The section 4960 excise tax is a 21% tax that a tax-exempt employer pays on any covered employee's remuneration above $1 million in a year and on any excess parachute payment. For taxable years beginning after December 31, 2025, the One Big Beautiful Bill Act (OBBBA) extended "covered employee" from the five highest-paid people to every employee and certain former employees.
That change turns the section 4960 excise tax from a top-five calculation into an organization-wide payroll review. This guide covers what the tax is, who now counts, which medical pay is carved out, how Notice 2026-36 applies the new definition, how the tax is reported on Form 4720 and how the numbers work in a worked example. Figures and guidance are current as of October 2026.
Congress added Section 4960 in the Tax Cuts and Jobs Act of 2017. The statute imposes "a tax equal to the product of the rate of tax under section 11" (the 21% corporate rate) on two amounts: remuneration paid to a covered employee "in excess of $1,000,000," and "any excess parachute payment paid by such an organization to any covered employee." The text of 26 U.S. Code § 4960 states plainly that "The employer shall be liable for the tax." The employee owes nothing under this section.
The tax applies to an applicable tax-exempt organization (ATEO). The IRS instructions for Form 4720 say an ATEO "includes section 501(a) exempt organizations, section 527 political organizations, section 521 farmers' cooperatives, and government entities that have income excluded under section 115(1)." Hospitals, universities, private foundations, trade associations and public charities all fall inside that definition.
Section 4960 is separate from the excess benefit rules. Those rules tax the insider who received unreasonable value, and a charity can owe the section 4960 excise tax on pay that is entirely reasonable. For the insider side, see the guide to excess benefit transaction rules under Section 4958. A large compensation package can trigger both regimes at once.
Remuneration starts with wages as defined in section 3401(a), the same base used for income tax withholding. The Form 4720 instructions add that remuneration "also includes amounts required to be included in gross income under section 457(f)." Bonuses, taxable fringe benefits and vested deferred compensation all count. Teams that already classify taxable benefits for payroll can reuse that work; the guide to fringe benefits and taxes covers which perks become wages.
Timing follows vesting. Remuneration "shall be treated as paid when there is no substantial risk of forfeiture" of the right to it. A deferred compensation award that vests in 2026 counts toward the 2026 total even if the cash is paid years later, which is how many executives cross $1 million in a single vesting year.
Three amounts are left out of remuneration:
Pay from related organizations is added together. Remuneration from any person or governmental entity that controls or is controlled by the ATEO, shares common control with it, or is a supported or supporting organization under section 509 counts toward the $1 million. When several related employers pay the same person, each is liable for a share of the tax equal to its share of total remuneration.
Before 2026, a covered employee was one of the ATEO's five highest-compensated employees for the year, or anyone who had been a covered employee in any year beginning after December 31, 2016. The 2025 Form 4720 instructions still describe that rule, because it governs 2025 tax years.
Section 70416 of the OBBBA rewrote the definition. Under the amended statute, a covered employee "means any employee of an applicable tax-exempt organization (or any predecessor of such an organization)," plus former employees who were employees "during any taxable year beginning after December 31, 2016." The amendment applies "to taxable years beginning after December 31, 2025." For a calendar-year organization, that is the 2026 year. A fiscal-year organization with a July 1 start comes under the new rule for the year beginning July 1, 2026.
The $1 million threshold and the 21% rate did not change. What changed is that every employee whose countable pay crosses $1 million now generates tax, where previously only the top five did. A health system with many physician executives or a university with highly paid coaches and investment staff can now see liability on people who were never in scope.
Treasury and the IRS issued Notice 2026-36 to explain how they read the amendment ahead of proposed regulations. It covers three points.
Former employees. The IRS reads the effective date to keep the old definition for years beginning on or before December 31, 2025. A former employee counts as a covered employee in 2026 only if that person was a covered employee under prior law in an earlier year, or is employed by the ATEO in a year beginning after 2025. In the notice's own example, Employee C worked for the ATEO in 2020 without being one of its five highest paid, so C "was not a covered employee for any taxable year through 2025 under prior law" and is not covered in 2026. Covered employee status, once obtained, is permanent.
Exceptions that survive. The forthcoming proposed regulations are expected to keep covered employee exceptions "for limited hours and nonexempt funds similar to those" in the existing regulations. These exceptions mainly help employees of taxable related companies who do limited work for the ATEO.
The exception that goes away. The limited services exception will not carry over, because the concern behind it, an employee with minimal ATEO pay displacing someone from the top five, "is no longer relevant."
Until the proposed regulations are issued, ATEOs "may rely on the rules described in section 4.01 of this notice." The comment deadline was August 4, 2026. As of late October 2026 the proposed regulations had not been published, so organizations should watch for them before closing their 2026 calculations.
The medical exclusion is the most valuable rule for hospitals and academic medical centers, and it has two parts.
For the $1 million test, only the portion of a licensed professional's pay that is for performing medical or veterinary services is excluded. A physician who spends part of the year seeing patients and part running a department has split pay. The clinical portion is left out and the administrative portion counts. A documented allocation, usually based on time records or employment agreement terms, is what supports the split.
For parachute payments, the statute excludes payments to a licensed medical professional "to the extent that such payment is for the performance of medical or veterinary services." Separation pay tied to giving up an executive role generally falls outside this exception.
The expansion makes this carve-out far more important. Under the old top-five rule, many high-earning clinicians were never covered employees. From 2026, every physician whose non-clinical pay exceeds $1 million is in scope, so the allocation between clinical and administrative work now drives the tax directly.
A parachute payment is any payment in the nature of compensation that is contingent on the employee's separation from employment and has a present value of at least three times the employee's base amount. The base amount uses rules similar to section 280G, which works from the employee's annualized includible compensation for "the most recent 5 taxable years" before the triggering event. Once the three-times test is met, the excess parachute payment is the amount above the portion of the base amount allocated to the payment. For a single payment, that is everything above one times the base amount, and all of it is taxed at 21%.
Several payments are excluded: payments under qualified plans, payments under a 403(b) annuity or 457(b) plan, the medical services portion described above, and payments to anyone who is not a highly compensated employee under section 414(q). The IRS COLA table sets the highly compensated employee threshold at $160,000 for 2026. The parachute rules apply to covered employees even when annual pay stays below $1 million, so a large severance to a mid-level employee can create tax on its own.
Assume a calendar-year nonprofit health system (an ATEO) has the following 2026 facts. The base amounts and allocations are hypothetical, and the figures were checked in Python.
| Employee | Countable amount | Taxable excess | Tax at 21% |
|---|---|---|---|
| A | $1,400,000 | $400,000 over $1M | $84,000 |
| B | $1,800,000 − $500,000 = $1,300,000 | $300,000 over $1M | $63,000 |
| C | $1,500,000 − $1,100,000 = $400,000 | $0 | $0 |
| D | $900,000 + $300,000 = $1,200,000 | $200,000 over $1M | $42,000 |
| E | $1,800,000 is at least 3 × $500,000 = $1,500,000 | $1,800,000 − $500,000 = $1,300,000 | $273,000 |
| Total | $2,200,000 | $462,000 |
Three details drive the result. The clinical carve-out removes $500,000 of B's pay and keeps C out entirely. For D, the related foundation pays 25% of total remuneration ($300,000 of $1,200,000), so it owes $10,500 and the health system owes $31,500. For E, if the separation payment had been $1,400,000 instead, it would fall below three times the base amount and no excess parachute payment would arise.
Under the pre-2026 rule, several of these people might have sat outside the five highest-compensated group. From 2026, each one is a covered employee unless an exception applies.
The tax is reported on Form 4720, Schedule N. The instructions say an ATEO "that pays to any covered employee more than $1 million in remuneration or pays an excess parachute payment during the year must file Form 4720." The Form 990 asks about the tax in Part V, line 15, and a "Yes" answer leads to Schedule N.
On Schedule N, column (b) lists each covered employee paid more than $1 million or an excess parachute payment, column (c) shows remuneration above $1 million, column (d) shows any excess parachute payment and column (e) adds them. With more than five covered employees, the organization attaches a statement. Each related employer that bears part of the tax files its own Form 4720, with a statement giving the names and EINs of the related employers.
Form 4720 is due on the regular due date, without extensions, of the organization's Form 990 or 990-PF. Form 8868 gives an automatic extension. There is "no requirement to make estimated tax payments for the section 4960 tax," so the full amount is paid with the return. Organizations that file a Form 990-T for unrelated business income should keep in mind that the section 4960 tax goes on Form 4720 instead.
Boards that set executive pay should see these numbers before approving contracts. A nonprofit CFO or outside finance team can build the tracking schedule, and organizations that use outsourced bookkeeping for nonprofits can have the related-entity payroll data gathered each month. Large one-time payments such as bonuses are often processed as supplemental wages, so withholding and section 4960 review can happen in the same payroll cycle.
What is the section 4960 excise tax rate? The rate equals the corporate income tax rate under section 11, which is 21%. It applies to remuneration above $1 million paid to a covered employee and to any excess parachute payment.
Who pays the section 4960 excise tax? The employer pays it. The ATEO and any related organization that contributed to the employee's pay each owe a share in proportion to the remuneration they paid, and each files its own Form 4720.
When does the expanded covered employee definition start? It applies to taxable years beginning after December 31, 2025. Calendar-year organizations apply it for 2026, and fiscal-year organizations apply it from the first fiscal year that begins in 2026.
Is physician pay subject to the tax? Only the part that is not for medical services. Pay for patient care by a licensed medical professional is excluded, while pay for administrative or executive duties counts toward the $1 million threshold.
Can an organization rely on Notice 2026-36? Yes. Until the proposed regulations are issued, ATEOs may rely on the notice's reading of the new definition and on its limited hours and nonexempt funds exceptions.
Madras Accountancy supports nonprofits and the CPA firms that serve them with bookkeeping, payroll reconciliation, tax return preparation and CFO-level reporting, including the schedules needed to review executive compensation across related entities. To talk through your organization's needs, contact our team.
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