Section 4960: Excise Tax on Executive Compensation

Under Section 4960 of the Internal Revenue Code, a tax-exempt organization owes a 21% excise tax on any compensation above $1 million it pays to any of its five highest-paid employees, and on certain large separation payments to those same employees. The organization pays the tax itself, not the executive, and reports it on IRS Form 4720. The Section 4960 excise tax on executive compensation applies whether the excess comes from salary, bonuses, vested deferred compensation, or a departure package.¹

Which Organizations Owe the Tax

Section 4960 applies to what the IRS calls an applicable tax-exempt organization, or ATEO. Four categories qualify:²

Organizations exempt from federal income tax under Section 501(a), which covers most nonprofits including public charities, private foundations, trade associations, and social welfare organizations.³
Farmers’ cooperatives described in Section 521(b)(1).
Governmental entities with income excluded under Section 115(1), such as state university systems or public hospital authorities.
Political organizations described in Section 527(e)(1).

A government body that relies only on sovereign immunity for its tax exemption, rather than holding a specific exemption under Section 501(a) or having income excluded under Section 115(1), generally falls outside the ATEO definition. ATEO status is redetermined each year.

Who Counts as a Covered Employee

The tax reaches compensation paid only to “covered employees.” A person becomes a covered employee by ranking among an ATEO’s five highest-compensated employees for any taxable year, with pay from the ATEO and all related organizations combined for that ranking.⁴

Once covered, always covered. Anyone who qualifies as a covered employee in a taxable year beginning after December 31, 2016 keeps that status permanently, even if their pay drops out of the top five later or they leave the organization entirely.¹ The rule reaches through predecessor organizations, so a merger or reorganization doesn’t reset the clock. Deferred payouts and severance to long-departed executives still get tested against Section 4960.

The $1 Million Compensation Trigger

If a covered employee’s total remuneration for the year exceeds $1 million, the organization owes 21% on the excess.¹ The $1 million threshold is not indexed for inflation and stays fixed regardless of cost-of-living changes.⁵ Pay a covered employee $1.5 million and the excess is $500,000; the tax is 21% of that, or $105,000, owed by the organization.

The 21% rate is written into the statute by cross-reference to the Section 11 corporate income tax rate, so if Congress changes the corporate rate, the Section 4960 rate moves with it.¹

What Counts as Remuneration

Remuneration means wages subject to income tax withholding, plus amounts required to be included in gross income under Section 457(f) deferred compensation plans. That captures salary, bonuses, taxable fringe benefits, and noncash compensation.¹

Deferred compensation is treated as paid when it vests, not when the cash actually changes hands. A large deferred plan that vests all at once can push a covered employee past $1 million in a single year even if the underlying amounts accrued slowly over a career.

What Does Not Count

Two carve-outs matter. Designated Roth contributions to retirement plans are excluded from remuneration. So is compensation paid to a licensed medical professional, including veterinarians, for performing medical or veterinary services.¹ The medical exclusion matters most at hospitals and health systems, where physician-executives may spend a real share of their time on patient care. The final regulations let employers use any reasonable, good-faith method to allocate a physician-executive’s pay between clinical and administrative duties.⁵

The Separation-Payment Trigger

The second trigger reaches large payouts made when a covered employee leaves, which the statute calls parachute payments. This trigger works independently of the $1 million rule, so an organization can owe the tax on a parachute payment even when the employee’s regular annual compensation never crossed $1 million.

A parachute payment is compensation contingent on a covered employee’s separation from employment when the total present value of all separation-contingent payments equals or exceeds three times the employee’s base amount.¹ The base amount is calculated under rules similar to Section 280G and generally equals the employee’s average annualized compensation over the five taxable years before the year of separation.

If an executive’s base amount is $400,000, the three-times threshold is $1.2 million. Separation payments totaling $1.2 million or more in present value trip the parachute rules. The taxable excess, though, is the amount by which each parachute payment exceeds the base amount allocated to it, not the excess over the three-times figure.² That distinction catches many organizations off guard because the tax base is larger than they expect.

Payments That Are Excluded

Not every payment tied to departure counts. Payments under qualified retirement plans, 403(b) annuity contracts, and 457(b) eligible deferred compensation plans are excluded. So are payments for medical or veterinary services by a licensed professional, and separation payments to employees who are not highly compensated as defined under Section 414(q).¹

Amounts already vested before separation generally are not treated as contingent on separation, even if the payout happens to coincide with departure. The final regulations clarify that when a right to deferred compensation vested based on years of service completed before the separation, the separation affects only when the money is paid, not whether it is paid, and that keeps the payment outside the parachute rules.⁵

When Related Organizations Get Pulled In

Section 4960 prevents organizations from sidestepping the tax by routing pay through affiliated entities. All compensation from related organizations is combined when identifying the top-five highest-paid employees and when testing whether the $1 million threshold has been crossed.⁴

A related organization is any entity that controls, is controlled by, or shares common control with the ATEO, along with supporting and supported organizations. Control generally means more than 50%, measured by stock (vote or value) for corporations, profits or capital interests for partnerships, beneficial interests for trusts, and directors or trustees who are representatives of or controlled by the other entity for nonprofit and governmental entities. Power to remove and replace a director or trustee also counts as control.²⁶

When an ATEO and a related taxable subsidiary both pay the same covered employee, the amounts combine for the $1 million test and the resulting tax splits proportionally by each entity’s share of total pay. If the ATEO pays $500,000 and a related for-profit subsidiary pays $600,000, the combined $1.1 million triggers 21% on the $100,000 excess, and each entity carries its share. The ATEO holds primary liability for the tax on any excess parachute payments even when related entities made some of the underlying payments.¹

Filing and Paying

The excise tax is reported on IRS Form 4720, using Schedule N to calculate the amount owed.⁷ The deadline is the 15th day of the fifth month after the end of the employer’s taxable year, which is May 15 for calendar-year filers and aligns with the Form 990 due date.⁸

Filing extensions are available, but the tax must still be paid by the original deadline to avoid penalties and interest. Standard failure-to-file and failure-to-pay penalties under Section 6651 apply, plus interest at the underpayment rate set under Section 6621.⁷ There is no estimated-tax requirement for the Section 4960 excise tax, so no underpayment penalties attach to missed quarterly estimates.

Where Compliance Tends to Break Down

The permanent covered-employee rule is the hardest piece to maintain over time. An organization needs a system that tracks every person who has ever landed in the top five, including former executives who left years ago, so that any later deferred payout or severance installment can be run through the Section 4960 calculation. The longer an organization has been operating under these rules, the longer that list grows, and the easier it is for a payment to slip past unreported.

Auditors look at W-2s and payroll records against Form 990 Part VII and Schedule J compensation data, so inconsistencies among those filings draw scrutiny. IRS examiner materials include specific questions about whether any employees earn over $1 million (including taxable fringe benefits), whether compensation flowed through related organizations, whether any parachute payments were made, and whether Form 4720 was filed.⁴

For hospitals and other organizations with licensed medical professionals in top-five positions, documenting the split between clinical and administrative duties is essential. The reasonable, good-faith standard gives employers flexibility, but the IRS can challenge an allocation that appears to shrink taxable remuneration without a defensible method behind it.

1
Office of the Law Revision Counsel. 26 U.S. Code 4960 – Tax on Excess Tax-Exempt Organization Executive Compensation
2
Internal Revenue Service. Interim Guidance Under Section 4960 – Notice 2019-09
3
Office of the Law Revision Counsel. 26 U.S. Code 501 – Exemption From Tax on Corporations, Certain Trusts, Etc.
4
Internal Revenue Service. Excise Tax on Excess Tax-Exempt Organization Executive Compensation
5
Federal Register. Tax on Excess Tax-Exempt Organization Executive Compensation
6
Legal Information Institute. 26 U.S. Code 512(b)(13) – Definition of Control
7
Internal Revenue Service. Instructions for Form 4720
8
Internal Revenue Service. Form 4720 – When to File