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Article | Executive Pay Memo North America

IRS announces focus on IRC section 4960 compliance

Governance Advisory Services |Executive Compensation

By Gary Chase , Betsy Field , Steve Seelig and Susan Sulisz | December 16, 2020

The 2021 IRS compliance priority list includes a focus on tax-exempt organizations that pay more than $1 million to their covered employees.

Tax-exempt organizations may soon face additional scrutiny as to their compliance with the new Internal Revenue Code section 4960 excise tax, according to the IRS’s updated compliance priorities for the 2021 fiscal year (which started on October 1, 2020). The excise tax applies to those organizations that pay compensation in excess of $1 million to current or former employees.

The IRS focus on section 4960 compliance will include "compliance checks," which involve the IRS sending questionnaires to selected organizations regarding the organization's section 4960 compliance. The compliance checks are intended by the IRS to encourage voluntary compliance, and are not as invasive or time consuming as an IRS audit. Organizations that receive a questionnaire should make sure they timely respond with the consultation of their tax advisors, as failure to respond can trigger a formal IRS audit.

Background on section 4960 excise tax and filing requirement

Section 4960 was enacted as part of the Tax Cuts and Jobs Act of 2017 to impose a 21% excise tax on compensation paid to a "covered employee" that exceeds $1 million. A covered employee is generally defined as a current or former employee who is among the 5 highest compensated of the organization (or any predecessor organization) for the current tax year or any prior tax year beginning after 2016. An employee or former employee who qualifies as a covered employee will remain a covered employee in all subsequent years, which can result in a growing list of covered employees as time passes.

Compensation for purposes of the section 4960 excise tax is generally equal to wages that are subject to federal income tax withholding (i.e., W-2 compensation) excluding designated Roth contributions and payments to licensed medical professionals (including veterinarians) for performing medical or veterinary services.

Section 4960 compliance focus

The IRS explained in its fiscal year 2021 priorities that an "[o]n-going review of filing data shows there continues to be a high volume of exempt organizations that paid compensation of over $1 million to at least one 'covered employee' but did not report IRC Section 4960 excise tax on Form 4720." The IRS's focus on section 4960 compliance will include reviews of Form 4720 filings (used to report and pay the section 4960 excise tax) and compliance checks.

Based on past practice, if an organization is selected for a compliance check, the IRS will send a questionnaire regarding the organization's section 4960 compliance. The IRS will include an explanation which specifies that completing the IRS questionnaire is voluntary, but that the IRS reserves the right to initiate an audit if a response is not received. Organizations that receive a questionnaire should respond timely to minimize the risk of an audit, and tax advisors should be consulted for their views on the appropriate responses.

We speculate that the IRS may be focused on organizations that did not report compensation as subject to the section 4960 excise tax for individuals who are listed on the Form 990, Schedule J as having more than $1 million in compensation. However, the Schedule J compensation definition includes amounts that are excluded from compensation used to calculate the excise tax (such as Roth Contributions and certain payments to licensed medical professionals). Therefore, there may be legitimate reasons that an individual is reported as having more than $1 million in compensation on Schedule J of Form 990 but is not subject to the section 4960 excise tax.

Next steps

The IRS compliance checks are an important reminder of the need to carefully document the process for determining covered employees, tracking current and former employees who are considered covered employees and determining if they receive compensation in excess of $1 million from the organization. As the number of covered employees increases over time, ensuring the Form 4720 is accurately completed and excise tax is paid will become increasingly complex. Organizations may consider discussing with their tax advisors whether their Forms 990 filings should include more details in the Form 990, Schedule O, describing how they determine compensation in compliance with section 4960.


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