Cast a wider net: Notice 2026-36 previews new era for the Section 4960 excise tax

I. Background: Section 4960 and the Excise Tax on Executive Compensation

Section 4960 generally imposes an excise tax on any ATEO, or related person or governmental entity, that compensates a covered employee in excess of $1 million in a single taxable year, or otherwise provides excess parachute payments. The excise tax applies to remuneration paid by the ATEO and to remuneration from certain related organizations. For these purposes, a related organization includes an entity that controls or is controlled by the ATEO, or is controlled by one or more persons which control the ATEO, as well as certain other relationships. Hence, many corporate foundations could be treated as being related to a for profit business. Furthermore, tax-exempt organizations that have a for profit subsidiary would have to take into account remuneration paid by the subsidiary.

The Tax Cuts and Jobs Act of 2017 (TCJA), in which section 4960 was originally enacted, defined a “covered employee” as any employee of an ATEO if the employee (1) was one of the five highest compensated employees of the applicable tax-exempt organization for the taxable year, or (2) was a covered employee of the applicable tax-exempt organization (or any predecessor) for any preceding taxable year beginning after December 31, 2016. 

II. Exceptions under the Existing Regulations 

The existing regulations at Treas. Reg. § 53.4960-1(d)(2) establish three exceptions to the covered employee definition: (1) the limited hours exception; (2) the nonexempt funds exception, and (3) the limited services exception.

A. Limited Hours and Nonexempt Funds Exceptions

The limited hours and nonexempt funds exceptions were adopted in response to commenters requesting relief for situations in which employees of non-ATEO related organizations perform limited or temporary services for the related ATEO. The predicate for these exceptions is that the employee cannot receive remuneration from the ATEO or a related ATEO or, in the case of the nonexempt funds exception, from a taxable related organization controlled by the ATEO. 

B. Limited Services Exception

The limited services exception under the existing regulations permits the ATEO to pay the employee up to 10% of the employee’s total remuneration from the ATEO and all related organizations, so long as other conditions are met. Notice 2026-36 characterizes the limited services exception as having been adopted to prevent an employee to whom the ATEO paid minimal remuneration from displacing an employee who would otherwise have been one of the five highest-compensated employees of the ATEO. 

Under these exceptions, an individual meeting any of these criteria was disregarded for purposes of determining an ATEO’s five highest-compensated employees for a taxable year. Importantly, once an individual became a covered employee, that status carried over to all future years. 

III. OBBBA Amendments 

OBBBA significantly revised the definition of “covered employee” to include any employee of an ATEO (or predecessor organization) and any former employee of an ATEO (or its predecessor) who was such an employee during any taxable year beginning after December 31, 2016. After OBBBA, the definition of covered employee is no longer limited to an ATEO’s five highest-compensated employees. The statute provides that this amendment to the definition of covered employee is applicable to taxable years beginning after December 31, 2025.

IV. The Notice and Forthcoming Proposed Regulations 

Treasury and the IRS confirm in the Notice that they interpret OBBBA’s effective-date provision to broaden the definition of covered employee only for taxable years of an ATEO beginning after December 31, 2025, and to retain the prior definition of covered employee for taxable years beginning on or before December 31, 2025. 

A. Updated Definition of “Covered Employee” 

Accordingly, the post-OBBBA definition of “covered employee” includes only: 

• Any individual who was an employee of an ATEO in any taxable year beginning after December 31, 2016, and on or before December 31, 2025, if the individual was a covered employee for the taxable year under prior law; and
• Any individual who is an employee of an ATEO in any taxable year beginning after December 31, 2025, subject to any exceptions provided in future guidance.

In the Notice, Treasury and the IRS announced their intention to issue proposed regulations revising the section 4960 regulations by removing references to an ATEO’s five highest-compensated employees and making conforming changes. 

B. Exceptions under the Forthcoming Proposed Regulations Will Not Include a Limited Services Exception

The Notice also states that the forthcoming proposed regulations are anticipated to provide covered employee exceptions for limited hours and nonexempt funds. The limited services exception will not be included in the regulations, because the concern that motivated that exception, the displacement of an employee who would otherwise have been one of the five highest-compensated employees, is no longer relevant under the OBBBA definition of covered employee. The forthcoming proposed regulations may also address other issues, such as issues reserved in the existing section 4960 regulations.

Hence, exempt organizations that pay nonzero compensation to employees who are highly compensated by related organizations should consider restructuring the relationship if needed to avoid the 21% excise tax pursuant to Code section 4960. 

Treasury and the IRS included an example in the Notice of how this may impact ATEOs. In the example, CORP 2 is a taxable organization related to ATEO 1. Employes A and B have been employees of CORP 2 and ATEO 1 since 2017. Employee A was a covered employee for ATEO 1’s taxable year beginning on January 1, 2025, because Employee A was one of ATEO 1’s five highest compensated employees. Employee B has never been one of the five highest compensated employees and meets the limited hours exception for ATEO 1’s taxable year beginning on January 1, 2026. Employee A is covered employee of ATEO 1 for taxable year 2026 because Employee A was a covered employee for 2025. Employee B is not a covered employee for taxable year 2026.

C. Additional Information on the Forthcoming Proposed Regulations 

The Notice also states the following about the forthcoming proposed regulations: 

• Treasury and the IRS anticipate that the forthcoming proposed regulations would be prospective and would not apply to taxable years beginning before the issuance of final regulations 
• ATEOs may rely on the rules in the Notice that are anticipated to be included in the forthcoming proposed regulations, including the interpretation of the post-OBBBA definition of covered employee and the limited hours and nonexempt funds exceptions. As noted below, the proposed regulations could make these exemptions unavailable to officers of the ATEO.
• Treasury and the IRS are requesting comments be submitted on or before August 4, 2026. They are specifically requesting comments on: (1) any changes needed to adapt the current limited hours and nonexempt funds exception and the appropriateness of applying these exceptions to officers of the ATEO; and (2) any other issues that should be addressed in the forthcoming proposed regulations.

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