Signed into law by President Trump on December 22, the final version of the tax reform bill (the “Act”) is not as far-reaching on executive compensation as the earlier version we previewed. However, the Act makes several significant changes to employee benefits and executive compensation arrangements, of which employers should be aware. This article highlights some of the primary benefits-related changes that will take effect next year, including changes to executive compensation arrangements and the Affordable Care Act.
Expansion of Code Section 162(m) Deduction Limits
Under the current Code Section 162(m), a publicly held company may only deduct up to $1 million of compensation to certain covered employees – the company’s chief executive officer and the next three highest-compensated officers (excluding the chief financial officer) as of the end of the taxable year – but that limit is undercut by exceptions for certain common types of executive compensation, such as performance-based compensation (which includes stock options) and commissions. The Act eliminates the exceptions for performance-based and commission-based compensation and expands the list of covered employees to consist of the company’s chief executive officer, chief financial officer, and the next three highest-paid officers at any point in any taxable year beginning after December 31, 2016 (with an exception for written, binding contracts that were in effect as of November 2, 2017, and which are not materially modified thereafter).
- Going forward, public company employers should note that gain on stock options, previously exempt as performance-based compensation, will now be included in the $1 million deduction limit. There may be opportunities to circumvent these restraints with incentive stock options.
- These employers should also be aware that the current rule that “covered employee” status was determined as of the last day of the taxable year to structure severance arrangements in excess of $1 million is no longer available.
- Given the uncertainty surrounding the definition of a “written, binding contract” (for example, it is unclear whether an existing agreement that requires the company’s compensation committee to set performance goals for each year would qualify), employers should analyze whether they can rely on the exemption for contracts that were in effect before November 2, 2017, and ensure that they do not take any actions to materially modify arrangements that do qualify for such exemption.
- Depending on the effect of the loss of this deduction, public company employers may consider accelerating certain performance-based compensation payments due in 2018 to this year to take advantage of current tax rules (while still complying with Code Section 409A and securities law requirements).
Excise Tax on Tax-Exempt Organization Executive Compensation
Tax-exempt organizations have traditionally enjoyed freedom from certain limits on compensation that apply to many for-profit corporations. Under the Act, tax-exempt organizations will be subject to taxation for certain compensation paid to the five highest-compensated employees of the organization (as of any year after 2016) in excess of certain thresholds. First, tax-exempt organizations (rather than the employees) will be subject to a 21 percent excise tax on compensation to one of these individuals in excess of $1 million. In addition, the organization will be subject to the 21 percent excise tax on certain severance arrangements that are considered “excess parachute payments.” Though the term is borrowed from the limit on corporate change-in-control payments, for these purposes, a change in control is not required. A parachute payment is defined as compensation that (i) is contingent on the employee’s separation from employment, and (ii) exceeds three times the employee’s base amount (that is, the average of the employee’s annualized compensation for the five most recent taxable years that end before the employee’s separation from employment). Excess parachute payments are those that exceed the base amount. The Act does exempt payments made to employees who are non-highly compensated (generally, less-than-5-percent owners and, for 2018, those who earned $120,000 or less in the preceding calendar year) and creates special rules for compensation paid to certain qualified and licensed medical professionals.
- Universities, hospital systems, public utilities, and other large nonprofit entities with significant executive compensation arrangements should analyze their current compensation arrangements. For example, this rule change may impact universities who have coaches or presidents/chancellors who have compensation in excess of the $1 million threshold.
- Hospital systems should determine whether some of their highest paid executives will qualify for the special rules applicable to qualified and licensed medical professionals.
Qualified Equity Grants
The Act adds a new provision to the Code that allows a private corporation’s employees who are granted employer stock (“qualified stock”) in connection with the exercise of stock options, including statutory stock options, or in settlement of restricted stock units to elect to defer recognition of gain on the grant for up to 5 years. Certain individuals, including the current or prior chief executive officer or chief financial officer, as well as any of the 4 highest paid officers or 1-percent owners (at any point during the 10 preceding calendar years) cannot make such elections.
This arrangement is limited to private corporations that sponsor written plans that provide at least 80 percent of the corporation’s employees with grants of either stock options or RSUs with the same rights and privileges to receive qualified stock. Additionally, in order to take advantage of these rules, the employee must file the deferral election with the IRS no later than 30 days after the first date that the rights of the employee in such qualified stock are transferrable or no longer subject to a substantial risk of forfeiture, and employers must meet certain notice requirements.
- Employers may find it difficult to ensure that these types of arrangements are structured properly to comply with the numerous requirements under this provision. For example, this arrangement may not be available if the employee can sell stock back to the company, or if the company repurchases outstanding stock in certain circumstances.
- For start-ups and other companies with low-valuations, it may still be preferable to employees to receive restricted stock and file Section 83(b) elections.
Health and Welfare Plans
Elimination of the Affordable Care Act Individual Mandate
The Act eliminates the Affordable Care Act’s individual mandate, which imposes a tax penalty on individuals who fail to maintain appropriate health insurance coverage. The Act does not, however, repeal the Affordable Care Act, so the employer mandate, which requires large employers to offer affordable and minimum value health coverage to full time employees and their dependents, still applies.
- Although this provision does not directly affect employer-sponsored plans, employers may find that certain employees are no longer interested in participating in their group health plans since they will no longer be subject to a penalty for failing to have coverage.
- To the extent that employees are looking to drop their health insurance coverage midyear, employers should carefully follow their cafeteria plan election change rules.
- Employers may see health insurance costs rise as younger and healthier employees drop coverage.
Extended Rollover Period for Plan Loan Offsets
An employee who terminates employment with a qualified retirement plan loan outstanding may be subject to a plan loan offset (i.e., the outstanding loan balance is paid with funds from the participant’s account and is deemed to be a distribution), which, under current law, may be rolled over to another qualified retirement plan within 60 days. The Act extends the time by which such loan offsets may be rolled over to the due date of the individual’s tax return.
- This rule should be helpful for employees whose plans terminate or who separate from service while having a plan loan outstanding.
- This extended rollover period may be helpful in coordinating loan offset rollovers in the context of acquisitions.
Repeal of Recharacterization of Roth IRA Conversions
Currently, a taxpayer who converts his or her traditional IRA to a Roth IRA may unwind, or recharacterize, the conversion until the due date of the taxpayer’s tax return the following year. The Act repeals the special rule permitting taxpayers to unwind Roth IRA conversions after December 31, 2017.
- Individuals considering recharacterizing their Roth IRA conversions should do so by the end of this year.
The Act also makes a number of changes to fringe benefit arrangements. For example, it significantly narrows the exclusion from gross income and employer deduction for certain employee achievement awards by eliminating cash, gift cards, cash equivalents, vacations, meals, lodging, tickets to theater or sporting events, stocks, bonds, other securities, and other similar items. In addition, the Act suspends until 2026 the exclusion from gross income for employee moving expense reimbursements and qualified bicycle commuting reimbursements. The Act also eliminates employer deductions for certain entertainment, amusement, or recreation expenses, and qualified transportation benefits, and also significantly limits the employer’s deduction for certain employee meals.
- Employers should review some of the common fringe benefits they provide employees to determine if they are still cost-effective without the deductions, and educate employees that certain benefits may no longer be excludible from their gross income.
Now that President Trump has signed the bill into law, employers should begin reviewing their plans and benefits to anticipate any year-end planning opportunities that may be available and what changes, if any, may be needed for the upcoming year.