More Nonprofit Employees Could Now Trigger the Section 4960 Excise Tax: What Tax-Exempt Organizations Need to Know

Estimated reading time: 15 minute(s)

For several years, Section 4960 of the Internal Revenue Code has imposed a federal excise tax on certain high compensation paid by tax-exempt organizations.

Before 2026, the rules generally focused on an organization’s five highest-paid employees for the year, plus anyone who had already become a “covered employee” in a prior year. In other words, once someone became covered under Section 4960, they generally remained covered in later years.

That rule is now expanding.

For taxable years beginning after December 31, 2025, recent legislation broadens who may be treated as a covered employee. Instead of focusing only on the five highest-paid employees, the rules can now apply more broadly to employees of an applicable tax-exempt organization, or ATEO.

This does not mean every nonprofit will owe the tax. For many organizations, Section 4960 will never apply. But nonprofits with employees earning more than $1 million—or with certain large severance or separation-related payments—should pay closer attention.

WHAT IS SECTION 4960?

Section 4960 is a federal excise tax rule that applies to certain tax-exempt organizations and, in some cases, related organizations that help pay compensation.

For simplicity, this article uses the word “compensation,” although the tax law uses the term “remuneration.”

The tax generally applies to:

• Compensation over $1 million paid to a covered employee during the tax year; and
• Certain “excess parachute payments,” which are generally large payments connected to an employee’s separation from employment.

The tax rate is currently 21%, matching the federal corporate income tax rate.

Importantly, this is a tax paid by the employer—not by the employee.

Section 4960 can apply to many types of tax-exempt organizations, including charitable organizations, certain governmental or quasi-governmental organizations, political organizations, and certain other tax-exempt entities. These organizations are referred to in the law as applicable tax-exempt organizations, or ATEOs.

WHAT CHANGED?

Before this change, covered employees generally included:

• The organization’s five highest-compensated employees for the year; and
• Anyone who had already become a covered employee in a prior year.

For taxable years beginning after December 31, 2025, the definition expands significantly.

The rule is no longer limited to just the top five highest-paid employees. As a result, a nonprofit may need to review a broader group of employees when determining whether Section 4960 applies.

In practical terms, this means an organization with more than five employees earning over $1 million may no longer be able to focus only on the top five earners. Compensation paid to additional highly compensated employees may also need to be evaluated.

SIMPLE EXAMPLE

Assume a tax-exempt organization has seven employees who each earn more than $1 million.

Under the prior rules, the organization generally focused on its five highest-compensated employees, plus anyone who had already become covered in a prior year.

Under the expanded rules for taxable years beginning after December 31, 2025, the organization may need to evaluate all seven employees—not just the top five.

That could increase the number of employees whose compensation is subject to the Section 4960 excise tax.

IRS NOTICE 2026-36 PROVIDES INTERIM GUIDANCE

The Treasury Department and IRS have announced that they plan to issue proposed regulations explaining how the expanded rules will work.

In the meantime, IRS Notice 2026-36 provides interim guidance.

The notice explains that:

• Individuals who became covered employees under the old rules remain covered employees.
• The expanded definition applies for taxable years beginning after December 31, 2025.
• Organizations may continue to rely on certain existing exceptions, including the limited hours and nonexempt funds exceptions, while future regulations are being developed.
• Some prior guidance tied to the old “top five” structure is expected to be revised or removed because the law has changed.

The key takeaway is that organizations should not wait for final regulations before reviewing their compensation arrangements.

WHAT SHOULD NONPROFITS DO NOW?

Many nonprofits will never pay any employee more than $1 million, so the expanded Section 4960 rules may not affect them.

However, organizations with highly compensated executives, physicians, investment professionals, coaches, university administrators, or other senior employees should begin reviewing their compensation practices.

Steps to consider include:

• Identifying employees whose annual compensation may exceed $1 million.
• Reviewing bonus, incentive, deferred compensation, and severance arrangements.
• Looking at compensation paid by related organizations.
• Tracking individuals who were already covered employees under the prior rules.
• Reviewing whether any special exclusions may apply, such as compensation for certain medical or veterinary services.
• Coordinating compensation reporting and excise tax filing responsibilities.

Because compensation from related organizations can matter, nonprofits should look beyond the wages paid directly by the main organization.

LOOKING AHEAD

Notice 2026-36 is temporary guidance while the Treasury and the IRS develop proposed regulations. Additional guidance is expected before the rules are finalized.

For now, affected organizations should start reviewing compensation arrangements for taxable years beginning after December 31, 2025.

The most important point is simple: Section 4960 is no longer just a “top five employees” issue. Organizations with employees earning more than $1 million should review a broader group of employees to determine whether the excise tax may apply.

Interested in learning more about nonprofit compliance? Check out our recent blogs.