Tax-Exempt Organizations — IRS and Treasury Announce Planned Guidance on Expanded Covered Employee Rules for Excise Tax on Compensation Over $1 Million

The IRS and U.S. Department of the Treasury recently issued Notice 2026-36 (“the Notice”), announcing their intent to issue proposed regulations under Internal Revenue Code section 4960 to implement the expansion of the definition of “covered employee” for purposes of the excise tax on remuneration in excess of $1 million paid to employees of applicable tax-exempt organizations (ATEOs) and remuneration taken into account under the related organization rules.

The July 2025 reconciliation act, often referred to as the One Big Beautiful Bill Act (OBBBA), amended section 4960 to significantly expand the definition of “covered employee” beyond an ATEO’s five highest‑compensated employees. As amended, section 4960 generally defines a covered employee to include “any employee of an ATEO […] and any former employee […] who was such an employee during any taxable year beginning after December 31, 2016,” although the Notice interprets the effective date of that amendment to limit the inclusion of pre-2026 employees to individuals who were covered employees under prior law. This expanded definition applies to taxable years beginning after December 31, 2025 (January 1, 2026, for calendar year organizations). Please read our prior alerts for additional background information:

• “Tax-Exempt Organizations — Amended Rules on Excise Tax on Compensation Over $1 Million Take Effect January 1, 2026,” (December 2025)
• “Tax-Exempt Organizations and the OBBBA: Legal Analysis, Compliance Risks, and Planning Strategies,” (July 2025)

The Notice further provides that the forthcoming proposed regulations are expected to include exceptions from the definition of “covered employee” similar to the limited hours and nonexempt funds exceptions under the existing section 4960 regulations. Under existing regulations, an individual meeting any of the “limited hours,” “nonexempt funds,” or “limited services” exceptions is disregarded for purposes of determining an ATEO’s five highest-compensated employees for a taxable year. Because these exceptions are tied to the determination of an ATEO’s five highest-compensated employees, the OBBBA’s expansion of the definition of “covered employee” created uncertainty regarding their continued applicability, leaving it unclear whether certain highly compensated individuals of a related organization would be included as covered employees under the expanded definition. The Notice indicates that the Treasury and the IRS expect the forthcoming proposed regulations to include exceptions similar to the existing limited hours and nonexempt funds exceptions and permits ATEOs to rely on those anticipated rules pending further guidance, which is particularly helpful for organizations with highly compensated individuals who provide volunteer services (for example, corporate executives serving on a volunteer basis as officers of a related corporate foundation) or could otherwise be impacted by the changes resulting from the OBBBA.

However, the Notice indicates that the proposed regulations will not retain the limited services exception because the concern that led to this exception — namely, “displacement of an employee who would otherwise have been one of the five highest-compensated employees” — is no longer relevant under the broadened definition of “covered employee.”

Until the forthcoming proposed regulations are issued, organizations may rely on the rules described in the Notice that the Treasury and the IRS anticipate including in the forthcoming proposed regulations, including the Treasury’s interpretation of the expanded post-OBBBA definition of “covered employee” and the application of the limited hours and nonexempt funds exceptions. The forthcoming proposed regulations are not expected to be issued before August 4, 2026, when comments on the Notice are due, and the Notice states that the proposed regulations are anticipated to apply only to taxable years beginning after the issuance of final regulations.

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We hope you found this alert helpful. To discuss how these changes to excess compensation and anticipated proposed regulations may affect your organization specifically, please contact Sue Abbott, Alyssa Chandler Fitzgerald, Natalie Chaudhury, or Carrie Garber Siegrist.