “remuneration shall be treated as paid when there is no substantial risk of forfeiture (within the meaning of § 457(f)(3)(B)) of the rights to such remuneration” (the “Timing Rule”). Section 457(f)(3)(B) describes the definition of a “substantial risk of forfeiture” in providing that “[t]he rights of a person to compensation are subject to a substantial risk of forfeiture if such person's rights to such compensation are conditioned upon the future performance of substantial services by any individual.”

The Timing Rule is critical under § 4960(a) for purposes of properly associating remuneration to a taxable year, which can impact the applicability of the § 4960(a) excise tax to remuneration. In this regard, we recommend that published guidance clarify that the Timing Rule determines when and if the § 4960(a) excise tax is applicable to all remuneration described in § 4960(c)(3) and is not limited to amounts subject to § 457(f) or amounts that have been subject to federal income tax withholding (“FITW”). Interpreting the Timing Rule to apply to all remuneration follows the plain language of the statute quoted above. We note that the parenthetical in the Timing Rule incorporates only the definition of a “substantial risk of forfeiture” under § 457(f) and in no way limits the Timing Rule's application to amounts includible under § 457(f). Rather, the Timing Rule applies to all “remuneration.” This suggests that Congress intended to have all remuneration taken into account at the time the employee vested in the right to these amounts (i.e., when they are no longer subject to a substantial risk of forfeiture).5

We understand that at least one commentator has taken the view that, because the definition of “remuneration” refers to § 3401(a), an amount constitutes “remuneration” only when it is actually subject to withholding under § 3402 (other than amounts includible under § 457(f)). Under this view, an amount not subject to withholding is not “remuneration” until actually or constructively paid (other than inclusion under § 457(f)). In essence, this interpretation would have FITW timing (other than under a § 457(f) plan) replace the very clear Timing Rule under § 4960(a) for purposes of associating compensation to an applicable year. In our view, that was not the intent of Congress.

As an initial matter, the reference to § 3401(a) should not be read as a timing rule since the timing of FITW is generally governed by § 3402, not § 3401(a).6 Further, the interpretation that an amount constitutes “remuneration” only when withholding is required (other than amounts includible under § 457(f)) is not supported by the statute which, by its plain language, provides for all remuneration to be taken into account under the Timing Rule.7 It is incongruous to have the Timing Rule apply to amounts subject to § 457(f) but to, instead, have all other amounts treated as “paid” under the statute only when actually or constructively paid and subject to FITW under § 3402. For example, if an employee accrues fully vested benefits (not subject to a substantial risk of forfeiture) under both a § 457(b) plan and a § 457(f) plan, the accruals under both plans should be taken into account at the same time under § 4960(a). Whether withholding is actually required at that time under § 3402 is not relevant for purposes of determining when the amount is “paid” for purposes of the Timing Rule under § 4960(a). If it were, Congress would have used § 3402 as the Timing Rule.

2. Treatment of amounts “paid” before § 4960 was effective

Section 13602(c) of the Act provides that “the amendments made by this section shall apply to taxable years beginning after December 31, 2017.”8 We recommend that Treasury and the Service provide guidance that clarifies that remuneration “paid” under the Timing Rule in a taxable year beginning before January 1, 2018 is not subject to the excise tax.

This conclusion is required by the plain language of the statute. Congress specifically included the Timing Rule to establish when amounts are treated as “paid” for purposes of the excise tax and further provided that the excise tax applies only for taxable years beginning after December 31, 2017. In the case of a calendar year, the only reasonable conclusion is that amounts treated as “paid” under the Timing Rule in a taxable year beginning before January 1, 2018 are not subject to the excise tax. This interpretation also provides a uniform and consistent application of the Timing Rule to remuneration that was “paid” before and during years in which § 4960 applies.

Applying the excise tax to amounts paid before the effective date would result in a retroactive excise tax, and neither the Conference Report nor the statutory language would support such retroactive application. Published guidance should make it clear that § 4960(a) will not impose a retroactive tax on accruals under nonqualified deferred compensation plans that have been maintained by tax-exempt organizations for many years. It would be unfair to tax vested amounts under Pre-457(f) Plans when tax-exempt organizations could not modify or terminate such arrangements to cause benefits earned before the effective date of § 4960 to be exempt from the excise tax, due to contractual restrictions or other restrictions under § 409A and the grandfather rules under § 457(f). It would also be unfair to put some tax-exempt organizations at a disadvantage simply because they chose to establish a nonqualified deferred compensation plan many years ago before § 457(f) became effective and to rely on the grandfather rules for relief from § 457(f).

3. Amounts “paid” in taxable years beginning before January 1, 2018 includes all “remuneration” under § 4960(c)(3)

We also recommend that Treasury and the Service provide guidance clarifying that, for purposes of determining the amounts “paid” under the Timing Rule in taxable years beginning before January 1, 2018, the term “remuneration” includes all remuneration under § 4960(c)(3), and not simply amounts taxable under § 457(f). Specifically, we request guidance that clarifies that the term “remuneration” for purposes of determining amounts “paid” under the Timing Rule in taxable years beginning before January 1, 2018, and therefore not subject to the excise tax, include amounts accrued under a Pre-§ 457(f) Plan. As it concerns a Pre-457(f) Plan, amounts paid under such a plan constitute “wages” for purposes of § 3401(a), thus Pre-457(f) Plan accruals should be included in the term “remuneration.” This interpretation is again supported by the plain reading of the statute which would include all “remuneration” treated as paid under the Timing Rule.9

In addition, the term “remuneration” for purposes of determining the amounts paid under the Timing Rule in taxable years beginning before January 1, 2018 (and therefore exempt from the excise tax) should also include any earnings on prior deferrals to the extent such earnings and accruals are no longer subject to a substantial risk of forfeiture. In the case of a calendar year taxpayer, this would clarify that any earnings that accrued before January 1, 2018 are exempt from the excise tax. Again, the plain language of § 4960(c) would capture earnings in the definition of “remuneration” if such earnings would constitute “wages” under § 3401(a). For the avoidance of doubt, earnings are treated as “wages” for § 3401(a) purposes whether the earnings are accrued under an eligible plan under § 457(b), an ineligible plan subject to § 457(f) or a Pre-§ 457(f) Plan. Further, such earnings should be treated similarly to the underlying deferrals under the Timing Rule if such earnings are vested at that time because they are not subject to a substantial risk of forfeiture. This treatment is contemplated by the Conference Report which provides that the tax under § 4960(a) “can apply to the value of remuneration that is vested (and any increases in such value or vested remuneration)”, even if it is not yet received.10

4. Earnings accrued after inclusion under Timing Rule

We recommend that Treasury and the Service provide guidance to clarify the treatment of earnings in a deferred compensation arrangement accrued in a year following the year in which the underlying remuneration was taken into account under the Timing Rule. For example, assume an employee accrues $100 under a deferred compensation arrangement in 2019 and that $100 is taken into account in 2019 under § 4960(a) under the Timing Rule. If the $100 accrual is credited with a net earnings gain of $5 during 2020, future guidance should specify when the additional $5 is taken into account.

We believe that the plain language of § 4960 would require the earnings, when combined with any additional accruals or deferrals, to be taken into account each year under the Timing Rule.11 Again, earnings would constitute “remuneration” under § 4960(c)(3) and, assuming such earnings would no longer be subject to a risk of forfeiture in that year, the Timing Rule would require taking into account such earnings in the year earned. When compared to other compensation tax provisions that take amounts into account before payment, it becomes clear that other possibilities are limited. For example, § 4960 does not include the reference to § 72 provided under § 457(f) that would justify delaying the taxation of earnings until payment. Nor does § 4960 include a statement that earnings would escape taxation as provided in § 3121(v)(2) with respect to FICA taxes.

We also recommend that published guidance make clear that once a deferred compensation accrual, or earnings, is taken into account, such amount would not be included under the Timing Rule at any later time.

5. Limited definition of “excess parachute payment”

Section 4960(a)(2) imposes an excise tax on any “excess parachute payment” paid by an applicable tax-exempt organization to any covered employee. Under § 4960(c)(5)(A), the term “excess parachute payment” means an amount equal to the excess of any parachute payment over the portion of the base amount allocated to such payment. Under § 4960(c)(5)(B), the term “parachute payment” means any payment in the nature of compensation to (or for the benefit of) a covered employee if such payment is contingent on such employee's separation from employment with the employer, and the aggregate present value of the payments in the nature of compensation to (or for the benefit of) such individual which are contingent on such separation equals or exceeds an amount equal to 3 times the base amount.

Section 4960(c)(5) does not define when a payment is to be treated as contingent on such employee's separation from employment. However, the phrase implies that no present interest exists and that whether such interest or right ever will exist depends upon a future uncertain event. A common example of this would be severance payable only upon an employee's involuntary separation from employment.

Many nonqualified deferred compensation plans maintained by tax-exempt organizations are designed to provide supplemental retirement benefits payable only after the employee's separation from employment. Consequently, depending on how the phrase “contingent on such employee's separation from employment” is interpreted, many tax-exempt organizations could have a significant additional excise tax burden with respect to benefits that vested during the employment term but that are not paid until after an employee separates from employment. We recommend that Treasury and the Service clarify that this phrase excludes a payment under a nonqualified deferred compensation plan that (i) is attributable to benefits that vested before the employee's separation from employment or (ii) is made for reasons that are beyond the control of the applicable tax-exempt employer or the employee (such as the employee's death or disability) or pursuant to a prior employee election or the terms of the plan on or after retirement.

We appreciate your consideration of these comments and would be pleased to clarify any points or answer any questions.

Sincerely,

Anthony Provenzano
Miller & Chevalier Chartered

Ruth Ann Maloney
Baker Hostetler

cc:
Stephen Lagarde, Esq.

FOOTNOTES

1The term “Pre-§ 457(f) Plan” refers to a deferred compensation arrangement exempt from § 457(f) under the grandfather provisions described in the Tax Reform Act of 1986, P.L. 99-514, Section 1107(c)(3) and Internal Revenue Service Notice 87-13.

2Essentially, the statute requires an “accrual method” of accounting as opposed to the cash method of accounting to determine the time at which the taxable amount is taken into account for purposes of computing the excise tax.

3Assume the $50,000 will be adjusted for interest until payment.

4Section 4960(c)(3)(A) also provides that the term “remuneration” shall not include any designated Roth contribution (as defined in § 402A(c)). The exclusion of such contributions is not relevant to the issues addressed herein, and this exclusion is therefore not addressed further.

5We note that the Code provides a number of different definitions of the term “substantial risk of forfeiture” in the compensation area, including separate definitions under § 457(f), § 83, § 409A (under Treas. Reg. 1.409A-1(d)), and § 457A. The mere fact that Congress chose to utilize the more limited definition of that term under § 457(f) was not intended to limit the application of the Timing Rule to amounts subject to § 457(f).

6Treasury Regulations § 31.3402(a)-1(b) provides as follows: “The employer is required to collect the tax by deducting and withholding the amount thereof from the employee's wages as and when paid, either actually or constructively. Wages are constructively paid when they are credited to the account of or set apart for an employee so that they may be drawn upon by him at any time although not then actually reduced to possession.”

7Even if § 4960(c)(3) is read by itself to refer only to compensation that is currently subject to FITW (plus § 457(f) amounts), one must acknowledge that the Timing Rule then modifies “remuneration” to treat such amounts as actually paid — and therefore subject to FITW — at the time of vesting. If compensation is treated as “paid” then such amount must constitute wages for FITW purposes.

8We understand that several other comment letters have requested guidance regarding the definition of a “taxable year.” We agree that further clarification on this point would be helpful. Our discussion below assumes the employer maintains a calendar taxable year.

9We again note that the reference to § 457(f)(3) merely references the definition of a “substantial risk of forfeiture” and does not, in any manner, limit the application of the Timing Rule to amounts subject to § 457(f).

10H.R. Rep. No. 115-446, at 493-494 (2017) (Conf. Rep.).

11Any investment losses, or hypothetical investment losses, would offset any investment gains or additional deferrals accrued during the year.

END FOOTNOTES

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