What’s Changed: Definition of Covered Employee Under Section 4960
Under the One, Big, Beautiful Bill Act (OBBBA), Public Law 119-21, the definition of a “covered employee” in tax-exempt organizations has expanded. For taxable years beginning after December 31, 2025, any employee of an applicable tax-exempt organization (or predecessor), and former employee who was such during any taxable year after December 31, 2016, is now considered a covered employee. The previous limitation—only the five highest-compensated employees—is rescinded. (irs.gov)
Existing exceptions for “limited hours” or “nonexempt funds” might still apply in upcoming proposed regulations, but the limited services exception will likely be eliminated because its rationale tied to displacement under the old five-person rule no longer applies. (irs.gov)
Implications for Tax-Exempt Organizations and Executives
| Affected Party | Risk Area | Action Needed |
|---|---|---|
| All execs (including those formerly excluded) | Excise tax under Section 4960 for excess compensation over $1 million or parachute payments | Identify who is now covered under new definition; monitor compensation structure |
| Boards and comp committees | Compliance and disclosure obligations | Review policies on executive pay, ensure reporting reflects broader definition |
| Employees formerly outside the top 5 | Unaware of covered employee status | Educate and communicate with staff about new status and potential tax consequences |
Example
Suppose Dr. Smith was one of the five highest-paid employees in 2023 but not in 2025; under prior law, her status would be temporary. Under the new definition, Dr. Smith remains a covered employee permanently, even if her compensation falls below the top five in subsequent years. (irs.gov)
Another employee, Ms. Lopez, performed limited services in 2024 and was never among the top five. If she meets the limited hours or nonexempt funds exception in proposed regs, she might not be covered—but limited services exception likely removed. (irs.gov)
Actionable Steps
- Audit current and former employees to determine who now qualifies as a covered employee under the OBBBA definition.
- Model potential excise tax liabilities for excess compensation (over $1 million) and parachute payments for newly covered employees.
- Monitor IRS guidance on the limited hours and nonexempt funds exceptions to determine applicability.
- Update board charters and compensation policies to reflect these changes in oversight and documentation.
- Train payroll, legal, and HR teams on reporting obligations and the new definition to avoid surprises.
Wrap-Up
The broadened definition in Section 4960 marks a major shift for how nonprofits must approach executive compensation. Rather than focusing only on the “top 5,” any individual who meets the expanded criteria may be subject to excise taxes on high pay or parachute payments. Early preparation—and clear internal communication—will help minimize compliance risk and financial exposure.