The One Big Beautiful Bill Act (the “OBBBA”), signed into law on July 4, 2025, expanded the tax on excess tax-exempt organization executive compensation imposed under Section 4960 of the Internal Revenue Code, as amended (the “IRC”). The change affects any applicable tax-exempt organization (“ATEO”) that pays remuneration exceeding $1 million as well as certain excess parachute payments.
As a result, ATEOs should revisit all employee compensation agreements to determine whether certain arrangements will be costlier than expected. In short, the bill widened the pool of employees to whom Section 4960 applies by removing the cap that previously limited the tax to the ATEO’s five highest-compensated employees in current and prior years. Now, the tax applies to any employee (both current and former) paid remuneration above $1 million, effective beginning after December 31, 2025.
Congress initially created Section 4960 when it passed the Tax Cuts and Jobs Act in 2017 (the “TCJA”). In doing so, Congress intended to limit abuse and tax avoidance by mirroring or applying similar concepts to tax-exempt organizations as applied to publicly held corporations under IRC Section 162(m). Primarily driven by public concerns over executive pay, Congress passed both statutes to curb excessive executive compensation for all corporations by making it less tax-advantageous for the companies paying it. It is important for ATEOs to understand the nuances associated with identifying remuneration for purposes of calculating or avoiding the tax altogether.
From the outset, the tax-exempt organization must determine whether it is subject to the statute as an ATEO. The statute defines an ATEO to include all organizations exempt from taxation under Section 501(a). In short, these include 501(c)(3) organizations, such as hospitals and universities, certain political or government organizations and any organization related to such entities. Notably, Sections 162(m) and 280G impose comparable results, though through different mechanisms in the for-profit sector, and work in tandem with Section 4960 per the regulations. The interrelation of these three statutes underlines Congress’s intent to treat all types of entities similarly with regard to paying high compensation to top-tier employees.
Because the primary purpose of Section 4960 is to ensure ATEOs do not benefit from using their unique tax-exempt status to circumvent Congress’s initiative to limit executive compensation, the IRS scrutinizes payment arrangements that overstep the statutory limits.
To minimize the risk of an unexpected tax bill or examination, ATEOs should consider several situations, including whether:
- an individual is a “covered employee” – either current or former – with respect to remuneration paid in excess of $1,000,000;
- an employee currently is or formerly was compensated in whole or in part by a related organization, which may cause such individual’s remuneration to be subject to the excise tax; and
- any payments exceed statutory contribution limits for benefits excludible from income tax withholdings, resulting in the inclusion of such benefits in total remuneration.
Who is a covered employee?
Specifically, under the OBBBA, Section 4960 broadened the definition of a “covered employee” to mean any employee of an ATEO (or any predecessor of such an organization) and any former employee of such an organization (or predecessor) who was such an employee during any taxable year beginning after December 31, 2016. This definition is seen specifically in Section 4960(c)(2). This expansion significantly increases the number of ATEO employee compensation agreements that will trigger the tax. More importantly, ATEOs may be subject to unforeseen taxes due to the nuances associated with identifying who is a covered employee for purposes of the tax (discussed further below). As a result, ATEOs should keep careful records of all employee compensation agreements to determine the individuals identified as “covered employees” under the statute and whether the remuneration paid to these individuals triggers the excise tax. In particular, care should be taken when a board determines bonus amounts.
When does the excise tax apply?
In situations where a covered employee works for a single ATEO, the excess remuneration subject to the excise tax will be obvious and expected. However, ATEOs should be aware of the potential tax pitfall when multiple related organizations make payments to an employee and the total remuneration paid to the individual exceeds $1 million, causing such employee to be classified as a covered employee, even if each employer separately pays such individual less than $1 million. This is because Section 4960 applies to annual earnings paid to a single employee from both the exempt entity and all related entities.
For example, as outlined in Treasury Regulation Section 53.4960-4(c), if a covered employee is paid $900,000 by the ATEO and $300,000 by a related organization, both employers will be liable for their pro-rata share of the excise tax on the aggregated compensation over $1,000,000 paid. This pro rata allocable tax will likely surprise the ATEO who finds itself liable for the excise tax despite entering a compensation agreement for less than $1 million. Liability for severance benefits paid from multiple related entities also may generate additional surprise where ATEOs of all sizes are made to pay the excise tax based on a pro rata allocation of more than one excess parachute payment made by the ATEO and a related entity due to involuntary termination of employment.
One factor that ATEOs should always consider is that a covered employee remains a covered employee for all subsequent tax years, even after termination of employment. Therefore, a covered employee of an ATEO who stops providing services to the ATEO, but continues providing services to a related organization, could continue to have compensation that is paid by the related organization subject to the Section 4960 excise tax. Given this possibility, the ATEO may want to institute robust tracking procedures for all individuals who become covered employees and are likely to continue employment with a related organization after termination from the ATEO. While the payment of the tax may fall upon the current employer, reporting is another matter.
What is remuneration under Section 4960?
From the outset, remuneration under Section 4960 means annual wages, with very few exceptions other than where payments are not taxable under the IRC by reason of specific statutory exclusions. As an example, IRS Chief Counsel recently issued CCA 202515014 (Apr. 11, 2025), offering new insight into calculating Section 4960 remuneration. Specifically, the IRS discussed the interplay between Sections 3401 and 3402 in defining “wages” under the statute and determined that elective contributions to 403(b) and cafeteria plans should not be included in gross income for purposes of calculating remuneration under Section 4960 to the extent such benefits are excluded from income tax withholding.
Correspondingly, ATEOs should be mindful of payments that exceed statutory contribution limits as these amounts are included in gross wages for purposes of calculating the excise tax. Although a CCA is informal and nonbinding, this guidance offers better clarity in the IRS’s view on Section 4960 and the tax implications of compensation packages for top executives and highly skilled employees.
Section 4960 presents many other complexities that lead to an excise tax or reporting requirement against an unsuspecting organization. Given these unique complexities, and the current environment that tax-exempt organizations find themselves in, along with additional coming changes in the OBBBA, taxpayers should seek counsel experienced in this area to avoid potentially costly surprises or consequences.
Sarah Husbands is a tax associate at Zerbe, Miller, Fingeret, Frank & Jadav LLP. Her expertise includes helping tax-exempt taxpayers with the unique challenges they face. Husbands also helps taxpayers with issues, including: IRS Collection proceedings, entity formations and dissolutions, local and federal audits and appeals, lien and levy releases, penalty abatements, payroll filing disputes, and identity theft matters.
