What Is the Section 4960 Excise Tax?

The Tax Cuts and Jobs Act of 2017 introduced Section 4960 to the Internal Revenue Code, establishing a new excise tax on certain tax-exempt organizations. This tax targets organizations that provide substantial compensation to their highest-paid employees. The law imposes a 21 percent tax on the organization for compensation exceeding specific thresholds. This provision was designed to create parity between tax-exempt and for-profit entities, which have their own limitations on deducting executive compensation. The tax applies to tax years beginning after December 31, 2017, and the organization, not the employee, is responsible for payment.

Determining Applicability

The first step is to determine if an organization is an “Applicable Tax-Exempt Organization” (ATEO). This category is broad and includes:

• Any organization exempt from taxation under Internal Revenue Code Section 501, such as charities and social welfare organizations.
• Farmers’ cooperative organizations under Section 521.
• Certain governmental entities with income excluded under Section 115.
• Political organizations described in Section 527.

An ATEO must aggregate the compensation paid to an employee from all related entities, which can include for-profit companies, to determine if the tax thresholds are met. This aggregation prevents organizations from avoiding the tax by spreading compensation across multiple related entities. If multiple organizations pay a single employee, the liability for the tax is prorated among them based on the proportion of remuneration each paid.

Once an organization confirms it is an ATEO, it must identify its “covered employees.” For current and prior tax years, a covered employee is one of the organization’s five highest-compensated employees for the taxable year. For tax years beginning after December 31, 2025, this definition will expand to include any current or former employee who earns over $1 million annually. This determination is made for each ATEO within a related group, meaning a group of related organizations could have more than five covered employees in total.

The rules also include a “lookback” provision. Once an individual is identified as a covered employee for any taxable year beginning after December 31, 2016, they remain a covered employee for all future years. This means an organization must continue to track compensation for these individuals even if they are no longer one of the top five earners in a subsequent year. This permanent status ensures that large, deferred payments in later years are still subject to the tax.

Identifying Taxable Compensation

The excise tax is triggered by two distinct types of payments: remuneration and excess parachute payments.

Remuneration

“Remuneration” is defined broadly and encompasses most forms of compensation paid to a covered employee, including regular salary, bonuses, and the cash value of most non-cash benefits. The definition references wages as defined under Internal Revenue Code Section 3401 and includes amounts that become taxable under Section 457 deferred compensation rules.

Compensation is not counted toward the tax until it has vested, meaning it is no longer subject to a “substantial risk of forfeiture.” For example, if an executive is promised a $200,000 bonus that only pays out if they remain employed for three more years, that amount is not considered remuneration until the service condition is met. This vesting rule means the tax can apply to compensation earned in years before the law was effective if it vested after December 31, 2017.

Excess Parachute Payments

The second trigger is an “excess parachute payment.” A parachute payment is compensation that is contingent on an employee’s separation from employment. These are often associated with severance packages or payments triggered by a change in control of the organization. The payment becomes “excess” and subject to the tax only if the total amount equals or exceeds three times the employee’s “base amount.”

The base amount is calculated by averaging the employee’s annualized compensation over the five most recent taxable years ending before the date of separation. If a parachute payment is three times this base amount, the portion of the payment that exceeds one time the base amount is the “excess parachute payment.” For instance, if an employee’s base amount is $300,000 and they receive a $1,000,000 severance payment, the excess parachute payment would be $700,000 ($1,000,000 payment – $300,000 base amount).

Calculating the Excise Tax

The excise tax rate is fixed at the current corporate tax rate, which is 21 percent. The tax is applied to the sum of two separate components: remuneration over $1 million and any excess parachute payments.

For the first component, the tax is calculated on the amount of remuneration paid to a covered employee that exceeds $1 million in a taxable year. For example, if a covered employee receives $1.5 million in vested remuneration during the year, the organization would owe tax on $500,000. The resulting excise tax liability would be $105,000 ($500,000 x 0.21).

For the second component, the tax is calculated directly on the amount determined to be an excess parachute payment. Using the previous example, if an employee received a $700,000 excess parachute payment, the tax would be $147,000 ($700,000 x 0.21). The organization would be liable for this amount in addition to any tax owed on remuneration exceeding $1 million.

To prevent double taxation, the rules specify that any remuneration that is part of an excess parachute payment is not also counted toward the $1 million threshold for regular remuneration. The final liability for the organization is the sum of the tax calculated on excess remuneration and the tax calculated on any excess parachute payments.

Reporting and Paying the Tax

The excise tax must be reported on IRS Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code. The specific calculations and reporting for the Section 4960 tax are detailed on Schedule N.

The filing deadline for Form 4720 is determined by the organization’s fiscal year. The return is due by the 15th day of the 5th month after the end of the organization’s taxable year. For an organization with a calendar year-end of December 31, the due date would be May 15 of the following year.

The form can be filed electronically or mailed to the address specified in the form’s instructions. Any tax due must be paid by the filing deadline. Payments can be made through the Electronic Federal Tax Payment System (EFTPS) or by mailing a check or money order with the return.