Entity Setup
Preparing Entities for the Broader Definition of Covered Employee Under Section 4960
Section 4960’s changings under OBBBA expand which tax-exempt org executives are subject to hefty pay excise tax—learn who is newly in, what it means, and how to plan.
By NomadicTax Research Team • 5-8 min read • August 3, 2026
## What is Section 4960?
Section 4960 imposes an excise tax on **“applicable tax-exempt organizations” (ATEOs)** for compensation paid to **covered employees** above $1 million or for excess parachute payments. Under prior law, only the top five highest-compensated employees were “covered.”([irs.gov](https://www.irs.gov/irb/2026-26_irb?utm_source=openai))
## Expansion under the One, Big, Beautiful Bill (OBBBA)
With enactment of **Public Law 119-21** (signed July 4, 2025), the definition of “covered employee” under Sec. 4960 was broadened for taxable years beginning **after December 31, 2025**. Now, it includes:
- Any employee who was employed by the ATEO in any taxable year **after December 31, 2016** and on or before **December 31, 2025**, if that individual was already a covered employee under prior law
- Any employee in any taxable year beginning **after December 31, 2025** (regardless of rank) unless an exception is carved out in forthcoming guidance.([irs.gov](https://www.irs.gov/irb/2026-26_irb?utm_source=openai))
## Implications for entities
- Entities may see many more employees subject to a $1 million compensation cap tax than before.
- Exempt organizations must assess compensation arrangements across a broader span of employees—for instance, someone who earned above the threshold in isolated years between 2017-2025 could now be permanently covered.
- Budgeting for the excise tax must incorporate costs for potentially more covered employees.
## What’s coming & how to prepare
The IRS and Treasury issued **Notice 2026-36**, signaling they intend to issue proposed regulations under Sec. 4960. These proposals will include **exceptions** (e.g., limited hours, nonexempt funds) and clarify the **effective date of the expanded definition**, although taxable years beginning after Dec 31, 2025 are already in scope.([irs.gov](https://www.irs.gov/irb/2026-26_irb?utm_source=openai))
To prepare:
- Identify if any employee who worked any time since 2017 might qualify under “covered employee” by compensation history.
- Review and document all compensation arrangements exceeding $1 million or parachute provision provisions.
- Assess whether contracts or deferred compensation may trigger the tax in unexpected employees.
- Monitor for upcoming proposed regulations to see options for exclusions or carve-outs.
## Example scenario
- **Organization X**, a nonprofit, had 10 employees. Only top 5 earned over $1 million in 2024—but a 10th‐rank employee earned just under threshold. That person *is not* a covered employee under prior law, so no tax—for that year. But under OBBBA’s new law, for taxable years post-2025, that same employee is likely treated as a covered employee, although tax on them depends on compensation exceeding limit.
- **Organization Y** employs someone who left in 2018 but earned over $1 million that year. Under new expanded definition, if they met “covered employee” under older rules then, they remain covered for future payable or parachute payments.
**Strategic tip:** Audit your compensation records from 2017-2025. If someone was “covered” previously, they may stay covered forever. Consider adjusting compensation strategy (bonuses, deferred pay) for newer hires if possible.