21% excise tax now covers all $1M+ nonprofit employees

The One Big Beautiful Bill Act significantly broadens the reach of the federal excise tax on excess executive compensation at tax-exempt organizations. Section 70416 expands the existing 21% excise tax on compensation over $1 million per year to apply to all current and former employees of tax-exempt organizations, government entities, and their related organizations, effective for tax years starting after December 31, 2025. The provision also closes long-standing loopholes that allowed organizations to spread compensation across multiple related entities or reclassify employees as independent contractors to stay below historical thresholds.

For nonprofit boards, university trustees, hospital systems, and government-affiliated entities, the change recalibrates the way executive compensation packages are structured, monitored, and reported. The 21% excise tax is paid by the organization, not the employee, which means every dollar of compensation above the $1 million threshold now costs the organization an additional 21 cents in federal excise tax. For a nonprofit paying eight executives more than $1 million each, the excise tax exposure can run into the millions of dollars per year, previously excluded from the tax base under the prior "top 5" limitation.

This article walks through what Section 70416 actually changed, which organizations and individuals fall inside the expanded base, the loophole-closing provisions and their practical effect, dollar-level scenarios showing how the excise tax can scale, and the structural responses tax-exempt organizations should consider as the 2026 tax year approaches.

What Section 70416 changed about Section 4960

The federal excise tax on excess executive compensation is set out in Internal Revenue Code Section 4960, originally enacted by the Tax Cuts and Jobs Act of 2017. Under the prior rules, the 21% excise tax applied only to compensation paid to "covered employees" of a tax-exempt organization, defined as the top five highest-compensated employees in any year, plus any employee who had been a covered employee in a prior year (creating a permanent inclusion list once an employee crossed the threshold).

That "top five plus historical" definition was the operational ceiling on the tax's reach. A large university or hospital system could pay seven, ten, or twenty executives more than $1 million each, and only the top five (plus prior-year carry-overs) would generate excise tax exposure. The remaining executives' compensation was entirely outside the tax base.

Section 70416 removes that ceiling. Effective for tax years starting after December 31, 2025, the 21% excise tax applies to compensation over $1 million paid to all current and former employees of:

1. Tax-exempt organizations (charities, private foundations, universities, hospitals, religious organizations with paid staff above the threshold)
2. Government entities (public hospitals, state agencies, public universities, certain instrumentalities)
3. Related organizations (subsidiaries, affiliates, and entities under common control with a tax-exempt or government parent)

The expansion captures every employee of these organizations whose compensation exceeds $1 million, not just the top five. For organizations with broad-based, highly compensated employee populations, the practical excise tax exposure can increase several times under the new rules.

Section 70416 also tightens loophole-closing provisions designed to prevent organizations from circumventing the tax through structural maneuvers. Specifically, the provision blocks the practice of distributing compensation among multiple related entities to keep any single entity's payments below the threshold, and it prevents reclassifying employees as independent contractors to remove them from the covered employee population.

Which organizations fall inside the expanded tax base

The reach of Section 70416 extends to several categories of entities that may not have historically considered themselves directly subject to federal excise tax.

Traditional tax-exempt charities and foundations remain central to the affected population. Public charities under Section 501(c)(3) that pay executives, scientists, or specialized professionals more than $1 million per year now face full excise tax exposure on every such employee, not just the top five.

Private foundations face the same expanded exposure. Family and corporate foundations, with senior staff and investment officers earning above the threshold, need to evaluate the full population of compensated individuals against the new base.

Universities and colleges, both private nonprofit and public, fall within the expanded base. The pre-OBBBA top-five limitation often resulted in situations in which a university taxed only its president and a few senior administrators, even though it paid significantly higher compensation to medical school deans, athletic coaches, lead researchers, and other specialists. Under the new rules, every individual at a covered institution earning more than $1 million is in scope.

Healthcare systems, including teaching hospitals, academic medical centers, and integrated nonprofit health networks, face significantly expanded exposure. Compensation for senior physicians, surgical leadership, hospital executives, and specialized clinical leaders frequently exceeds the $1 million threshold. Under Section 70416, all of these employees are covered, not just the named officers.

Government entities and public sector instrumentalities are explicitly included. Public hospitals, state university systems, government investment authorities, and certain quasi-governmental entities that compensate executives above the threshold are subject to the same 21% excise tax that applies to private-sector tax-exempt organizations.

Related organizations under common control are pulled into the calculation. A foundation supporting a university, a holding entity owning hospital operating subsidiaries, or a controlled service organization providing back-office support to a charity are all potentially in scope under the related-organization rules.

For tax-exempt organizations operating subsidiaries structured as C Corporations or S Corporations, the related-organization analysis requires a careful, entity-by-entity review to determine where compensation is included in the calculation.

How does the loophole-closing provision work in practice

The loophole closures in Section 70416 target two specific structural tactics that organizations had used to manage excise tax exposure under the prior rules.

The multi-entity compensation distribution loophole applied when an employee performed services for multiple related entities and received separate compensation from each. Under prior interpretive frameworks, organizations could sometimes argue that the $1 million threshold applied separately to each entity's compensation, allowing total compensation across entities to exceed $1 million without triggering the excise tax at any single entity. Section 70416 explicitly aggregates compensation paid to a single individual by a tax-exempt organization and all related organizations for purposes of the $1 million threshold.

The contractor reclassification loophole was exploited when organizations recategorized highly compensated individuals as independent contractors rather than employees, theoretically removing them entirely from the covered employee population. Section 70416 closes this by including former employees in the definition of covered employees and by requiring a substance-over-form analysis when evaluating contractor classifications. An individual who previously served as an employee and now provides similar services as a contractor remains within the excise tax base if the substance of the relationship has not materially changed.

These loophole closures matter most for organizations that have already been structuring around the prior limits. The aggregation rule means that a hospital system that historically paid a senior executive partially through the operating entity and partially through an affiliated foundation now treats those amounts as combined for excise tax purposes.

How much does the expanded base actually cost organizations

The dollar-level impact of Section 70416 depends on how many employees an organization pays above the $1 million threshold. Three illustrative scenarios show the scale of the expansion.

Scenario one. A mid-sized academic medical center under prior rules paid five covered employees a combined $7.5 million in excess compensation above the $1 million threshold (an average of $1.5 million per covered employee, with $0.5 million per employee above the threshold). Total excise tax under prior rules: approximately $1.05 million per year. Under the expanded base, the same medical center has eight additional employees earning above the threshold, with $0.4 million per employee, on average, above $1 million. New combined excess compensation across all 13 employees: approximately $10.7 million. New excise tax: approximately $2.25 million per year. The increase from the prior law is approximately $1.2 million per year.

Scenario two. A private research university operating under prior rules paid five covered employees with combined excess compensation of $4 million, generating approximately $840,000 in excise tax. The university actually has 12 additional employees earning more than $1 million (medical school faculty, athletic coaches, senior researchers, the business school dean). Combined additional excess compensation: approximately $7 million. Total new excise tax base: approximately $11 million, generating approximately $2.31 million in annual excise tax. The annual increase: approximately $1.47 million.

Scenario three. A national charitable foundation paying its top five executives combined excess compensation of $2 million faced approximately $420,000 in annual excise tax under prior rules. The foundation has three additional senior investment professionals earning above $1 million. Combined additional excess compensation: $1.5 million. New total excise tax: approximately $735,000 per year. The annual increase: approximately $315,000.

For tax-exempt organizations evaluating broader employee benefit and compensation strategies, Health reimbursement arrangement structures and other non-cash benefits operate independently of the Section 4960 excise tax calculation, since the excise tax is based on reportable compensation rather than on every form of employee remuneration.

How should organizations restructure compensation reviews

The expansion of the covered employee population requires tax-exempt organizations to refresh their compensation review processes for the 2026 tax year and beyond.

Three core process updates make sense for affected organizations:

• Move from a top-five tracking model to a comprehensive compensation review covering every employee whose total compensation may approach or exceed $1 million across the organization and its related entities
• Aggregate compensation across all related-organization sources for each individual to determine whether the combined amount crosses the threshold, including amounts paid by foundations, supporting organizations, and controlled subsidiaries
• Build excise tax costs into compensation modeling in the planning phase, treating the 21% excise tax as a real cost of the compensation decision rather than an after-the-fact reporting matter.

For organizations that have used Late S Corporation elections or Late C Corporation elections for taxable subsidiaries operating in service of a tax-exempt parent, the entity-structure decisions interact with whether compensation paid by those subsidiaries is included in the related-organization aggregation for the parent's Section 4960 calculation.

For nonprofits employing executives who also serve inside roles that require reimbursement of Travel expenses or Vehicle expenses coverage, those reimbursements remain excludable from the excise tax base when properly structured under accountable plan rules.

How does this interact with the broader compensation strategy

A tax-exempt organization's compensation strategy operates at the intersection of several considerations: market-rate compensation requirements to attract and retain talent; public scrutiny and IRS reporting requirements (Form 990 disclosures); the 21% excise tax under Section 4960; and various state-level governance requirements for nonprofit executive compensation.

Section 70416 raises the federal tax cost of paying any employee more than $1 million per year. Organizations that historically rationalized higher pay because only the top five were subject to excise tax exposure now bear that cost across all highly compensated executives. The decision framework shifts.

Three strategic responses are emerging across the tax-exempt sector.

Some organizations are evaluating compensation caps for non-essential roles, capping certain positions below the $1 million threshold to avoid the excise tax while continuing to compensate at market rates for true top leadership. This is most viable for roles where the market-rate compensation ranges from $800,000 to $1.2 million, and shaving back to the cap is a manageable adjustment.

Some organizations are evaluating whether non-cash compensation forms can reduce the reportable amount that triggers the excise tax. Deferred compensation, retirement plan contributions through Traditional 401k and Roth 401k plans, and certain fringe benefit structures may shift compensation outside the excise tax base. However, specific rules around what counts as "remuneration" under Section 4960 require careful analysis.

Some organizations are simply absorbing the excise tax cost as a function of attracting and retaining critical leadership. For mission-driven institutions where market compensation requires running the excise tax exposure, the cost flows through institutional budgets. It may show up in eventual program reductions or in fundraising priorities.

For executives whose total compensation packages include Employee achievement awards or other recognition components, those amounts generally fold into the reportable compensation that flows through the Section 4960 base.

What documentation supports a Section 4960 calculation

Tax-exempt organizations subject to Section 70416's expanded base need to refresh their documentation practices to support the broader compensation tracking required.

Required documentation now includes year-by-year reportable compensation for every employee whose annual total is $1 million or more, broken out by the paying entity within the related-organization group. The aggregation rule means organizations must maintain integrated records showing the combined compensation paid to a single individual across all related entities, even when the individual is technically employed by only one entity.

Substance-over-form documentation for any individual reclassified between employee and contractor status during the lookback period supports the related-organization aggregation rules. It helps demonstrate that no improper reclassification was used to manage the excise tax exposure.

Form 4720 filing requirements for organizations subject to the excise tax continue under the new rules. The form reports the excess compensation, calculates the 21% excise tax, and pays the resulting tax. Organizations newly entering the broader excise tax base for the first time in 2026 should plan for this filing requirement well in advance of the original return due date.

For organizations operating across multiple Partnerships and other related-entity structures, the compensation aggregation rules require integrated tracking, which has historically been handled separately by each entity's payroll function.

How Instead supports tax-exempt organizations in 2026

Section 70416 takes effect for tax years starting after December 31, 2025. Tax-exempt organizations and their related entities should plan their compensation review processes, related-organization aggregation methodology, and excise tax cost modeling well ahead of the 2026 tax year. The expanded base and loophole-closing provisions materially change the federal tax cost of executive compensation at affected organizations.

Visit Instead's comprehensive tax platform to model excise tax exposure under the expanded base, integrate compensation tracking across related entities, and coordinate Section 4960 reporting with broader nonprofit tax compliance. Review pricing plans to find the support tier that matches your organization's compensation review complexity.

Frequently asked questions

Q: Does Section 70416 change the $1 million threshold itself?

A: No. The $1 million threshold for excess compensation remains the same. Section 70416 changes who is subject to the threshold (now all current and former employees, rather than just the top five) and closes loopholes around multi-entity compensation aggregation and contractor reclassification.

Q: Who pays the 21% excise tax, the organization or the employee?

A: The organization pays the excise tax under Section 4960. The tax is reported on Form 4720 and represents an additional cost to the tax-exempt organization, in addition to the underlying compensation paid to the employee. The employee's individual tax obligations on the compensation are unchanged by Section 4960 or by Section 70416's expansion.

Q: When does the expansion take effect?

A: Section 70416 applies to tax years starting after December 31, 2025. For most tax-exempt organizations operating on calendar tax years, the first full year under the expanded base is the 2026 tax year, with reporting due on the corresponding 2026 information returns and excise tax filings.

Q: Are former employees covered under the expanded definition?

A: Yes. The expanded definition includes both current and former employees of the tax-exempt organization. This closes the prior pathway of reclassifying or terminating employees to remove them from the covered employee population, and supports the substance-over-form analysis used to evaluate contractor classifications.

Q: How does the related-organization aggregation work?

A: Compensation paid to a single individual by a tax-exempt organization and any related organization (subsidiaries, affiliates, entities under common control) is aggregated for purposes of the $1 million threshold. An employee paid $600,000 by a charity, and $500,000 by its supporting foundation, has $1.1 million in combined compensation under the new rules, putting them $100,000 above the threshold and subject to the 21% excise tax.

Q: Does Section 70416 affect retirement plan contributions paid for highly-compensated employees?

A: Retirement plan contributions and other deferred compensation are generally treated under separate rules within Section 4960. Specific items may or may not be included in the reportable compensation base, depending on the type of plan and the timing of payment. Organizations should review each compensation component against the current Section 4960 guidance to determine whether it is subject to Section 4960.