These tax-exempt entities will be in an entirely new world of compliance as the IRS starts to implement changes in rules relating to executive compensation. The IRS has issued Notice 2026-36, and this notice will provide the guidance needed for the implementation of the new rules in light of the legislation amended by the One Big Beautiful Bill Act (OBBBA). The amendment expands the category of employees that may come under the taxation ambit of IRC Section 4960. Hence, it is important for nonprofit organizations, foundations, schools, hospitals, and other tax-exempt entities to reconsider their executive compensation plans.
This blog will discuss how the executive compensation excise tax rule has changed for the year 2026, what is provided in the IRS Notice 2026-36, covered employees as per the new rule, related organizations impact and actions that tax-exempt organizations should consider.
How the IRS Expanded Executive Compensation Rules for 2026
The most recent guidance that has come from the IRS represents the biggest overhaul in how executive compensation is taxed for tax-exempt organizations since the enactment of Section 4960 in the Tax Cuts and Jobs Act. While the tax hasn’t actually been amended, its applicability scope has significantly expanded, which means that a new burden of compliance will begin in the 2026 tax year.
Understanding the Purpose of Section 4960
Section 4960 is an excise tax that is levied at 21% on ATEOs and related organizations where either compensation exceeding one million dollars is paid to covered employees or the parachute payments made qualify beyond the specified threshold following separation from employment.
This tax policy was initially aimed at bringing certain exempt organizations in line with existing rules regarding executive compensation that were already applicable to publicly held corporations. It does not limit the compensation; rather, it adds a penalty for giving excessive executive compensation.
The Definition of a Covered Employee Has Changed
Prior to the changes through the OBBBA, Section 4960 generally only applied to an organization’s five highest paid individuals in any one taxable year. After being considered a covered individual under the Section 4960 rules, the individual was deemed to remain a covered individual for following years, even if the individual were to leave the organization.
Starting with any tax year beginning in 2026, the definition becomes much more inclusive. Not only will it no longer focus on the five highest compensated individuals but many, if not most, of the currently employed individuals at an applicable tax-exempt organization might qualify as covered employees. There are a few regulatory exclusions that might still apply.
Why IRS Notice 2026-36 Matters
Even though the legislation was passed by Congress in 2025, there were still questions from many organizations regarding the application of the new definition. In this context, the Internal Revenue Service has provided an interim guidance in Notice 2026-36 that can be used by organizations until the issuance of final regulations.
In this way, the guidance brings much-needed certainty regarding two major issues: the treatment of the expanded definition of the term "employee" over time, as well as the applicability of the existing regulatory exceptions.
Key Guidance Organizations Should Understand Before 2026
Several questions have been answered by the IRS regarding those raised following the law change. Clarification of these points allows organizations to understand which individuals need to be considered in compensation formulas and how current exemptions will work.
The Expanded Rules Apply Prospectively Rather Than Retroactively
One of the primary issues that arose due to the changes made to OBBBA had to do with whether the expanded definition would apply retroactively to employees employed by the tax-exempt employer between 2017 and 2025 despite the fact that they were not the highest-paid employees in the organization.
The issue has been clarified by the IRS through Notice 2026-36 that states that the expanded definition will only apply prospectively starting from tax years that began after December 31, 2025. Those who were employed in any of the prior years will not be automatically considered covered employees.
Existing Covered Employees Continue to Remain Covered
It also sustains the well-known principle of “Once a covered employee, always a covered employee.” The persons who were considered as covered employees under the old Act will remain in that category for all coming tax years.
This implies that the companies will not be able to ignore the records of past salaries while assessing their compliance in the future. The HR, payroll, and finance department will have to keep track of those covered employees along with newly added covered employees from 2026 onwards.
Organizations Can Rely on the Interim Guidance
While no official regulations have yet been issued, the IRS clearly states that “organizations may use the guidance provided in Notice 2026-36 while waiting for publication of the proposed regulations.”
Such an approach allows organizations to feel certain regarding the actions they must take currently when preparing packages of executive remuneration, calculating costs related to their employees' salaries, or considering their tax responsibilities.
Compliance Considerations for Tax-Exempt Organizations Moving Forward
The new guidelines have far more implications than just executives' salaries. Organizations that have a corporate structure which involves affiliates or shared workers need to be aware of how their compensation reporting process works.
Related Organizations Face Greater Reporting Responsibilities
Section 4960 already mandates that an organization must consider the compensation of related parties in making the determination for applicability of the excise tax. This would include compensation paid by a taxable corporation where there is joint employment between the taxable corporation and the tax-exempt organization.
For instance, if there is joint employment between the taxable corporation and the charity, compensation received by an executive from both organizations might be aggregated to determine if the executive surpasses the compensation threshold limit.
Some Regulatory Exceptions Remain Available
According to the IRS, two essential exemptions already included in the current regulations shall remain in place under the expanded exemptions. This applies to the limited hours exemption and the nonexempt funds exemption because such exemptions apply to cases of employees of related entities performing limited services to a tax-exempt organization without getting compensated by that organization.
The exemptions remain applicable for practical reasons in case of organizations functioning as part of a greater corporate group. It means that not all shared employees require any additional obligations because their contribution to the tax-exempt organization is limited.
The Limited Services Exception Will Be Eliminated
The difference between this exception and the others is that the IRS has no intention of keeping the limited services exception in the upcoming rules. According to the prior Top Five rule, this exception ensured that people earning only small amounts of money could not displace those who would have been the most highly compensated employees.
In view of the broader definition, which no longer requires finding five employees, this exception is no longer necessary. Companies utilizing this exception need to change their plans when the rules come into effect.
Notice 2026-36 by the IRS brings clarity in times when tax-exempt organizations need it the most, as they are preparing for the new provisions on executive compensation and excise taxes to be implemented in 2026. Through clarifying the prospective application of the wider covered employee definition and specifying which of the existing regulatory exceptions will continue to apply, the IRS has decreased the level of uncertainty and provided nonprofits enough time to improve their systems in order to avoid possible problems.
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