On November 2, 2017, the U.S. House of Representatives unveiled the Tax Cuts and Jobs Act (H.R. 1) (the “Bill”) as part of proposed tax reform legislation. The Bill is sweeping in scope and provides for significant changes to the U.S. Internal Revenue Code (the “Code”), including in the area of executive compensation and employee benefits.
The Bill makes far-reaching changes in the executive compensation arena, which would curtail employees’ ability to defer taxation of compensation and incentive awards (other than under a tax-qualified retirement plan) and employers’ ability to provide fully tax-deductible compensation to their executives. If enacted in its current form, it will require fundamental rethinking and restructuring of many present-day incentive compensation packages. Some highlights of the Bill are as follows:
- The Bill requires that nonqualified deferred compensation (which under the Bill include stock options and stock appreciation rights which are generally excluded from such definition under current guidance) attributable to services performed after 2017 be subject to income tax when it is no longer subject to a substantial risk of forfeiture (i.e., when it vests, rather than when it is subsequently paid, as is currently permitted under Code Section 409A). For this purpose, only a condition requiring the future performance of substantial services will generally constitute a substantial risk of forfeiture. The Bill “grandfathers” existing nonqualified deferred compensation arrangements until 2025, at which time they will also become subject to the foregoing rules. Note that an amendment to the Bill released by the House Ways and Means Chairman Kevin Brady includes a watering-down of some of these requirements as it provides that certain employees of non-public companies who receive stock options or restricted stock units as compensation for the performance of services may elect to defer recognition of income for up to 5 years.
- The Bill greatly expands the reach of Code Section 162(m) (which denies a corporate deduction for compensation in excess of $1 million paid to certain top executives of publicly traded companies) by eliminating current exceptions from this rule for performance-based compensation and broadening its application in various other respects.
- The Bill also imposes an excise tax on compensation in excess of $1 million paid by tax-exempt employers to their five highest paid employees, as well as on certain payments contingent on separation from employment paid to such employees.
Though relatively less sweeping, the Bill also makes various changes to the current tax rules governing various employee benefit arrangements (and a number of these changes are beneficial to employees):
- The Bill removes taxpayers’ ability to change the tax characterization (Roth or traditional) of their contributions to individual retirement accounts (IRAs).
- The Bill reduces the age at which in-service distributions are permitted under defined benefit plans (as well as certain state and local government plans) from age 62 to age 59 ½.
- The Bill makes various changes to the rules governing participant hardship distributions under retirement plans, which would likely have the effect of facilitating larger and more frequent hardship distributions.
- The Bill extends the deadline for individuals who leave employment, or whose plan terminates while they are employed, to roll over their outstanding plan loan balances to an IRA in order to avoid adverse tax treatment.
- The Bill grants relief from nondiscrimination testing and certain other qualification requirements for some defined benefit retirement plans.
- The Bill limits the deductibility or exclusion of certain employer-provided fringe benefits.
- The Bill eliminates dependent care assistance programs, although a recent amendment to the Bill would continue the exclusion for up to $5,000 of employer-provided dependent-care assistance through Dec. 31, 2022.
If the Bill were to be passed in current form, the foregoing changes would generally apply to taxpayers beginning in 2018. However, as the Bill progresses through Congress, we expect that these provisions will undergo further revision and evolution. Although it is too early to speculate about the final form of the Bill, it could ultimately require employers to perform a comprehensive review and restructuring of their executive compensation practices and benefit plans.