The 2017 Tax Act enacted section 4960 to the Internal Revenue Code, a new provision imposing a 21% tax on “applicable tax exempt organizations”, including 501(c)(3) charitable organizations, that pay any of their top five paid employees more than $1 million in annual compensation. This tax was supposed to even the playing field with for profit public corporations that lost the ability to deduct compensation in excess of $1 million. Additionally, applicable tax exempt organizations must pay the tax on excess parachute payments. These are payments on account of termination of employment that exceed three times the average compensation paid to the employee for the past five years.
The types of applicable tax exempt organizations subject to the tax is quite broad. It specifically includes all organizations exempt under Internal Revenue Code section 501(c) such as 501(c)(6) trade associations, 501(c)(5) labor organizations, and 501(c)(7) social clubs. It also includes tax exempt farmers cooperatives under Code section 521, Political Action Committees under Code section 527 and any organization whose income is excluded from taxation under Code section 115(1) as the exercise of an essential government function accruing to a state or political subdivision of a state.
This is quite a large net designed to ensnare many tax exempt organizations and it was so intended. However, when the IRS issued interim guidance on the tax in January under Notice 2019-09, it legitimized a major loophole in the statutory language that permits certain public colleges and universities to escape the tax. This is a major development because the compensation of athletic coaches at public universities is one of the sources the tax was aimed at.
The issue surrounds the definition of an applicable tax exempt organization subject to the tax. Public colleges and universities were not specifically named in the statute. Many state colleges and universities have not been recognized by the IRS as tax exempt educational organizations under Code section 501(c)(3) because they never applied for such recognition from the IRS. Others have applied and been so recognized to help with charitable giving efforts. Also, many state schools are not separate entities from the state government and therefore, Code section 115(1) does not apply to them. Instead, they consider themselves an integral part of the state government and exempt from taxation under the “implied statutory immunity” doctrine. That doctrine basically says that if the federal government wants to tax states or political subdivisions it must specifically do so or implied immunity will prevent it. An example of specific Congressional action was specifically including public colleges and universities as organizations subject to the unrelated business income tax when it was enacted in the 1950’s. However, as mentioned, public colleges and universities are not specifically named in Code section 4960.
Thus, many public universities such as the University of Alabama that pays its football coach, Nick Saban, over $8 million annually, arguably escape the tax as the law is written. However, according to the General Explanation of the 2017 Tax Act prepared by the Congressional Joint Committee on Taxation (Committee), the statute was intended to apply to all public colleges and universities but the committee acknowledged that a legislative technical correction may be needed to reach this intention. In its approach to section 4960 in Notice 2019-9, the IRS admitted that the statutory language does not reach public colleges and universities exempt under implied statutory immunity. In fact, the Notice advises that such institutions that have received a determination letter from the IRS recognizing them as exempt under Code section 501(c)(3) may relinquish this status to avoid being subject to the tax.
Prior to the issuance of the Notice, legal scholars debated whether the IRS could still impose the tax on colleges and universities exempt under implied statutory immunity. Some argued that regardless of whether an institution applies for recognition as exempt under Code section 501(c)(3) from the IRS, they are exempt under that section as an educational institution because the law grants them exemption not the IRS. Therefore, the tax applies. Others argued that all such schools fall under Code section 115(1). The interpretation of the statute by the IRS in the Notice ends any such debate and makes it clear that legislation is needed to close the loophole.
Thus, the current status of the law is that Code section 4960 is not reaching one of the major sources of tax that it was intended to, well compensated coaches and athletic directors at public colleges and universities. According to a 2016 study by ESPN the highest paid state employee was a college football or men’s basketball coach in 39 of the 50 states. Therefore, without a legislative change this tax is likely to fall well short of the Committee’s estimate of raising $1.8 billion over 10 years. Additionally, this loophole is unfair to private colleges and universities who pay coaches over $1 million such as Stanford, Northwestern, and Notre Dame, who cannot avoid the tax like their public counterparts.
Unfortunately, the prospect of legislation to close this loophole getting through a divided Congress and being signed by President Trump doesn’t look very promising.