On May 23, the staff of the Senate Finance Committee issued the seventh in a series of reports outlining alternatives for the members of the committee to consider as they begin work on tax reform legislation. The most recent report, Economic Security, discusses potential goals that could be achieved by modifying tax rules in the areas of retirement income, healthcare benefits, executive compensation, life insurance and annuities and employee fringe benefits. The report also summarizes a wide range of modifications that have been proposed in each of these areas.
The report is significant for a number of reasons. First, it confirms that each of these areas will receive close scrutiny during the debate over tax reform. For example, the tax preferences currently in place for retirement income and healthcare benefits will likely receive special focus because these areas constitute two of the largest categories of “tax expenditures” under current law. Second, the report provides a comprehensive outline of reform proposals that have been suggested to date and that may be included in any legislative compromise on tax reform that ultimately is developed. Finally, the report highlights the complex nature of our current tax system and the competing goals that are at stake, which will likely complicate Congress’s efforts to fashion a set of reforms. As evidence of this, some of the proposals described in the report are directly contrary to each other because they represent opposing views of what tax reform should primarily accomplish.
Many of the reform proposals reviewed in the report focus on employer-provided retirement benefits. The proposals are grouped into the following categories:
Limit or Eliminate the Preferences for Retirement Savings
These proposals range from eliminating all preferences (such as deductions and exclusions for retirement savings) in favor of universal enrollment in an expanded version of Social Security, to more surgical measures aimed at specific types of exclusions. Examples of more specific modifications include lowering the dollar limits on tax-preferred contributions to defined contribution plans and IRAs, capping the employer deduction for amounts contributed to fund defined benefit plans and limiting the total amount that can be accrued over a lifetime in tax-preferred retirement plans. A version of the last proposal was included in the Obama administration’s fiscal-year 2014 budget. Under the administration’s proposal, an individual’s total balance across tax-preferred accounts would be limited to an amount sufficient to finance an annuity of not more than $205,000 per year in retirement. For someone retiring in 2013, such a balance would be approximately $3 million.
Replace All Deductions, Exclusions and Credits with a Unified Tax Credit
Under current law, there are a number of deductions, exclusions and, to a more limited degree, tax credits designed to incentivize retirement savings. Some have recommended that this system be replaced (either in whole or in part) with a refundable tax credit. The tax credit would act as a government-funded matching contribution to employer plans.
Expand Existing Retirement Savings Incentives
There are certain limited incentives currently in place to encourage retirement savings. For example, there is a saver’s tax credit that provides low- and moderate-income taxpayers with a credit for up to 50 percent of the first $2,000 they defer into a tax-preferred retirement vehicle. In addition, small employers can qualify for a credit to offset the costs of establishing a retirement plan for their employees. The report discusses proposals to expand these credits (such as by making the saver’s tax credit refundable). In addition, the report mentions proposals to eliminate various nondiscrimination rules, contribution limits and distribution restrictions if the existing tax system were replaced with a flat tax, as well as various new types of retirement plan options (such as “multiple small employer plans” and “lifetime savings accounts”).
Modify the Current System to Increase Its Effect on Providing Retirement Income
This category of proposals includes requiring employers that do not have a retirement plan to automatically enroll their employees in IRAs, expanding the current rules that allow employers to automatically enroll employees in their retirement plans and encouraging the use of retirement savings to purchase life annuities or long-term care insurance.
Simplify or Expand Employers’ Option for Providing Tax-Preferred Retirement Income
These include a range of proposals designed to make retirement plans more attractive and easier for employers to maintain. An example is a proposal to combine all current types of retirement plans into a single “Save at Work” plan that would be subject to a single set of administrative requirements. The proposals would revise the administrative requirements imposed under current law, such as by reducing the number (and simplifying the content) of notices that employers must to send to employees, and by updating current regulations to better accommodate electronic delivery of such notices.
There are also various proposals for reducing “leakage” from the current retirement savings system, such as by prohibiting any distributions before retirement and making rollover easier. The report also discusses a contrary set of proposals that would allow more flexibility in distributions. These proposals would allow for penalty-free withdrawals to make mortgage payments or pay adoption expenses, and eliminate the required minimum distribution rules for IRAs below a certain dollar amount.
Employer-provided healthcare benefits enjoy a number of tax preferences under current law. The value of employer-provided health insurance is excluded from employees’ income, and employees can separately deduct the amounts that they pay for health insurance premiums or that they transfer to tax-advantaged arrangements, such as health savings accounts (HSAs) and flexible savings accounts (FSAs). The tax preferences available for employer-provided healthcare are together the single-largest tax expenditure under current law.
The report describes a range of reform proposals in this area. The chief proposal is to simply repeal the tax exclusion for employer-provided healthcare (generally over a phaseout period) and disallow new contributions to HSAs or FSAs. A less severe proposal (which was included in a 2005 advisory panel on tax reform) would be to limit the exclusion to the average cost of health coverage. Under this proposal, persons not covered under an employer’s plan could deduct the cost of health coverage in the individual market up to the average cost for such coverage, or be entitled to a deduction equal to the amount of the exclusion permitted for employer-provided coverage. Other recommendations include:
- Modifying or replacing portions the Patient Protection and Affordable Care Act (which include proposals to repeal the employer shared-responsibility requirements and minimum essential coverage rules; replacing the exclusion for employer-provided health coverage with a tax credit; and reducing the excise tax for high-premium health insurance in conjunction with reducing the exclusion for employer-provided health coverage)
- Expanding the tax preferences for healthcare benefits (such as repealing the floor on deducting medical expenses for taxpayers under 65 with no employer coverage; excluding from employees’ income the amounts paid by the employer for athletic or fitness facilities; and repealing the $2,500 annual cap on FSAs provided through an employer cafeteria plan)
- Expanding long-term care benefits
- Reforming excise and other taxes that apply to healthcare benefits (such as increasing alcohol taxes and imposing a tax on the recreational use of marijuana)
The report also lists many possible avenues of reform for the taxation of executive compensation.
At the top of the committee staff’s list is Section 162(m) of the Internal Revenue Code (Code). Section 162(m) limits a public company’s deduction for the annual compensation it pays to its CEO and each of its other three most highly compensated officers (excluding the CFO) to $1 million each. “Performance-based” compensation, including stock options, is not subject to this limitation. Nor is compensation that is earned in one year but paid in a future year, when the executive may no longer be covered by Section 162(m).
Congress has recently taken the opportunity to substantially expand the Section 162(m) deduction limitation as it applies to both financial institutions that participated in the government’s Troubled Asset Relief Program (TARP) and health insurance companies. Congress’s willingness to expand Section 162(m) in these specific areas suggests a broader expansion is something more than a remote possibility. The specific reform proposals listed in the report include:
- Repealing the limitation completely (presumably on the basis that Section 162(m) encourages the use of stock options, which have recently fallen out of favor among institutional shareholder groups and some policymakers)
- Expanding the group of covered employees (notably, the expanded version of Section 162(m) that applies to health insurance companies covers all employees)
- Removing stock options from the performance-based compensation exemption
- Capping the deduction at the lower of a multiple (e.g., 25 times) of the lowest compensation paid to any other employee or a set dollar amount
Other potential Section 162(m) reforms that are not mentioned in the report might include removing the performance-based compensation exception completely and limiting the deduction of deferred compensation as well. Both of these were features of the expanded versions of Section 162(m) applicable to TARP institutions and health insurance companies.
Other executive compensation-related reforms mentioned in the report include:
Nonqualified Deferred Compensation
- Repealing Code Section 409A (for all companies, or for private companies only), or repealing just the additional 20 percent and interest income taxes (few, other than executive compensation lawyers, would disagree with this)
- Taxing employees on nonqualified deferred compensation when it is earned or vested (as it is currently taxed for FICA purposes, and as it is currently taxed for employees of some partnerships owned by tax-exempt entities or offshore corporations under Code Section 457A)
- Taxing nonqualified deferred-compensation earnings on a current basis (instead of when the compensation is paid), payable either by the employee or the employer
- Imposing a $1 million limit on the total amount of nonqualified deferred compensation that can be deferred in a single year
- Repealing favorable tax treatment for incentive stock options (which is probably unnecessary, given that alternative minimum tax has already effectively repealed this treatment in many cases)
- Tying the timing and amount of the deduction for nonstatutory options to the timing and amount of the compensation expense associated with the options (but not, apparently, altering the income recognition rule for the employee)
Although not mentioned in the report, a likely candidate for reform that has been mentioned in the Obama administration’s budget for several years running and has been the subject of several pieces of proposed legislation is the elimination of the favorable tax treatment for partnership profits interests (taxing the income generated by profits interests as ordinary income rather than capital gain).
- Repealing the Code Section 280G deduction loss and Code Section 4999 excise tax on excess golden parachute payments (apparently on the theory that these rules simply impose additional costs on shareholders, e.g., via tax gross-ups, without actually reducing golden parachutes; whether this theory still holds in the age of “say-on-pay” and institutional proxy voting advisers is an open question)
Life Insurance and Other Fringe Benefits
The report also suggests several possible reforms for life insurance and fringe benefits, including:
- Tax the inside buildup of life insurance policies and annuity contracts on a current basis
- Deny the exclusion for death benefits over a certain amount
- Increase the $50,000 exclusion limit for nondiscriminatory employer group life insurance plans
Other Fringe Benefits
- Apply a 50 percent excise tax on employers for excludable meal and entertainment expenses
- Increase the taxable income associated with the use of corporate jets for personal travel
- Repeal or reduce exclusion for parking benefits, or equalize tax treatment of parking and transit benefits
What Lies Ahead
Although some say the prospects for comprehensive tax reform this year have dimmed, the appetite for increasing taxes (or reducing tax expenditures) has not. Therefore, some of the proposals discussed above could end up being served up in piecemeal legislation this year or in the near-term future.