Compliance
Compliance Challenges for Tax-Exempt Organizations: Understanding the New Definition of Covered Employee
Tax-exempt organizations must heed changes to the definition of 'covered employee' under section 4960, effective 2026, as the scope of excise tax liability broadens significantly.
By NomadicTax Research Team • 5-8 min read • July 23, 2026
## What’s New Under Section 4960 for ATEOs
The One, Big, Beautiful Bill (OBBBA) amended sec. 70416, which changed who qualifies as a “covered employee” for purposes of the **excise tax** imposed under § 4960:
- **Expanded Definition**: Now includes ANY employee of an Applicable Tax-Exempt Organization (ATEO) (or predecessor) for taxable years *after* December 31, 2025. Also includes former employees who served after December 31, 2016. ([irs.gov](https://www.irs.gov/irb/2026-26_irb?utm_source=openai))
- **Prior Rule** limited coverage to an entity’s *five highest compensation* employees—no longer sufficient.
- Some exceptions (like limited hours, nonexempt funds) may still apply; IRS intends to issue proposed regulations to clarify these exceptions. ([irs.gov](https://www.irs.gov/irb/2026-26_irb?utm_source=openai))
## Risks & Compliance Actions
### What Can Trigger Excise Tax Exposure
- Excessive compensation (over $1 million/year per covered employee).
- Parachute payments.
- Making payments to formerly excluded employees who now fall under covered definition.
- Failing to track which employees are “covered” under new definitions; paying without requisite reporting.
### Steps ATEOs Should Take Now
- **Audit your employee roster**: See who was employed any time after December 31, 2016, or hired thereafter.
- **Review compensation practices**: Bonuses, perks, severance could be impacted.
- **Update internal policies and control frameworks**: Contract language, board oversight, executive awards.
- **Prepare for proposed regulations** that will clarify exceptions (limited hours, nonexempt funds). Consider providing input during public comment period (due August 4, 2026). ([irs.gov](https://www.irs.gov/irb/2026-26_irb?utm_source=openai))
## Practical Example
- **Before 2026**, a mid-level director not among top five earners avoided covered employee status—even if making $500,000.
- **Post-2025**, that same director, since employed post-2016, becomes a covered employee under the broader definition and could trigger excise tax liability for the organization if remuneration exceeds $1 million.
## Key Takeaways for ATEOs
- The definition shift renders many more employees subject to compensation limits.
- Excise tax is not only about top-tier salaries; second-tier executives and long-time employees could be affected.
- Organizations need to plan compensation, benefit, and retirement packages accordingly.
- Stay tuned for IRS proposed regulations to understand exceptions and recordkeeping requirements.
**Bottom line**: Nonprofits, charities, hospitals, universities—any ATEO—should immediately update compliance frameworks and compensation policies to avoid excise tax surprises in 2026+.