On Dec. 22, President Trump signed into law the 2017 Tax Act, the most comprehensive set of changes to the Internal Revenue Code since 1986. Some of the changes affect executive compensation and employee benefits. Because many of the provisions take effect in 2018, employers should begin evaluating their potential impact as soon as possible.
It is important to note that the employee benefits and executive compensation changes in the 2017 Tax Act are not as sweeping as they could have been. For example, proposals for limiting retirement plan contributions did not make their way into the 2017 Tax Act, and a major proposed revision to the taxation of nonqualified deferred compensation was dropped before the legislation was finalized. (For reference, the 2017 Tax Act is P.L. 115-97. The proposed short title for the Act, the “Tax Cut and Jobs Act,” was dropped before enactment on procedural grounds.) While some of the proposals did not find their way into the final 2017 Tax Act, they are discussed briefly below because they could resurface at some point.
Executive Compensation
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Modification of Deduction Limit on Compensation for Public Company Executives: The 2017 Tax Act repeals the exception to the Internal Revenue Code Section 162(m) $1 million deduction limitation for commission and performance-based compensation paid to a covered employee of a publicly traded corporation. This exception currently applies to compensation payable to covered employees defined to include the chief executive officer (CEO) and the three other highest-compensated officers, but excluding the chief financial officer (CFO). The 2017 Tax Act revises the definition of covered employee to include the CFO.
The 2017 Tax Act also expands the categories of public companies subject to the deduction limitation. Currently, Section 162(m) applies only to companies with a registered class of securities. Going forward, it also will apply to any company that is required to file public reports with the Securities and Exchange Commission (SEC).
The 2017 Tax Act also provides that, starting with those persons who are covered employees for 2017, once an officer becomes a covered employee, he or she remains a covered employee forever. This means that deferred compensation still would be subject to the $1 million deduction limitation even if paid in a year after the officer ceases to be CEO, CFO or one of the top-paid officers. The 2017 Tax Act treats beneficiaries of covered employees as covered employees for this purpose. Effective Date — applies for tax years beginning after Dec. 31, 2017. However, compensation paid pursuant to a written binding agreement in effect on Nov. 2, 2017, that has not been materially modified thereafter is grandfathered and can continue to qualify for the performance-based compensation exemption, assuming all other Section 162(m) requirements are met.
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Practice Note: Companies should review incentive plan documents and policies to determine what changes may be necessary to reflect the new Section 162(m) rules. Compensation committee charters and directors and officers liability insurance (D&O) questionnaires also should be reviewed and revised, if necessary. Compensation discussion and analysis sections (CD&As) for 2018 proxy statements should be reviewed to determine if any changes are advisable related to the Section 162(m) discussion. Companies should catalog grandfathered arrangements and implement processes to ensure that such arrangements are not unintentionally materially modified. Companies should also re-examine incentive compensation plan designs in light of the new Section 162(m) rules (including equity grant design and practices), as the new rules offer significant new flexibility and, at the same time, may make some practices (such as stock options) less attractive than before.
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New Tax on Excessive Executive Compensation Paid by Tax-Exempt Organizations: The 2017 Tax Act imposes a 21 percent tax on most tax-exempt organizations — including most state governmental organizations and political subdivisions thereof — on compensation in excess of $1 million and any golden parachute compensation paid to the organization’s covered employees, defined to include the five highest-paid executives for the current taxable year or any preceding year after 2016. The tax is imposed on the organization, not the employee (which would have been the case under earlier versions of this provision).
The provision takes into account all W-2 wages paid to any such executive in a taxable year, excluding designated Roth contributions under qualified retirement plans, but specifically including wages under a Section 457(f) deferred compensation plan. There is no grandfathering rule in the 2017 Tax Act for existing arrangements, although the Treasury Department and IRS may consider adding such a rule when implementing regulations are developed.
For purposes of the tax on excess golden parachute payments, an excess parachute payment generally includes a payment contingent on the executive’s separation from employment with an aggregate present value of at least three times the executive’s base compensation. Similar to existing golden parachute rules for taxable organizations under Section 280G, the base amount is equal to the executive’s trailing five-year average W-2 compensation. Effective Date — applies for tax years beginning after Dec. 31, 2017.
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Practice Note: Covered tax-exempt organizations should determine who their covered executives are and begin cataloging executive compensation arrangements for those officers to determine if and when the tax imposed by the 2017 Tax Act would apply. This may include employment agreements, Section 457(f) deferred compensation plans, severance agreements, and annual or long-term incentive arrangements, in addition to salary and taxable benefits. Organizations should also monitor regulatory developments, as the IRS is likely to offer significant interpretive guidance under the statute when it issues regulations. Since the golden parachute tax rules are designed to track the existing golden parachute tax rules for taxable entities under Section 280G, organizations may want to familiarize themselves with those rules or seek guidance from outside experts already familiar with the Section 280G provisions.
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Qualified Equity Grants: The 2017 Tax Act offers a significant new tax planning opportunity for private companies that widely distribute stock options or stock-settled restricted stock units (RSUs) to their employees.
If a company distributes stock options or RSUs to at least 80 percent of its U.S. employees (determined on a controlled group basis), an employee (other than a 1 percent shareholder, the CEO or CFO or one of the top four most highly compensated officers at any time during the current or previous 10 years) can elect to defer the income tax associated with the stock option exercise or RSU settlement for up to five years after the option exercise or RSU settlement date. If the stock delivered upon option exercise or RSU settlement is unvested and nontransferable, the employee can defer the tax for up to five years after the stock vests or becomes transferable. The amount of income tax will be based on the value of the shares at the time of option exercise or RSU settlement (or at the time of vesting or transferability, if later). Options or RSUs granted after 2017 must have the same rights and privileges (other than grant size, provided that each employee receives more than a de minimis grant) to qualify for this rule.
The provision applies only to corporations, not limited liability companies taxed as partnerships, and only to grants made to employees. In addition, the favorable tax treatment does not apply if the stock is transferable when it is issued, — including to the employer. An employer is required to give notice to an employee who is issued qualified employer stock and the employee has 30 days after receiving the stock to make the election and may revoke the election at any time. The new rule applies in addition to (and does not supersede) the existing Section 83(b) election regime and the rules relating to qualified stock options (incentive stock options or ISOs, and employee stock purchase plans) — however, the rules cannot be combined. For example, if an employee elects to take advantage of the new rules with respect to an ISO, the ISO treatment ends. Effective Date — applies to stock options exercised or RSUs settled after Dec. 31, 2017.
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Practice Note: The new rules offer a potential planning tool around the existing problem with employees of private corporations having to pay income taxes on illiquid shares they receive from incentive awards. However, the requirement that companies have to issue awards to at least 80 percent of their employees may make the new rules unattractive for many companies and relatively limited in application. For a certain type of private company, however, that broadly issues equity awards to its employees or is contemplating doing so, these rules are worth serious consideration.
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Retirement Plans and Individual Retirement Accounts (IRAs)
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Longer Period for Rollover of Certain Plan Loan Offsets: The 2017 Tax Act extends the time period in which employees, whose plans terminate or who separate from employment with outstanding plan loans, may contribute an amount equal to the unpaid balance of such loans to an IRA to avoid that amount being treated as a distribution to the employee. A plan loan is considered outstanding until it is repaid or “offset.” Offset occurs when the participant’s remaining plan balance is used to repay the loan, thus resulting in a deemed distribution to the participant of the repaid loan amount. Deemed distribution can be avoided if the participant’s plan benefits are eligible for rollover and an amount equal to the offset amount is included in the rollover. Previously, such amounts could only be rolled over to an IRA during the 60-day period beginning on the date offset occurred. The 2017 Tax Act extends the deadline for rollover to the due date of the employee’s tax return for the year the plan terminated or the employee separated from employment (as applicable). Effective Date — applies to loan offsets that arise in tax years beginning after Dec. 31, 2017.
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Practice Note: Employers that sponsor plans allowing for loans should consider whether plan participant communications should be revised early next year to alert participants to the greater flexibility allowable for rollover of loan offset amounts.
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Repeal of Roth IRA Recharacterizations: The 2017 Tax Act repeals a special rule permitting recharacterization of Roth IRA contributions or conversions as instead having been made to traditional IRA amounts. As a result, a popular technique to unwind Roth IRA conversions will cease to be available. The 2017 Tax Act keeps in place provisions allowing for recharacterization of other contributions, thereby continuing to allow recharacterization of a Roth IRA contribution as a contribution to a traditional IRA. Effective Date — applies for tax years beginning after Dec. 31, 2017.
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Length of Service Award Programs for Public Safety Volunteers: Section 457 provides special tax treatment for certain programs designed to benefit public service volunteers (i.e., those who provide firefighting, emergency medical and ambulance services). The maximum annual benefit limit for such programs is increased under the 2017 Tax Act from $3,000 to $6,000, subject to adjustment for cost-of-living increases. Effective Date — applies for tax years beginning after Dec. 31, 2017.
Other Employer-Provided Benefits
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Qualified Moving Expenses: Employers now will be precluded from reimbursing employees on a tax-free basis for eligible moving expenses (except for certain moves by members of the armed services). Effective Date — applies for tax years 2018 to 2025.
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Employee Achievement Awards: Certain awards granted to employees in recognition of length of service or safety achievement are not taxable to the employee and are deductible by the employer. The 2017 Tax Act clarifies that the following types of awards do not qualify for this special tax treatment: cash, cash equivalents, gift cards, gift coupons or gift certificates (other than arrangements conferring only the right to select and receive tangible personal property from a limited array of such items preselected or preapproved by the employer), vacations, meals, lodging, tickets to theater or sporting events, stocks, bonds, other securities, and other similar items. Effective Date — applies to amounts paid or incurred after Dec. 31, 2017.
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Individual Mandate Tax Penalty Under the Affordable Care Act (ACA): The 2017 Tax Act effectively repeals the tax penalty assessed on individuals for not obtaining health coverage by reducing the penalty to zero. Effective Date — applies for months beginning after Dec. 31, 2018.
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Practice Note: Changes to ACA rules that directly affect employer-provided health coverage were not enacted, such as the employer mandate and the so-called “Cadillac Tax” on high-value health plans. Because the employer mandate remains in effect, covered employers must continue to offer health coverage in order to avoid penalties. However, the effective repeal of the individual mandate may result in reduced enrollment through the ACA exchange and thereby reduce potential exposure for some employers to employer mandate penalties. In addition, the repeal of the individual mandate may provide increased initiative for later legislative action to modify or repeal the employer mandate.
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Qualified Transportation Benefits: Employees are not taxed on and employers may deduct the cost of “qualified transportation fringes” (i.e., certain commuting and parking benefits). Under the 2017 Tax Act, employers can continue to provide qualified transportation fringes to employees on a tax-free basis, except for bicycle commuter reimbursements. Employers will no longer be able to deduct the cost of any qualified transportation fringe. Effective Date — the repeal of the exclusion for bicycle commuter reimbursement applies for tax years 2018 to 2025. The elimination of the employer deduction for all qualified transportation fringes applies to amounts paid or incurred for tax years beginning after Dec. 31, 2017.
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Expenses for Entertainment and Meals: Under prior law, employers were generally permitted to deduct up to 50 percent of entertainment and meal expenses directly connected to a business activity. In addition, employers generally could deduct meals furnished on premises for their convenience. The 2017 Tax Act eliminates the deduction for entertainment expenses. The deduction for meal expenses (subject to the same prior law 50 percent limit) remains in effect, as does the deduction for meals provided for the convenience of the employer (but only until 2025). Effective Date — applies to amounts paid or incurred for tax years beginning after Dec. 31, 2017. The repeal of the deduction for meals provided at the convenience of the employer will apply to amounts paid or incurred after Dec. 31, 2025.
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Certain Fringe Benefits Provided by Tax-Exempt Employers: The 2017 Tax Act creates new rules requiring tax-exempt employers to be taxed on the value of qualified transportation fringes, on-premises gyms and other athletic facilities they provide to their employees. The value of those benefits will now be treated as unrelated taxable income. Effective Date — applies to amounts paid or incurred for tax years beginning after Dec. 31, 2017.
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New Tax Credit for Paid Leave: Employers will be eligible for a business tax credit equal to 12.5 percent to 25 percent of the wages they pay to certain employees on qualified family and medical leave. To be eligible, an employer must pay employees on leave at least 50 percent of their hourly rate of pay (or a prorated amount for those not paid hourly) and must provide at least two weeks of paid leave per year. The amount of the credit increases by a quarter of a percent for every percent above the minimum 50 percent rate of pay and is capped at 25 percent for leave pay equal to 100 percent of regular pay. Effective Date — applies to tax years 2018 and 2019.
Significant Reform Proposals Not Contained in the 2017 Tax Act
Unlike earlier versions of tax reform, the 2017 Tax Act does not alter the existing tax rules for nonqualified deferred compensation plans under Section 409A. These complex rules, which expose employees to severe adverse tax consequences if nonqualified arrangements fail to comply in form or operation, will continue to apply to such arrangements going forward. The existing tax regime for nonqualified arrangements of tax-indifferent entities under Section 457A also remain in place.
Despite early indications that tax reform might spell doom for the existing favorable tax regime for equity awards in the form of “profits interests” granted to individuals performing services for a partnership or a limited liability company taxed as a partnership, the 2017 Tax Act leaves the existing profits interest regime mostly intact. It changes only the holding period, from one year to three years, for profits interests to qualify for long-term capital gains treatment, and then only for a capital-raising or investment-related trade or business.
Early versions of the 2017 Tax Act targeted for repeal the tax exclusion for a number of popular employer-provided benefits, such as qualified educational assistance, dependent care assistance and adoption assistance programs. None of those proposals were enacted.
