Overview of the Change
Notice 2026-36, issued June 5, 2026, signals forthcoming regulations that broaden the definition of “covered employee” under tax-exempt organizations (Applicable Tax-Exempt Organizations, or ATEOs). Under the One, Big, Beautiful Bill (OBBB), this tax now applies to any employee earning over $1 million or receiving an excess parachute payment—not just the previous top five highest-paid employees. (irs.gov)
Key Definitions & Exceptions
- Covered Employee: Was restricted to the top five highest-paid but now includes employees exceeding $1 million in compensation for tax years after Dec. 31, 2025. (irs.gov)
- Exceptions include:
- Limited hours exception;
- Nonexempt funds exception (e.g., salaries funded by grants, etc.). These still apply temporarily until final regulations come out. (irs.gov)
What ATEOs Need to Do Now
- Audit compensation scales: Identify all employees earning over $1 million and track parachute payments.
- Review funding sources: Distinguish between exempt vs. nonexempt funds as exceptions are temporary but depend on these categorizations.
- Document compensation agreements carefully: Which years apply, when payments were made—these matter for both compensation and parachute pay.
- Monitor rulemaking process: Comments requested by August 4, 2026; stay tuned for proposed regulations. (irs.gov)
Potential Impacts & Risks
- Tax liability: More employees may now trigger excise taxes, increasing costs or redistributing compensation strategies.
- Governance and pay transparency: ATEOs should rethink their executive pay policies.
- Contractual obligations: Parachute payment contracts may face new scrutiny or require modifications.
Example Scenario
A tax-exempt hospital pays its chief surgeon $1.2 million/year and uses grants (nonexempt funds) to pay for some portion of her compensation. Under the new rules, unless a valid exception is met, that compensation could be subject to the excess compensation excise tax—even if she wasn’t in the top 5 by pay. Same for severance packages considered parachute payments.
Actionable Best Practices
- Benchmark executive compensation now, anticipating changes;
- Revise compensation agreements or severance terms to minimize excess parachutes;
- Ensure robust documentation of employee classification, hours worked, and funding sources;
- Consult with tax advisors—new or revised policies needed immediately so compliant with upcoming regulations.
Timeline to Watch
- June 5, 2026: Issuance of Notice 2026-36 (alert to rulemaking) (irs.gov);
- August 4, 2026: Deadline for public comments; regulation language likely released afterward.
For tax-exempt entities, this signals a shift toward greater accountability and expanded tax liability. Compliance requires prompt review of pay structures, documentation, and policies under OBBB’s revised definitions.