2026 Section 4960: Build the Nonprofit Compensation Tax File Before Year-End

Section 70416 of Public Law 119-21 rewrote the Section 4960 covered-employee definition for tax years beginning after December 31, 2025. Before 2026, an applicable tax-exempt organization generally tracked its five highest-compensated employees and anyone permanently carried forward from an earlier year. For a calendar-year nonprofit in 2026, the statute now reaches every employee of the organization or its predecessor, subject to the transition interpretation and limited exceptions in IRS Notice 2026-36.

The tax still targets compensation above $1 million and excess parachute payments, but the compliance population is much larger. A nonprofit that waits for Form 990 preparation may discover too late that a Section 457(f) vesting event, related-entity payroll, physician-administrator allocation, or separation agreement created a six-figure excise tax.

Why the 2026 Covered-Employee Rule Is Different

The old top-five test no longer controls for tax years beginning after 2025. An individual who is an employee of an applicable tax-exempt organization in a post-2025 tax year is a covered employee for that year unless an available exception applies. Once covered, the individual's status is permanent for that organization and its predecessor.

Notice 2026-36 prevents an overbroad retroactive result. A former employee whose service occurred only from 2017 through 2025 is carried into 2026 only if that person was a covered employee under the prior top-five rule. If the former employee returns to work in 2026, however, the expanded rule can make that person covered from the rehire year forward.

The result is a one-way roster. Every new hire, internal transfer, shared-services assignment, and rehire can create permanent Section 4960 tracking even if the person is not highly paid today.

Map Employees and Related Organizations Before Testing Pay

Section 4960 applies to organizations exempt under Section 501(a), certain Section 521 cooperatives, organizations with income excluded under Section 115(1), and Section 527 political organizations. The analysis then extends through related persons and governmental entities based on control, common control, and supporting-organization relationships.

Build three controlled lists:

1. Legacy covered employees. Roll forward everyone who became covered under the pre-2026 top-five test. Do not delete terminated or retired individuals.
2. Post-2025 employees. Capture common-law employees, officers, rehires, and individuals assigned through related organizations. Confirm worker classification rather than relying on payroll labels.
3. Documented exceptions. Record hours, remuneration sources, reimbursements, control relationships, and the tax year for each position taken under Notice 2026-36.

The tax file should identify the employee, each payer, the related-party status, and which employer bears a ratable share of the tax.

Calculate the 21% Tax With All Compensation Layers

The remuneration component equals 21% of covered-employee remuneration above $1 million for the year. The $1 million threshold is not indexed. Remuneration generally follows Section 3401(a) wages, excludes designated Roth contributions, and includes Section 457(f) amounts when the right is no longer subject to a substantial risk of forfeiture.

Aggregate Related-Entity Pay and Section 457(f) Vesting

Pay cannot be tested entity by entity. Remuneration from a related organization or governmental entity is included when paid with respect to the covered employee's employment. If multiple employers contribute to the excess, liability is allocated by each employer's share of total remuneration, and the filing instructions require each liable employer to submit its own Form 4720.

Deferred compensation creates a separate timing problem. A Section 457(f) amount is treated as paid for Section 4960 when it vests, not necessarily when cash is distributed. Finance should reconcile payroll, general ledger accruals, deferred-compensation schedules, employment agreements, and board minutes.

Model vesting before modifying agreements. Section 457(f), Section 409A, employment, and state-law consequences require coordinated tax and legal review.

Use Notice 2026-36 Exceptions With Evidence

Treasury and the IRS intend to preserve versions of the existing limited hours and nonexempt funds exceptions. Until proposed regulations are issued, Notice 2026-36 permits reliance on those anticipated rules. The IRS also says the old limited-services exception is not expected to continue because there is no longer a top-five list for a minimally paid employee to displace.

Under the existing limited-hours framework, neither the nonprofit nor a related exempt organization pays or grants a right to remuneration for the nonprofit services, and the individual generally performs no more than 10% of total group hours for the exempt entities. The regulation supplies a 100-hour safe harbor. The nonexempt-funds exception is more restrictive and examines who pays, whether an exempt or controlled entity funds the pay, service-fee arrangements, and whether the employee primarily serves a related nonexempt organization.

Keep time records, intercompany agreements, reimbursement data, control analysis, and the exact regulation provision applied. Notice 2026-36 anticipates prospective regulations, but final rules do not yet exist.

Separate Medical Services and Parachute Payments

Compensation for services performed by a licensed medical professional, including a veterinarian, is excluded from remuneration. Administrative, management, teaching, research, and other nonmedical services are not automatically excluded. A physician-executive package therefore needs a reasonable, good-faith allocation supported by duties, time, compensation studies, and contract terms.

The parachute-payment branch of Section 4960 can apply even when annual remuneration does not exceed $1 million. A separation-contingent payment becomes a parachute payment when the aggregate present value reaches at least three times the employee's base amount; the excess over the allocated base amount is taxed at 21%. Before approving severance, retention acceleration, or a change-in-control package, calculate the base amount and present value rather than using the annual-pay threshold as a shortcut.

Build the 2026 Year-End Compliance File

Use a controlled close process rather than a Form 990 afterthought:

1. Freeze the population. Reconcile the legacy roster, 2026 employees, rehires, predecessors, and shared-service assignments.
2. Reconcile remuneration. Combine payroll, taxable fringe benefits, related-entity compensation, Section 457(f) vesting, medical-service allocations, and separation payments.
3. Calculate and allocate. Compute tax by covered employee, then allocate liability across related employers using the remuneration ratio.
4. Tie the returns together. Reconcile Form 990 Part V, Form 4720 Part I line 13, Schedule N, and each related employer's separate return.
5. Calendar filing and payment. Form 4720 is generally due with the organization's Form 990-series return. Form 8868 can extend filing when properly completed, but the balance shown is due by the original Form 4720 deadline.

The current Form 4720 instructions also say Section 4960 has no estimated-tax-payment requirement, so Form 990-W does not apply. As of August 29, 2026, the IRS has posted a draft 2026 Form 4720; use the final form and instructions when released.

Common Mistakes

• Keeping only the five highest-paid employees. That screen no longer controls for post-2025 tax years.
• Making every 2017-2025 former employee retroactively covered. Notice 2026-36 preserves prior-law status for pre-2026 years unless the person returns after 2025.
• Testing only nonprofit payroll. Related-organization remuneration must be aggregated.
• Following cash instead of vesting. Section 457(f) remuneration is generally counted when the substantial risk of forfeiture lapses.
• Excluding a physician's entire package. Only remuneration for medical services is excluded; administrative pay requires allocation.
• Ignoring severance below $1 million. Excess parachute payments have a separate three-times-base test.
• Using the former limited-services exception. Notice 2026-36 does not preserve it under the expanded definition.
• Filing one group return. Each related employer liable for a ratable share generally files its own Form 4720.
• Treating forthcoming regulations as final. Current positions should cite the Notice and preserve supporting evidence.

The Bottom Line

Section 4960 is now an employee-population and data-governance issue, not merely a top-five compensation calculation. Before the 2026 books close, reconcile the permanent roster, new employees, related-entity pay, Section 457(f) vesting, medical-service allocations, and separation packages. Compute liability by employer, preserve the Notice 2026-36 exception file, and tie Form 4720 Schedule N to the Form 990 process. Have a CPA and employee-benefits counsel review judgment-heavy classifications before filing.