For years, a tax-exempt organization only had to worry about the Section 4960 excise tax for a small handful of its top earners. That kept the compliance burden narrow and predictable. The One Big Beautiful Bill Act blew that limit open. Starting in 2026, the pool of employees who can trigger the tax expands dramatically, and nonprofits that never had to track this closely now do.
If you run or advise a tax-exempt organization with any highly paid staff, this change deserves attention. Here is what the Section 4960 excise tax is, what expanded, and what it means for compliance.
Section 4960 imposes a 21% excise tax on an applicable tax-exempt organization (ATEO) when it pays "excess" compensation. Excess means remuneration above $1 million to a covered employee in a year, plus certain large parachute-style separation payments. The tax falls on the organization, not the employee, and 21% mirrors the corporate tax rate, so the provision is meant to put nonprofits on similar footing to for-profit companies that lose deductions for pay over $1 million.
The point was never to punish nonprofits broadly. It was aimed at very high pay at hospitals, universities, foundations, and similar organizations. What changed is not the rate or the $1 million threshold, but who counts.
Here is the heart of it. Under the old rule, a covered employee was limited to the organization's five highest-compensated employees for the year, plus anyone who had been a covered employee in a prior year going back to 2016. That kept the group small and stable.
The One Big Beautiful Bill Act removed that top-five cap. For tax years beginning after December 31, 2025, the definition of covered employee expands to reach essentially all current and former employees of the organization, subject to some exceptions. In practice that means any employee whose pay crosses $1 million can now trigger the 21% tax, not just the top five.
For large organizations with several highly paid people beyond the top five, physicians at a hospital system, coaches, senior investment staff at an endowment, this can pull in compensation that was never exposed before.
Because the statute moved ahead of formal rules, the IRS issued Notice 2026-36 to explain how it reads the expanded provision, and organizations can rely on it until proposed regulations are finalized.
The notice signals that Treasury intends to keep two existing exceptions that narrow the count. The limited hours exception and the nonexempt funds exception survive, which spares certain employees who work minimal hours or are paid from unrelated for-profit sources. One exception goes away: the limited services exception is being removed, since the new broad definition makes it unnecessary. The IRS also invited public comment, with an early August 2026 deadline, on how those exceptions should be scoped, so more detail is coming.
The practical effect is a bigger tracking job. An organization can no longer just watch its top five earners. It now has to identify every current and former employee whose compensation, including amounts from related organizations, could cross $1 million, and calculate the tax accordingly.
That is a real change in process. Compensation data has to be aggregated across related entities, former employees stay in the picture, and the exceptions have to be applied correctly to avoid over- or under-reporting. For a large health system or university with many highly compensated people, the number of individuals in scope can jump sharply.
This is exactly the kind of area where getting ahead of the filing beats scrambling at year end. If your organization or your nonprofit clients need to map who is now a covered employee and model the exposure, Madras Accountancy can build the compensation tracking and coordinate it with your broader audit and assurance and tax work so nothing slips through.
1. What is the Section 4960 excise tax? It is a 21% excise tax on an applicable tax-exempt organization that pays a covered employee more than $1 million in compensation in a year, plus certain large separation payments. The tax is owed by the organization.
2. What changed under the One Big Beautiful Bill? The definition of covered employee expanded. It used to be limited to the top five highest-paid employees plus prior covered employees. Now it reaches essentially all current and former employees.
3. When does the expansion take effect? For tax years beginning after December 31, 2025, according to Notice 2026-36.
4. Did the $1 million threshold or the 21% rate change? No. The threshold is still $1 million and the rate is still 21%. Only the group of employees who can trigger the tax expanded.
5. Who now counts as a covered employee? Essentially all current and former employees of the organization whose compensation crosses the threshold, subject to limited exceptions, rather than just the five highest paid.
6. What exceptions still apply? Notice 2026-36 indicates the limited hours exception and the nonexempt funds exception are being kept, while the limited services exception is being removed.
7. Does compensation from related organizations count? Yes. Compensation is generally aggregated across related organizations when determining whether the $1 million threshold is met for a covered employee.
8. Can organizations rely on the notice before final regulations? Yes. Organizations may rely on the positions in Notice 2026-36 until proposed regulations are finalized. The IRS also requested public comments on the exceptions.
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