Tax on excess executive compensation
Section 4960 imposes an excise tax on most tax-exempt organizations and their related organizations to the extent that certain highly compensated employees (covered employees) receive remuneration in excess of $1 million or severance payments in excess of certain thresholds. Liability for the excise tax is imposed on the employer(s) of the covered employees. Seemingly simple on its surface, section 4960 complexity arises from the need to determine compensation under special rules, evaluate deferred compensation through a different lens, understand compensation paid by related organizations, and consider the reasons for separations from employment.
Covered employees
For tax years beginning 2018 through 2025, a covered employee is an employee (including a former employee) if the employee:
(i) Is one of the five highest compensated employees of the organization for the taxable year; or
(ii) Was a covered employee of the organization (or a predecessor) for any preceding taxable year beginning after Dec. 31, 2016.
For tax years beginning after Dec. 31, 2025, all current and former employees (for tax years beginning after Dec. 31, 2016) will be treated as covered employees.
Trap #1: Covered employee status is permanent
For tax years beginning after 2016, an employee who is a covered employee remains a covered employee forever. Therefore, organizations may have more than five covered employees in any given year.
Tip #1: Maintain a covered employee roster
Through calendar year 2025, systematically track and review the compensation of the top five highest remunerated employees even if their compensation did not exceed the $1 million threshold. This tracking ensures a complete analysis of section 4960 remuneration in each year and also provides support in an audit.
Trap #2: Related organizations
Section 4960 remuneration includes compensation paid by related organizations (including for-profit entities), and each tax-exempt organization must separately evaluate its covered employees.
Tip #2: Monitor and collaborate with related organizations
Know how to identify related organizations. Coordinate closely and establish communication channels with these related entities to ensure accurate reporting and compliance.
Vesting
Section 4960 remuneration vests and is considered paid when it is no longer subject to a substantial risk of forfeiture. Examples of substantial risks of forfeiture include the following:
- Performing substantial services, such a condition that requires an employee to work for a specified period of time.
- Refraining from performing services, pursuant to an enforceable non-compete agreement that the employer intends to enforce.
- Occurrence of a condition related to the purpose of the remuneration, requiring satisfaction of a specific, measurable event, like a successful completion of a capital campaign.
However, a “for cause” clause is not a substantial risk of forfeiture.
Trap #3: Nonqualified deferred compensation plans
Current year earnings on vested but undistributed amounts in section 457(f) and non-governmental section 457(b) plans must be included in the section 4960 remuneration calculation for the year.
Tip #3: Monitor vesting dates
Review the terms of nonqualified deferred compensation plans to identify when compensation vests compared to when distribution occurs. Develop a chart with dates for vesting, earnings, and distribution dates by employee and regularly update it for new employment contracts or new plan enrollments. Coordinate with finance, tax, and human resources (HR) teams to support accurate and timely reporting.
Trap #4: Short-term deferrals
If an employee has an irrevocable right to receive a payment as of Dec. 31 (Year 1), and that payment is made after the end of the year but no later than March 15 (Year 2), section 4960 includes the payment in the employee's Year 1 remuneration (as an example, a section 457(f) short-term deferral payment that vests in Year 1 but is designed to fully pay out the vesting amount within 2.5 months after the vesting year). While the payment may be reported on the Year 2 Form W-2, section 4960 excludes it from the Year 2 remuneration calculation. An exception applies to payments made for a normal payroll period that crosses calendar years; those payments are included in section 4960 remuneration in the year of payment.
Tip #4: Acknowledge and track prior-year attribution
Implement internal controls to track timing differences between payments that vest in a year different from when they’re reported on Form W-2. Ensure inclusion of short-term deferrals into prior year section 4960 remuneration while excluding them from section 4960 in the year of payment.
Trap #5: Cliff vesting and the unexpected tax liability
A deferred compensation plan that cliff vests (e.g., after three or five years of employment) can have a significant impact on section 4960 because the entire amount constitutes remuneration in the year it vests, even in situations where it is distributed later.
Tip #5: Consider graded vesting schedules
Alternative arrangements may offer opportunities to spread remuneration over a period of years to minimize the excise tax impact in a particular year. A graded vesting schedule, which vests a portion of the compensation each year, spreads the remuneration over a period of years. For example, rather than cliff vesting after five years, the plan can vest a portion in each of the first four years and pay out the entire balance in the fifth year.
Separations
Payments made based on involuntary separations can trigger an excise tax under section 4960 in two ways. First, if the total compensation paid in a single year, including vested severance, exceeds $1 million. Second, if the payments contingent upon separation total at least three times the employee’s average compensation over the prior five years.
Trap #6: Retirements and sabbaticals
Although retirements and sabbaticals may suggest a voluntary departure, accelerating the vesting of bonuses and other deferred compensation (e.g., arrangements conditioned on continued service that vests upon separation without cause) may indicate an involuntary separation.
Tip #6: Look beyond the label
Calling a departure a retirement does not determine its voluntary or involuntary nature. Review the specific circumstances of the separation and all relevant agreements, including employment agreements, separation agreements and deferred compensation plans, to determine if any payments are contingent on separation. Collaborate with tax, legal, finance, and HR teams before onboarding a new employee and before separating from a current employee to evaluate accelerated vesting provisions and severance payments in the context of section 4960.
Trap #7: Noncash benefits
For purposes of separation payments, section 4960 remuneration includes noncash benefits, including COBRA premiums, transfer of employer-provided property (e.g., company car or laptop), and life insurance.
Tip #7: Comprehensively review separation benefits
Before entering into a separation agreement, analyze all benefits, both cash and noncash, to determine the total compensation. Ensure finance, tax, legal, and HR teams collaborate and understand the section 4960 implications so appropriate liability reserves can be made.
Trap #8: Severance without protective language
Severance agreements without limiting or protective language on the amount paid may subject the organization to a significant excise tax.
Tip #8: Implement payment limitations
Consider limiting payments to minimize the section 4960 excise tax through the use of a “cut-back” clause, which caps separation payments to less than three times the employee’s average salary.
Conclusion
Complying with the nuanced requirements of section 4960 is an important component of compensating tax-exempt organization executives. RSM tax professionals can assist with reviewing, modifying, or structuring compensation packages and navigating the associated regulatory requirements, including section 4960.
