The Section 4960 Excise Tax: When Nonprofit Pay Crosses $1 Million

Section 4960 of the Internal Revenue Code imposes an excise tax — at the corporate rate, currently 21% — on applicable tax-exempt organizations that pay any “covered employee” remuneration over $1 million in a year, or that pay an “excess parachute payment” on separation. Unlike §4958 intermediate sanctions, which fall on individuals, the §4960 tax is owed by the organization itself, and it applies even when the compensation is entirely reasonable.

That last point surprises boards: §4960 is not a penalty for excessive pay. It is a flat surcharge Congress added in 2017 — and broadened in 2025 — to parallel the for-profit world's $1 million deduction limit. An organization can run a flawless §4958 process, document a bulletproof comparability file — and still owe the tax on every dollar of remuneration above $1 million.

Who is a “covered employee”?

The answer changed in 2025, and materially. Under the rule as enacted in 2017 — which still governs taxable years beginning on or before December 31, 2025 — the covered employees were the five highest-compensated employees of the organization for the taxable year, plus anyone who had been a covered employee in any prior year beginning after December 31, 2016. The One Big Beautiful Bill Act (signed July 4, 2025) removed the top-five limitation: for taxable years beginning after December 31, 2025 — calendar year 2026 for most organizations — a covered employee is any employee of the organization, and anyone who attained covered-employee status under the old top-five rule keeps it. Coverage remains permanent — once covered, always covered.

The practical effect is that “who is covered” stops being the gatekeeping question. For post-2025 years the analysis moves to the tax triggers — remuneration over $1 million and excess parachute payments — and the expansion reaches employees the top-five rule never touched: the sixth-highest-paid executive, a highly compensated investment officer, a specialist whose one-time vesting event spikes past $1 million.

Interim IRS guidance (Notice 2026-36, issued June 5, 2026) confirms this reading and may be relied on until proposed regulations arrive. It carries forward the “limited hours” and “nonexempt funds” exceptions for certain employees of related organizations, drops the now-moot “limited services” exception, and requests public comments by August 4, 2026 — so the details may still shift at the margins, which is a reason to involve the organization's tax advisor, not a reason to defer planning.

What counts as remuneration?

Wages for income-tax withholding purposes, plus amounts deferred under a §457(f) plan when they vest — which is the trap. A retention arrangement that vests a decade of deferred compensation in a single year can spike a covered employee's remuneration past $1 million in that year even though annual pay never approached it. Remuneration paid by related organizations is aggregated. Compensation paid to licensed medical professionals for the direct performance of medical or veterinary services is excluded from the $1 million test — the exclusion that keeps many hospital systems' physician pay out of scope (their administrative pay still counts).

What is an excess parachute payment?

Separation payments that equal or exceed three times a covered employee's “base amount” (roughly, five-year average compensation) trigger the tax on the amount above one times the base — a separate prong with no $1 million threshold. Severance arrangements for long-tenured executives at mid-sized organizations can trip this prong at total figures well below $1 million, which is why exit packages deserve §4960 modeling before they're signed, not after.

How should boards manage §4960 exposure?

Three practices cover most situations. Know your exposure roster — the pre-2026 covered-employee list (cumulative, including departed employees) still controls for former employees, while for taxable years beginning after December 31, 2025 the practical watch list is every employee whose remuneration or potential separation package could approach the triggers. Model vesting events before adopting them — deferred compensation and retention plans should be designed with the vesting-year remuneration spike in view, sometimes by staging vesting across years. Model separations the same way — test any severance against the three-times-base-amount trigger before terms are offered. The tax is reported and paid on Form 4720; budgeting for a known liability is far better than discovering it at filing.

Frequently asked questions

Further reading: our analysis of how far the expanded §4960 rules now reach puts numbers to which organizations are newly in scope.

Educational information, not legal or tax advice — §4960 calculations should be run with the organization's tax advisor. CauseComp's executive benchmarks show where pay falls in the market that context comes from; the §4960 modeling belongs in your annual comp planning alongside it.