Expanded executive pay rules may affect tax-exempt organizations

Tax-exempt organizations have long been subject to special rules governing executive compensation. Recent legislative changes, however, may significantly expand the number of employees whose compensation could trigger an excise tax, creating new compliance considerations for exempt organizations and their advisors.

In Notice 2026-36, the IRS provides interim guidance on changes made by the One Big Beautiful Bill Act (OBBBA) to §4960. The guidance focuses on how organizations should determine who is considered a covered employee for purposes of the excise tax on certain compensation arrangements.

A brief review of §4960

Section 4960 imposes an excise tax on applicable tax-exempt organizations (ATEOs) that pay more than $1 million in annual compensation to certain employees or provide excess parachute payments. Since its enactment, the provision has generally applied to an organization's highest-paid employees and individuals who previously met the definition of a covered employee.

As a result, many organizations focused their compliance efforts on a relatively small group of executives.

A broader definition of covered employee

Beginning with taxable years starting after Dec. 31, 2025, the definition of a covered employee has expanded beyond the organization's five highest-compensated employees. This means organizations may need to evaluate a much larger population of employees when determining whether Section 4960 applies.

The broader definition may increase administrative responsibilities for exempt organizations. Organizations with multiple related entities may face additional challenges because compensation from related organizations can affect the Section 4960 calculation.

Exceptions expected in future regulations

Notice 2026-36 indicates that the Treasury and IRS intend to preserve certain concepts from existing regulations that help organizations determine whether an employee should be treated as a covered employee.

In particular, future proposed regulations are expected to address situations involving employees who perform limited hours of service or whose compensation is paid from nonexempt funds. For example, this may include fractional executives or other employees who satisfy a limited-hours or nonexempt-funds exception.

Planning considerations  

While organizations await additional regulations, now is an appropriate time to assess existing compensation structures and reporting processes. Consider asking the following questions with affected clients:

• Have compensation review procedures been updated to account for the expanded definition of covered employee?
• Are there employees outside the executive team whose compensation could now require additional analysis?
• Do related organizations share employees or compensation arrangements that may affect compliance?
• Are adequate records maintained to support compensation calculations and reporting requirements?

Addressing these questions early may help organizations avoid surprises when the revised rules take effect.

Looking ahead

Notice 2026-36 offers an early look at how the IRS intends to implement the expanded executive compensation rules under §4960. Although additional guidance is expected, understanding these changes now can help clients prepare for future compliance obligations and make informed decisions about compensation planning.