For eight years, Section 4960 of the Internal Revenue Code imposed a 21% excise tax on compensation above $1 million paid to a narrow group: the five highest-compensated employees of an applicable tax-exempt organization, plus anyone who had ever been in that group. Hospital systems, universities, and large nonprofits built their compensation monitoring around that five-person cap. The cap no longer exists.
The One Big Beautiful Bill Act, signed into law on July 4, 2025, as Public Law 119-21, eliminated the five-highest-compensated limitation for tax years beginning after December 31, 2025. For calendar-year organizations, that means 2026. On June 5, 2026, the IRS issued Notice 2026-36 announcing its intent to issue proposed regulations under Section 4960 and providing interim guidance that ATEOs can rely on now. Comments are due August 4, 2026.
This post covers what the notice says, who is now a covered employee, which exceptions survive, which one was eliminated, and what your finance and HR teams need to do before August 4.
What Is Section 4960 and Who Did It Apply to Before?
Section 4960 was enacted as part of the Tax Cuts and Jobs Act in December 2017. It imposes an excise tax equal to the corporate tax rate, currently 21%, on any applicable tax-exempt organization (ATEO) or related person or governmental entity that pays a covered employee either remuneration in excess of $1 million in a taxable year or an excess parachute payment exceeding a defined threshold.
The excise tax liability falls on the employer, not the employee. If the compensation is split between the ATEO and a related taxable organization, the tax is allocated proportionately between them based on the compensation each pays.
Under the pre-OBBBA rules, a covered employee was defined as any employee who was either:
One of the five highest-compensated employees of the ATEO for the taxable year, or
A covered employee of the ATEO or any predecessor for any preceding taxable year beginning after December 31, 2016.
The second prong is the "once a covered employee, always a covered employee" rule. Once an individual landed in the top five, they stayed covered permanently, even after leaving the organization. That permanence was already aggressive in scope. The OBBBA made the first prong dramatically broader.
One carve-out that matters for healthcare organizations: remuneration paid to a licensed medical professional, including a physician, nurse, or veterinarian, for the performance of medical or veterinary services is excluded from Section 4960 remuneration. This exclusion has not changed.
What Did the One Big Beautiful Bill Change About Section 4960?
The OBBBA, through Section 70416 of Public Law 119-21, struck the "five highest-compensated employees" language from Section 4960(c)(2). Effective for taxable years beginning after December 31, 2025, the definition of covered employee no longer has a cap based on relative compensation rank within the organization.
What that means in plain terms: starting in 2026, any employee of an ATEO is potentially a covered employee for Section 4960 purposes, not just the top five. A mid-level administrator earning $1.1 million at a large university system who was never among the five highest-paid employees is now potentially within scope.
The practical expansion is significant for large tax-exempt organizations with complex compensation structures. Hospital systems with employed physician groups, universities with high-earning research faculty and athletics administrators, and large national nonprofits with multiple related entities all need to rethink how they monitor Section 4960 exposure.
Notice 2026-36, issued June 5, 2026, is the IRS's first formal guidance on how the OBBBA expansion will be implemented. It does three things:
It interprets the effective date of the OBBBA amendment in a way that is favourable to ATEOs by limiting retroactive application.
It confirms that certain existing regulatory exceptions will carry forward into the new framework.
It announces that one exception will not carry forward.
Comments on the notice are due August 4, 2026. The IRS has specifically requested input on two issues: whether the limited hours and nonexempt funds exceptions should be adapted to the new definition, and whether those exceptions should be available for officers of the ATEO.
What Is a Covered Employee Under the New Rules?
Notice 2026-36 provides a two-tier structure for determining covered employee status under the post-OBBBA definition.
Tier 1: Legacy covered employees from prior years. For taxable years beginning on or before December 31, 2025, the old five-highest-compensated rule continues to apply. An individual is a legacy covered employee only if they were actually treated as a covered employee under prior law for a taxable year in that period. Specifically, a former employee who worked at an ATEO during a taxable year beginning after December 31, 2016, and on or before December 31, 2025, is treated as a covered employee in post-2025 years only if they were among the five highest-compensated employees of the ATEO (without qualifying for an exception) during those prior years.
This is significant. Without this interpretation, there would have been uncertainty about whether every former employee who had worked at an ATEO at any point since 2017 was automatically a covered employee going forward, even if they had never been among the top five. The IRS's interpretation forecloses that result: the lookback period uses the old five-highest framework, not the new broad definition.
Tier 2: Current employees in 2026 and after. For taxable years beginning after December 31, 2025, any individual who is an employee of an ATEO is a covered employee, subject to exceptions. There is no longer any requirement that the individual be among the highest-compensated employees of the organization for the current year.
The notice includes an example to illustrate how the tiers interact. Employee A has been employed by ATEO 1 and a related taxable corporation (CORP 2) since 2017. Employee A was among ATEO 1's five highest-compensated employees for the taxable year beginning January 1, 2025, and did not qualify for an exception. As a result, Employee A is a covered employee of ATEO 1 for 2026 and all future years through Tier 1. Employee B worked alongside Employee A but was never among the five highest-compensated employees and qualified for an exception during all prior years through 2025. For 2026, Employee B is a covered employee through Tier 2 because the old five-highest cap no longer applies.
What Does "Once a Covered Employee, Always a Covered Employee" Mean?
The permanent covered employee rule existed before the OBBBA and continues to apply after it. Once an individual achieves covered employee status under either the old rules (top five) or the new rules (any employee of an ATEO in a taxable year beginning after December 31, 2025), that status is permanent for all future taxable years.
This rule has real operational bite. An employee who joined an ATEO for the first time in 2026 and earned over $1 million triggers covered employee status. If they later leave and take a position at a related taxable entity earning $2 million per year, Section 4960 potentially applies to that compensation through the related-organization aggregation rules, for the rest of their career.
For organizations with high turnover in senior positions, or for those that have related taxable subsidiaries employing former ATEO employees, the population of individuals subject to the permanent rule expands with every year under the new framework.
The Clark Nuber analysis of Notice 2026-36 illustrates how the permanence rule interacts with the two-tier structure through a concrete example. A son who worked as a paid summer employee at a family foundation in 2017 earning typical summer wages is not a Tier 1 legacy covered employee because he was not among the foundation's five highest-compensated employees that year. He is also not a Tier 2 covered employee in 2026 if he is not currently an employee of any ATEO. He is a volunteer board member, but unpaid board service is not employment for Section 4960 purposes. His $1 million salary at a related taxable corporation is therefore not subject to Section 4960 in this scenario.
The point of the example is that not every individual associated with a tax-exempt organization falls within the expanded definition. The analysis still requires careful application of both tiers to each individual.
Which Tax-Exempt Organizations Are Affected?
Section 4960 applies to applicable tax-exempt organizations (ATEOs). An ATEO is any organization exempt from tax under Section 501(a), any state or local government or political subdivision, any agency or instrumentality of a state or local government, and any other organization that has income excluded from gross income under Section 115.
Common ATEOs include Section 501(c)(3) organizations (public charities, private foundations, hospitals, universities), Section 501(c)(4) social welfare organizations, Section 501(c)(6) trade associations, and governmental entities with excluded income.
Related organizations are also within the Section 4960 framework. A related organization is one that controls or is controlled by the ATEO, or is controlled by persons who control the ATEO. Control is defined by reference to existing IRC provisions. When a covered employee receives compensation from both an ATEO and a related organization, the Section 4960 remuneration includes compensation from all entities in the related-organization group. The liability is allocated proportionately between them.
For large multi-entity systems, the practical implication is that compensation tracking must span the entire family of related entities, not just the ATEO itself. A hospital system with an employed medical group structured as a taxable subsidiary, a research foundation, and a holding company structure needs to aggregate compensation across all of those entities to determine whether any individual's combined remuneration exceeds $1 million.
What Are the Limited Hours and Nonexempt Funds Exceptions?
The existing Section 4960 regulations at Treasury Regulation Section 53.4960-1(d)(2) provide three exceptions to the covered employee definition. Two of them survive into the post-OBBBA framework under Notice 2026-36's interim guidance.
Limited hours exception. An individual is not treated as a covered employee of an ATEO if neither the ATEO nor any related ATEO pays remuneration to the individual for services rendered to the ATEO and the individual performs services for the ATEO for no more than 100 hours during the taxable year. This exception was designed for employees of related non-ATEO entities who perform occasional services for the ATEO without being compensated by it directly.
Nonexempt funds exception. An individual is not treated as a covered employee of an ATEO if any remuneration paid by the ATEO to the individual is solely for services performed as an employee of a related organization whose income is not excluded under Section 501(a) or Section 115. This exception addresses situations where the ATEO acts as a conduit for compensation that is economically attributable to a taxable related entity.
Notice 2026-36 confirms that both the limited hours and nonexempt funds exceptions will be carried into the forthcoming proposed regulations in a form similar to the current regulations. ATEOs can rely on these exceptions now, without waiting for the proposed regulations to be issued. The IRS has specifically requested comments on whether these exceptions need to be adapted to work with the new broad definition of covered employee, and whether they should be available for officers of the ATEO.
What Happened to the Limited Services Exception?
The third exception, the limited services exception at Treasury Regulation Section 53.4960-1(d)(2)(iv), is not being carried forward.
Under the old rules, the limited services exception provided relief for employees of related non-ATEO organizations who performed limited services for the related ATEO, preventing those employees from counting toward the ATEO's five highest-compensated employee list. The purpose of the exception was specifically tied to the five-highest-compensated cap: it prevented an employee who performs minimal services for the ATEO from inadvertently displacing someone who genuinely belongs on the top-five list.
With the five-highest-compensated cap gone, the rationale for the limited services exception disappears. Notice 2026-36 explains this directly: the concern that motivated the exception, displacement of an employee who would otherwise have been one of the five highest-compensated employees, no longer applies under the OBBBA's expanded definition. There is no longer a top-five list to be displaced from.
For organizations that have been relying on the limited services exception to exclude employees of related taxable entities from Section 4960 analysis, the elimination of this exception requires a review. Those individuals may now be covered employees under Tier 2 if they are employees of an ATEO in a taxable year beginning after December 31, 2025, even if their services for the ATEO are minimal.
The IRS's decision not to carry forward the limited services exception is the most operationally significant conclusion in Notice 2026-36 for large multi-entity exempt organizations. HR and compensation teams that have treated certain shared-service employees as outside the Section 4960 analysis based on the limited services exception need to revisit that classification.
What Should Your Organization Do Before August 4, 2026?
Four things, in order of urgency.
Map the covered employee population for 2026. Apply both tiers of the new definition to identify who is a covered employee of each ATEO in your organizational structure for the taxable year beginning after December 31, 2025. For calendar-year organizations, that means your 2026 taxable year. Tier 1 covers anyone who was among the five highest-compensated employees in any year from 2017 through 2025 without qualifying for an exception. Tier 2 covers anyone who is an employee of an ATEO in 2026, subject to the limited hours and nonexempt funds exceptions.
Aggregate compensation across related entities. Section 4960 remuneration includes compensation paid by the ATEO and all related organizations. For each individual identified as a covered employee, aggregate their total compensation from all entities in the related-organization group. The $1 million threshold applies to the aggregate, not just the ATEO's direct compensation.
Assess the limited services exception elimination. Identify any individuals who were previously excluded from Section 4960 analysis under the limited services exception. Those individuals are now potentially covered employees under Tier 2. Determine whether they qualify for the limited hours or nonexempt funds exceptions instead, and document the analysis.
Consider submitting a comment. The IRS has specifically requested input on two issues: how the limited hours and nonexempt funds exceptions should be adapted to the new covered employee definition, and whether those exceptions should be available for officers of the ATEO. If your organization has views on either question based on your operational structure, August 4 is the deadline for written submissions. Comments can be submitted in writing as specified in the notice.
Frequently Asked Questions
What is IRS Notice 2026-36?
IRS Notice 2026-36 was issued on June 5, 2026, published in Internal Revenue Bulletin 2026-26. It announces the IRS's intent to issue proposed regulations under Section 4960 of the Internal Revenue Code addressing the expansion of the covered employee definition made by the One Big Beautiful Bill Act (OBBBA). It also provides interim guidance that ATEOs can rely on now, confirms that the limited hours and nonexempt funds exceptions will be carried into the proposed regulations, and announces that the limited services exception will not be carried forward. Written comments are due August 4, 2026.
Who is a covered employee under the expanded Section 4960 rules?
Under the two-tier structure in Notice 2026-36, a covered employee is either: any individual who was a covered employee under prior law (top five highest-compensated) for a taxable year beginning after December 31, 2016, and on or before December 31, 2025 (Tier 1), or any individual who is an employee of an ATEO in a taxable year beginning after December 31, 2025, subject to the limited hours and nonexempt funds exceptions (Tier 2).
Does Section 4960 now apply to all employees over $1 million?
It potentially applies to all current employees of an ATEO for taxable years beginning after December 31, 2025, subject to exceptions. The five-highest-compensated cap no longer limits scope. However, the $1 million remuneration threshold still applies: Section 4960 is triggered only if a covered employee receives more than $1 million in remuneration or receives an excess parachute payment. An employee who is a covered employee but earns $300,000 does not trigger the excise tax.
When do the new Section 4960 rules take effect?
The OBBBA's expansion of the covered employee definition applies to taxable years beginning after December 31, 2025. For calendar-year ATEOs, the new rules apply to the 2026 taxable year. The IRS's interpretation in Notice 2026-36 limits retroactive application by using the old five-highest framework for lookback periods through 2025.
When is the comment deadline for Notice 2026-36?
Written comments on Notice 2026-36 are due August 4, 2026. The IRS will consider comments submitted after that date if doing so will not delay the issuance of guidance. Comments should address the scope and operation of the limited hours and nonexempt funds exceptions under the new definition, including whether those exceptions should apply to officers.
Key Takeaways
- Section 4960 imposes a 21% excise tax on remuneration above $1 million paid to covered employees of applicable tax-exempt organizations. The OBBBA, effective for taxable years beginning after December 31, 2025, eliminated the five-highest-compensated employee cap that previously limited the tax's reach.
- IRS Notice 2026-36, issued June 5, 2026, provides interim guidance ATEOs can rely on now. It interprets the OBBBA's effective date to limit retroactive application: the old five-highest framework continues to govern the 2017 through 2025 lookback period.
- The post-OBBBA covered employee definition has two tiers. Tier 1 preserves legacy status for individuals who were covered employees under prior law through 2025. Tier 2 makes any employee of an ATEO in a taxable year beginning after December 31, 2025, a covered employee, subject to exceptions.
- The once-a-covered-employee-always-a-covered-employee rule continues to apply under both tiers. Covered employee status is permanent for all future taxable years.
- The limited hours and nonexempt funds exceptions carry forward into the post-OBBBA framework. ATEOs can rely on both exceptions now. The limited services exception does not carry forward because it was specifically tied to the five-highest-compensated cap that no longer exists.
- Organizations that relied on the limited services exception to exclude employees of related taxable entities from Section 4960 analysis need to reassess those individuals under the new Tier 2 definition.
- Comments on Notice 2026-36 are due August 4, 2026. The IRS has specifically requested input on how the limited hours and nonexempt funds exceptions should be adapted to the new definition and whether they should be available for officers.
