IRC 4960: Tax on Excess Compensation for Tax-Exempt Organizations

The IRS imposes an excise tax on certain compensation paid by tax-exempt organizations to their highest-paid employees. Established under Internal Revenue Code (IRC) Section 4960, this rule addresses concerns about excessive pay at nonprofits and tax-exempt entities.

Entities Subject to the Excise Tax

Organizations affected by IRC Section 4960 include those exempt from federal income tax under Section 501(a), such as charities, private foundations, and social welfare organizations. Certain governmental entities claiming tax-exempt status under Section 115(1) or maintaining 501(c)(3) status, including public universities and hospitals, must also assess their compensation structures for potential liability.

Related organizations must be considered. If an entity is affiliated with or controls a tax-exempt organization, it may need to include compensation paid to shared employees when determining liability. This is especially relevant for large healthcare systems, university networks, and other complex nonprofits where executives receive compensation from multiple entities.

For-profit entities are generally exempt, but if they are part of a controlled group that includes a tax-exempt organization, they may still be implicated. The IRS applies aggregation rules to ensure compensation across related entities is properly accounted for, preventing organizations from avoiding the tax by splitting payments among multiple entities.

Covered Employees

IRC Section 4960 applies to highly compensated individuals within tax-exempt organizations.

Compensation Threshold

A covered employee is one of the five highest-compensated employees of the organization for the current tax year. There is no minimum salary requirement—designation is based solely on ranking within the organization’s pay structure. Once identified, an individual retains covered employee status indefinitely, even if they later fall outside the top five earners. Over time, an organization may accumulate more than five covered employees, increasing the likelihood of triggering the excise tax.

Compensation includes wages subject to federal income tax withholding, such as salary, bonuses, and certain fringe benefits. Deferred compensation is counted when it vests, not when it is paid. A large deferred compensation payout in a given year could elevate an executive into the top five earners, even if their regular salary is lower. Organizations must track all forms of remuneration to ensure accurate identification of covered employees.

Excess Payment Determination

The excise tax applies to compensation exceeding $1 million in a tax year and certain excessive parachute payments. The $1 million threshold includes taxable wages, bonuses, and vested deferred compensation but excludes employer contributions to qualified retirement plans and certain other benefits. Any amount exceeding this limit is taxed at 21%.

Parachute payments refer to compensation provided due to an employee’s separation from service, such as severance packages or lump-sum payouts from deferred compensation plans. A parachute payment is excessive if it equals or exceeds three times the employee’s average annual compensation over the previous five years. The portion exceeding one times the average annual compensation is subject to the excise tax.

For example, if an executive’s five-year average annual compensation is $500,000 and they receive a severance package of $1.8 million:

1. Three times the average annual compensation: $500,000 × 3 = $1.5 million
2. Excess portion: $1.8 million – $500,000 = $1.3 million
3. Taxable amount: $1.3 million × 21% = $273,000 excise tax

Organizations must structure compensation agreements, particularly severance packages and deferred compensation arrangements, to minimize tax liabilities.

Aggregation Rules

To prevent organizations from avoiding the excise tax by distributing compensation across multiple entities, the IRS applies aggregation rules. If an employee works for multiple related organizations, their total compensation from all entities must be combined when determining whether they exceed the $1 million threshold or receive an excess parachute payment.

Entities are considered related if they have common control or significant financial interdependence, including parent-subsidiary relationships, organizations under common management, and entities sharing board members or executives. For example, if a hospital executive receives $700,000 from a nonprofit hospital and $400,000 from a related research foundation, their total compensation of $1.1 million is subject to the excise tax on the excess $100,000.

Proper documentation and coordination between related organizations are necessary to ensure compliance and avoid unexpected tax liabilities.

Calculating the Tax

Determining the excise tax under IRC Section 4960 requires assessing total compensation, including base salary, bonuses, vested deferred compensation, and other taxable benefits. Since this tax applies to amounts exceeding $1 million in a given tax year, organizations must ensure accurate calculations.

The timing of compensation recognition plays a key role. Certain payments—such as those from nonqualified deferred compensation plans—may not be taxed when earned but rather when they vest, potentially pushing an employee’s total compensation above the threshold unexpectedly.

Applying the 21% excise tax to the portion exceeding $1 million determines tax liability. For example, if a nonprofit hospital pays its CEO $1.3 million in taxable compensation for the year, the excess amount subject to tax is $300,000. Applying the 21% rate results in a tax liability of $63,000.

This calculation becomes more complex when employees receive compensation from multiple related entities, as total earnings must be aggregated before determining the taxable amount. Organizations must maintain a consolidated view of executive pay structures to avoid miscalculations. Deferred compensation plans should be structured to spread out vesting periods, minimizing tax exposure in any single year.

Reporting Requirements

Organizations subject to the excise tax must ensure accurate reporting to comply with IRS regulations. The tax is reported on Form 4720, “Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code.”

Form 4720 must be filed by the 15th day of the fifth month following the end of the organization’s tax year. For calendar-year filers, this means a May 15 deadline. Organizations may request a six-month extension by filing Form 8868, but this applies only to filing, not to tax payment. Taxes must still be paid by the original due date to avoid interest and penalties.

Beyond Form 4720, tax-exempt organizations must ensure that compensation details are correctly reflected in their annual Form 990 filing. The IRS requires detailed disclosures on Schedule J, which reports executive compensation, deferred compensation arrangements, and other benefits provided to highly paid employees. This public disclosure increases scrutiny from regulators, donors, and stakeholders, making accurate reporting essential.

Penalties for Noncompliance

Failing to comply with IRC Section 4960 can result in financial penalties and increased IRS scrutiny. Organizations that underreport or fail to pay the required excise tax may be subject to interest charges and late payment penalties. The IRS generally imposes a failure-to-pay penalty of 0.5% of the unpaid tax per month, up to a maximum of 25% of the total amount due. If an organization also fails to file Form 4720 on time, an additional penalty of 5% of the unpaid tax per month may apply, with a maximum penalty of 25%.

Noncompliance can also trigger audits. The IRS has increased its focus on executive compensation within tax-exempt organizations, particularly when compensation structures appear to circumvent the intent of the law. If an audit reveals significant underreporting or intentional misclassification, additional penalties may be imposed, including accuracy-related penalties of 20% on the underpaid tax. Organizations that repeatedly fail to comply may face heightened scrutiny in future tax years.