A children's hospital pays its CEO $1.4 million, its CFO $1.1 million, and its chief medical officer $1.3 million. Until this year, the hospital was on the hook for a 21 percent excise tax on roughly $800,000 of excess pay—about $168,000. Starting with the 2026 tax year, the same hospital may owe excise tax on every employee who breaks the $1 million threshold, not just the top five. For a large academic medical center with a dozen high earners, that change can quietly add hundreds of thousands of dollars in tax to a single Form 4720.
That is the practical reality of Section 4960 after the One Big Beautiful Bill Act (OBBBA). The provision was already a sleeper rule for nonprofits, hospitals, universities, and large foundations. The OBBBA expansion makes it a board-level concern.
This guide walks through who owes the tax, what counts as "covered" compensation, how the calculation works, the recent OBBBA changes that take effect for the 2026 taxable year, and the documentation work nonprofits should do now to avoid surprises on Form 4720.
What Section 4960 Is and Why It Exists
Internal Revenue Code Section 4960 was enacted in the Tax Cuts and Jobs Act of 2017 and took effect in January 2018. It imposes an excise tax—at the corporate income tax rate, currently 21 percent—on two specific categories of pay made by certain tax-exempt organizations:
- Remuneration in excess of $1 million paid to a "covered employee" during the taxable year.
- Excess parachute payments to a covered employee triggered by separation from employment.
The policy idea was to mirror, on the nonprofit side, the cap on deductibility of compensation over $1 million that for-profit public companies face under Section 162(m). For-profit employers lose the deduction; nonprofits, which already pay no income tax, instead pay a flat 21 percent excise tax. The math is meant to land in roughly the same place.
The catch is that nonprofits are not used to thinking like taxable corporations. Hospitals, universities, large research institutes, and complex foundation structures often spread compensation across multiple related entities, pay physicians and clinicians, and use deferred compensation arrangements that vest in lumpy chunks. Section 4960 reaches into all of that.
Which Organizations Are on the Hook
Section 4960 applies to "applicable tax-exempt organizations," or ATEOs. An ATEO is any organization that for the taxable year is one of the following:
- Exempt from tax under Section 501(a) (the broad pool that includes 501(c)(3) charities, 501(c)(4) social welfare organizations, 501(c)(6) trade associations, and so on)
- A farmers' cooperative described in Section 521(b)(1)
- An entity with income excluded from tax under Section 115(1) (typically state and local government instrumentalities)
- A political organization described in Section 527(e)(1)
Public colleges and state hospitals can qualify as ATEOs under the Section 115(1) prong even when they are not technically 501(c)(3) charities. That single line drags much of the public university system into the rule.
Related organizations get aggregated
A nonprofit cannot dodge Section 4960 by routing payroll through a captive for-profit subsidiary or a separate management company. The final regulations require remuneration from "related organizations" to be aggregated with what the ATEO pays directly.
For Section 4960 purposes, two entities are "related" under a controlled-group-style test, but the threshold is 50 percent rather than the usual 80 percent used elsewhere in the Code. That means even minority-controlled affiliates can be pulled in. For a university with a captive medical practice plan, a research foundation, and a real-estate-holding LLC, the aggregation can produce a much larger compensation pool than the parent's own books suggest.
The 21 Percent Excise Tax: How the Math Works
There are two separate triggers, and an ATEO may owe tax under both for the same employee in the same year.
Trigger 1: Excess remuneration over $1 million
For each covered employee, total all "remuneration" the ATEO and its related organizations paid during the taxable year. If that total exceeds $1 million, the excess is taxed at 21 percent.
"Remuneration" for this purpose is essentially the same wage base that applies to Section 162(m), with one twist: deferred compensation is generally included as it vests, not as it is paid. So a phantom-stock-style retention package that vests in year five can produce a single year of $1.5 million reported pay even if the employee receives the cash later.
A few items are excluded from remuneration:
- Roth IRA-equivalent designated Roth contributions to certain retirement plans
- Compensation paid to a licensed medical professional for medical or veterinary services (more on this below)
Trigger 2: Excess parachute payments
Section 4960 also borrows from the for-profit golden-parachute rules of Section 280G. If a covered employee separates from employment and receives separation-contingent compensation that has a present value equal to or greater than three times the employee's "base amount," the entire excess over the base amount is treated as an excess parachute payment.
The base amount is generally the employee's average compensation over the five completed calendar years before separation (or fewer years if the employee was there a shorter time). When parachute payments cross the 3x threshold, the excise tax applies to the difference between the parachute payments and the base amount allocated to those payments. There is no $1 million floor for this trigger; it can apply at much lower compensation levels for an employee who has been at the organization a short time.
The medical-services exception
Compensation paid to a licensed medical professional for the actual delivery of medical or veterinary services is excluded from the Section 4960 calculation. The exception is one of the few real reliefs in the rule, and it is critical for hospitals.
In practice, hospitals must split a physician's pay between clinical and administrative components. A chief medical officer who spends 30 percent of her time seeing patients and 70 percent running departments will have only the 30 percent excluded; the rest counts. The IRS expects a "reasonable, good-faith" allocation, but in audits it will press on the supporting time records. Hospitals that fail to track these allocations contemporaneously often end up with a much larger taxable base than they expected.
Who Counts as a "Covered Employee" — The Big OBBBA Change for 2026
This is where the 2026 landscape shifts. Originally, a "covered employee" was any employee who, in the current or any prior year going back to 2017, was one of the ATEO's five highest-compensated employees. Once on the list, an employee stayed on the list for life. That meant a long-tenured organization could end up with a roster of 15 or 20 covered employees by tracking former CEOs, CFOs, and other executives over the years.
OBBBA Section 70416 dramatically expanded that definition. Effective for taxable years beginning after December 31, 2025—so the 2026 calendar year for most organizations—a "covered employee" now means any individual who was employed by the ATEO at any time after December 31, 2016, regardless of whether the person was ever in the top five.
That single change blows past the original "five executives" framing. For a large hospital system or research university, the number of covered employees may now run into the thousands. Practically, the rule still only matters for individuals who actually receive more than $1 million from the ATEO and its related organizations in a year, but the gating function of "top five" is gone.
The downstream effect is that organizations with multiple seven-figure earners—academic medical centers, sports-program-rich universities, large endowed foundations—will see their excise-tax base grow. A hospital with eight $1.2 million earners under the old rule paid tax on roughly $1 million of excess pay (the top five). Under the new rule, the same hospital pays tax on roughly $1.6 million.
The AICPA has formally asked the IRS for transition guidance on how the OBBBA expansion interacts with the existing limited-hours, nonexempt-funds, and limited-services exceptions, and for explicit relief so unpaid volunteers are not pulled in as covered employees. As of the 2026 filing season, that guidance has not been issued, so organizations should plan around the statute as written.
The Three Key Exceptions That Survive (For Now)
The final regulations issued in 2021 include three exceptions that prevent compensation paid by related organizations from inappropriately spilling into the ATEO's calculation:
Limited Hours Exception
An employee is excluded if the ATEO and other related tax-exempt organizations pay them nothing for ATEO services and the employee performs ATEO services for no more than 10 percent of total work hours, or no more than 100 hours per year. Common use case: a for-profit affiliate's CFO who serves on the ATEO board with minimal time commitment.
Nonexempt Funds Exception
Similar to the limited-hours exception but with more headroom—the employee can spend up to (but less than) 50 percent of working time on the ATEO, as long as no portion of the compensation comes from exempt funds.
Limited Services Exception
An employee is excluded if the ATEO paid less than 10 percent of the employee's total remuneration across the ATEO and related organizations. There is a tie-breaker: if no ATEO crosses the 10 percent line, the rule still applies to the ATEO that paid the most.
These exceptions become more important under the OBBBA expansion because the universe of potential covered employees is now much larger. Documenting which employees qualify for an exception is now a substantive compliance task, not a one-time spreadsheet exercise.
Reporting and Paying the Tax: Form 4720
The Section 4960 excise tax is reported on Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code, on Schedule N.
A few mechanical points trip up first-time filers:
- Same due date as Form 990. Form 4720 is due the 15th day of the fifth month after the close of the organization's taxable year (May 15 for calendar-year filers). It picks up the same six-month extension as the Form 990 if extended on Form 8868.
- Tax must be paid by the original due date. An extension to file is not an extension to pay. Interest and underpayment penalties accrue from the original due date.
- Both the ATEO and the related organization can file. When compensation comes from multiple related organizations, each related organization may file its own Form 4720 and pay its allocable share, or the ATEO may report and pay the entire amount. Coordination matters; double-payment or under-payment both happen.
- Penalties for late filing or payment track the standard Section 6651 framework: 5 percent per month for late filing (capped at 25 percent), and 0.5 percent per month for late payment.
Most large nonprofits and hospitals should treat Form 4720 as a parallel return to the 990, not a side schedule.
The Documentation Work Nonprofits Should Do Now
The OBBBA expansion creates a meaningful compliance lift. Three steps will save organizations the most pain:
1. Build a roster of every employee who ever crossed the threshold
Identify every person who, at any point since January 1, 2017, was paid more than $1 million by the ATEO and its related organizations in a single taxable year. That roster is now the working list of "covered employees" for Section 4960 going forward, plus any new joiners who clear the threshold.
2. Map the related-organization perimeter
For each affiliated entity—captive professional services group, real-estate LLC, supporting organization, foreign affiliate—run a fresh 50-percent-control test under the Section 4960 aggregation rules. This perimeter often has not been refreshed since the original 2021 final regulations, and reorganizations, new joint ventures, or recent affiliations can add or remove entities from the group.
3. Document medical-services allocations contemporaneously
For hospital systems, the medical-services exception is the single largest reduction in the taxable base. Allocations between clinical and administrative time should be supported by contemporaneous time records, written job descriptions, and consistent year-over-year methodology. Reconstructing this after the fact during an audit rarely goes well.
Why Accurate Bookkeeping Matters Here
Section 4960 sits at the intersection of payroll, deferred compensation, related-party transactions, and tax-exempt reporting. The calculation depends on tracking remuneration across multiple entities, splitting clinician pay between clinical and administrative roles, and reconciling deferred compensation that vests in one year but pays in another.
When records live in disconnected systems—payroll in one platform, deferred compensation tracked in a spreadsheet, intercompany allocations buried in a chart of accounts that does not match the related-organization perimeter—the Section 4960 number gets reconstructed from memory at year-end. That is when errors creep in. Accurate, transaction-level books that tag each compensation event by entity, employee, and category are what make the eventual Form 4720 calculation a five-minute exercise instead of a five-week scramble.
For organizations that want a clear audit trail, plain-text accounting offers something many off-the-shelf nonprofit tools do not: every entry is human-readable, version-controlled, and queryable. When the IRS asks why $1,287,432 was reported as remuneration for a particular covered employee, the underlying transactions—and the reasoning behind every allocation—should be one query away.
Common Mistakes That Trigger Section 4960 Surprises
A few patterns show up repeatedly in practice:
- Treating deferred comp as paid when received, not when vested. Section 4960 generally follows vesting, not cash payment. A four-year vesting cliff can produce a $2 million spike in a single year of "remuneration" even if the employee took home a quarter of that.
- Forgetting to aggregate related-organization pay. Leaving out compensation from a captive practice group or a separate research institute is one of the most common audit findings.
- Over-claiming the medical-services exception. Hospitals sometimes treat 100 percent of a physician executive's pay as exempt when the executive spends substantial time on administration. The IRS pushes back on these allocations.
- Missing the parachute trigger entirely. A separation package that crosses 3x the base amount can produce excise tax even if the executive never crossed $1 million in any single year of employment.
- Stale covered-employee lists. Under the OBBBA expansion, organizations need to re-baseline their covered-employee roster for the 2026 tax year and beyond. Lists built under the old "top five plus prior years" framework will undercount.
Looking Ahead: Possible Future Changes
The OBBBA expansion has drawn pushback from the nonprofit sector, particularly from health systems and higher education associations. The AICPA has formally requested transition relief and clarifying guidance. Several proposals would exempt unpaid volunteers and clergy compensation, extend the existing related-organization exceptions to the broader covered-employee base, and provide fiscal-year filers with a pro-rated transition.
Whether any of that guidance materializes in time for 2026 returns is uncertain. Organizations should plan based on the statute as enacted and treat any subsequent relief as upside.
Keep Your Nonprofit's Financial Records Audit-Ready
Section 4960 compliance ultimately depends on whether your books can support every line of the calculation when the IRS asks. Plain-text accounting with Beancount.io gives nonprofits a transparent, version-controlled ledger where every transaction—payroll runs, deferred compensation accruals, intercompany allocations, and medical-services splits—is human-readable and queryable. Get started for free and see why finance teams at mission-driven organizations are moving to plain-text accounting.