Understanding the Section 4960 Landscape
Section 4960 of the Internal Revenue Code has been a persistent compliance challenge for tax-exempt organizations since its enactment under the Tax Cuts and Jobs Act. The provision imposes a 21% excise tax on applicable tax-exempt organizations that pay more than $1 million in remuneration to a "covered employee" in a taxable year, as well as on certain excess parachute payments made to such individuals. For nearly a decade, organizations have relied on a relatively stable definitional framework—identifying covered employees as the five highest-compensated employees for the current or any preceding taxable year beginning after 2016.
Treasury's interim guidance, issued as Notice 2026-36, signals a meaningful recalibration of that framework. For tax-exempt hospitals, universities, foundations, and other applicable organizations, the guidance expands the operative definition of "covered employee" and tightens related-organization aggregation rules in ways that materially increase excise tax exposure for the 2026 taxable year and beyond.
What the Interim Guidance Changes
Notice 2026-36 does not alter the statutory $1 million threshold, but it meaningfully broadens the universe of individuals whose compensation must be tracked and aggregated. Organizations should pay particular attention to three core shifts reflected in the interim guidance:
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Expanded Lookback Scope: The guidance clarifies that an individual who qualifies as a covered employee in any year—including years preceding a merger, spin-off, or corporate restructuring of a related exempt entity—retains that status indefinitely for successor and related organizations, consistent with the "once covered, always covered" principle already embedded in the statute, but now applied more aggressively to multi-entity health systems and university affiliates.
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Related Organization Aggregation: Treasury has signaled heightened scrutiny of compensation paid across related organizations, including for-profit subsidiaries, management companies, and foreign affiliates that share common control or governance with the tax-exempt parent. Compensation arrangements that were historically treated as compensation from a separate, non-exempt entity may now require aggregation if the related entity performs services for or on behalf of the exempt organization.
- Clarified Treatment of Deferred and Equity-Linked Compensation: The interim guidance addresses the timing of includible remuneration for certain deferred compensation arrangements, equity awards, and supplemental executive retirement plans, narrowing prior ambiguity about when such amounts are treated as "paid" for Section 4960 purposes.
Taken together, these changes mean that organizations previously confident in their covered-employee determinations may now find additional executives, physicians, or management-company personnel swept into the excise tax base.
Why This Matters for Tax-Exempt Organizations
The practical consequence of this expanded regime is straightforward but significant: organizations that have not recently revisited their Section 4960 compliance methodology face a materially higher risk of underreporting excise tax liability on Form 4720. Given that the excise tax applies at the organizational level—not the individual level—and liability can be allocated across multiple related organizations, the compliance burden now extends well beyond the HR and payroll functions of the exempt entity itself.
Boards, compensation committees, and general counsel offices should treat this guidance as a prompt to reassess governance around executive compensation design, particularly for organizations operating through complex affiliate structures such as integrated health systems, university medical centers, and multi-entity charitable enterprises.
A Strategic Compliance Framework
Given the expanded scope of Notice 2026-36, we recommend that applicable tax-exempt organizations undertake a structured compliance review built around the following pillars:
1. Comprehensive Entity Mapping
Identify all related organizations under the Section 4960 aggregation rules, including taxable subsidiaries, joint ventures, and management entities. Document the nature of control relationships and the services each entity provides to or on behalf of the exempt parent.
2. Historical Covered-Employee Audit
Review compensation data for the current year and all prior years since 2017 to confirm whether any individual has ever qualified as a covered employee at the organization or a related entity. Because covered-employee status is permanent once triggered, a one-time historical review is essential to avoid overlooking legacy exposure.
3. Deferred Compensation Inventory
Catalog all nonqualified deferred compensation arrangements, equity-linked incentives, and severance provisions to determine the taxable year in which amounts will be treated as paid under the clarified timing rules. This is particularly important for organizations with long-vesting executive retirement arrangements.
4. Parachute Payment Modeling
Reassess severance and change-in-control provisions in executive employment agreements to determine whether separation payments could trigger excess parachute payment exposure under the three-times-base-amount threshold, independent of the $1 million covered-employee test.
5. Governance Documentation
Ensure that compensation committees maintain contemporaneous documentation supporting reasonableness determinations and excise tax calculations, consistent with rebuttable presumption procedures that remain relevant to intermediate sanctions exposure under Section 4958.
Mitigation Considerations
While the expanded guidance increases compliance complexity, it does not eliminate planning opportunities. Organizations should evaluate compensation structuring alternatives, including the timing of equity vesting, the allocation of duties among related entities, and the potential restructuring of management service arrangements to minimize unnecessary aggregation. However, any restructuring undertaken primarily to avoid Section 4960 exposure should be evaluated carefully against anti-abuse principles that Treasury has historically applied to similar excise tax regimes.
Preparing for the 2026 Filing Season
With the expanded framework set to govern compensation reporting for taxable years beginning after 2025, applicable tax-exempt organizations should treat the current period as a critical window for remediation. Early engagement with tax counsel, compensation consultants, and finance leadership will be essential to accurately identify covered employees, quantify potential excise tax liability, and implement governance safeguards before the next Form 4720 filing cycle. Organizations that proactively align their compensation reporting infrastructure with the expanded regulatory expectations will be far better positioned to manage both financial exposure and reputational risk in an increasingly scrutinized compliance environment.