Tax-Exempt Organizations — Amended Rules On Excise Tax On Compensation Over $1 Million Take Effect January 1, 2026

Beginning with taxable years that start after December 31, 2025, changes to section 4960 of the Internal Revenue Code (IRC) will take effect that may substantially affect tax-exempt organizations, such as certain colleges and universities, corporate foundations, private foundations, other 501(c)(3) organizations, and their related entities. These changes were included in this summer's reconciliation act (commonly referred to as the One Big Beautiful Bill Act or OBBBA), amending section 4960, which the 2017 Tax Cuts and Jobs Act (TCJA) originally enacted. Because section 4960 aggregates remuneration across an applicable tax-exempt organization (ATEO) and all "related organizations," it is essential for ATEOs and their related organizations to reassess organizational relationships and compensation flows under the amended rules given the expanded definition of a "covered employee" for purposes of this tax.

Expanded 4960 Executive Compensation Tax

As adopted under the TCJA, section 4960 imposes a 21% excise tax on the sum of (i) remuneration in excess of $1 million paid by an ATEO and its related organizations to the ATEO's five highest-compensated employees who are "covered employees" and (ii) any excess parachute payments to a covered employee. Remuneration is treated as paid when it is no longer subject to a substantial risk of forfeiture (generally at vesting), and remuneration paid by related organizations, including related for-profit organizations, is aggregated with remuneration paid by the ATEO itself.

Under the OBBBA, the definition of "covered employee" is expanded from "the five highest‑compensated employees" in the relevant tax year, plus anyone who was ever a covered employee after 2016, to any individual who was employed by the ATEO at any time after December 31, 2016, regardless of position, current employment status, or whether they are one of the five highest‑compensated employees in a given tax year. In practical terms, any such individual's remuneration over $1 million (aggregated across the ATEO and its related organizations) will now be subject to the excise tax, and the number of covered employees is expected to grow significantly. These changes apply to taxable years beginning after December 31, 2025 (January 1, 2026, for calendar‑year organizations).

What does not change under section 4960: (i) the excise tax rate continues to equal the prevailing corporate tax rate (currently 21%); (ii) the medical‑services exclusion still applies to the portion of remuneration paid to licensed medical professionals for performing medical/veterinary services; and (iii) the rules for identifying and taxing "excess parachute payments" remain unchanged.

"Related Organization" and Aggregation: Key for 2026 Exposure Analysis

A "related organization" includes a person or governmental entity that controls, is controlled by, or is controlled by the same persons as the ATEO, as well as supported or supporting organizations (and, for voluntary employees' beneficiary associations, contributors). Control for nonstock organizations generally exists if more than 50% of the trustees/directors are representatives of, or directly/indirectly controlled by, the person or entity; attribution principles under IRC section 318 apply in determining control through chains of entities. Compensation paid by a related organization is treated as remuneration paid by the ATEO for purposes of section 4960, and liability for the tax is allocated among employers pro rata based on how the remuneration is paid.

While the definition of a "related entity" is not changing, more instances of compensation paid by a related entity to any employee of an ATEO may now be subject to the excise tax, especially if certain exceptions included in applicable Treasury regulations no longer apply.

Regulatory Exceptions: Status and Uncertainties Post‑OBBBA

Prior to the OBBBA, the final Treasury regulations provided three important exceptions used to determine the ATEO's five highest‑compensated employees: the "limited hours," "nonexempt funds," and "limited services" exceptions. Because the OBBBA's expanded "covered employee" definition is no longer limited to the five highest‑compensated employees, the applicability of these exceptions is uncertain pending regulatory guidance. Until clarified, organizations should avoid assuming that prior exceptions remove individuals from the expanded covered‑employee population.

The Treasury Department and the IRS are expected to issue guidance on the amended scope of section 4960 and clarify whether and how exceptions apply under the new rules. Until proposed guidance is issued, however, tax-exempt organizations and their related organizations may consider taking the following actions:

1. Conduct a historical review back to 2017. Identify any individuals who were employed by the ATEO at any time after December 31, 2016, and whose aggregated remuneration could exceed $1 million (including vested nonqualified deferred compensation and amounts paid by related organizations).
2. Evaluate whether organizations are related. Inventory corporate affiliates, foundations, supporting/supported organizations, and entities under common control, including for-profit organizations; document control pathways (including control of board appointments) and apply attribution rules as needed; and analyze whether organizations are related for purposes of section 4960, noting that this relatedness test differs from others applicable to tax-exempt organizations.
3. Coordinate across related entities. Collaborate with corporate affiliates, foundations, and supporting organizations to assess shared exposure and ensure consistent tracking of covered employees.
4. Analyze compensation architecture. Examine current employment and compensation arrangements, especially those for employees who have moved between related entities, and assess total remuneration paid as aggregated between all related entities. Review employment agreements, severance arrangements, window programs, and nonqualified deferred compensation to model potential 4960 exposure.
5. Build internal compliance protocols. Develop or enhance internal systems to track and document remuneration paid across related entities for compliance and audit readiness.
6. Board and committee briefings. Brief compensation committees, audit committees, and/or the board of directors on OBBBA changes, transitional risk in 2026, and the need for coordinated governance across related organizations.

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