What’s Changing Under Section 4960
The One, Big, Beautiful Bill Act (OBBBA) amended IRS Code Section 4960 to broaden which individuals at Applicable Tax-Exempt Organizations (ATEOs) are considered covered employees. Previously, only the top five highest-paid employees in ATEOs were in scope. Now, any employee (or former employee if they were ever covered in a post-2016 year) who earns more than $1 million in a tax year or receives an excess parachute payment is a covered employee. (irs.gov)
Transitional Relief and Exceptions
Notice 2026-36 offers some relief during the transition:
- The new definition applies only to taxable years beginning after December 31, 2025. Prior years are under the old rules. (irs.gov)
- Exceptions are expected in the forthcoming regulations for employees with limited hours or whose pay comes from nonexempt funds. These mirror existing exceptions for “highest paid employees” status. (irs.gov)
- There is no limited services exception anticipated under the amended definition. (irs.gov)
Practical Steps for Nonprofits
To stay compliant and limit surprise tax exposure, organizations should:
- Identify individuals who will be covered employees under the new definition. Check both current and former employees (post-2016) who earned > $1 million or would do so under the new test.
- Audit historical compensation practices, including parachute payments or any large severance payments that could trigger the tax.
- Assess sources of compensation, distinguishing between exempt and nonexempt funds (such as endowments vs. donor-restricted or nonpublic sources) to apply the nonexempt funds exception. Verify hours worked to apply limited hours exception if relevant.
- Track and document compensation and hours meticulously. Maintain records so that any argument for exception is supported by verifiable data.
- Monitor forthcoming regulations, scheduled to be released post-Notice 2026-36. Since IRS solicited comments due Aug. 4, 2026, final rules may clarify definitions, timelines and compliance obligations. (irs.gov)
Example Scenario
Case: Jane Doe, who works part-time (20 hours/week) for a university foundation (an ATEO), earns $1.2 million per year, funded partially via nonexempt funds. Under the expanded definition, she would be a covered employee unless she qualifies for the limited hours exception (yes, possibly given part-time status) or nonexempt funds exception (yes, some income from parts nonexempt). If she qualifies on either exception, the excise tax on excess compensation may not apply; if not, the excise tax of 21% (for nonprofits) on her excess over $1 million could be triggered. Proper documentation from payroll and fund source tracking enables reliance on exceptions.
Action Plan Before Fiscal Year End
- Perform an internal review of all employees near or exceeding $1 million in compensation.
- Identify which employees may qualify for limited hours or nonexempt fund exceptions.
- Evaluate your fiscal year, begin mapping what changes in payroll policies or staff time tracking you need to implement.
- Draft commentary or feedback if the proposed regulations' current structure imposes undue burdens before they become final.
- Update governance materials and communicate with leadership about financial risk under expanded excise tax.
Bottom line: The expansion of Section 4960 under OBBBA dramatically increases the number of individuals in tax-exempt entities who may be subject to excise tax on excess compensation. Nonprofits must act promptly to evaluate coverage, document exceptions, and prepare for compliance under final regulations.