The Treasury and the IRS recently released IRS-2026-73 and Notice 2026-36, announcing their intent to issue proposed regulations and clarifying some aspects of Section 4960 excise tax.
While this guidance isn’t the final regulatory law, public sector organizations should consider it when mapping out compensation strategies going forward. The IRS and Treasury anticipate issuing formal proposed regulations later and are currently requesting public comments.
Crucially, the IRS noted this: “The proposed regulations are not expected to apply to tax years beginning before the issuance of final regulations,” meaning the eventual final rules will only apply prospectively, not retroactively.
What is the excise tax rate under IRC Section 4960?
IRC Section 4960 imposes an excise tax at the corporate rate of 21% on an applicable tax-exempt organization (ATEO). The tax applies to two types of payments:
- Compensation in excess of $1 million paid to a covered employee in a taxable year.
- Any excess parachute payment paid to a covered employee. An excess parachute payment is defined as a separation-contingent payment to a covered employee that equals or exceeds 3x a base amount.
How Does OBBB Change the Definition of “Covered Employee”?
The OBBB significantly broadens who counts as a covered employee under Section 4960, increasing exposure for tax-exempt organizations.
Before OBBB, “covered employee” generally meant the ATEO’s five highest-compensated employees for the year, plus anyone who had previously been a covered employee (once covered, always covered). For taxable years beginning after Dec. 31, 2025, OBBB expands “covered employee” beyond the top-five framework to potentially include any employee or former employee, significantly broadening Section 4960 exposure.
How Does the New “Covered Employee” Definition Impact Severance Pay?
This expanded definition of covered employee is particularly significant in the context of parachute payments, such as severance packages. Under prior law, Section 4960’s rules about parachute payments generally applied only to a limited group of highly compensated executives. Under the expanded definition, however, parachute payment rules can now apply to any covered employee.
When Does Expanded Definition Apply to Employees?
The expanded definition applies only for taxable years beginning after Dec. 31, 2025, and does not retroactively sweep in every person employed since 2017.
Because the statutory definition refers to current and former employees and looks back to tax years beginning after December 31, 2016, there was some confusion in the public sector about whether every person employed at any time since 2017 would be treated as a covered employee starting in 2026.
Notice 2026-36 addresses this by interpreting the amended definition as applying only for taxable years beginning after Dec. 31, 2025, while retaining the prior definition for years beginning on or before that date (including when determining whether someone is a “former employee” for later years). As such, individuals who were not covered employees under the previous top-five framework do not become covered employees solely as a result of the expanded definition.
Your Takeaway
Until proposed regulations are issued, ATEOs may rely on the rules described in the notice, which states that proposed regulations are expected to be prospective and are not expected to apply to taxable years beginning before issuance of the final regulations. That means that until the final rules are written, organizations can safely follow the guidelines in the notice and be assured that permanent rules will only apply moving forward.
Who Is Impacted & When: Five Section 4960 Scenarios
The following scenarios illustrate how the expanded Section 4960 rules might apply to a typical public sector or tax-exempt organization. Each example assumes the relevant taxable year begins after Dec. 31, 2025.
- Senior-level employee receiving a large severance package — Rules likely APPLY. Assume a senior administrator at a large tax-exempt health system has a $350,000 base salary. The administrator separates from employment and receives a package totaling $1,075,000. Because that amount exceeds three times the employee’s $350,000 base, the package may produce an excess parachute payment subject to the 21% excise tax, even though the employee’s annual compensation never exceeded $1 million
- Executive earning more than $1 million in annual compensation — Rules APPLY. A senior executive paid $1.3 million in a taxable year triggers the excise tax on the $300,000 that exceeds the $1 million threshold. This outcome is consistent under both prior law and the expanded definition.
- Long-departed employee who was never in the top five — Rules likely DON’T APPLY. A staff member who left in 2019 and was never among the ATEO’s five highest-compensated employees does not become a covered employee solely because of the expanded definition. Per Notice 2026-36, the prior top-five framework still governs years beginning on or before Dec. 31, 2025.
- Small severance payment below the parachute threshold — Rules likely DON’T APPLY. A covered employee earning $150,000 receives a $200,000 severance payment. Because the payment falls below 3x the base amount, it generally would not qualify as an excess parachute payment, and the excise tax would not be triggered on that basis.
- Severance paid before the proposed regulations take effect — Rules expected NOT to apply (prospectively). Because the proposed regulations are expected to be prospective and not apply to taxable years beginning before final regulations are issued, organizations may rely on Notice 2026-36 in the interim. Confirm timing carefully, as the interplay between the notice and future final regulations will determine the precise treatment.
Note: These scenarios are illustrative. Treasury and the IRS have requested comments, and final regulations may refine how these rules apply. Organizations should consult a qualified tax advisor before acting. If you have questions how IRC Section 4960 might impact your organization, reach out to Rehmann’s public sector team.
Frequently Asked Questions
Q: Can corporate executives who volunteer or split time with a nonprofit accidentally trigger the 21% tax penalty?
A: No, as long as they meet specific time and funding limits. The notice confirmed the IRS will preserve two critical “safe harbor” exceptions, Limited Hours (under 10% of time) or Nonexempt Funds (paid by a related commercial entity) rules. These protections ensure that, under certain criteria, high-profile board members or corporate executives who split their time with a related nonprofit branch won’t accidentally trigger a massive tax bill for the nonprofit organization.
Q. Does IRS Notice 2026-36 mean every employee is now a covered employee?
A: Yes, for tax years beginning after 2025, essentially all current employees will fall under the covered employee scope by default.
The key distinction is that while you no longer need to calculate who the “Top 5” are each year, once an individual becomes a covered employee, they remain one permanently. Note on Exceptions: The IRS plans to retain narrow exceptions for specific scenarios (e.g., employees of related non-exempt organizations who work limited hours or are paid from non-exempt funds). However, for standard ATEO payroll, the “Top 5” threshold is gone.