The new federal tax reform, signed into law by President Trump on December 22, 2017, will change tax liabilities and strategies for many organizations and individuals beginning this year. The following is a summary of key provisions affecting compensation, benefits and endowments under the Tax Cuts and Jobs Act (P.L. 115-97) as they affect employers, individuals and tax-exempt entities.
PROVISIONS AFFECTING EMPLOYERS
Deduction for Excessive Compensation. Beginning in 2018, the $1 million limit on the compensation deduction of officers of public companies will be harder to avoid. It now applies to a broader group, the CEO, CFO and three highest paid employees. In addition, the exceptions to the $1 million limit for commissions and performance-based compensation have been eliminated, thus closing an avenue for circumventing the rule. A transition rule survived, however, allowing a public company to take advantage of the looser, prior rules if the company has a written, binding contract in effect on November 2, 2017 that is not modified.
New Deferral Rules for Qualified Equity Grants. Beginning in 2018, an employee of a private corporation who is granted stock options or restricted stock units for services may elect to defer taxes when the equity becomes transferable or vested. The employee’s election must be made within 30 days of the stock’s becoming vested or transferable. The employee can defer income taxation up to 5 years or, if earlier, the occurrence of certain events such as the company’s stock becoming readily tradeable. To be eligible for this tax treatment, the corporation must adopt a written plan granting at least 80% of employees’ stock options or restricted stock units with the same rights and privileges to all employees. The 80% requirement is met if employees are either granted stock options or RSUs for that year and not a combination of both. Excluded from deferral elections are business owners holding at least 1% of the company in the current year or any of the preceding 10 years, one of the four highest paid officers in the current year or any of the preceding 10 years, or anyone who has ever served as CEO or CFO. The election to defer income taxes does not apply to FICA and FUTA which continue to apply.
This new provision leaves in place prior treatment of restricted property, 83(b) elections and incentive stock options and Code §409A considerations for deferred compensation.
PROVISIONS AFFECTING INDIVIDUALS
Pass-Through Tax Treatment. Beginning in 2018 (and expiring in 2025) an individual, trust or estate with qualified business income (“QBI”) from a pass-through entity (such as an S corporation, partnership or sole proprietorship) can deduct 20% of that income after compensation is paid. “QBI” refers to business income REIT dividends, but excludes compensation, other dividends, investment interest, and capital gains. If QBI is negative for any tax year that loss is carried over to the succeeding tax year.
Limitations on Deductions. The deduction is capped at the lesser of:
- 50% of W-2 wages paid from the pass-through, or
- the sum of 25% of the W-2 wages of the business plus 2.5% of the unadjusted basis of certain depreciable property (such as real estate).
There is no deduction if the pass-through business neither pays W-2 wages nor has the type of depreciable property subject to the second part of the limit.
There is generally no 20% deduction for compensation for services in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services and brokerages. An individual making $157,500 or less (or a married couple earning $315,000 or less) is not subject to the limits on W-2 wages or the prohibition for certain services, however, and can qualify for the deduction. The deduction is phased out for persons earning over these dollar thresholds, and the restrictions on the type of services and the limits on W-2 wages fully apply for individuals with taxable income exceeding $415,000 (if married) or $207,500 for other individuals.
If the individual qualifies for the deduction, it reduces taxable income (“below the line”), and is available whether or not the taxpayer itemizes deductions.
No Change to §409A. Section 409A of the Code continues to regulate deferred compensation as before.
Loans from Retirement Plans. Beginning in 2018, an employee who would otherwise pay income tax on the unpaid balance of a loan from a retirement plan (incurred when the employee quits working or when the plan terminates) may instead now defer tax on the unpaid loan balance. The employee has until the due date (including extensions) of filing his or her tax return to contribute the unpaid loan balance to an IRA to avoid having the loan amount treated as a taxable distribution.
Healthcare. Beginning in 2019, individuals will no longer be subject to tax penalties for failing to have health insurance. But employers with 50 or more full-time employees must continue to provide health insurance to employees under federal law to avoid penalty taxes.
Re-characterization of Traditional IRA and Roth Contributions. Beginning in 2018, taxpayers will not be permitted to re-characterize contributions to a traditional IRA as Roth contributions (or vice versa).
Carried Interest. Beginning in 2018, certain partnership interests (typically of private investment funds) must be held for at least 3 years to be treated as long-term capital gains (“carried interests”). If the 3-year holding period is not met, the taxpayer's gain will be treated as short-term gain taxed at ordinary income rates.
PROVISIONS AFFECTING TAX-EXEMPT ORGANIZATIONS
Private Schools, Colleges and Universities. Beginning in 2018, a private educational institution having at least 500 students and an endowment of at least $500,000 per full-time student (excluding assets used to pay for educational purposes) is subject to a 1.4% excise tax.
Excise Tax on Executive Compensation. Beginning in 2018, tax-exempt organizations that pay over a $1 million of compensation to any executive will be subject to 21% tax over the threshold. The tax levied is on the sum of:
- currently taxable compensation over $1 million that is paid to one of the 5 highest paid employees in the current tax year or any year after 2016; and
- any excess parachute payment (g. severance exceeding three times the executive’s average compensation over a lookback period).
The compensation limit includes payments made to executives from entities related to the tax-exempt organization. Each employer is liable for a proportionate share of the tax based on the amount of compensation it pays the executive.