The Tax Cuts and Jobs Act was signed into law by President Trump on December 22, 2017. While the news has been full of discussion of how the new law will affect the taxes of individuals and companies, less attention has been paid to its effect on employee benefits. As discussed below, the new law will have substantial effects in the area of employee benefits and compensation. Most of the provisions discussed below are effective January 1, 2018; many of the provisions affecting individual income taxation are scheduled to expire after December 31, 2025.
HEALTH AND WELFARE CHANGES
Affordable Care Act – Repeal of Individual Mandate
Before 2018, individuals who do not obtain health insurance (through their employers or otherwise) pay an additional tax (the "individual mandate"). The new law repeals the individual mandate. While the requirement that employers provide affordable health insurance does not change, the repeal of the individual mandate may cause some employees to decline any employer-provided health insurance that requires them to pay a portion of the cost. As healthier employees are more likely to decline coverage, while those with more health problems are more likely to remain in the employer plan, the per-employee cost of providing health insurance may rise. Moreover, employers may face a less healthy workforce if employees who decline coverage fail to get preventative care and necessary medical treatment.
Family and Medical Leave – Employer Tax Credit for Paid Leave
Under current law, employers are required to provide up to twelve weeks of leave for medical conditions and certain family obligations. However, the leave need not be paid. Under the new law, companies that provide at least two weeks of paid family leave benefits will receive a tax credit of up to 25% of the value of the paid leave wages. This provision is effective only for 2018 and 2019.
Health Savings Accounts – Slower COLA Increases for Contribution Limits
Health Savings Accounts (HSAs) allow an employee with a high-deductible health plan to put aside money on a pre-tax basis for healthcare. To the extent the money is not used currently, it can be rolled over to future years and even into retirement. As long as the money is eventually used for healthcare expenses (including payment of Medicare premiums), it is not taxed when withdrawn.
For 2018, the limit on contributions to an HSA is $3,450 for someone with individual coverage, and $6,900 for someone with family coverage, with an additional $1,000 if the person is age 55 or over. Under pre-2018 law, the limits rise based on cost-of-living adjustments. The new law adjusts the cost-of-living formula so that the limits will rise more slowly.
EXECUTIVE AND EQUITY COMPENSATION CHANGES
$1M Deduction Limit for Publicly Traded Companies Is Expanded
Before 2018, for publicly traded companies, there is a $1M cap on deducting annual compensation of certain "covered employees" (the CEO and three highest-paid employees other than the CFO), with exceptions for performance-based compensation and commissions. Much of the compensation provided by publicly traded companies to covered employees is structured to qualify as performance-based, such as options, stock appreciation rights, and metric-based cash incentive payments.
The new law repeals the performance-based compensation and commission exceptions, so that any compensation in excess of $1M provided by a publicly traded company to a covered employee for a year will be nondeductible. The new law also conforms the definition of "covered employee" to the SEC proxy "named executive officer" group (CEO, CFO, and other three top-paid employees). Also under the new law, once someone becomes a covered employee, they remain a covered employee for all future years, even if they have terminated employment or are otherwise no longer in the named executive officer group. The deduction limit is extended to companies with SEC-registered debt or equity securities (even if they are not traded on an exchange).
The provision is effective beginning in 2018, but provides transition relief for certain binding agreements in effect on November 2, 2017 that are not materially modified.
New Excise Tax for Nonprofit Compensation over $1M or Excessive Severance
The new law imposes a new excise tax on compensation in excess of $1M per year, and on excessive severance payments (see below), paid by a nonprofit organization to a covered employee. The tax is determined at the corporate tax rate (now 21%). The organization's five highest-paid employees for a year are covered employees, and once a covered employee, always a covered employee. Amounts provided under a Section 457(f) deferred compensation arrangement are taken into account upon vesting.
Excessive severance payments are payments that are contingent on separation from employment that equal or exceed three times the employee's five-year average annual compensation. If this threshold is reached, severance payments in excess of one times the employee's five-year average annual compensation are subject to the new excise tax.
Compensation paid to a licensed medical provider for the performance of medical services is not subject to this new tax.
The provision is effective beginning in 2018, and there is no transition relief, even for binding agreements already in effect.
Nonqualified Stock Options and RSUs of Privately Held Companies – Deferral of Taxation Beyond Exercise
In the past, employees of privately held companies who received nonqualified stock options or restricted stock units (RSUs) have been required to recognize income when the options or RSUs were exercised. This has in many cases created a hardship for the employees, inasmuch as the lack of a market for the shares has left them without cash to pay the tax. The new law allows qualified employees to elect to defer taxation for up to five years on the gain under certain circumstances. To qualify, at least 80% of the employer's U.S. employees must be granted options or RSUs for the year on similar terms. Qualified employees do not include 1% owners, the CEO, or the CFO.
QUALIFIED RETIREMENT PLAN CHANGES
Rollovers of Plan Loans – Extended Rollover Period
If a retirement plan participant terminates employment with an outstanding plan loan or the plan is terminated and that participant does not promptly repay the outstanding loan, the account balance is typically offset by the amount of the loan. For example, if the participant has an account balance of $10,000, and an outstanding loan of $4,000 which is not promptly repaid, the participant's account balance will typically be reduced to $6,000. However, under pre-2018 law, even if the participant rolls over the $6,000 to an IRA or another employer plan, they will be taxed on $4,000 unless they can contribute $4,000 in other funds to the rollover IRA within 60 days after the distribution. The new law extends the 60-day deadline to repay the loans until the participant's tax filing deadline (including extensions) for the tax year in which the offset occurred.
Relief for Victims of 2016 Disasters
Relief from the 10% early withdrawal tax will be provided to eligible victims of any 2016 presidentially declared disaster:
- Qualifying 2016 and 2017 distributions of up to $100,000 before age 59½ are exempt from the 10% additional penalty tax.
- Qualifying distributions from employer-sponsored retirement plans are free of tax if repaid within three years.
- Distributions not repaid are subject to tax over a 3-year period.
- Mandatory withholding is waived from qualifying distributions.
The change does not apply to disasters in 2017 or subsequent years. Plans offering this relief need to be amended by the end of the first plan year, beginning on or after January 1, 2018.
OTHER BENEFIT-RELATED CHANGES
Moving Expense Reimbursement – Repeal of Taxable Income Exclusion
Currently, certain employer-provided reimbursements for moving expenses are excluded from employees' taxable income. The new law repeals the exclusion starting in 2018, but reinstitutes it starting in 2025.
Transportation Fringe Benefits – Repeal of Deduction (For-Profit Employers) and Imposition of UBIT (Nonprofit Employers)
Currently, employers may provide certain transportation fringe benefits (parking, public transit passes, and bicycling expenses) free of tax to the employee, but still can deduct the cost. The new law repeals the employer deduction for transportation fringe benefits starting in 2018. In addition, the new law treats as unrelated business taxable income (UBTI) any transportation fringe benefits provided by a nonprofit employer to its employees, starting in 2018.
Employees will continue to receive most of the benefits free of tax, to the extent that employers continue to maintain the plan. (However, bicycling expense reimbursements will become taxable to employees.) The loss of the tax deduction to the employer (or treatment as UBTI for a nonprofit employer) may discourage employers from having such plans, or encourage them to discontinue the plans.
The change affects even transportation benefits entirely funded by pre-tax employee contributions. For example, suppose that Joe currently has a salary of $2,000 a month and contributes $250 to a pre-tax parking benefit. Before 2018, the employer can deduct the $2,000 paid in salary from its taxable income. With the legislation, the employer will be able to deduct only $1,750 of Joe's salary, because the remainder will be treated as a nondeductible transportation benefit (or, in the case of a nonprofit employer, $250 will be treated as UBTI).
Business Entertainment, Amusement, or Recreation – Deduction Eliminated
Before 2018, employers may deduct 50% of the cost of business-related entertainment, amusement, or recreation. Effective in 2018, the new law eliminates the employer tax deduction altogether for entertainment. This affects expenses such as the cost of sporting or theater tickets for use with customers, and employee holiday parties.
Employee Achievement Awards
Currently, employee achievement awards for length of service or safety achievements are not taxable to employees and are deductible by the employer. Effective beginning in 2018, the employee achievement awards would be taxable and not deductible if provided in cash, cash equivalents, gift cards, gift coupons, gift certificates, vacation, meals, lodging, tickets to sporting or theater events, securities, or similar items. However, such awards would still be excluded from taxation and deductible if the employee can select tangible property only from a limited array of preselected items.
Meals Furnished for the Convenience of the Employer – Deduction Eliminated After December 31, 2025
Currently, meals furnished by an employer on premises for the convenience of the employer are excluded from employees' income, but 50% of the cost of de minimis meals is still deductible to the employer. This would apply, for example, if a hospital provides meals to its employees so that they can be on call and immediately available during meal times, rather than going out to a restaurant. Effective in 2025, the new law repeals the deduction for meals provided for the employer's convenience.
Tax Rate Reductions Diminish Value of Employee Benefit Tax Preferences
The reduction in the corporate tax rate and the more favorable tax treatment of certain pass-through entities (S corporations and partnerships) will diminish the tax benefits to employers of maintaining employee benefit plans. At the same time, the reduction in individual income tax rates will reduce the tax advantages to the employee of employer-provided benefits and pre-tax employee contributions.
For example, the top corporate tax rate was 35% before 2018. This means that a corporation that contributes $10,000 to an employee benefit plan for years before 2018 will receive 35% of it, or $3,500, back in the form of a reduction in income tax. Under the new law, the top rate will be 21%, so a corporate employer will get back only $2,100.
Similarly, an employee with $450,000 in taxable income is taxed at a 39.6% marginal rate for years before 2018. If the employee defers $18,000 under a 401(k) plan before 2018, the employee's taxes will be reduced by $7,128. Under the new law, the employee's marginal rate will decrease to 35%, so the reduction in taxes due to the deferral will be only $6,300.
The change in tax rates may cause employees to rethink whether to put money aside in the form of pre-tax or Roth deferrals. In general, a Roth deferral is more favorable if an employee anticipates being in a higher tax bracket at retirement. Given that tax rates are being reduced to historically low levels, those who anticipate future rises in tax rates may see Roth deferrals as more advantageous than pre-tax contributions.
PROVISIONS NOT INCLUDED IN THE LEGISLATION
There were numerous provisions discussed in the media or included in earlier versions of the bill that were not included in the final legislation, such as the following:
- Reduction in pre-tax contribution limits for retirement plans, or a requirement that most deferrals be made as Roth contributions
- Taxation of deferred compensation provided by for-profit employees upon vesting, even before payment
- Sunset of employer-provided dependent care assistance programs
- Allowance of in-service distributions at 59½ for defined benefit plans and governmental 457(b) plans
- Elimination of 6-month deferral suspension upon hardship distribution
- Allowance of hardship distributions from employer contributions and earnings on elective deferrals; elimination of requirement to take available loans before a hardship distribution
- Easing of nondiscrimination rules for frozen defined benefit plans
- Imposition of dollar limit on employer-provided housing exclusion
- Repeal of tax exclusion for employer-provided adoption assistance
- Repeal of qualified tuition reduction provided by educational institutions