IRS issues notice on proposed exec comp excise tax rules

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The IRS gave notice (PDF - 125.32KB) June 5 of its intent to issue proposed regulations for the expanded excise tax on executive compensation for certain tax-exempt organizations.

The tax was significantly expanded by the One Big Beautiful Bill Act (OBBBA), signed into law on July 4, 2025, and is effective for tax years beginning in 2026. IRS Notice 2026-36 previewed two key items of guidance anticipated to be in the proposed regulations for that expanded excise tax, which applicable tax-exempt organizations (ATEOs) can rely on until regulations are formally proposed and finalized.

Section 4960, which was originally enacted as part of the Tax Cuts and Jobs Act of 2017, imposes a 21% excise tax on ATEOs (and their related organizations) that pay covered employees remuneration in excess of $1 million or parachute payments — compensation contingent on separation from employment — equal to at least three times a covered employee’s average pay. These excise taxes were first effective for tax years beginning in 2018.

Prior to the OBBBA, the term “covered employee” was defined to include any employee (including any former employee) of an ATEO who (i) was one of the five highest-compensated employees of the ATEO for the current tax year (“Top 5”), or (ii) was a covered employee of the ATEO (or any predecessor) for any of the ATEO’s preceding tax years beginning after 2016 (known as the “once a covered employee, always a covered employee” rule).

The OBBBA significantly expanded the definition of covered employee beginning with the 2026 tax year to include all current employees of an ATEO; the definition is no longer limited to the Top 5 for the current year. This expansion could significantly increase the excise taxes an ATEO, and its related organizations, may have to pay under Section 4960 beginning with the 2026 tax year.

As noted, Notice 2026-36 also provides guidance on two key issues that the IRS anticipates will be in the forthcoming proposed regulations. The first involves the IRS’ interpretation of the effective-date provision in the OBBBA that broadens the definition of covered employee, which provides that the new definition applies to tax years beginning after Dec. 31, 2025.

Because the new statutory language added by the OBBBA provides that the term “covered employee” includes any current or former employee of an ATEO “who was such an employee during any taxable year beginning after Dec. 31, 2016,” there has been a concern that the new definition would include all employees who performed services for an ATEO during the pre-OBBBA period beginning in 2017 and ending in 2025 — that is, whether the new definition would apply retroactively to tax years before 2026. 

The IRS announced in Notice 2026-36 that it interprets the effective-date provision in OBBBA to broaden the definition of covered employee only for tax years of an ATEO beginning after Dec. 31, 2025, and to retain the prior definition of covered employee for tax years beginning on or before Dec. 31, 2025, including for purposes of determining whether a former employee was a covered employee in a tax year beginning  before 2026.

The new definition would essentially apply only prospectively beginning with the 2026 tax year. Under this interpretation, the definition of covered employee, as amended by OBBBA, would include only:

• Any individual who was an employee of an ATEO in any taxable year beginning after Dec. 31, 2016, and on or before Dec. 31, 2025, if the individual was a covered employee for the taxable year under prior law (that is, under the Top 5 rule), and
• Any individual who is an employee of an ATEO in any taxable year beginning after Dec. 31, 2025, subject to applicable exceptions.

The second guidance item included in Notice 2026-36 addresses whether certain exceptions to the definition of covered employee provided in current final regulations under Section 4960 will continue to apply to the expanded definition for tax years beginning after 2025.

Under the related organization rules, compensation paid by all related organizations to an ATEO employee must be taken into account for purposes of applying the Section 4960 excise taxes, even compensation paid by taxable organizations. For example, if a taxable company has a foundation that is an ATEO and the company’s employees provide services to the foundation or are officers of the foundation, the compensation paid by the company and foundation to the shared employees generally must be aggregated for purposes of applying the Section 4960 excise taxes, including determining the covered employees of the ATEO foundation.

The final regulations issued under the pre-OBBBA definition of covered employees include exceptions intended to ensure that certain employees of a related non-ATEO providing services as an employee of an ATEO are not treated as one of the top five employees of the ATEO, provided that certain conditions related to the individuals’ remuneration or hours of service are met. These exceptions are known as the “limited hours,” nonexempt funds,” and “limited services” exceptions, and an individual meeting the conditions for any of these exceptions is disregarded for purposes of determining an ATEO’s Top 5 for a taxable year.