The Tax Cuts and Jobs Act, the amended version of which was released by the House on November 3, 2017, proposes sweeping changes to the taxation of executive compensation and employee benefits. It aims to be effective as of January 1, 2018 - which means limited time to react.
The key proposed changes of the amended version of the bill are outlined below. However, given that we have already seen one amended version of the initial bill come out in its first 24 hours, be aware that the proposals are in a state of flux. We will try to keep up with the changes, but please feel free to reach out to us to confirm any specific points.
Elimination of Nonqualified Deferred Compensation
- Deferred Compensation Taxable At Vest. The bill introduces new section 409B, which seeks to eliminate nonqualified deferred compensation by imposing income tax once such compensation is no longer subject to a substantial risk of forfeiture. Compensation is considered subject to a substantial risk of forfeiture under the bill only if it is subject to the future performance of substantial services. In other words, a performance-based condition would not suffice to delay taxation beyond the end of any service-based vesting period.
- Equity-Based Compensation is Captured. The bill’s definition of "nonqualified deferred compensation plan" expressly includes stock options, stock appreciation rights (SARs) and other rights to compensation based on the value or appreciation in value of stock of an employer company (whether cash or stock-settled). Unlike section 409A and 457A, the bill does not exclude from the definition of non-qualified deferred compensation statutory stock options or non-qualified stock options that are granted with an exercise price equal to the fair market value of the underlying stock on the date of grant. This means stock options and SARs would be taxed at vesting. It excludes other compensation which would be taxed under other Code provisions such as a transfer of property under section 83 (e.g., restricted stock, which can’t be deferred in any event) or a transfer to a trust under section 402(b).
- Limited Short-Term Deferral Exception. The bill retains the “short-term deferral exception” concept that we are familiar with under section 409A. However, the exception is narrower than under the current 409A rules and requires that payment occur not later than 2.5 months after the end of the tax year of the applicable employer company during which the compensation vests (based on performance of services). The exception is also narrower than the twelve month short-term deferral exception of section 457A (relating to nonqualified deferred compensation sponsored by certain non-U.S. companies), such that unvested deferrals structured to be exempt from 457A will need to be modified to comply with the new more limited short-term deferral exemption.
- Repeal of 409A and 457A. Consistent with the above, the bill strikes sections 409A and 457A from the Code.
- Application to Vested Deferrals. The new rules do not apply to deferred compensation attributable to services performed before 1 January 2018, but require that such amounts be included in income no later than 2025. Therefore, any such amounts will need to be distributed before 2026. The bill also requires the Treasury to provide guidance (within 120 days of enactment) on accelerating payments under existing vested deferred compensation arrangements to address these requirements without violating section 409A.
- Transition Issues for Unvested Deferrals. The transition rules raise concerns for pre-existing but unvested deferred compensation arrangements. In particular, the bill applies to amounts attributable to services performed after 31 December 2017 and does not provide “grandfathering” for arrangements entered into before 1 January 2018.
As an example, as of 1 January 2018, unvested stock options, deferred unvested restricted stock units (RSUs) including RSUs with a retirement vesting provision where the employee is not yet retirement-eligible, and unvested performance-based RSUs that do not also contain a service-based vesting requirement, would become taxable in the year in which they "vest." This means taxation upon any scheduled vesting date for the options or deferred RSUs, upon meeting retirement-eligibility for the RSUs with retirement vesting, or immediately for performance-based RSUs that lack a service-based requirement. The bill does not address how the income should be calculated in circumstances where the income cannot be ascertained at the time that the substantial risk of forfeiture lapses (e.g., performance-based RSU with no service-based requirement).
- Tax Exempt Organization 457(b) Deferred Compensation Arrangements Also Eliminated. The bill eliminates the ability to defer compensation for employees of tax exempt organizations (but not government entities) that was previously permitted under section 457(b).
Disallowance of Various Compensation Related Deductions
- Section 274’s Disallowance of Entertainment Expenses is Expanded. Certain compensation related deduction disallowances are included in the bill. For example, the bill disallows deductions for qualified transportation fringe and parking benefits, on-premises athletic facilities, other amenities of a personal nature provided to employees, and the expenses of recreational or social activities for employees (such as the company picnic or holiday party), unless the benefit is treated as compensation to the employee.
Additionally, where the employer imputes a benefit into an employee’s income, the deductible amount is limited to the amount imputed in compensation. This is true for all employees – not just for top officers as under current law. Accordingly, employers with corporate aircraft could face larger deduction disallowances if they continue to use SIFL (Standard Industry Fare Level) to value personal aircraft use. Additionally, the bill limits a taxpayer’s ability to pass the deduction disallowance for reimbursed expenses, such as meals, along to entities that are not subject to tax (such as tax exempt organizations and the government). The provision is proposed to be effective for expenses incurred after 31 December 2017.
- Section 162(m) Expanded and Performance-Based and Commissions Exceptions Repealed. Section 162(m) is amended to limit the deduction disallowance for more than USD 1 million in compensation paid to certain executives:
- The exception from section 162(m) for commissions and performance-based compensation is repealed. This means that annual bonuses, performance RSUs, and options will no longer be exempt from the deduction disallowance.
- Employers subject to section 162(m) include not only those companies whose stock is listed on a US public stock exchange, but also those companies that have registered a public stock or debt offering.
- Individuals covered by section 162(m) will include individuals who serve as the CEO, CFO, or another top three officer any time during the year (not just as of the close of the year) or for a preceding year.
- The deduction disallowance applies even to payments made to a covered employee’s beneficiaries after his or her death.
The provision is proposed to be effective for years beginning after 31 December 2017.
Elimination of Certain Employer-Provided Fringe Benefits
The bill would do away with tax exemptions for a number of relatively popular employer-provided excludable fringe benefits, such as the exclusion for employee achievement awards under section 74, education assistance under section 127, dependent care assistance under section 129, qualified moving expense reimbursements under section 132 (a)(6), and adoption assistance under section 137. The working condition fringe benefit is retained and some education reimbursements should continue to be excludable as a working condition fringe benefit. These changes are proposed to be effective for tax years beginning after 31 December 2017.
The bill also limits the exclusion for lodging provided on the employer’s premises for the convenience of the employer to a maximum of USD 50,000 in value and one residence at a time.
Liberalization of Certain Health and Retirement Plan Rules
- In-Service Distributions. Participants in 401(k) plans are generally permitted to take in-service distributions from the plan after attaining age 59½ . However, for defined benefit pension plans and governmental defined contribution plans, participants are not allowed to take in-service distributions prior to age 62.
The proposed legislation would lower the in-service distribution minimum age for defined benefit plans and governmental defined contribution plans from age 62 to age 59 ½. Reasons cited for the change are that it would create uniformity between 401(k) plans and defined benefit and governmental plans and would encourage Americans to continue working full or part-time instead of retiring early in order to access retirement savings at age 59½. The theory being that many employees choose to retire instead of continuing to work because they cannot otherwise access their retirement accounts.
- Changes in Hardship Distribution Rules. Many 401(k) plans permit participants to take distributions of a portion of their account balance in certain permitted hardship situations. Currently, participants cannot include employer contributions or any investment earnings related to their own employee contributions in the amount available for a hardship distribution. In addition, current regulations generally prohibit participants from making contributions to the plan for six months after taking a hardship distribution.
The proposed changes would permit participants to include vested employer contributions as well as earnings on their employee deferrals as a part of a permitted hardship distribution. In addition, the bill would eliminate the requirement to suspend employee contributions for six months following a hardship distribution.
- 401(k) Plan Loan Changes. As with hardship distributions, many 401(k) plans permit participants to take loans from their existing account balances. If the loan goes into default, the amount of the loan is typically taxable as a deemed distribution and, depending on the age of the participant, possibly subject to an additional 10% tax for an early withdrawal. Under current law, if a participant terminates employment with an outstanding loan, the loan generally must be paid off in full or rolled over to an IRA within 60 days to avoid a default. The proposed changes extend the rollover period until the due date for filing the participant’s tax return for the year (including extensions).
- Frozen Plan Nondiscrimination Testing. Defined benefit pension plans are required to satisfy nondiscrimination tests intended to ensure that the benefits provided under the plan do not discriminate in favor of highly compensated employees. Many employers have imposed a “soft freeze” in their defined benefit pension plans under which the plan does not permit new employees to participate in the plan, but existing participants as of the freeze date continue to accrue benefits. Over time, that type of soft freeze may violate the required testing due to changes in the demographics of the participants accruing benefits. For employers sponsoring both a defined benefit and defined contribution plan, the nondiscrimination rules allow limited cross-testing between the two plans in order to pass testing. The new legislation would provide some limited relief from testing for frozen plans and would make it easier to do cross-testing for employers sponsoring both a defined benefit and defined contribution plan.
- Changes to MSA Rules. Currently, an individual may claim an above-the-line deduction for contributions to an Archer Medical Savings Account (MSA) and can exclude MSA employer contributions from income. In general, MSAs may be set up by an individual employed by a small employer and who participates in the employer’s high-deductible health plan. The total amount of monthly contributions to a MSA may not exceed one-twelfth of 65% of the annual deductible for an individual with a self-only plan and one-twelfth of 75% of the annual deductible for an individual with family coverage. Distributions from the accounts used to pay qualified medical expenses are not taxable. MSAs could not be established after 2005. MSA balances may be rolled over on a tax-free basis to another Archer MSA or to a Health Savings Account (HSA).
Under the new law, no deduction would be allowed for contributions to a MSA, and employer contributions to a MSA would not be excluded from income. Existing Archer MSA balances, however, could continue to be rolled over on a tax-free basis to an HSA. The reasons cited for the change are that there is no situation in which MSAs are more favorable than HSAs (thus, no taxpayer would see his ability to save for future health costs restricted). As a result, the change merely simplifies the Code by consolidating two similar tax-favored accounts into a single account with more taxpayer-friendly rules (i.e., HSAs).
Repeal of Credits
The bill does away the employer provided child care credit under section 45F, and the work opportunity credit under section 51. It also places additional conditions on the availability of the credit under section 45B for FICA taxes on tips.
Although this is a proposed bill, it would be prudent to identify the compensation arrangements, particularly the deferred compensation and equity compensation arrangements, which would be impacted by this proposal. If these changes go forward, there will be a short time window for implementing modifications and for developing participant communications regarding the changes.
If enacted, these changes will have a substantial impact on equity compensation, and issuers will need to re-evaluate the types of equity awards they offer, likely moving away from stock options and the use of retirement eligible provisions for RSUs and performance-based RSUs (PSUs).
Please contact your Compensation attorney with any questions related to the proposed tax regulations.
For more information on the broader implications of the proposed tax regulations on your company, please see the Tax News and Developments alert Ways and Means Committee Releases "Tax Cuts and Jobs Act," issued by Baker McKenzie’s tax practice (3 November 2017).