07 November 2017 House tax reform bill would generally benefit taxable healthcare providers, but could negatively impact tax-exempt entities The tax reform bill released by the House Ways and Means Committee on November 2 (Tax Cuts and Jobs Act) would, if passed into law, have different impacts for the healthcare provider sector depending on the tax status of the entity. Taxable entities would generally benefit from lower corporate rates and immediate expensing of capital costs, as explained in more detail in our corporate tax alert (See Tax Alert 2017-1849), though a few provisions could negatively impact certain taxable corporations (e.g., limitation on interest expense deduction for leveraged companies, Section 409B, replacing Section 409A, which would require immediate taxation of deferred compensation at the point in time when restrictions to the funds no longer apply (see Tax Alert 2017-1841). However, tax-exempt entities could face a higher tax burden in the form of excise and unrelated business income taxes as well as curtailed access to funds through the repeal of tax-exempt bond benefits and reduction in incentives for charitable giving, as explained in Tax Alert 2017-1844) Tax-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 or taxation on the compensation amounts paid to executives, other than the limitation on private inurement and potential sanctions under Section 4958 if the executive's compensation is considered excessive relative to the value provided to the organization. Taxable businesses, unlike tax-exempt organizations, are subject to limitations on compensation paid to employees in certain circumstances. Under current law, publicly held C corporations are limited to a compensation deduction of $1 million paid to certain executives, subject to applicable exceptions. 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". The provision 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, public utility organization, and certain governmental entities and political subdivisions. 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. Excluded from the definition of an excess parachute payment are payments under qualified plans, or any payment under or to an annuity contract described in Section 403(b) or a plan described in Section 457(b). Similar to the changes related to taxation of fringe benefits, this provision would mirror the limitations on compensation deductibility for certain taxable entities. It would impose an excise tax on compensation paid by tax-exempt entities that exceed amounts that would be deductible for a publicly held C corporation. If this provision were enacted, it would have a significant financial impact on tax-exempt organizations that employ highly compensated executives. Tax-exempt organizations should review the current and nonqualified deferred compensation 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 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. Unrelated business taxable income increased by amount of certain fringe expenses for which deduction is disallowed Tax-exempt organizations, like taxable entities, may provide their employees with transportation fringe benefits, and on-premises gyms and other athletic facilities, free from income tax at both the employer and employee level. Taxable entity employers may deduct the costs of such benefits, while tax-exempt entities do not need to deduct those costs. In either case, employees may exclude the values of those benefits from their taxable incomes. The provision would impose tax on tax-exempt entities with respect to transportation fringe benefits, and on-premises gyms and other athletic facilities. Specifically, the provision would treat the funds used to pay for such benefits as unrelated business taxable income, thus subjecting the values of those employee benefits to a tax equal to the corporate tax rate. This is a companion provision to changes to the deductibility of these benefits for taxable entities. The provision is intended to mirror a companion provision for taxable entities, which would change the deductibility of certain fringe benefits. The taxable entity provision would make certain benefits non-deductible; this provision attempts to replicate the effect of that change for tax-exempt entities by treating the costs of those benefits as taxable income. This would introduce additional complexities for tax-exempt entities, particularly for those that may have a policy against engaging in activities subject to unrelated business income tax (UBIT) but historically have provided employees with transportation fringe benefits or access to on-premises gyms and other athletic facilities. Clarification of unrelated business income tax treatment of entities treated as exempt from taxation under section 501(a) When an organization that is tax exempt under Section 501(a) derives income from a trade or business that is not substantially related to its exempt purposes, the income is generally subject to UBIT. It is unclear, however, if the UBIT rules apply to certain state and local government entities (such as public pension plans) that are exempt under Section 115(1) as well as under Section 501(a). Entities that are tax-exempt under Section 501(a) would be subject to UBIT on unrelated business taxable income, regardless of whether they are also exempt under another Code Section. This provision would remove any ambiguity for "dual status" government-affiliated entities under the respective exemption under Section 501(a) and Section 115(1) and could increase UBIT liabilities for these entities. For example, because of the UBIT partnership look-through rules, dual status entities invested in partnership vehicles with business activities in lower-tiered partnerships could now face UBIT on such investments, adversely impacting the yield they currently enjoy. Under current law, UBIT does not apply to income derived from a research trade or business in the following instances: (1) research performed for the US government, federal agencies, or a state or local government, (2) research performed by a college, university or hospital for any person, and (3) research performed by an organization operated primarily for the purposes of carrying on fundamental research the results of which are freely available to the general public. The provision would amend the third instance to make explicit that organizations may only claim the exclusion for income from research that they make freely available to the general public. For companies that perform both public and private research, the provision would clarify that the exclusion does not apply to income from private research, even if the company's income comes primarily from research made freely available to the public. The Section 4940 excise tax on net investment income that applies to private foundations does not apply to public charities, including colleges and universities with substantial investment income. The provision would add Section 4969 to impose a 1.4% excise tax on the net investment income of certain private colleges and universities (the same rate as proposed for private foundations). The excise tax would not apply to state colleges and universities, and an exception would apply for private colleges and universities with fewer than 500 students or assets (other than those used directly in carrying out the institution's educational purposes) valued at less than $100,000per full-time student. For tax-exempt healthcare providers that are part of, or receive funding from, private colleges or universities, the tax imposed by this provision may reduce the working capital available to the healthcare provider. Current law allows a taxpayer who itemizes deductions to claim deductions for charitable contributions made by the last day of the tax year. The deduction is limited to a certain percentage of the taxpayer's AGI, which varies depending on the type of property contributed and the type of tax-exempt organization to which the donation is made. Generally, deductions for contributions to public charities, private operating foundations and some non-operating foundations are limited to 50% of the donor's AGI. Contributions to private foundations may be deducted up to the lesser of: (1) 30% of AGI; or (2) the amount by which the 50%-of-AGI limitation for the tax year exceeds the amount of charitable contributions subject to the 30% limitation. Deductions of up to 30% of AGI may be claimed for capital gain property contributed to public charities, private operating foundations and certain non-operating private foundations. For donations of capital gain property to non-operating private foundations, deductions may be claimed for the lesser of: (1) 20% of AGI; or (2) the amount by which the 30%-of-AGI limitation exceeds the amount of property subject to the 30%-limitation for contributions of capital gain property. Excess contributions may be carried over for up to five years (15 years for qualified conservation contributions). To claim a charitable deduction for a contribution of $250 or more, the taxpayer generally must provide the IRS with a contemporaneous written acknowledgment by the donee organization. This requirement does not apply if the done organization files a return with the required information. The provision would change a number of rules applicable to the charitable contribution deduction, including: — Imposing a 60%-limitation for cash contributions to public charities and certain private foundations — Repealing a rule that allows a charitable deduction of 80% of the amount paid for the right to purchase tickets for athletic events — Adjusting the deduction for mileage driven for charitable purposes to a "rate [that] takes into account the variable cost of operating an auto mobile" — Repealing the exception that relieves a taxpayer from obtaining and providing a contemporaneous written acknowledgement for contributions over $250 if the donee organization files a return with the required information Although the provision would increase AGI limitations and provide inflationary adjustments to the charitable mileage rate, the increase in the individual income tax standard deduction in the Tax Cuts and Jobs Act may provide less of an incentive for many taxpayers who would no longer itemize deductions to donate to charitable organizations. Further, taxpayers who used to rely on the charity's reporting of their charitable contribution on the charity's information return will no longer be able to use this method for substantiating their gift of $250 or more. Instead, the taxpayer would have to request a separate acknowledgment from the charity to claim a charitable deduction. Increase in credit against estate, gift, and generation-skipping transfer tax; repeal of estate and generation-skipping transfer taxes Current law generally applies a top tax rate of 40% to property inherited through an estate. If a donor makes a gift of property during life, a top gift tax rate of 40% applies to any gift that exceeds the annual per-donee gift tax exclusion ($14,000 for 2017, $15,000 for 2018). If the donor gives property directly to grandchildren, for example, a generation-skipping tax applies, also at the 40% rate. The first $5 million in transferred property (the basic exclusion) is exempt from any combination of estate, gift, and generation-skipping taxes. Transfers between spouses are generally exempt from these taxes, and a surviving spouse may carry over (add) to his own basic exclusion any portion of his spouse's basic exclusion that has not been exhausted. A beneficiary who receives property from an estate receives a stepped-up basis in the property, but a donee who receives a gift from a living donor takes a carryover basis in the property. With regard to the estate tax, the provision would: (1) double the basic exclusion amount to $10 million, indexed for inflation; (2) repeal, beginning after 2023, the estate and generation-skipping taxes; and (3) retain the stepped-up basis for estate property. With regard to gift tax, the provision would: (1) lower the gift tax to a top rate of 35%; (2) retain the $10 million basic exclusion; and (3) retain the annual gift tax exclusion. Both exclusion amounts would be indexed for inflation. The provision would be effective for tax years beginning after 2017, and would repeal the estate tax after 2023. According to JCT, the changes would reduce revenues by $172.2 billion over 2018 - 2027. If fewer taxpayers are subject to the estate tax, some taxpayers may be less inclined to make charitable bequests. Section 103 excludes from gross income the interest on any state or local bond. This includes private activity bonds, which are qualified bonds within the meaning of Section 141. The exclusion presently includes interest on certain bonds used for professional stadiums. Sections 54, 54A-54F and 54AA allow holders of certain bonds (tax credit bonds) a credit against their income taxes in the amount determined under those sections. Any use of issue proceeds to advance refund private activity bonds other than qualified Section 501(c)(3) bonds disqualifies the interest from the Section 103 exemption for all bonds in the issue. The Section 103 exemption is also forfeited for interest on bonds that advance refund governmental or qualified Section 501(c)(3) bonds unless certain requirements are met. The provision would repeal the exclusion from gross income for interest on qualified private activity bonds and for interest on any bond issued to advance refund a tax-exempt bond. In addition, the provision would repeal, prospectively, all the existing authority for issuing tax credit bonds. The provision would also repeal the federal tax exemption for interest on bonds issued to finance the construction of, or capital expenditures for, a professional sports stadium or arena used for sports exhibitions, games or training. The repeal of the exclusion from gross income for interest on qualified private activity bonds and advance refundings and the repeal of all existing authority for issuing tax credit bonds would be effective for such bonds issued after December 31, 2017. The repeal of tax exemption for interest on professional sports stadium bonds would be effective for bonds issued after November 2, 2017. The proposed changes in the law for tax-exempt bond financings would dramatically affect the tax consequences of many bond issuances, and negatively affect investors in such financing vehicles. The changes would also reduce the available options for organizations seeking ways to finance their capital expenditures. Current law taxes a corporation's regular income tax liability by applying this rate schedule to its taxable income: The 15% and 25% rates are phased out for entities with taxable income between $100,000 and $335,000, meaning that a corporation with taxable income between $335,000 and $10 million is effectively taxed at a 34% rate. Similarly, the 34% rate is phased out for corporations with taxable income between $15 million and $18.33 million, so that corporations with taxable income above this amount are effectively subject to a 35% flat rate. Personal service corporations (e.g., health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting) may not use the graduated corporate rates below 35%. The bill would tax corporate income at a flat 20% rate, and impose a flat 25% rate on the income of personal services corporations. The reduction in the corporate tax rate to 20% would reduce the value of a corporation's existing losses (including built-in losses) and credits. Corporations should consider opportunities for accelerating the use of losses and credits in 2017, to maximize the benefit of such attributes. Current law allows taxpayers to claim additional depreciation (i.e., bonus depreciation) under Section 168(k) in the year in which qualified property (as described later) is placed in service through 2019 (with an additional year for qualified property with a longer production period, as well as certain aircraft). The bonus depreciation generally equals 50% of the cost of the property placed in service in 2017 and phases down to 40% in 2018 and 30% in 2019. Qualified property is defined as tangible property with a recovery period of 20 years or less under the modified accelerated cost recovery system (MACRS), certain off-the-shelf computer software, water utility property or qualified improvement property. Certain trees, vines, and fruit-bearing plants also are eligible for additional depreciation when planted or grafted. To be eligible for bonus depreciation, the original use of the property must begin with the taxpayer. Under current law, taxpayers have the option of making an annual election to not claim bonus depreciation with respect to qualified property under Section 168(k)(7). Alternatively, taxpayers may elect under Section 168(k)(4) to accelerate AMT credits (as refundable credits) in lieu of claiming bonus depreciation with respect to qualified property. Such election comes with the added requirement to depreciate that qualified property using a straight-line recovery method. The provision would allow taxpayers to immediately expense 100% of the cost of qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023 (January 1, 2024, for certain qualified property with a longer production period, as well as certain aircraft). The provision also would expand the property eligible for immediate expensing by repealing the requirement that the original use of the property begin with the taxpayer; instead, property would generally be eligible for immediate expensing if it were the taxpayer's first use of that property. Qualified property would not include property used by a regulated public utility company, or any property used in a real property trade or business (as defined in Section 469(c)(7)(C)). Additionally, the provision would repeal Section 168(k)(4) (i.e., the election to accelerate AMT credits in lieu of claiming bonus depreciation) for tax years beginning after December 31, 2017. However, the provision would retain the annual election to not claim bonus depreciation with respect to qualified property under Section 168(k)(7). Generally, the provision would apply to property that is acquired and placed in service after September 27, 2017. Similar to prior bonus depreciation transition rules, property would not be treated as acquired after September 27, 2017, if a written binding contract for its acquisition was entered before September 27, 2017. The provision would apply to specified plants planted or grafted after September 27, 2017. The provision would allow taxpayers to elect to apply Section 168, without regard to the amendments made by the provision (i.e., the current law), to a taxpayer's first tax year ending after September 27, 2017. For taxpayers that instead choose to apply the provision to its first tax year ending after September 27, 2017, the provision would place limitations on the ability to carry back any losses attributable to the 100% expensing rules (by only allowing those taxpayers to carry back the portion of the loss that would have been generated under the current law). — Extending expensing to taxpayers that buy existing qualified property is likely to increase the tax benefit to acquirers of structuring transactions as asset acquisitions for tax purposes. Accordingly, acquisitions of subsidiary members of a consolidated group likely will continue to be structured as asset acquisitions (or stock acquisitions with Section 338(h)(10) elections). — Increased expensing is likely to turn many companies into loss corporations, broadening the relevance of loss limitation provisions of Section 382 and Section 384. — Extending expensing to taxpayers that buy existing qualified property would provide a potentially significant benefit to corporations with losses whose use is limited under Section 382. As mentioned, one of the requirements for 50% bonus depreciation under current-law Section 168(k) is that the "original use" of the property must commence with the taxpayer. Therefore, bonus depreciation is not available in the case of a deemed acquisition of depreciable property pursuant to a Section 338 election. Accordingly, under current law, we do not believe bonus depreciation is taken into account in determining hypothetical cost recovery and recognized built-in gain under the 338 approach of Notice 2003-65. However, with the removal of the "original use" requirement, it appears that the 100% depreciation deduction claimed under amended Section 168(k) would appear to be available for computing hypothetical cost recovery of qualified property under the 338 approach. This could significantly increase recognized built-in gain (RBIG) for some loss corporations. Current law allows business interest as a deduction in the tax year in which the interest is paid or accrued, subject to limitation rules, as applicable. Section 163(j) limits a corporation's ability to deduct disqualified interest (i.e., interest paid or accrued to a related party when no federal income tax is imposed on the interest) paid or accrued in a tax year if: (1) the payor's debt-to-equity ratio exceeds 1.5 to 1.0 (safe harbor ratio); and (2) the payor's net interest expense exceeds 50% of its adjusted taxable income. In general, adjusted taxable income is the corporation's taxable income calculated without taking into account deductions for net interest expense, NOLs, domestic production activities under Section 199, depreciation, amortization and depletion. Disallowed interest amounts may be carried forward indefinitely, and any excess limitation may be carried forward for three years. The provision would limit the net interest expense deduction for every business, regardless of form, to 30% of adjusted taxable income. The provision would require the interest expense disallowance to be determined at the tax filer level. Adjustable taxable income for purposes of this provision would be a business's taxable income calculated without taking into account business interest expense, business interest income and NOLs, as well as depreciation, amortization and depletion. The provision would allow businesses to carry forward interest amounts disallowed under the provision to the succeeding five tax years, and those interest amounts would be attributable to the business. The provision would include special rules to allow a pass-through entity's owners to use the unused interest limitation for the tax year and to ensure that net income from pass-through entities would not be double-counted at the partner level. The provision would exempt businesses with average gross receipts of $25 million or less from these rules. The provision also would not apply to certain regulated public utilities and real property trades or businesses; these businesses would be ineligible for full expensing. Additionally, the provision would repeal Section 163(j). For discussion of the additional limitation on deductibility of net interest expense in addition to this general limitation, see Tax Alert 2017-1845. — As currently drafted, the proposal does not include a grandfather rule for existing debt obligations. Therefore, it appears that the limitation on interest deductibility would apply to such debts. Companies with significant leverage should assess the potential impact of this proposal on their cost of capital. — The proposal would reduce the advantage of financing M&A transactions with debt in certain circumstances. To the extent the acquirer cannot deduct interest on acquisition debt, the proposal would increase the economic cost of debt-financed stock acquisitions compared to current law. However, the proposal's effect on debt-financed asset acquisitions would depend on the cost of the loss of interest deductions compared to the benefits of increased expensing (as compared to depreciation and amortization). — Companies facing deferral or disallowance of interest deductions would have incentives to: (i) decrease their interest expense by converting non-deductible interest expense into deductible non-interest expense; and (ii) increase their interest income by converting taxable non-interest income into interest income. Strategies for realizing these incentives could involve the use of financial products as well as changes to a variety of ordinary course business arrangements. — The treatment of disallowed interest carryovers as pre-change losses significantly broadens the relevance of Section 382. It is likely that highly leveraged companies will be subject to Section 382 solely as a result of having disallowed interest. Furthermore, because the Section 163(o) carryforward is only five years, it will be critical to maximize the Section 382 limitation during that five-year period to realize the full benefit the disallowed interest carryovers. Under current law, Section 172 allows taxpayers to carry back a net operating loss (NOL) arising in a tax year for two years, and carry forward the NOL for 20 years to offset taxable income. Generally, an NOL is the excess of the taxpayer's business deductions over its gross income. Section 172 also provides special provisions modifying the carryback period for specific types of losses or losses arising in particular years. Included in these special provisions is Section 172(f), which allows a 10-year carryback of losses arising from specified liabilities. The AMT rules do not allow a taxpayer's NOL deduction to reduce the taxpayer's alternative minimum taxable income by more than 90%. The provision, Section 3302 of the bill, would allow indefinite carryforward of NOLs arising in tax years beginning after December 31, 2017. The provision also would repeal all carrybacks, but would add back a special one-year carryback for small businesses and farms for certain casualty and disaster losses. The provision would define an eligible disaster loss in Section 172(b) as an NOL attributable to federally declared disasters. The provision would limit the amount of an NOL that a taxpayer could use to offset taxable income to 90% of the taxpayer's taxable income (computed without taking into account the NOL deduction). In addition, the provision would permit NOLs arising in tax years beginning after 2017 and carried forward to be increased by an interest factor to preserve the NOL value. As part of the repeal of NOL carrybacks, the provision would repeal Section 172(f), the special rule allowing a 10-year carryback of specified liability losses. The indefinite carryforward and general repeal of carrybacks (including the repeal of Section 172(f)), and the special one-year carryback rule for casualty and disaster losses would be effective for losses arising in tax years beginning after December 31, 2017. The 90% limitation rule would be effective for tax years beginning after December 31, 2017. The annual increase of carryforward amounts would apply to amounts carried to tax years beginning after December 31, 2017. 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. Under 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. New 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. Section 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 timelimited. 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). Section 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.
Document ID: 2017-1862 | |||||||||||||||||||
