November 13, 2017 Senate tax reform proposal would have significant impact on executive compensation and employee benefits The Senate Committee on Finance released a description (the Senate proposal) of its proposed changes to the "Tax Cuts and Jobs Act," introduced in the House Ways and Means Committee (the House bill) earlier this month. The House bill, as amended, passed the Ways and Means Committee on November 9 and is expected to go before the House Rules Committee and then on to the full House for a vote this week. The Senate proposal will be marked up and amended this week. We expect there to be numerous and potentially material amendments to the Senate proposal, as well as a release of the actual legislative text (which was not released with the initial proposal). For executive compensation and employee benefits, there are significant areas of overlap as well as some key divergent provisions between the House and Senate. See below for a side-by-side chart comparing the House bill and the Senate proposals related to the compensation provisions. Compensation provisions Nonqualified deferred compensation and certain equity compensation The Senate proposal would eliminate the tax deferral for nonqualified deferred compensation (NQDC), including elective deferrals, supplemental retirement plans, stock appreciation rights, and nonqualified stock options. This provision was included in the original House bill, but was eliminated in the Manager's Amendment passed by the Ways and Means Committee. This discussion provides a brief summary of the current law and the Senate proposal's NQDC provision. (For a detailed discussion of the specific provisions related to the NQDC proposal, see Tax Alert 2017-1841, discussing the original House bill prior to its amendment in the committee markup.) Current law Under current law, most employees and service providers are not taxable on NQDC until payment, or 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. Service providers who perform services for an employer located in a "tax-indifferent" jurisdiction (e.g.,the Cayman Islands or Bermuda) are subject to the requirements of Section 457A. Section 457(f) taxes the present value of "compensation deferred" by employees of tax-exempt organizations 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. Senate proposal The Senate proposal would dramatically change the current taxation of NQDC and would repeal Sections 409A, 457A and 457(f). For compensation earned in tax years in 2018 and thereafter, NQDC would be includible in employees' and other service providers' income when it is no longer subject to a substantial risk of forfeiture. Under the Senate proposal, compensation would be considered subject to a "substantial risk of forfeiture" only if it is conditioned on the future performance of substantial services. Performance conditions and non-compete conditions would not qualify as valid vesting conditions. In a significant departure from current law, the proposal would define NQDC to include nonqualified stock options and stock appreciation rights. An individual who receives stock options or appreciation rights would include in income the fair market value of these awards when they vest, rather than when they are exercised or paid, as is the current law. Certain compensatory payments would not be subject to this proposed NQDC income inclusion rule, including transfers of property under Section 83 (e.g.,restricted stock), profits interests, statutory options under Section 422 (incentive stock options) and Section 423 (employee stock purchase plan options), and amounts paid within 2 ½ months of the end of the employer's tax year in which the compensation becomes vested. (Note: The original House bill did not explicitly include the exemption for qualified stock options.) Effective date The Senate proposal would apply the NQDC income inclusion rule to amounts deferred that are attributable to services performed after December 31, 2017. Amounts earned prior to 2018 ("grandfathered amounts") would continue to be subject to the existing rules under Sections 409A, 457(f), and 457A and must be included in income prior to 2027. The IRS would be required 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 law Section 409A provisions that presumably still continue to apply to these amounts until paid. Implications The House and Senate proposed legislation is a moving target. The Senate proposal likely will see a number of amendments and this NQDC provision could be eliminated or significantly modified in the process. Businesses should proceed cautiously before making material changes to their compensation programs. Nevertheless, businesses should be prepared for and consider the impact of this potential change to the taxation of their compensation programs. Some of the steps businesses might consider include: — Complete an inventory of all NQDC arrangements to assess the potential impact of the proposed rules, particularly regarding the following structures: — Elective deferred compensation plans. Deferral elections typically are made prior to the beginning of the calendar year for which the deferral election would apply. This means that executives and employees may be making elections at the end of 2017 to defer a portion of their salary and bonuses earned in 2018. Businesses will need to consider whether plans should contemplate the potential tax rule and the potential that the compensation earned in 2018 would be taxable when earned notwithstanding the deferral election. — Long-term and equity incentive plans. Businesses should assess whether their incentive compensation plans would be affected by the proposed rule, with a particular focus on nonqualified stock options, stock appreciation rights, and awards that allow for early vesting (such as a retirement age vesting). — Consider accelerating vesting of NQDC to 2017 to ensure that the compensation is grandfathered and not required to be included in income until 2026 — Consider modifications that would increase benefits in tax-qualified plans and reduce nonqualified benefits — Consider converting executive compensation plans to arrangements that are not subject to the proposed rule, including restricted stock, restricted stock units (RSUs) that vest and pay, profits interests, statutory stock options, and increasing qualified retirement plan benefits — Assess the impact on the timing of the deduction; the Senate proposal does not address the timing of the employer's deduction, which means that some employers might not be able to claim a tax deduction until the year in which the cash-based NQDC is actually paid or the year in which a stock option is exercised. If so, there may be a mismatch between when amounts are included in the employee's income (i.e., in the year of vesting) and when the employer may claim its deduction. Modification of limitation on excessive employee remuneration The Senate proposal to expand the Section 162(m) compensation deduction limitation is similar to and broader than the House bill that was passed by the Ways and Means Committee. (See Tax Alert 2017-1892). Current law Section 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 (but specifically excluding the CFO). The $1-million per tax year deduction limitation applies to compensation that is 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. Only publicly traded companies that are required to register their common stock under Section 12 of the Securities Exchange Act are subject to Section 162(m). Because of the specific definition used in the statute, Section 162(m) does not apply to other companies that register debt, voluntarily register their common stock, or are foreign private issuers traded on US exchanges via American Depository Receipts (ADRs). Senate proposal Like the House bill, the Senate proposal 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 deduction limitation would apply to compensation paid to that individual at any point in the future, including after a separation from service. In addition, the House bill and Senate proposal would provide that any executive who is a covered employee for the tax year after December 31, 2016, would remain a covered employee for all future years. The Senate proposal also would expand the definition of public company to include other securities registrations. While not completely clear, it appears that the Senate proposal is intended to include private companies that have registered debt offerings and may include foreign private issuers. More clarity around these provisions is expected. Effective date The proposal to expand the application of Section 162(m) would be effective for tax years beginning after December 31, 2017. Implications The House bill and Senate proposal include identical language proposing to expand the Section 162(m) compensation deduction limitation. Because the provision is in both proposals, there is a strong possibility that this proposal, potentially with modifications, would be included in the final tax reform legislation. As currently drafted, the House and Senate proposals do not appear to provide for any transition rules. Therefore, the expanded Section 162(m) provisions may apply to compensation paid to a covered employee after the 2018 effective date, including the payment of accrued long-term incentive and equity-based compensation that previously was excluded as performance-based compensation. In addition, the proposals provide that any executive who is a covered employee for a tax year after December 31, 2016 will remain a covered employee subject to the compensation deduction limitation for all future years. If enacted, the expanded Section 162(m) provisions would cause public companies to have an increased amount of non-deductible compensation. The proposal could further impact publicly traded businesses in multiple ways: — The group of covered employees subject to the $1-million compensation deduction limitation at any time may well exceed the current number of covered employees that is limited to the CEO and three most highly compensated officers as a consequence of the "once a covered employee, always a covered employee" rule. — There is a potential impact on a business's effective tax rate and financial reporting that may require an immediate reduction in a portion of the deferred tax asset for a covered employee's accrued compensation in excess of $1 million that would no longer be deductible. — On the positive side, the repeal of the performance-based compensation exception to the deduction limitation may provide companies with greater flexibility to award more compensation that is not based on objective performance goals; employers could consider compensation designs that are more consistent with business and commercial objectives. — Companies that are not currently subject to Section 162(m) should monitor the proposed expansion of the definition of businesses that may become subject to the compensation deduction limitation. To be prepared for the enactment of the expanded Section 162(m) provisions, businesses subject to the rule should consider calculating the amount of the lost tax deduction and assessing the financial statement impact on their effective tax rate and reduction in deferred tax assets. Excise tax on tax-exempt organization payment of excess executive compensation The Senate proposal would impose an excise tax on tax-exempt organizations on compensation in excess of $1 million paid to a "covered employee" defined as one of the five highest compensated employees for the tax year or an employee in this category in the preceding tax year. The Senate proposal is identical to the House bill that was passed by the Ways and Means Committee. Qualified retirement plan provisions Like the House bill, the Senate proposal would not change the existing rules that permit individuals to make pre-tax contributions to Section 401(k) plans or IRAs. However, the Senate proposal would make several other changes to qualified retirement plans, but would not make any of the changes proposed in the House bill. (Tax Alert 2017-1841 discusses the House bill's changes to tax-qualified retirement plans.) — Conformity of contribution limits for employer-sponsored retirement plans — The Senate proposal would apply the same limit for contributions for an employee under a government 457(b) plan that applies under present law to elective deferrals to Section 401(k) or 403(b) plans. It also would repeal special rules allowing additional elective and catch-up contributions under Sections 403(b) and 457(b) plans, as well as the current rule allowing employer contributions to 403(b) plans for five years after termination of employment. The proposal would also revise the limit on aggregate contributions to a qualified defined contribution plan, so that a single overall limit applies with respect to contributions for any employee by the same employer. — Modification of catch-up contributions for high-wage employees — Under current law, employees aged 50 or older are allowed to make additional contributions (generally $6,000 for 2017) to a 401(k), 403(b), or 457(b) plan. Under the proposal, employees who receive wages of $500,000 or more would not be permitted to make catch-up contributions for the following year. It is anticipated that this provision may be amended to limit pre-tax catch-up contributions and allow "Roth" catch-up contributions. Implications The Senate proposal does not include the House bill provisions for which employers have long advocated, such as more flexible nondiscrimination testing for employers with frozen defined benefit plans and more flexible hardship withdrawal and rollover rules. These provisions may be added if the House and Senate bills are negotiated in conference. Deductions and fringe benefits The Senate proposal would limit the deduction for entertainment and other fringe benefits provided to employees. The Senate proposal follows the House bill in part. However, unlike the House bill, the Senate bill would not repeal certain pre-tax employer-provided benefits, including employer-provided educational assistance, employee achievement awards, and employer-provided housing. In addition, the Senate proposal also would retain the medical expense itemized deduction, which was repealed in the House bill, the pre-tax dependent care assistance, and qualified adoption assistance benefits that were repealed in the original House bill, but restored (in the case of dependent care assistance, subject to a five-year sunset provision) in the amended House bill. Deductibility of meals and entertainment expenses Current law Section 274 currently disallows a taxpayer's otherwise deductible business expenses for entertainment activities unless the expenses directly relate to or are associated with substantial and bona fide business discussions. To the extent that such a deduction is not entirely disallowed by Section 274(a), Section 274(n) further limits deductions for entertainment or meals to 50% of the expense. A considerable number of exceptions mitigate these limits, including, for example, amounts treated as compensation, reimbursed expenses, or recreational events for employees, and meals excluded from income under Section 132 as de minimis fringe benefits. 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. Senate proposal Like the House bill, the proposal would expand the scope of the current meals and entertainment disallowance in a number of ways. The proposal would repeal the exception from the disallowance for entertainment activities directly related to the taxpayer's trade or business, and disallow deductions for social club membership dues, and for expenses incurred in providing a qualified transportation fringe or otherwise reimbursing an employee for commuting costs except as needed to ensure the safety of the employee. The proposal generally would continue to permit a taxpayer to deduct 50% of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work travel). However, the proposal would eliminate an exception to the 50% deduction limitation for expenses associated with providing food and beverages to employees through an eating facility that meets the requirements for a de minimis fringe benefit. Effective date The proposal would apply for amounts paid or incurred after December 31, 2017. Worker classification Current law Under current law, service providers must be classified as employees or as independent contractors. For employees, employers are generally required to withhold income and payroll taxes from employee wages and to pay the employer share of payroll taxes. For independent contractors, employers generally do not have withholding or employment tax obligations. Worker classification is based on a common law test for determining whether an employment relationship exists. The main determinant of whether a worker is an employee is whether the employer controls the way in which work is done (instead of just the outcome). Section 530 of the Revenue Act of 1978 has prohibited the IRS from issuing guidance addressing the proper classification of workers. This has created uncertainty about the correct classification of workers. Employers report employee wages on Form W-2. Certain independent contractors receive payment via a settlement payment system, such as a payment card or third-party network. In this case, the company is required to file Form 1099-K to report a worker's income only if the worker earns more than $20,000 and has more than 200 transactions in any year. Due to this high reporting threshold, many of these workers do not receive information reporting for their earnings, raising their compliance burden. In contrast, companies paying independent contractors without such a settlement payment system must report payments on a Form 1099-MISC if these workers receive $600 or more per year. Classification as an employee may be significant for eligibility to receive health and welfare benefits and participation in qualified retirement plans (from which independent contractors are generally excluded). Senate proposal The Senate proposal would include a provision that was first introduced by Sen. John Thune (R-SD) in July 2017 as S. 1549, the New Economy Works to Guarantee Independence and Growth (or NEW GIG) Act of 2017 (the July bill). The July bill would add a new Section 7706 to the Code, which would create an elective safe harbor that treats workers as independent contractors for all purposes under the Code. The July bill would also modify the thresholds that trigger requirements to report payments on Forms 1099-MISC and 1099-K. To fall within the safe harbor, the worker and the company would have to meet certain requirements relating to the relationship of the parties, the place of business or use of equipment, the contract between the parties, and reporting. A company relying on the safe harbor would have to withhold individual income taxes (but not employment or self-employment taxes) from payments to the worker at a rate of 5% on the first $20,000 of payments. If a company and worker relying on the safe harbor are reclassified as employer and employee for failure to meet the requirements of the safe harbor, any reclassification would generally be prospective if the parties had a reasonable basis for the classification, met the contractual and reporting requirements, and otherwise properly paid employment taxes. Other than the creation of the safe harbor, the July bill would not modify the common law rules that currently govern whether an individual is an employee. In addition to establishing the worker classification safe harbor, the July bill would amend Sections 6041, 6041A, and 6050W to modify reporting thresholds for certain payments. Specifically, the July bill would increase the threshold for reporting certain 1099-MISC payments from $600 to $1,000; and decrease the threshold for reporting 1099-K payments from $20,000 and 200 transactions to $1,000 without regard to the number of transactions. Although companies relying on the safe harbor may be affected by these threshold changes, the modified thresholds would apply to all reporting required under the amended sections whether or not the safe harbor is used. Implications The requirements for the safe harbor are particularly relevant in the gig economy space, but would apply to any worker who meets the safe harbor requirements. As a result, the July bill would allow worker classification certainty for most gig economy workers and also for traditional independent contractors, but would introduce withholding requirements that do not currently exist for most independent contractor relationships.
——————————————— — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg. ———————————————
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