IRS Announces Interpretation of the Expanded Group of Nonprofit Employees Subject to Compensation Limitations Under Section 4960

Under Section 4960 of the Internal Revenue Code, a nonprofit organization is generally subject to a 21% excise tax on compensation paid to “covered employees” in excess of $1 million in any year (and on certain severance and similar “parachute payments” exceeding a defined threshold). Prior to the One Big Beautiful Bill (OBBB), “covered employees” were generally limited to (i) an organization’s top-five most highly compensated employees for the taxable year, and (ii) anyone who was a “covered employee” in a prior taxable year. Effective for 2026 and beyond, the OBBB enacted a significant expansion of the definition of “covered employee” to generally include all current and former employees since 2017.

In Notice 2026-36 the IRS announced how it intends to interpret the changes made by the OBBB to the definition of a “covered employee” in proposed regulations, which are favorable to nonprofits. First, the IRS will take a narrow view of the OBBB lookback rule for the period from 2017 through 2025 for determining “covered employees” for 2026 and beyond. Rather than include as a “covered employee” anyone who was employed by the organization during that timeframe, as the language of the OBBB suggests, the IRS stated that for years 2017 through 2025 it will only include persons who would have qualified as “covered employees” during that period under pre-OBBB law (including pre-OBBB Treasury Regulations and its exceptions). Second, the IRS anticipates that the proposed regulations will carry over the existing regulatory exceptions for “limited hours” and “nonexempt funds,” but will not include the “limited services” exception (which is not expected to apply under the OBBB changes).

The Notice states that taxpayers may rely on the interpretations set forth in the Notice until proposed regulations are issued.