Executive compensation has always been one of the areas that has attracted the attention of the tax authorities, especially in instances involving tax-exempt organizations enjoying certain exemptions and benefits regarding taxes. In this regard, the issuance of the Internal Revenue Service (IRS) Notice 2026-36 is a big change that has been made on the application of the excise tax under Section 4960 because of the changes that were made through the amendments brought about by OB3 Act.
This blog highlights what has been announced by the Internal Revenue Service through IRS Notice 2026-36, what the changes brought about by the new definition of a covered employee mean for the excise tax, the transitional guidance provided, and the actions tax-exempt employers should take pending the final regulations.
Understanding IRS Notice 2026-36 and the Expanded Executive Compensation Rules
With regard to the issuance of Notice 2026-36, it becomes evident that one may get the first indication regarding how the government is going to enforce new legislation concerning executive compensation of tax-exempt entities. Although Notice 2026-36 does not provide conclusive instructions, it allows tax-exempt entities to understand the direction in which regulations should be developed in the near future.
Why Section 4960 Matters for Tax-Exempt Organizations
Initially, Section 4960 was created to levy an excise tax on unreasonable executive pay provided by the particular tax-exempt organization. This provision becomes applicable when an individual is paid more than $1 million annually or is granted a parachute pay after separation from service. The aim of this provision was to hold the tax-exempt organizations responsible for providing excessive pay to executives in spite of their tax exemption.
In accordance with previous legislation, the tax only concerned the top five compensated individuals within an organization. Thus, it greatly narrowed down the list of covered individuals. Nevertheless, the latest legislative changes significantly expand the scope of this provision.
How the One Big Beautiful Bill Act Changes the Rules
The One Big Beautiful Bill Act dramatically broadens the coverage criteria within Section 4960. While previous legislation confined coverage to no more than the top five highest-paid individuals, the expanded provisions allow for the inclusion of any individual whose salary exceeded one million dollars during the calendar year, or those receiving an excess parachute payment.
Such a change has significant implications regarding compliance efforts. While in the past a company might have focused on a handful of key executives regarding their compensation practices, under the new rules they must be concerned about compensation practices for far more individuals. Large medical organizations, universities, research facilities, and national nonprofit organizations would likely be most affected.
Who Qualifies as a Covered Employee Under the New Guidance
Notice 2026-36 clarifies how the IRS plans to interpret and implement the modified definition during the transition period. Individuals who are considered covered employees based on the former rule for tax years starting after December 31, 2016, and through December 31, 2025, will be considered covered employees under the historical definition.
For tax years after December 31, 2025, most employees have the possibility of becoming covered employees depending on whether their compensation exceeds the threshold except when an exception is applied. This new approach aims to fulfill Congress's intention of applying the excise tax to senior executives beyond a small pool of such individuals.
Key Transitional Guidance and Compliance Considerations
While final rules have not been released yet, Notice 2026-36 provides transitional guidance on which employers can rely. The transitional rules enable employers to continue their compliance with Section 4960 and give the Treasury Department the necessary time to issue final regulations.
Continued Availability of Certain Exceptions
An important feature in this notice is how it handles the exemptions currently existing. In the Notice 2026-36, the Internal Revenue Service (IRS) says the new regulations should maintain some of the existing exemptions such as the limited hours exemption and nonexempt funds exception. This means organizations can use these exemptions to determine their covered employees until further notice.
This exemption is especially important since the previous regulations made provisions for determining the five highest compensated employees in the organization. However, with the change in the definition brought by the amendments, it is difficult to use this method, which makes these exemptions necessary.
Limited Services Exception Expected to Be Removed
Contrary to the limited-hours and nonexempt-funds exclusions, the limited-services exclusion is likely to be obsolete under the new regime. As the definition of a covered employee has been substantially altered, this particular exception has no longer become consistent with the new law and is thus unlikely to be continued.
Companies depending upon this limited-services exception would need to consider if their remuneration scheme could now come within the ambit of Section 4960. Early assessment could ensure identification of tax liability before the promulgation of final regulations.
Effective Dates and Future Regulations
According to the IRS, the anticipated future proposed regulations will be applicable for tax years following the final issuance of the regulations. This is meant to give the organization adequate time to get acquainted with the new guidelines before implementing the regulations.
Despite this delay, it is still imperative to prepare well ahead of time. This is because executive compensations are often complicated by several factors such as employment contracts and deferred compensations.
Preparing for the Future of Executive Compensation Compliance
Since Section 4960 will affect a larger number of organizations, it is prudent to start evaluating the organization’s compensation arrangements early on before the final regulations take effect, thus reducing the risk of exposure to unnecessary tax liabilities.
Reviewing Executive Compensation Policies
Organizations need to begin the process of evaluating current executive compensation schemes in order to identify those that could cause employees to fall within the realm of the $1 million compensation limit. Such an analysis would consider all forms of compensation including salaries, bonuses, deferrals, incentives, severances, and any other form of compensation.
Compensation review also helps organizations identify areas where excess parachute payments would lead to excise taxes and gives room for planning ahead to avoid problems in future employment contracts.
Strengthening Internal Compliance Procedures
The more inclusive definition for “covered employee” would mean that there is a need for improved recordkeeping and internal monitoring practices. In this regard, HR, payroll specialists, accountants, and legal advisers can be involved in the process to make sure that accurate data on employee compensation is maintained over the entire year.
Companies may also implement some regular evaluations aimed at detecting workers who reach the relevant levels of compensation. Such evaluations will help to avoid any possible reporting omissions.
Opportunity to Participate in the Rulemaking Process
An opportunity for commenting is available until August 4, 2026, concerning Notice 2026-36. In particular, the IRS calls on all parties concerned to share opinions regarding possible changes in the limited hours exception, nonexempt funds exception, and whether such exceptions can be applied to officers of the tax-exempt organizations.
Comments are highly appreciated since they will be considered when preparing the final regulations. Nonprofit organizations, tax professionals, and lawyers can utilize the opportunity to shape the future of regulations based on their practical expertise.
IRS Notice 2026-36 is significant when it comes to regulating executive pay in tax-exempt entities because by broadening the criteria under which the covered employee would be identified according to Section 4960, the IRS will be laying down the foundation of the excise tax on more highly compensated individuals, but will still allow some transition rules until the final regulations come out.
While the regulations are still under development, it is advisable for tax-exempt organizations to start thinking about how they will comply with the expanded rules that will apply soon.
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