The Internal Revenue Service (IRS) has provided interim guidance under section 4960 of the Internal Revenue Code of 1986 (the Code).1 The Code, as amended, generally imposes an excise tax on applicable tax-exempt organizations that either:

  • pay compensation in excess of $1 million to certain highly compensated employees, or
  • pay excess severance, or “parachute,” payments to certain covered employees in connection with their separation from service.

Section 4960 was added to the Code as part of the 2017 Tax Cuts and Jobs Act. Tax-exempt organizations may rely on this interim guidance, summarized below, while the IRS develops further guidance to be issued in the form of proposed regulations.

Applicable Tax-Exempt Organizations (ATEOs)

The excise tax under section 4960 applies only to applicable tax-exempt organizations, known as ATEOs, which include any organization which for the taxable year:

  • is exempt from taxation under section 501(a),
  • is a farmers’ cooperative organization described in section 521(b),
  • has income excluded from taxation under section 115(1), or
  • is a political organization described in section 527(e).

The IRS guidance clarifies that certain governmental entities, including federal instrumentalities exempt from tax under section 501(c)(1) and public universities with determination letters recognizing their tax-exempt status under section 501(c)(3), are ATEOs. Governmental entities that are not exempt from tax are not ATEOs.

Compensation paid by an organization that is related to an ATEO is treated as paid by the ATEO itself. An organization is “related” to an ATEO if it: (i) controls, or is controlled by, the ATEO, (ii) is controlled by one or more individuals or entities that control the ATEO or (iii) is a supported organization, a supporting organization or a voluntary employees’ beneficiary association. “Control” for these purposes is based on the definition of control in section 512(b)(13)(D).       

Related Organization Issues. One issue applicable to certain organizations arises when an ATEO such as a company foundation, family foundation or trade association is under common control with a business corporation or partnership, and an individual is highly compensated by the business corporation or partnership and also provides voluntary services to the ATEO. It seems unreasonable in many situations and inconsistent with the purposes of section 4960 that an uncompensated position with an ATEO could be considered a “covered employee” position and as such could cause a related corporation or partnership to be subject to an excise tax under section 4960. Although the interim IRS guidance does not address this issue, the IRS has noted at a recent nonprofit organization conference that it is aware of these concerns and will take them into account when drafting proposed Regulations for section 4960. In the meantime, an IRS official has stated that positions taken by taxpayers will be respected if they are consistent with any reasonable, good-faith interpretation of the statute.

Covered Employees

General. Section 4960 applies only to compensation paid to a “covered employee,” which includes any current or former employee of an ATEO who:

  1. is one of the five highest compensated employees of the organization for the taxable year, or
  2. was a covered employee of the organization (or any predecessor) for any preceding taxable year beginning after December 31, 2016.

Determination of Remuneration. The determination of whether an employee is one of the five highest compensated employees is based on remuneration for services performed as an employee of the ATEO, including remuneration for services performed for a related organization, but does not include remuneration for medical or veterinary services, as described below. The compensation is taken into account in the calendar year in which it is paid to the employee. There is no minimum compensation threshold for determining who is a covered employee.

Limited Services Exception. Each ATEO will have its own group of covered employees, even if it is related to other affiliated ATEOs. However, an employee will not be considered one of an ATEO’s five highest compensated employees if, during the calendar year, the ATEO paid less than 10% of the employee’s total remuneration (i.e., more than 90% of the employee’s compensation was paid by affiliates). However, if no ATEO paid more than 10% of the total remuneration, then the exception does not apply to the ATEO that paid the employee the most remuneration during that year. Excess Remuneration

General. Section 4960 imposes an excise tax equal to the rate of tax under section 11 of the Code (currently 21%) multiplied by the compensation paid to a covered employee in excess of $1,000,000.

Excess Remuneration. Remuneration has the same meaning as the term “wages” used for income tax withholding purposes, except that it excludes any designated Roth contributions, but includes deferred compensation that is required to be included in gross income under section 457(f). Fees paid to directors are not included because such fees are considered “self-employment” income.

Remuneration is treated as paid when it is vested (i.e., when it is no longer subject to a substantial risk of forfeiture). Remuneration will be considered unvested if it is conditioned on the employee’s future performance of substantial services or, at least under proposed section 457(f) regulations, if it is subject to other conditions that are related to a purpose of the compensation, such as sufficiently challenging performance goals.

The amount of remuneration treated as paid upon vesting is the present value of the future payments to which the employee has a binding right, including any earnings that have accrued as of the vesting date.

Compensation that is considered a parachute payment because it is conditioned on a termination of employment, as described below, is taken into account in determining the employee’s excess remuneration. However, if the parachute payment is subject to an excise tax as an “excess parachute payment,” then it will not also be subject to the excise tax on remuneration in excess of $1 million.2


Implications of Section 457(f) Deferrals. Many believe that it is unfair that section 457(f) deferred compensation should be taken into account in the year it becomes vested because it penalizes organizations that choose to impose vesting conditions as a way to retain key employees over a period of years. Some commentators have argued persuasively that section 457(f) deferrals should be allocated ratably over the applicable vesting period, which is when the compensation was earned.


In 2019, the CEO of a tax exempt organization, and one of its five highest paid employees, receives base compensation of $500,000 and an annual bonus of $400,000 and becomes vested in a 457(f) deferred compensation benefit in the amount of $300,000, which consists of an underlying deferral credit of $250,000, which vested based on services performed over a five-year period, and accrued earnings in the amount of $50,000. The organization would be subject to an excise tax under section 4960 in the amount of $42,000 (21% of $200,000).  Excess Parachute Payments

General. In addition to the tax on excess remuneration, described above, section 4960 also imposes an excise tax equal to the rate of tax under section 11 of the Code (currently 21%) multiplied by the amount of an “excess parachute payment” paid to a covered employee.

Parachute Payment. In order to determine the amount of an “excess parachute payment,” it is first necessary to determine the amount of each “parachute payment.” The term “parachute payment” means any payment of compensation to or for a covered employee if:

  • the payment is contingent on the employee’s involuntary separation from employment, and
  • the aggregate present value of the compensation payments to or for such individual which are contingent on such involuntary separation equals or exceeds three times the employee’s “base amount,” as described below.

Exception. The term does not include any payment:

  • under a qualified retirement plan, including section 403(b) and 457(b) plans,
  • to a licensed medical professional (including a veterinarian) to the extent that such payment is for medical or veterinary services, or
  • to a person who is not a highly compensated employee (i.e., has compensation less than $125,000 for 2019).

Payment that is Contingent on an Employee’s Separation from Employment. For purposes of determining an employee’s parachute payments, a payment is contingent on the employee’s separation from employment if the facts and circumstances indicate that the employer would not make the payment in the absence of an involuntary separation from employment.

Three-Times-Base Amount Test. A parachute payment exists if the aggregate value of the payments conditioned on separation equals or exceeds three times the employee’s base amount. The present value of a payment is determined as of the date of the separation from employment, or, if the payment is made prior to that date, the date on which the payment is made. The base amount is generally the average annual compensation over the employee’s base period (the employee’s five most recent taxable years, or, if not an employee for the entire five-year period, the portion of the five-year period during which the covered employee performed services for the ATEO or related organization), for services performed as an employee of the ATEO or a related organization. Payments in the form of excludible fringe benefits or excludible healthcare benefits are not included in the base amount but may be treated as parachute payments.

Computation of Excess Parachute Payments. If an employee receives parachute payments because the payments conditioned on separation exceed three times the employee’s base amount, as described above, then the excise tax applies to the value of the parachute payments in excess of one times (not three times) the base amount. This excess is known as the “excess parachute payment.” To determine the portion of the base amount allocated to each parachute payment, the base amount is multiplied by a fraction, the numerator being the present value of that particular parachute payment, and the denominator being the aggregate present value of all parachute payments.


The CEO of a tax-exempt organization, and one of its five highest paid employees, is terminated involuntarily and receives a severance payment of $700,000. The CEO’s average W-2 compensation over the five years prior to the year of termination was $200,000—the “base amount.” The CEO has received a “parachute payment” because the severance payment ($700,000) exceeds three times the CEO’s base amount ($600,000). The organization would be subject to an excise tax in the amount of $105,000 (i.e., 21% of the excess of $700,000 over $200,000). Medical and Veterinary Services

For purposes of determining both excess remuneration and excess parachute payments, the term remuneration does not include the portion of any compensation paid to a licensed medical professional (including a veterinarian) for the performance of medical or veterinary services. Medical services are services for the diagnosis, cure, mitigation, treatment or prevention of disease, including services for the purpose of affecting any structure or function of the body. For example, documenting the care and condition of a patient or supervising a licensed professional who is performing medical services are the direct performance of medical services. However, managing an organization’s operations is not the performance of medical services.

If an employer pays a covered employee remuneration for both medical and other services during a calendar year, the employer must make a reasonable, good faith allocation between remuneration for the two types of services. The organization may rely on a reasonable allocation in an employment agreement that explicitly allocates the compensation between medical services and other services.  Liability

Liability. The common law employer, as generally determined for federal tax purposes, is liable for the excise tax under section 4960, even if the compensation is paid by an affiliate of the common law employer. A common-law employer may not avoid treating a payment as a remuneration by reason of a third-party payor arrangement. If an ATEO and a related organization are both common law employers of a covered employee, each employer is liable for its proportionate share of the excise tax, even if the related organization is a for-profit or governmental entity. Miscellaneous Issues

Year Used to Calculate Excise Tax. The guidance clarifies that the excise tax on excess remuneration and excess parachute payments is calculated based on excess remuneration paid and excess parachute payments made during the calendar year ending with or within the employer’s taxable year.

Relationship to Sections 4958 and 4941. The imposition of a section 4960 excise tax does not determine whether the remuneration paid to the covered employee is excessive or unreasonable compensation and subject to tax under section 4958, which imposes a tax on excess benefit transactions. An excess benefit transaction is any transaction in which an ATEO provides an economic benefit to or for certain employees that exceeds the value of services provided by certain employees. Similarly, the imposition of a section 4960 excise tax is not determinative as to whether the remuneration is excessive or unreasonable compensation for purposes of section 4941. Section 4941 imposes a tax on self-dealing, which includes the payment of excessive or unreasonable compensation to certain employees.

Reporting of Excise Tax. ATEOs are required to report an excise tax payable under section 4960 on IRS Form 4720, within 4 1/2 months after the end of the ATEO’s fiscal year (May 15th for calendar year organizations), although an extension may be obtained.

Effective Date and Grandfathering. Section 4960 applies to taxable years beginning after December 31, 2017. Remuneration paid prior to the first taxable year that begins after the effective date (paid prior to January 1, 2018 for calendar year organizations) is not subject to the excise tax. Surprisingly, the IRS refused to issue grandfathering rules that would exempt from section 4960 any compensation arrangements that were subject to a written binding contract in effect as of November 2, 2017, similar to the grandfathering rules under section 162(m) of the Code, which apply to the deductibility of compensation in excess of $1 million payable by publicly traded corporations. The IRS merely noted that compensation that became vested prior to January 1, 2018 would have been considered “paid” prior to the effective date of section 4960, and therefore such vested compensation (but not subsequent earnings) would not be subject to section 4960.