IRS outlines §4960 rules for expanded tax-exempt executive compensation tax
Tax-exempt organizations should view the post-2025 §4960 covered-employee rules as much broader, but these changes do not apply retroactively to employees who were not covered under the rules before.
IRS Action
The IRS said that Treasury and the IRS plan to issue proposed regulations under §4960, which places an excise tax on excess executive pay by certain tax-exempt organizations. These new rules will cover the expanded definition of “covered employee” from the One, Big, Beautiful Bill Act and will offer limited exceptions for employees who work few hours or are paid from nonexempt funds.
Why It Matters
This is consequential guidance for tax-exempt organizations because §4960 will no longer apply only with respect to the five highest-compensated employees after 2025.
The IRS gives transition clarity. Pre-2026 employee status will continue to be tested under the old five-highest-compensated framework.
The notice preserves practical relief for employees who perform limited services for a related tax-exempt organization.
The IRS does not plan to preserve the limited services exception because it depended on the old five-highest-compensated-employee structure.
Key Facts
§4960 imposes an excise tax on an applicable tax-exempt organization, related person, or governmental entity that pays a covered employee remuneration over $1 million in a taxable year or makes an excess parachute payment.
Before the OBBBA amendment, a covered employee was limited to either:
One of the five highest-compensated employees of the applicable tax-exempt organization for the taxable year.
A person who was a covered employee of that organization, or its predecessor, for a prior taxable year beginning after December 31, 2016.
The OBBBA changed the definition for taxable years beginning after December 31, 2025. After that date, the definition of covered employee generally includes any employee of an applicable tax-exempt organization and certain former employees.
Statutory Framework
§4960 applies to “covered employees” of an applicable tax-exempt organization. An applicable tax-exempt organization means an organization exempt from tax under §501(a), a farmers’ cooperative under §521(b)(1), a political organization under §527(e)(1), or certain entities with income excluded under §115(1).
The existing regulations include three exceptions tied to the old five-highest-compensated employee test:
Limited hours exception.
Nonexempt funds exception.
Limited services exception.
The IRS expects the forthcoming proposed regulations to retain only the limited hours and nonexempt funds concepts under the expanded post-2025 rule.
IRS Interpretation
The IRS interprets the OBBBA effective date as broadening the definition of covered employee only for taxable years of an applicable tax-exempt organization beginning after December 31, 2025.
That means the old definition still applies to taxable years beginning on or before December 31, 2025, including when determining, after 2025, whether a former employee became a covered employee before 2026.
Under the IRS interpretation, the amended definition includes only:
Individuals who were employees in taxable years beginning after December 31, 2016, and on or before December 31, 2025, if they were covered employees under prior law.
Individuals who are employees in taxable years beginning after December 31, 2025, subject to exceptions in future guidance.
Forthcoming Regulations
The IRS expects the proposed regulations to:
Remove references to an applicable tax-exempt organization’s five highest-compensated employees.
Make conforming changes to the existing §4960 regulations.
Adopt the notice’s effective-date interpretation.
Provide covered employee exceptions similar to the current limited hours and nonexempt funds exceptions.
Omit the limited services exception because the old displacement concern no longer applies.
The IRS also expects the forthcoming proposed regulations to apply prospectively and not to taxable years beginning before final regulations are issued.
Reliance
Applicable tax-exempt organizations may rely on the rules described in the notice until the forthcoming proposed regulations are issued.
The reliance rule covers:
TheIRS'sS interpretation of the post-OBBBA covered-employee definition.
The anticipated limited hours exception.
The anticipated nonexempt funds exception.
Example
The notice gives a calendar-year example involving an applicable tax-exempt organization and a taxable related corporation.
Employee A was one of the tax-exempt organization’s five highest-compensated employees in 2025 and did not qualify for an exception. Employee A remains a covered employee in 2026 because covered employee status, once obtained, is permanent.
Employee B was never one of the five highest-compensated employees and qualifies for the limited hours exception in 2026. The organization may rely on the notice to treat Employee B as not covered for 2026.
Employee C worked for the tax-exempt organization only in 2020 and was not one of its five highest-compensated employees. The organization may treat Employee C as not covered for 2026 solely because of that prior 2020 employment. If Employee C works for the organization again after 2025 and does not qualify for an exception, Employee C becomes covered for that year and all future years.
Comments
The IRS requested comments on how to adapt the limited hours and nonexempt funds exceptions to the amended definition of covered employee. The IRS also asked whether those exceptions should apply to officers of applicable tax-exempt organizations.
Comments are due August 4, 2026. Commenters should reference Notice 2026-36.
The Takeaway
The notice helps prevent retroactive disruption and confirms that §4960 will become a much broader compliance issue for tax-exempt organizations after 2025. Practitioners should review their employee lists, service arrangements with related organizations, and officer pay structures before the new definition takes effect.
List of Citations
Notice 2026-36, 2026-26 IRB 1: Announces forthcoming proposed regulations under §4960 and provides interim reliance guidance.
§4960: Imposes an excise tax on excess remuneration and excess parachute payments paid to covered employees of applicable tax-exempt organizations.
§4960(c)(2): Defines “covered employee.”
OBBBA §70416: Expands the §4960 covered employee definition for taxable years beginning after December 31, 2025.
Treas. Reg. §53.4960-1(d)(2): Provides existing rules and exceptions for identifying five highest-compensated employees under prior law.