Companies with affiliated tax-exempt entities could find themselves surprised to be on the hook for a new tax, in light of interim guidance recently released by the Internal Revenue Service.

A controversial provision of the Tax Cuts and Jobs Act imposes a 21% excise tax on compensation that exceeds $1 million for the “covered employees” of tax-exempt entities. Such entities include 501(c)(3) public charities, private foundations, and other 501(c) exempt organizations.

Covered employees include the five highest-paid employees of an “applicable tax-exempt organization” (ATEO), as well as any employee who was a covered employee of the entity (or any predecessor) for a preceding tax year beginning after Dec. 31, 2016.

“Once an employee qualifies as a covered employee, the employee remains a covered employee permanently, even in subsequent taxable years when the employee is no longer one of the five highest-compensated employees of the [tax-exempt organization],” noted law firm Goodwin Procter in a notice on Tuesday.

The tax is assessed on the organization, not the covered employee. But why are for-profit companies at risk?

As clarified by the interim guidance, the tax applies to companies with affiliated ATEOs where a company executive fitting the definition of “covered employee” is also an employee of the ATEO. That’s the case even when all of the executive’s compensation is paid by the for-profit company.

“As incredible as [it] may seem, it is possible that the IRS might seek to enforce that interpretation,” Goodwin wrote, citing recent remarks by IRS representatives. One of them, the law firm added, “expressed concern that an ATEO could avoid the excise tax by simply having the compensation to individuals performing services for the ATEO paid by the private corporation.”

However, the IRS has requested comments on how it should address that scenario in forthcoming proposed regulations that will serve as additional guidance for applying the excise tax.

Also as provided for in the interim guidance, if the ATEO pays part of the executive’s compensation, each entity is liable for the excise tax in proportion to the amount of the compensation it pays.

An exception exists where the covered employee is not a “common law employee” of the tax-exempt entity. The test of whether someone is a common law employee is whether the entity has control over what the employee does and how it’s done. If not, then the excise tax does not apply.

The tax also generally doesn’t apply to compensation an ATEO pays to a member of its board of directors, provided the director is not otherwise treated as an employee.

Further, for publicly held entities, remuneration that is not deductible by virtue of IRS Section 162(m) is excluded from the excise tax.

Goodwin advised that employers with related ATEOs should “carefully consider the implications of [the interim guidance], including whether executives who may receive excess remuneration should provide services” to the ATEO.

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