Expanded Excise Tax Risk for Nonprofits Paying High Compensation
The Treasury Department and IRS have announced that they intend to issue proposed regulations addressing the excise tax on excess compensation and excess parachute payments paid by applicable tax-exempt organizations. The announcement, issued in Notice 2026-36, follows statutory changes that expanded the reach of Internal Revenue Code section 4960.
This is an important development for nonprofits, hospitals, universities, private foundations, tax-exempt affiliates, supporting organizations, and related entities that pay significant compensation to executives, physicians, investment professionals, athletic personnel, administrators, or other highly compensated employees.
The issue is no longer limited only to the five highest-compensated employees of a tax-exempt organization. Under the expanded rules, the tax may apply more broadly to any employee with compensation exceeding $1 million in a tax year or to an employee who receives an excess parachute payment.
That change can create new tax exposure, governance concerns, reporting obligations, and compensation-planning issues for organizations that may not have previously viewed themselves as subject to section 4960 risk.
The Karam Firm, PLLC assists tax-exempt organizations, businesses, executives, boards, and professional advisors with federal and state tax issues, IRS procedure, penalty exposure, reporting disputes, and tax controversy matters.
What Is Section 4960?
Internal Revenue Code section 4960 imposes an excise tax on certain excess compensation paid by applicable tax-exempt organizations. In general, the tax is imposed at the corporate tax rate on remuneration paid to covered employees in excess of $1 million, and on certain excess parachute payments.
The tax was originally enacted to create a rough parallel to limitations applicable to compensation paid by publicly held corporations. For tax-exempt organizations, however, the rules can be especially complex because compensation may be paid through multiple related entities, taxable affiliates, management companies, medical groups, foundations, governmental entities, or other related structures.
Section 4960 does not merely raise a payroll or executive-compensation issue. It can also create board governance, Form 990 reporting, audit, and controversy concerns.
What Changed?
Before the statutory expansion, section 4960 generally applied to the five highest-compensated employees of an applicable tax-exempt organization for the tax year, as well as individuals who were treated as covered employees in prior years.
The recent change broadens the covered-employee concept. Treasury and the IRS have announced that forthcoming proposed regulations will address the expanded definition and related rules.
Under the expanded framework, organizations may need to identify not only the traditional executive leadership group but also any employee whose compensation may exceed $1 million or who may receive an excess parachute payment.
That change matters. A tax-exempt organization that previously focused only on its top five executives may now need to review a much wider group of employees. This may include physicians, coaches, investment officers, researchers, university administrators, foundation executives, hospital system personnel, and employees compensated through related organizations.
Why This Matters for Tax-Exempt Organizations
The expansion can significantly increase the number of employees who need to be reviewed for section 4960 purposes. For some organizations, the issue may remain limited to a small executive group. For others, especially hospitals, university systems, large foundations, and complex nonprofit networks, the review may be much broader.
Organizations should not assume that compensation reported directly by one tax-exempt employer tells the full story. Section 4960 can require analysis of remuneration paid by related organizations. This means that compensation paid through affiliates, related taxable entities, management structures, disregarded entities, or commonly controlled organizations may need to be reviewed together.
The risk is not just that tax may be due. The risk is that the organization may fail to identify the tax, fail to report it properly, or fail to document the analysis before an IRS examination. Compensation issues can also attract governance scrutiny, particularly where the organization’s board, compensation committee, or audit committee did not consider the excise tax consequences when approving pay arrangements.
Related-Organization Structures Are a Key Risk Area
Many tax-exempt organizations operate through complex structures. A hospital system may include tax-exempt hospitals, taxable subsidiaries, physician groups, supporting organizations, foundations, and management entities. A university may have affiliated foundations, athletic organizations, research entities, medical centers, and investment offices. A private foundation may work through related trusts, family offices, investment vehicles, or operating entities.
These structures can make section 4960 analysis more difficult.
The central question is not always, “What did the exempt organization pay?” The better question may be, “What did the employee receive from the tax-exempt organization and all related entities that must be considered under the statute?”
If compensation is paid by more than one entity, the organization may need to determine whether the amounts are aggregated, how responsibility for the excise tax is allocated, and which entity must report and pay the tax.
This is where organizations can run into problems. Compensation may be tracked by human resources, payroll, accounting, legal, finance, outside payroll providers, or affiliated entities. If those systems are not coordinated, the organization may not identify section 4960 exposure until after the return is filed, or until the IRS asks questions.
Compensation Committees Should Review the Issue Now
The IRS has requested comments by August 4, 2026, and proposed regulations are expected. Tax-exempt organizations should not wait for final regulations before reviewing compensation arrangements.
Boards and compensation committees should consider whether section 4960 has been addressed in the organization’s compensation approval process. This is especially important for organizations that pay high compensation to executives, physicians, coaches, investment professionals, or other specialized employees.
A practical review should consider whether the organization has identified employees who may exceed $1 million in remuneration, whether related-organization payments are tracked, whether employment agreements include severance or parachute-type provisions, whether compensation consultants have considered section 4960, and whether the board minutes reflect appropriate review.
This is not simply a tax return issue. It is a governance and documentation issue.
Excess Parachute Payments Require Special Attention
Section 4960 also applies to certain excess parachute payments. These issues can arise in connection with severance arrangements, executive departures, changes in control, restructuring, leadership transitions, contract terminations, and other separation events.
For tax-exempt organizations, parachute payment analysis may be overlooked because the organization is not thinking in terms of public-company executive compensation rules. But section 4960 can create an excise tax issue even when the organization is otherwise exempt from income tax.
Organizations should review employment agreements, severance plans, deferred compensation arrangements, change-in-control provisions, retention agreements, and separation packages to determine whether excess parachute payment exposure may exist.
This review is particularly important before entering into or modifying executive employment agreements. It is easier to address section 4960 risk during negotiation than after a separation payment has already been made.
IRS Examination and Reporting Risk
Tax-exempt organizations should expect the IRS to pay attention to high compensation, particularly when compensation is disclosed on Form 990 or involves large related-organization systems.
If an organization fails to identify covered employees, fails to aggregate compensation correctly, or fails to report and pay the section 4960 excise tax, the issue may later become part of an IRS examination. That can create tax, penalty, interest, amended-return, governance, and public-disclosure concerns.
For organizations that rely heavily on reputation, donor confidence, public trust, or regulatory relationships, compensation tax issues can have consequences beyond the tax amount itself. A compensation issue may raise questions about internal controls, board oversight, and whether the organization properly evaluated tax compliance before approving compensation.
The Karam Firm can assist tax-exempt organizations and professional advisors in reviewing potential federal tax exposure, responding to IRS inquiries, evaluating penalty issues, and developing a strategy if reporting concerns are identified.
Which Organizations Should Pay Attention?
The expanded section 4960 rules may be relevant to many types of organizations, including:
Hospitals and health systems.
Universities and colleges.
Private foundations.
Large public charities.
Research organizations.
Tax-exempt health care affiliates.
Supporting organizations.
Tax-exempt entities with related taxable subsidiaries.
Organizations with highly compensated physicians, executives, coaches, investment professionals, or administrators.
Organizations with severance, retention, deferred compensation, or parachute-type arrangements.
Smaller organizations may also need to review the issue if they have one or more employees whose compensation may exceed $1 million or if they pay significant separation amounts.
The key point is that the risk turns on compensation and covered-employee status, not merely on the organization’s size.
Practical Steps Before Proposed Regulations Are Issued
Tax-exempt organizations should consider taking several practical steps now.
First, identify all employees who may receive more than $1 million in compensation for the year. This should include compensation paid directly and, where applicable, compensation paid through related entities.
Second, review related-organization structures. Organizations should determine whether compensation data is being captured across all entities that may be relevant under section 4960.
Third, review employment agreements, severance plans, deferred compensation arrangements, retention bonuses, and separation packages for excess parachute payment risk.
Fourth, evaluate whether the organization has a process for determining covered employees and calculating the excise tax.
Fifth, confirm whether the organization’s Form 990, payroll, accounting, legal, and tax reporting functions are aligned.
Sixth, consider whether board or compensation committee minutes should document the review of section 4960 issues when approving high compensation.
Seventh, consider whether comments should be submitted to Treasury and the IRS before the August 4, 2026 deadline.
Taking these steps before proposed regulations are issued can help organizations identify risk, improve documentation, and avoid surprises during return preparation or IRS examination.
What Professional Advisors Should Consider
Accountants, payroll advisors, executive compensation consultants, nonprofit counsel, and benefits professionals should also pay attention to the expanded rules.
An organization may assume that its compensation consultants or payroll providers are addressing section 4960, while those advisors may assume the issue is being handled by tax counsel or return preparers. That type of gap can create reporting errors.
Professional advisors should consider whether clients have high-compensation employees outside the traditional executive group, whether related entities are involved, whether compensation is being aggregated properly, and whether severance or parachute arrangements should be reviewed before payment.
If a potential issue is identified, early legal review may help determine whether the organization has reporting exposure, whether a filing position is supportable, whether corrective action is available, and whether penalties may be avoided or defended.
Why This Is a Tax Controversy Issue
Although Notice 2026-36 is framed as future regulatory guidance, the issue has clear tax controversy implications.
Once the IRS issues proposed and final regulations, organizations may face questions about whether they properly identified covered employees, whether compensation was correctly aggregated, whether excise tax was reported and paid, and whether prior-year filings require review.
If the IRS determines that an organization failed to comply, the organization may face tax, penalties, interest, and amended return issues. In some cases, the dispute may involve statutory interpretation, reasonable cause, reliance on advisors, reporting positions, or the adequacy of the organization’s internal procedures.
The Karam Firm assists clients with these types of tax controversy issues, including IRS examinations, penalty disputes, refund claims, administrative appeals, and federal and state tax procedure.
The Bottom Line
The Treasury Department and IRS have signaled that proposed regulations are coming for the expanded section 4960 excise tax on excess compensation and excess parachute payments paid by applicable tax-exempt organizations.
The change is significant because the covered-employee analysis may now reach beyond the five highest-compensated employees. Organizations may need to evaluate a broader group of employees and consider compensation paid through related organizations.
For nonprofits, hospitals, universities, private foundations, and related entities, this is a good time to review compensation structures, employment agreements, severance arrangements, board approval processes, related-entity payments, and tax reporting procedures.
The organizations that act now will be in a better position to respond when proposed regulations are issued.
Contact The Karam Firm, PLLC
If your organization pays high compensation, has related entities, operates in the nonprofit, health care, education, or foundation sector, or is concerned about potential section 4960 exposure, The Karam Firm, PLLC can help evaluate the tax issues involved.
The firm assists tax-exempt organizations, businesses, executives, and professional advisors with federal and state tax controversy matters, IRS procedure, penalty exposure, reporting issues, administrative appeals, and transaction-related tax disputes.
To discuss a tax issue, contact The Karam Firm, PLLC to determine whether the firm may be able to assist.
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