Congress passed the Tax Cuts and Jobs Act on December 20, 2017, and President Trump signed the bill into law on December 22nd. As everyone knows by now, the new law makes sweeping changes affecting most areas of income taxation. And while the final legislation contained fewer provisions affecting employee benefit plans and executive compensation than the original House Bill, employers will still be faced with a number of significant changes in law - most of which can fairly be characterized as revenue raisers - that will require careful review of their current arrangements.
Publicly traded companies will now have to include "performance based compensation" for purposes applying the $1 million limitation on the deduction of compensation paid to top executives. Before this year, the deduction limit under Code Section 162(m) excluded performance based compensation - such as long-term incentive plans and equity compensation grants tied to performance to escape the deduction limit - and pay-for-performance in its many forms became a mainstay of most executive compensation packages. The new law also expands the pool of "covered employees" who will be caught up in the cap by including the CEO, CFO, and the next three most highly paid officers required to be reported to shareholders in the employer’s annual proxy statement. In addition, once an executive is classified as a "covered employee" she will continue to be considered a "covered employee" for so long as she receives compensation from the public company. These changes are, of course, intended to reduce the size of the deductions now being taken by public companies for executive compensation and may cause affected employers to rethink the structures of their executive compensation programs.
Tax-exempt organizations face a new excise tax intended to parallel the Section 162(m) cap on deducibility of executive compensation. The new law imposes an excise tax of 21% (the corporate income tax rate starting in 2018) on compensation over $1 million paid by an exempt organization to any of the five most highly paid employees (or former employees). Importantly, compensation will be subject to the new excise tax when it ceases to be subject to a substantial risk of forfeiture (i.e., when it becomes vested). While many exempt organizations already have supplemental executive compensation arrangements in place, the new excise tax may create new incentives for organizations to use SERPs in an attempt to spread out compensation and avoid crossing the $1 million threshold. In addition, tax-exempt organizations will face a new 21% excise tax on "excess parachute payments" made to any of the five highest paid employees in connection with a separation from service. Excess parachute payments will include any amount that exceeds three times the covered employee's average annual compensation (determined over a look back period) for the prior three years. This generally parallels the provisions of Code Section 280G, which historically did not apply to exempt organizations. Fortunately for tax-exempt hospitals, compensation paid to medical professionals for the performance of medical services will be exempt from these limitations.
The changes to the deductibility of executive pay under Codes Section 162(m) and the new excise tax on compensation paid to executives in tax-exempt organizations will become effective immediately, with no transition period. However, the new rules for public companies under Code Section 162(m) will not apply to compensation under "written agreements" in effect on November 2, 2017, so long as the agreement is not modified in any material respect on or after that date. Public companies should probably avoid making changes to any "pre-existing plan" before further guidance is published.
Deferral of Gain on Qualified Equity Grants
The new law creates an opportunity for employees of non-publicly traded companies to defer for up to five years the recognition of gain from grants of employer stock options or restricted stock units (RSUs). To qualify for the tax deferral under new Code Section 83(i), the stock rights must be granted: (1) in connection with performance of services; and (2) pursuant to a written plan under which at least 80 percent of the company's U.S. employees will receive stock options or RSUs with the same rights and privileges as to the underlying employer stock. The following categories of employees will not be eligible to enjoy the deferral of gain under the new rule: (1) any person who has been a 1% owner of the company at any time during the prior 10 years; (2) the CEO and the CFO of the company; (3) family members of the individuals picked up by the first two categories; and (4) any of the four highest paid officers for any of the 10 prior years. Importantly, stock rights covered by the new rule will not be eligible for the Section 83(b) election and receipt of qualified stock is not treated as Code Section 409A deferred compensation.
Fringe Benefits and Related Deductions/Exclusions
The new law eliminates or modifies employer deductions and employee income exclusions for:
- Entertainment, amusement, and recreation activities
- Membership dues for a club organized for business, pleasure, recreation, or other social purposes
- Transportation fringe benefits
- Meals provided to employees for the employer’s convenience (deduction reduced to 50% of cost in 2018, with complete elimination beginning in 2026)
- Moving expense reimbursements (income exclusion and deduction available again in 2026)
- Restrictions on deductible employee achievement awards expanded to include cash, gift cards, vacations, meals, lodging, tickets to theater or sporting events, stocks, bonds, securities, and similar items
Human resources and payroll departments should team up now to review their fringe benefit arrangements and related pay codes to make the adjustments necessary to comply with the new rules in 2018.
The new law also includes provisions that:
- Eliminate the ability to recharacterize contributions to a Roth IRA as contributions to a traditional IRA and vice versa, and that allows recharacterization to unwind a conversion of a traditional IRA to a Roth IRA
- Allow a tax credit for businesses that provide at least two weeks annual paid family and medical leave to all employees (only available in 2018 and 2019)
- Increase the excise tax on stock compensation in a corporate inversion from 15 percent to 20 percent
- Extend the deadline for rollovers to avoid taxability of retirement plan loan amounts treated as distributions as a result of plan termination or severance from employment from 60 days to the due date for filing the employee’s tax return for the year of the deemed distribution
- Allow amounts improperly withdrawn from retirement plans due to an IRS levy to be returned to the original plan or rolled over to an IRA, and requiring the IRS to pay interest on amounts returned or rolled over
We are still analyzing the full impact of the new tax reform law. As we continue to assess the short- and long-term effects of the new law, we will provide updates through future blog posts and client advisories.