The Tax Cuts and Jobs Act, which at this writing is on the verge of being signed into law, contains the most significant changes to the US Tax Code in more than 30 years.
This Alert provides a brief overview of the Act's changes to taxation of executive compensation and employee benefits.
The Act does not contain the controversial changes to nonqualified deferred compensation and stock options that were in the House bill and does not eliminate some of the popular tax-favored employee benefits like tuition reimbursement, dependent care, or adoption assistance programs as earlier proposed. However, House bill provisions changing deductibility of public company executive compensation, adding an excise tax on excess compensation paid to executives of tax-exempts, and adding a new type of private company equity compensation deferral feature remain, with some revisions.
EXECUTIVE COMPENSATION AND EQUITY COMPENSATION
Public companies lose deduction for executive compensation. Currently, public companies can deduct up to $1 million in compensation paid in a year to the CEO and next three highest paid executives (excluding the CFO), but performance-based compensation derived from awards such as stock options, performance share units, and cash bonus plans is not counted towards this deduction limit, so that performance-based compensation is fully deductible subject to the rules under Section 162(m) of the Code.
Under the Act, starting in 2018, the exception for performance-based compensation and commissions is repealed, meaning that all compensation, even if it is performance-based, will be subject to the $1 million limit on deductible compensation. Also, starting in 2018, the group of covered executives will include the CFO along with the CEO, and the top three executives after the CEO and CFO, and will include individuals who may hold these positions at any time during the year. If an individual is a covered executive for 2017 or any later tax year, the individual is considered a covered executive for all future tax years.
The Act contains a very important grandfather rule. Written binding contracts in effect on November 2, 2017, including plans where the right to participate in the plan is part of a written contract with an executive, are grandfathered. However, to preserve the deduction for existing grandfathered performance-based arrangements, those arrangements cannot be materially modified on or after that date.
The expansion of the definition of covered executives and repeal of the performance-based exception may impact the cost of compensation packages. Compensation committees may need to factor these changes and the cost impact into structuring executive compensation in the coming years.
New private company equity compensation deferral opportunity. Starting in 2018, the Act contains a new equity compensation income tax deferral opportunity for non-executive employees of privately held companies under new Section 83(i) of the Code. The income tax deferral opportunity attempts to address the quandary of many non-executive employees of private companies – lack of liquidity to pay taxes when equity compensation income is triggered. Under this new tax provision, if an employer establishes a broad-based stock option or restricted stock unit (RSU) grant program for a year, when eligible employees exercise those options or when the RSUs vest and are settled, the employer would have to give the employees notice of the deferral opportunity, and the employee would have 30 days to elect to defer income taxation of the compensation triggered at that time for up to five years.
New excise tax on executive compensation paid by tax-exempt organizations. Starting in 2018, the Act imposes a 21 percent excise tax on "excess" compensation paid by tax-exempt organizations to any of their top five highest-paid executives earning more than $120,000 (as indexed). The tax is paid by the employer. The tax may apply in two cases. If an executive is paid separation pay that equals or exceeds three times the executive's average compensation over the past five years (or fewer years employed), then the excise tax applies to all amounts that exceed one times that average compensation amount. Also, if, in a year, the executive is paid or vests in compensation (other than excess separation pay) that exceeds $1 million, the excess is subject to the excise tax. Compensation for medical services paid to certain medical professionals is not included in amounts subject to this tax.
Carried interest holding period increased. Starting in 2018, carried interests, also known as "profits interests," issued to fund managers (ie, in the capital raising, investment and asset development businesses, such as real estate development) will now need to be held three years rather than one year to benefit from capital gains treatment.
Increase in excise tax on value of insider stock compensation. Currently, a 15 percent excise tax under Section 4985 of the Code applies to the value of stock compensation held by insiders of an expatriated corporation. The Act increases the excise tax to 20 percent for inversions effective after the date of enactment.
AMT change may make ISOs more attractive. When an employee exercises an "incentive stock option," the "spread" (excess of the shares' fair market value over aggregate exercise price) is not subject to ordinary income taxation, but is an addback to income when figuring the employee's alternative minimum tax (AMT). Starting in 2018, the Act increases both the AMT exemption amount and the exemption amount phase-out thresholds for individuals. Therefore, ISOs may become more attractive for executive grants given the potential reduction in AMT.
No change to existing law on deferred compensation and nonqualified stock options. Despite some early proposals to drastically change taxation of deferred compensation and nonqualified stock options, the Act makes no changes to these provisions.
RETIREMENT, HEALTH REFORM AND FRINGE BENEFITS
More time to avoid taxable distribution of 401(k) loan. Currently, when an employee terminates employment or when a plan terminates and the employee takes a distribution of his or her account balance, the amount of the outstanding loan is offset against the account balance and considered a taxable distribution subject to an early withdrawal penalty. Under the Act, starting in 2018, the participant will have until the employee's tax return due date for the year of offset to transfer the amount of the loan offset to the IRA or employer plan to which the employee rolled over the remaining account balance to avoid income and penalty tax on the loan amount.
Employer tax credit for paid leave. If an employer provides employees who have been employed at least a year, earning $72,000 or less (in the prior year, as indexed), at least two weeks paid FMLA leave (for full time employees, a prorated amount for part-time employees), payable at the rate of at least 50 percent of the employees' wage rate, then the employer can claim a general business credit of at least 12.5 percent of the FMLA wage payments. The credit increases by 0.25 percent for each percentage above 50 percent, up to a 25 percent maximum credit, and the credit is subject to a 12-week maximum for each tax year. This credit is only available for 2018 and 2019.
Health insurance reform. While the Act reduces the tax that applies if an individual does not obtain individual health insurance to $0 starting in 2019, the Act does not change employers' existing obligation to provide affordable group health plan coverage under the Affordable Care Act rules.
Other benefits. Starting in 2018, the Act eliminates employers' expense deduction for meals and entertainment expenses and transportation fringe benefits. However, unlike the House bill, the Act does not change tax-favored adoption assistance, education assistance, or dependent care flexible spending accounts.
This Alert is intended as a general high-level overview of very complex tax provisions that are new and in some cases vague or unclear. We do not address all of the requirements, exceptions and rules in this overview. Each employer's and taxpayer's circumstances are different and a thorough review of the law and facts is required in all cases. The IRS will need to issue significant additional guidance as part of the Act's implementation.