The Tax Cuts and Jobs Act (the “Act”) was signed into law on December 22, 2017. Among other major impacts, the Act created new Section 4960 of the Internal Revenue Code of 1986, as amended (the “Code”).
Effective for all taxable years after December 31, 2017, Code Section 4960 generally imposes a 21% excise tax on “applicable tax-exempt organizations” for compensation in excess of $1 million that is paid to any “covered employee.”
An applicable tax-exempt organization includes, among other entities, any tax-exempt entity under Code Section 501(a). This would include any tax-qualified retirement plan, including an employee stock ownership plan (an “ESOP”).
Will This Affect Your ESOP?
At first glance, it may appear that Code Section 4960 does not apply to ESOPs because employees of ESOP-owned companies are not employed by the ESOP. In fact, in order to be a “covered employee,” the individual must be one of the 5 highest compensated employees of the tax-exempt organization.
The Code states, however, that the $1 million excise tax threshold is calculated by including remuneration paid not just by the tax-exempt organization (the ESOP itself) but also compensation paid by any “related organization.” A related organization would include an ESOP-owned company if the company is controlled by the ESOP, which would be the case if the ESOP is a greater than 50% owner of the company.
The clearest reading of the statute is that employees of ESOP owned companies would not be “covered employees” and therefore the statute would not apply to ESOP-owned companies even though compensation of employees would be considered compensation for purposes of the $1 million threshold.
Notwithstanding this plain text reading of the statute, Congress also gave the Department of the Treasury broad authority to issue regulations under Code Section 4960, including regulations to prevent avoidance of such tax by providing compensation through a pass-through entity. As such, it is possible that these regulations could broaden the scope of “covered employees” to include employees of related pass-through organizations, such as the ESOP-owned subchapter S corporation.
Next Steps
Code Section 4960 was clearly intended to apply to tax-exempt organizations such as universities and hospitals and it does not appear that Congress intended to cause Code Section 4960 to apply ESOP-owned S corporations.
For now, ESOP companies should continue to monitor the regulatory guidance that develops under Code Section 4960.
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.
