November 6, 2017 House tax reform proposal would affect treatment of nonqualified deferred compensation, stock options, 162(m) $1m deduction limit, employee fringe benefits and retirement plans The House Ways and Means Committee's tax reform proposal (the Tax Cuts and Jobs Act (the "bill")) released November 2, 2017, would significantly change the tax treatment of compensation and employee benefits. The bill includes proposals that would: eliminate the tax deferral of nonqualified deferred compensation beyond the vesting period, tax stock options and appreciation rights at vesting, expand the Section 162(m) $1 million deduction limit, impose an excise tax on tax-exempt organizations for executive compensation and make changes to employee fringe benefits and retirement plans. If enacted, the bill would dramatically alter the taxation of compensation and benefits arrangements. Compensation provisions Nonqualified deferred compensation (NQDC) The bill effectively would eliminate tax deferral for most NQDC, including supplemental retirement plans, stock appreciation rights, and stock options under new Section 409B. Employees and other service providers would be subject to tax when they have completed all the services necessary to "vest" in the future compensation, even though these amounts continue to be subject to creditor risk and are not currently payable to them. Effectively, employees and service providers would be placed on an accrual method of accounting with respect to such amounts. Current lawUnder current law, most employees and service providers are not taxable (1) on NQDC until payment or (2) on stock options until the date of exercise. Cash-method taxpayers (which generally includes all employees and other individual service providers) are subject to the deferred compensation requirements of Section 409A. Under Section 409A, NQDC amounts must be payable solely at fixed dates or upon events permitted under Section 409A; otherwise the employee or service provider must include the NQDC in income upon vesting, and there is an additional 20% tax on top of the ordinary income tax, plus potentially a premium interest tax. Because of the tax rates imposed under Section 409A, the vast majority of NQDC arrangements are structured to comply with or be exempt from Section 409A. Key exemptions from the definition of NQDC under Section 409A include (i) stock options or stock appreciation rights issued at fair market value (i.e., not discounted) and (ii) amounts that pay within 2½ months of the end of the year in which the "vesting" event occurs, so-called "short term deferrals." There are two additional, special compensation tax rules that may apply under current law. Section 457A applies to any service provider (regardless of whether they are cash or accrual method) if they perform services for "tax-indifferent entities." A tax-indifferent entity includes a non-US business located in a jurisdiction that does not maintain a comprehensive income tax (e.g., Cayman Islands or Bermuda). Section 457A imposes taxation when the promised compensation amounts are no longer subject to a substantial risk of forfeiture (i.e., vested), with an exception for stock options and stock-settled appreciation rights. Under current Section 457A, employees and other service providers generally are subject to taxation at the time of vesting, regardless of whether the amounts are actually paid. In addition, "vesting" for these purposes is limited to the requirement to perform future services; a performance goal or other non-service-related forfeiture provision is not treated as a substantial risk of forfeiture under Section 457A. If, at the time of vesting, an amount is not determinable (such as amounts contingent on performance hurdles or other business events), Section 457A allows a delay in taxation until the point in time when the compensation is determinable; however, in this case Section 457A also imposes an additional 20% tax, similar to Section 409A. Finally, current law includes another special compensation timing rule for employees of tax-exempt organizations. Section 457(f) taxes the present value of "compensation deferred" in the year in which there is no substantial risk of forfeiture (i.e. vesting). Under Section 457(f) earnings on vested amounts are not included in income until the employee actually receives payment of the amount. ProposalNew Section 409B would eliminate Sections 409A, 457A and 457(f) with respect to NQDC that is earned after December 31, 2017. Beginning in tax years 2018 and thereafter, all NQDC would be includable in income when it vests and would be subject to ordinary income tax (but with no 20% additional tax) at that time. Section 409B is patterned after and would incorporate much of the tax regime that exists under current law Section 457A, although it imposes a harsher rule on stock options and appreciation rights. Under Section 409B, the concept of "vesting" and "substantial risk of forfeiture" are narrowly defined. Like current-law Section 457A, an amount is considered to be subject to a substantial risk of forfeiture, and therefore unvested, under Section 409B solely on account of a requirement to perform future significant services. This definition of a substantial risk of forfeiture is narrower than the definitions under current Section 409A or Section 83 that allow for other types of contingencies, such as the performance of investment assets, an IPO or liquidation event. These contingencies would not be taken into account for purposes of determining whether an amount is vested under Section 409B. This means that the accruals subject to Section 409B would have to be taken into income when services are performed, even if those amounts might be reduced in the future because of other business contingencies, such as the nonattainment of a performance goal or hurdle. Further, unlike Section 457A, new Section 409B does not provide for any delay in taxation for amounts that are vested but not determinable (e.g., where a performance hurdle or other event has yet to occur that will crystalize the amount of compensation that is owed). However, Section 409B does retain the "short-term deferral" exemption that allows for payment to occur within 2½ months following the service recipient's tax year in which the substantial risk of forfeiture lapses. As drafted, there would be no change to the timing of the employer's deduction for NQDC amounts. Under Section 409B, the service provider would be required to include an amount in income when it becomes vested; however, the employer may not be entitled to a deduction until the NQDC amount is actually paid. A further significant, somewhat dramatic departure from current law is the inclusion of stock options and stock appreciation rights in the definition of NQDC. Under Section 409B, there is no exception for stock options or stock-settled appreciation rights, which are currently excluded under both Sections 409A and 457A. Thus, an individual who receives options or appreciation rights would include in income the fair value of such awards when they vest and not when they are exercised or paid. As drafted, there is no change to the timing of the employer's deduction for stock options. Thus, it appears that an individual would have income inclusion on an option at vesting (and each year thereafter on additional accruals), but an employer would not appear to have an accelerated deduction under Section 83. Effective dateSection 409B would apply to amounts deferred that are attributable to services performed after December 31, 2017. Thus, as drafted, amounts that are fully vested (i.e., all services have been performed) would not be subject to Section 409B. The grandfathered amount also includes future earnings on amounts vested on December 31, 2017. However, this "grandfather" treatment of vested NQDC and earnings is time limited. Any grandfathered amounts must be included in income prior to 2026. The bill would require the IRS to publish guidance within 120 days of enactment that would provide for early payouts or changes in payouts, which may be necessary to avoid a violation of current Section 409A provisions that presumably still continue to apply to these amounts until paid. This 10-year window mirrors the provision that accompanied the enactment of Section 457A (under which taxpayers are required to include grandfathered amounts in income before 2018). ImplicationsSection 409B would be a radical change in the taxation of NQDC and likely would eliminate many types of plans that businesses currently utilize to incentivize their employees and management, because these plans would no longer be tax efficient. In particular, supplemental defined benefit pensions would be particularly hard to maintain given the valuation issues that would arise at the time of vesting and deemed taxation. Placing a value on a future pension stream at the moment of vesting, based upon future events and future interest rates, may be difficult. Taxing the present value of such a benefit has proven extremely challenging under current-law Section 457(f) in the limited situations where a tax-exempt employer provides such a plan. Current taxation of options and appreciation rights is likely to be met with surprise by many businesses. Section 409B would effectively overturn the taxation of options that has been in effect since Section 83 was enacted in 1969. Current taxation of vested but unexercised options and appreciation rights would be particularly difficult for "start-ups" that utilize these arrangements when there may be limited cash in the business to otherwise incentivize employees. If Section 409B were enacted without substantive changes, employers would need to significantly change their incentive compensation structure. They likely would utilize property transfers in lieu of NQDC where possible. Section 409B does not apply to any transfer of property that is taxable under Section 83. Thus, a transfer of restricted stock or a partnership interest (including a profits interest) would fall outside the ambit of Section 409B. Also, "short term deferrals" that are designed to pay upon the completion of services would continue to be viable, as would tax-qualified plans (e.g., tax-qualified pensions and 401(k) plans), although the current-law compensation and benefit limits under those arrangements may be challenging to businesses looking for management incentive programs. Limitation on excessive employee remuneration modified Current lawSection 162(m) applies to the compensation paid to a public company's "covered employees," consisting of the CEO and the next three highest compensated officers (excluding the CFO). The $1 million per-tax-year deduction limitation applies to compensation otherwise deductible in a given year that is paid to an individual who is a covered employee at the close of the tax year. Thus, compensation paid after an individual is no longer a covered employee (such as severance and other deferred compensation payments) is not subject to the $1 million deduction limit. In addition, a significant exception is provided in the statute for performance-based compensation, which includes stock options and stock appreciation rights. Amounts that constitute performance-based compensation are not subject to the $1 million deduction limit. ProposalThe bill would amend Section 162(m) to eliminate the exception for performance-based compensation, and to expand the definition of covered employees. Under the amendment, covered employees would specifically include the CFO plus any individual who has previously been a covered employee, even after the individual no longer holds such position. Thus, once an individual is named as a covered employee, the limitation would apply to compensation paid to that individual at any point in the future, including after a separation from service. Effective dateThese expansions would be effective for tax years beginning after December 31, 2017. ImplicationsThe bill would significantly expand the $1 million deduction limitation for public companies and includes no transition relief. Thus, compensation paid under existing arrangements in excess of the limit, including outstanding stock options, would no longer be deductible in the future for any covered employees. Companies would need to monitor compensation payable after individuals are no longer covered employees, which may significantly affect the deduction related to supplemental retirement plans and other post-separation payments. Excise tax imposed on excess tax-exempt organization executive compensation Current lawTax-exempt organizations must report employees' compensation in income in the tax year in which the compensation is paid or the year in which nonqualified deferred compensation amounts subject to Section 457(f) become vested. Tax-exempt organizations generally are not subject to limitations on the compensation amounts paid to executives, but are limited by the private inurement rules and potential sanctions under Section 4958 if the executive's compensation is considered excessive relative to the value provided to the organization. Taxable businesses are subject to limitations on compensation paid to employees in certain circumstances. Under current law, publicly traded C corporations are limited to a compensation deduction of $1 million paid to certain executives, subject to applicable exceptions (see above, however, for proposed expansion of the deduction limitations). In addition, taxable corporations may be subject to an excise tax and deduction limitation for severance and other compensation that is considered an excess "parachute payment." ProposalThe bill's intent appears to be to treat taxable and tax-exempt organizations in a similar manner with respect to compensation paid to executives above a specified threshold. The bill would impose an excise tax on tax-exempt organizations equal to 20% of remuneration payments in excess of $1 million and any excess parachute payments paid to a "covered employee." A covered employee is one of the five highest compensated employees for the tax year or an employee in this category in the preceding tax year. For purposes of this provision, a tax-exempt organization includes any Section 501(c)(3) organization, a public utility, and certain governmental entities and political subdivisions. Under the provision, remuneration includes all cash and compensation in a medium other than cash, except for payments to a tax-qualified retirement plan or other amounts that are excludable from the employee's gross income (i.e., Form W-2, box 1 wages). An excess parachute payment is an amount paid to a covered employee upon the employee's separation from employment in an amount with a present value that exceeds three times the employee's base amount (i.e., the employee's average compensation over the previous five tax years). Effective dateThe provision would be effective for tax years beginning after December 31, 2017. ImplicationsIf enacted, this provision would have a significant financial impact on tax-exempt organizations that employ highly compensated executives. Tax-exempt organizations should review their current and NQDC arrangements to assess when they may become subject to the excise tax. Organizations that maintain unvested, nonqualified deferred compensation arrangements may need to consider whether it would be permissible within the tax rules and beneficial to accelerate the vesting and payment of the deferred compensation to avoid the application of the excise tax. Going forward, tax-exempt organizations that may be subject to this provision would need to closely monitor the amount and timing of compensation payments to their executives. Qualified retirement plan provisions It was widely reported that the Ways and Means Committee members were considering limiting or eliminating the amount of pre-tax contributions an individual could make to a Section 401(k) plan or individual retirement account (IRA) — a proposal commonly referred to as "Rothification." However, as drafted, the bill does not change the existing rules that permit individuals to make pre-tax contributions to Section 401(k) plans or IRAs. Currently, employees may elect to contribute on a pre-tax basis up to $18,000 to a Section 401(k) plan in a single tax year, or up to $24,000 for employees age 50 and older; these amounts are indexed based on cost of living adjustments. Eligible individuals may make pre-tax contributions to IRAs of up to $5,500. For now, these rules continue to apply. Although the bill does not modify the Section 401(k) and IRA contribution limitations, it makes several other changes to qualified retirement plans, as set forth below. Special rule permitting recharacterization of Roth IRA contributions as traditional IRA contributions repealed Current lawUnder current law, an individual may recharacterize a contribution to a traditional IRA as a contribution to a Roth IRA, or vice versa, if the election is made in a timely manner. ProposalThe bill would repeal this provision allowing for such recharacterizations. Effective dateThe provision would be effective for tax years beginning after 2017. Withdrawals and plan loans The bill includes several proposals that would make it easier for individuals to access funds held in their retirement plans. These provisions are as follows: — Reduction in age for in-service distributions. Under current law, defined benefit plans and state and local government defined contribution plans may not permit an employee to take a distribution while still employed (that is, an in-service distribution) until age 62. For defined contribution plans, such as a Section 401(k) plan, the in-service distribution rule applies to those age 59 ½ and younger. The bill modifies the rules to permit all defined benefit plans and state and local government plans to permit employees to take in-service distributions beginning at age 59 ½, effective for plan years beginning after 2017. — Hardship distributions. Under current IRS regulatory guidance, Section 401(k) plans that permit employees to take a hardship distribution from the plan must require the employee to suspend making contributions for a period of six months. The bill directs the IRS to issue guidance that would allow employees who received hardship distributions to continue making contributions to the plan. — Additional hardship distribution provision. Current law limits a hardship distribution to the amounts actually contributed by an employee and does not permit a distribution of earnings or amounts contributed by the employer. The bill would allow hardship distributions to include earnings and employer contributions effective for plan years beginning after 2017. — Extended rollover period for plan loans. Under current law, employees may take a loan from a defined contribution plan. If the employee terminates employment, rolls over the remaining account balance, and fails to contribute the loan balance to the IRA, the loan will be treated as a distribution subject to an additional 10% tax. The bill would provide employees who terminate employment with an outstanding loan until the due date for filing their tax return to contribute the loan balance to an IRA. This provision would apply for tax years beginning after 2017. Nondiscrimination rules modified to protect older and longer service participants Current lawUnder current law, qualified retirement plans must comply with specific nondiscrimination and coverage requirements. Some employers who allow current employees to continue to accrue benefits under a plan, but have closed the defined benefit plan to new employees, violate the nondiscrimination rules. ProvisionThe bill would expand the nondiscrimination testing between an employer's defined benefit plan and defined contribution plan (referred to as "cross-testing") in a manner that would provide employers with greater flexibility to satisfy the requirements. Effective dateThis provision would take effect on the date of enactment. ImplicationsThe retirement plan proposals included in the bill are ones for which employers have long advocated and are not likely to be controversial. The bill's provisions also provide employees with greater flexibility to access retirement plan funds when they suffer an unforeseen hardship or need to borrow funds. Deductions and fringe benefits Medical expense deduction repealed Current lawCurrently, Section 213 allows a taxpayer an itemized deduction for unreimbursed medical expenses that exceed 10% of the taxpayer's adjusted gross income. Although Section 213 provides an individual deduction unrelated to an employment relationship, many Code provisions relating to employer group health plans rely on the Section 213(d) definition of "medical care" for other purposes. ProposalThe bill would repeal Section 213 and relocate its definition of "medical care" to Section 105, which excludes employer reimbursements for medical care from employee income. Effective dateThe provision would be effective for tax years beginning after 2017. ImplicationsThe provision would not have significant implications for employers. Denial of deduction for expenses attributable to the trade or business of being an employee Current lawUnder current law, employees are able to claim an itemized deduction for unreimbursed business expenses, subject to a 2% floor. For expenses that an employer does reimburse, those reimbursements are excludable to the extent that the working condition fringe and accountable plan rules are met. ProposalThe bill would eliminate any deduction for an employee's unreimbursed business expenses in tax years beginning after 2017. The working condition fringe rules would remain intact, leaving an employer reimbursement as the only method for recoupment of employee business costs. Effective dateThe provision would apply for tax years beginning after 2017. ImplicationsAlthough the change in treatment of unreimbursed expenses would not directly impact employers, the absence of the provision may create additional pressure on employers to reimburse expenses because employers no longer have any means to recoup the expense. If enacted, companies should consider reimbursement policies to minimize unreimbursed business expenses. Employer-provided education assistance Current lawSection 127 currently excludes from employee income employer-provided education in an amount up to $5,250 annually. Unlike education relating to an employee's current position, which is excludable from income as a working condition fringe, Section 127 allows an employer to provide education that is not job-related, up to the statutory maximum. ProposalThe bill would repeal Section 127, effective for amounts paid or incurred after 2017. Effective dateThe proposal would be effective for tax years beginning in 2017. ImplicationsThe bill would not affect educational expenses that are excludible on the basis of being a working condition fringe, where this education is being incurred for the convenience of the employer. Notwithstanding, Section 127 has been a useful tool for employers to reimburse educational expenses that are not excludable as a working condition fringe, such as those for unrelated education or programs that would provide qualification for a new line of business. Employee achievement awards Current lawCurrently, Section 74(c) excludes from employee income the value of certain employee achievement awards to the extent that an award is deductible by the employer. Section 274(j) caps an employer's deduction at $1,600 per employee for a qualified employee achievement award provided pursuant to a written plan that does not discriminate in favor of highly compensated employees and under which the average value of the award does not exceed $400. For other employee achievement awards, Section 274(j) limits the employer's deduction to $400 per employee. ProposalThe bill would repeal Sections 74(c) and 274(j). Effective dateThe provision would be effective for tax years beginning after 2017. After 2017, employers would be permitted to provide and deduct employee achievement awards, but the value of the award would be included in employee income. Repeal of exclusion for dependent care assistance programs Current lawUnder current law, an employer may establish an employer-provided dependent care assistance program under which employees are reimbursed for expenses associated with caring for a child while the employee is at work. Under Section 129, the employee may exclude from income the value of this dependent care assistance up to $5,000 per year. ProposalThe bill would repeal Section 129. Effective dateThe provision would be effective for tax years beginning after 2017. After 2017, to the extent that employers continue to reimburse dependent care expenses of employees, the amounts would be included in employee income. Exclusion for adoption assistance programs repealed Current lawCurrently, Section 137 allows employees an income exclusion up to an inflation-adjusted amount ($13,750 in 2017) for qualified adoption expenses paid by an employer under an adoption assistance program. ProposalThe bill would repeal Section 137. As a result, amounts paid by an employer for an adoption assistance program would no longer be excluded from income. Effective dateThe provision would be effective for tax years beginning after 2017. Repeal of exclusion for qualified moving expense reimbursement Current lawSection 217 currently allows taxpayers a deduction for moving expenses incurred in connection with a move to a new principal place of work. Section 132(a)(6) also excludes from employee income amounts reimbursed by an employer that could have been deducted by the individual under Section 217. ProposalThe bill would repeal Section 217 and a number of related provisions, including Section 132(a)(6). As a result, for tax years beginning after 2017, employees would not be permitted to deduct moving expenses associated with a job change and could not exclude the reimbursement of such expenses from income. The bill limits an employer's ability to provide a tax-free incentive to encourage employees to relocate. Employers are likely to continue to fund certain moving expenses of employees who are asked to move for a new position, but the reimbursed amounts will not be excludable from employee income. Effective dateThe provision would be effective for tax years beginning after 2017. Limitation on exclusion for employer-provided housing Current lawCurrently, Section 119 excludes the value of housing provided to employees if the housing is provided on employer premises for the convenience of the employer as a condition of employment. ProposalThe bill would limit the income exclusion by: 1. Limiting the exclusion to $50,000 2. In the case of a highly compensated employee, further limiting the exclusion by subtracting $1 for every $2 by which the employee's compensation exceeds the compensation amount applicable under Section 414(q) ($120,000 in 2017) 3. Permitting the exclusion for only one residence at a time 4. Eliminating the exclusion for an individual who is a 5% owner (within the meaning of Section 416(i)(1)(B)(i)) at any time during the tax year Effective dateThe proposal would be effective for tax years beginning after 2017. ImplicationsThe availability of Section 119 is quite narrow because it is limited to employees whose jobs require them to live on the employer's premises for the convenience of the employer. As a result, the changes would affect very few taxpayers as indicated by the estimate that the change would raise revenue by less than $50 million. Entertainment, etc. expenses Current lawSection 274 currently disallows a taxpayer's otherwise deductible business expenses unless the expenses directly relate to or are associated with substantial and bona fide business discussions. A considerable number of exceptions mitigate this disallowance. These exceptions include, for example, amounts treated as compensation, reimbursed expenses and recreational events for employees. Regarding personal entertainment air travel provided to specified individuals, the treatment of such travel as compensation recoups the employer's deduction only to the extent of the dollar amount of the value that is treated as income. ProposalFor amounts paid or incurred after 2017, the bill would: 1. Modify Section 274(a) to disallow all otherwise deductible entertainment expenses (without regard to whether the expense was directly related to or associated with a substantial and bona fide business discussion) 2. Modify Section 274(a) to add club dues, certain de minimis fringe expenses that are primarily personal nature and qualified transportation fringe and parking facilities to the categories of expenses subject to disallowance 3. Modify the compensation exception such that the deduction is recouped with respect to all entertainment expenses (rather than just the air transportation expenses of specified individuals), only to the extent of the dollar amount included in income 4. Remove the exception for recreational expenses of employees Effective dateThe provision would be effective for tax years after 2017. ImplicationsThis provision would significantly expand the scope of entertainment deduction disallowances. Employers should assess entertainment expenses and the interaction with fringe benefit exclusion provisions to assess potential deductibility notwithstanding the new limitations. ———————————————
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