Not-for-profit pay faces broader tax risk

Not-for-profit organizations have spent the past several years engaged in a difficult balancing act. They are competing for talent in a tight labor market while also managing donor expectations, operational demands, and increasing scrutiny from regulators and the public.

Now, another issue is moving higher on the list of concerns: the expanded reach of Sec. 4960 under H.R. 1, P.L. 119-21, commonly referred to as OBBBA. This development increases the risk for affected not-for-profit organizations that compensation paid to one or more employees may each exceed Sec. 4960’s $1 million threshold, exposing those organizations to an excise tax on that excess at the corporate income tax rate.

When Sec. 4960 was first enacted in 2017 as part of the Tax Cuts and Jobs Act, P.L. 115-97, many not-for-profit leaders viewed it as a fairly limited rule. The provision imposed a 21% excise tax on remuneration over $1 million paid to any highly compensated employee of an applicable tax-exempt organization (ATEO). The statute focused primarily on an organization’s five highest-paid employees.

H.R. 1 expanded the excise tax’s scope for tax years beginning after Dec. 31, 2025, by removing the annual limitation that restricted newly covered employees to the organization’s five highest-compensated employees. As a result, subject to certain exceptions, any individual who is an employee of an ATEO during a tax year beginning after Dec. 31, 2025, is generally a covered employee.

Also, any individual who was an employee of an ATEO in any tax year beginning after Dec. 31, 2016, and on or before Dec. 31, 2025, remains a covered employee if the individual was one for a tax year under prior law (Sec. 4960(c)(2); Notice 2026-36). If the compensation paid to a covered employee exceeds $1 million, the organization may be subject to the Sec. 4960 excise tax on the excess.

In many respects, the revised statute brings Sec. 4960 closer to the executive compensation framework applicable to publicly held for-profit corporations under Sec. 162(m). Although the two provisions operate differently — Sec. 162(m) generally limits an employer’s compensation deduction while Sec. 4960 imposes an excise tax on excess compensation paid to an ATEO’s covered employees — both now can apply to the compensation of current and former employees who are covered employees.

After H.R. 1, not-for-profit organizations are realizing that the Sec. 4960 excise tax may apply far more broadly than expected. It is becoming increasingly important for professionals involved in compensation, payroll, finance, governance, or compliance to understand how the revised rules work.

SEC. 4960′s APPLICABILITY

Sec. 4960 imposes a 21% excise tax on two categories of compensation paid by an ATEO:

1. Remuneration exceeding $1 million paid to a covered employee during the tax year.
2. Certain excess parachute payments made in connection with a covered employee’s separation from employment.

Notice 2026-36, issued June 5, 2026, affirmed the IRS’s intention to issue proposed regulations similar to pre-H.R. 1 Regs. Secs. 53.4960-1(d)(2)(ii) and (iii), preserving an exemption from covered-employee status for individuals serving limited hours or paid from nonexempt funds.

ATEOs include any organization that for the tax year is either tax-exempt under Sec. 501(a); is a farmers’ cooperative organization under Sec. 521(b)(1); has income excluded from tax under Sec. 115(1) (income derived from any public utility or the exercise of any essential governmental function and accruing to a state, any political subdivision of a state, or the District of Columbia); or is a political organization described in Sec. 527(e)(1) (Sec. 4960(c)(1)).

The tax applies not only to remuneration paid directly by the exempt organization itself but also to amounts paid by related organizations, including taxable subsidiaries, supporting organizations, and certain other affiliated entities. The tax is reported and paid on Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code.

THE $1 MILLION THRESHOLD

Sec. 4960’s definition of “remuneration,” unchanged by H.R. 1, is broader than many people assume. The analysis of whether an employee earns more than $1 million does not stop with base salary.

Depending on the circumstances, remuneration may also include bonuses; deferred compensation that vests during the year; incentive compensation; and compensation paid through related entities. In practice, an employee whose annual salary falls well below $1 million may still exceed the threshold once other items included in remuneration are taken into account.

Organizations with complex affiliate structures may face the greatest challenges. Health systems, universities, research institutions, and large social service organizations often compensate employees through multiple related entities. Physicians, investment professionals, athletic personnel, development executives, and specialized administrators may all fall within the expanded definition of covered employees.

However, the remuneration of licensed medical professionals does not include remuneration paid for the performance of medical services (Sec. 4960(c)(3)(B)). ATEOs will want to take the related-organization and predecessor-organization rules and their effect on remuneration into consideration when evaluating mergers and acquisitions.

For some organizations, the administrative burden alone may become substantial.

THE PRESSURE TO RECRUIT AND RETAIN TALENT

Not-for-profits continue to compete with private-sector employers for highly specialized talent.

In many markets, especially high-cost metropolitan areas, organizations have little choice but to offer substantial compensation packages to recruit and retain experienced executives, physicians, legal counsel, development officers, and technical professionals. At the same time, compensation levels that once seemed exceptional within the not-for-profit sector are becoming more common.

A significant Sec. 4960 liability tied to executive compensation may prompt difficult questions about organizational priorities, even when compensation decisions are supported by market data and legitimate operational needs. Not-for-profits across the country continue to face challenges in retaining rank-and-file staff members because of workload demands and concerns about pay equity.

In that environment, large executive compensation packages that trigger excise tax exposure and that may also be disclosed on Form 990, Return of Organization Exempt From Income Tax, can create morale issues internally or complicate conversations about budget limitations.

For not-for-profit leadership, Sec. 4960 presents more than a tax issue. It increasingly involves governance, optics, employee relations, and public perception.

In addition, organizations should expect greater scrutiny from regulators, media outlets, and stakeholders as executive compensation in the not-for-profit sector continues to draw public attention.

HOW ORGANIZATIONS ARE RESPONDING

As ATEOs work through the new Sec. 4960 regime, the boards of directors of many are reevaluating how compensation arrangements are structured. Deferred compensation has become an important area of focus.

Sec. 4960 generally treats vested deferred compensation as remuneration in the year of vesting. Therefore, organizations are reviewing supplemental executive retirement plans, retention agreements, and incentive compensation arrangements to better understand when amounts may be treated as remuneration for Sec. 4960 purposes.

Performance-based compensation is also receiving increased attention. Similar to publicly held corporations under Sec. 162(m) since the TCJA eliminated the general exception for qualified performance-based compensation, exempt organizations should not assume that compensation tied to individual or organizational performance falls outside the analysis.

Annual incentive bonuses, long-term incentive awards, and other performance-based arrangements may constitute remuneration under Sec. 4960, and deferred performance awards may be treated as remuneration when they vest. As a result, ATEOs are increasingly reviewing not only the amount of executive compensation but also the timing and structure of performance-based awards.

Some ATEOs are exploring whether compensation arrangements can be structured so that amounts vest over multiple years to avoid large vesting events that push remuneration above the threshold in a single year. Others are revisiting bonus structures or reconsidering the design of long-term incentive arrangements.

Compensation paid through related organizations is receiving closer attention as well. As noted above, the related-organization rules under Sec. 4960 can create unexpected exposure when employees receive remuneration from multiple affiliated entities.

For example, an executive may receive compensation from both a not-for-profit parent organization and a taxable subsidiary. Standing alone, neither payment may exceed $1 million. When combined, however, the aggregate remuneration may exceed $1 million and trigger the excise tax.

Separation agreements and benefits arrangements are also being reviewed more carefully, particularly where the Sec. 4960 parachute payment rules may apply.

In many situations, organizations are not necessarily trying to eliminate the tax entirely. Instead, they are trying to avoid surprises and make informed decisions about the financial impact of compensation arrangements.

STEPS ORGANIZATIONS MAY CONSIDER NOW

Not-for-profit organizations should work proactively to identify issues under the new rules before they arise.

First, organizations may wish to identify employees whose compensation could approach or exceed the $1 million threshold and employees who exceeded the threshold in past years going back to 2017. That review should extend beyond salary alone and include deferred compensation, bonuses, retention payments, and compensation paid by related entities.

Second, ATEOs can assess how compensation data is tracked across affiliated organizations. In many cases, payroll and human resources systems operate independently among related entities, making it difficult to calculate aggregate remuneration accurately for Sec. 4960 purposes.

Third, organizations should review deferred-compensation arrangements and vesting schedules carefully. Understanding when compensation becomes vested and taxable under Sec. 4960 is essential for forecasting future liabilities.

Fourth, not-for-profits should coordinate with tax advisers, auditors, payroll providers, and legal counsel regarding reporting obligations and compliance procedures. Sec. 4960 liabilities are generally reported on Form 4720, and organizations should confirm that responsible personnel understand the filing requirements.

Finally, organizations should document their compensation review process thoughtfully. Although Sec. 4960 does not prohibit high levels of compensation, compensation decisions may still be scrutinized by donors, regulators, employees, and the public. Also, as mentioned above, many organizations must file Form 990, and this information would be available to the public. Clear documentation demonstrating a deliberate compensation review process and rationale may help organizations address those concerns more effectively.

ATEOs should also recognize that Sec. 4960 exposure may fluctuate significantly from year to year depending on vesting schedules, retention incentives, or executive turnover. Compensation planning is becoming less of an annual reporting exercise and more of an ongoing governance issue that requires coordination among boards of directors, finance teams, legal counsel, and human resources professionals.

LOOKING AHEAD

The expansion of Sec. 4960 under H.R. 1marks a meaningful shift for the not-for-profit sector. An excise tax that was formerly based on the compensation an organization paid to its five highest-earning executives may now depend on a much wider group of employees.

For ATEO leaders, the challenge will be finding the right balance between maintaining competitive compensation practices and managing growing tax exposure, administrative complexity, and stakeholder scrutiny.

Organizations that diligently review compensation arrangements, improve internal tracking systems, and coordinate across departments will likely be in a far stronger position under the new rules.

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About the author

Andrew Dorado, J.D., LL.M., is senior counsel at Liebert Cassidy Whitmore in Los Angeles. To comment on this article or to suggest an idea for another article, contact Jeff Drew at Jeff.Drew@aicpa-cima.com.

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