United States: The Republican Tax Plan And The Revenue-Raising Assault On Employee Compensation

On November 2, 2017, the Republican caucus of the House of Representatives unveiled its plan to overhaul the nation's tax code.1 In an apparent effort to raise revenue, the "Tax Cuts and Jobs Act," if adopted, would fundamentally change the way many US employees are compensated. The Ways and Means Committee began its mark-up of the bill on November 6th, and the committee's first amendment was released that evening.2 Additional changes are expected. The Senate is expected to introduce its own tax bill this week.

The following is a summary of the amended bill's proposed changes to employee compensation, employee-related income deductions and the rules governing retirement savings. As the amended bill progresses, we will provide additional client publications on the bill's impact on the design and disclosure of employee compensation programs.

Changes to Nonqualified Deferred Compensation

Current law generally allows employees to defer taxation of compensation through the use of nonqualified deferred compensation plans. Under a properly structured plan, the employee is not required to include deferred compensation in income until it is actually received.

The primary tax rule governing nonqualified deferred compensation is set forth in Section 409A of the Internal Revenue Code (IRC). Generally, compensation is considered nonqualified deferred compensation when payment is made later than 2 ˝ months following the end of the year for which the compensation is no longer subject to a "substantial risk of forfeiture." Payment of nonqualified deferred compensation generally may be made only upon the occurrence of pre-established payment triggers (which may include fixed payment dates) permitted under Section 409A. Nonqualified stock options and stock appreciation rights (or SARs), if structured properly, are exempt from Section 409A, even though their payment date (i.e., the exercise date) is not pre-established.

The amended bill would repeal Section 409A and replace it with new provisions that provide that nonqualified deferred compensation is taxed at "vesting," even if payment occurs at a later time. Compensation is treated as vested when it is no longer subject to a substantial risk of forfeiture. The amended bill provides that a substantial risk of forfeiture would exist only if the employee's right to the compensation is conditioned on the future performance of substantial services.3 Further, the amended bill would apply not only to cash-based deferred compensation but to most equity-based compensation, including nonqualified stock options and SARs.

In addition, the amended bill would provide a sunset provision for deferred amounts attributable to services performed before January 1, 2018. These deferrals would be taxed in the last taxable year before 2026, or, if later, upon the lapsing of any substantial risk of forfeiture.

Creation of Qualified Stock

In an effort to provide relief to employees of "eligible corporations," the amended bill provides that, if an employee makes an election, he or she may defer the tax owed on "qualified stock" that has become transferable or is not subject to a substantial risk of forfeiture. Generally, subject to anti-abuse provisions, the taxes would be deferred until the earlier of the first date such qualified stock becomes transferable and the date any of the corporation's stock becomes readily tradeable on an established securities market.

Under the amended bill, "qualified stock" generally means stock received in connection with the exercise of an option or in settlement of a restricted stock unit (or RSU). "Qualified stock" excludes any stock that the employee may sell to the corporation or settle through the acceptance of cash from the corporation. "Eligible corporations" are corporations that (A) do not have stock readily tradeable on an established securities market and (B) have a written plan covering 80 percent of all of its "qualified" US employees. "Qualified employees" are full-time employees who elect to be subject to the rule, excluding one percent owners, the CEO, CFO and four most highly paid officers (as determined in accordance with the proxy disclosure rules).

Modification of $1 Million Compensation Deduction Limitation

The IRC currently prohibits public companies from deducting compensation in excess of $1 million paid to certain proxy officers, referred to as "covered employees." Current law, however, provides that payments that qualify as "performance-based compensation" will not be counted against the $1 million limitation. It is the rare public company that does not maximize deductibility by structuring at least a portion of its incentive compensation as "performance-based compensation." The amended bill would repeal this exception (as well as one for commissions).

Under current law, "covered employees" consist of the chief executive officer and the three highest paid executive officers, but the term does not include the chief financial officer. The amended bill corrects this. In addition, the amended bill provides that once an individual is a "covered employee," the individual would remain a covered employee for his or her employer, even if he or she no longer otherwise meets the statutory definition.

Finally, tax exempt organizations would be subject to a 20% excise tax on compensation in excess of $1 million paid to any of their five highest paid employees.

Carried Interest Reform

Under the IRC, the income, gains and losses of a partnership are passed through to its partners. This tax treatment applies to so-called "carried" or "profits" interests.

The amended bill provides that, with respect to partnership interests transferred to taxpayers in connection with the performance of substantial services in any "applicable trade or business," capital gain and loss would only be treated as long-term if the associated assets were held by the partnership for more than three years.

Changes to Retirement Savings

The amended bill would make the following changes to the rules governing qualified retirement plans:

  • Permit in-service withdrawals from defined benefit plans, as well as state and local government defined contribution plans to begin at age 59 ˝, rather than age 62. This change will bring uniformity across various plan types as private sector defined contribution plans already permit in-service withdrawals at 59 ˝.
  • Permit individuals making hardship withdrawals to continue making plan contributions. Current law prohibits plan contributions for six months following a hardship withdrawal.
  • Permit hardship distributions to include account earnings and employer contributions. Current law only permits distributions of amounts actually contributed by the employee.
  • Provide that all plan loans must be rolled over into an IRA by the due date for the employee's tax return following a termination of the plan or an individual's employment. Currently, plan loans must be rolled over within 60 days.
  • Permit expanded cross-testing between an employer's defined benefit and defined contribution plans for purposes of the nondiscrimination rules. This rule is intended to assist employers with defined benefit plans that are closed to new employees but allow current participants to continue accruing benefits. The defined contribution plan covering the new employees could be cross-tested with the defined benefit plan.
  • Eliminate the ability for employees of tax exempt organizations to defer compensation into IRC Section 457(b) or 457(f) plans.

Limitations on Certain Income Deductions and Exclusions

The amended bill would make the following changes to certain income deductions available to employees:

  • Cap the value of lodging furnished to employees that can be excluded from an employee's income at $50,000 (reduced by 50% of the amount of compensation in excess of the amount in effect under Section 414(q)(1)(B)(i) of the IRC).
  • Provide that employee achievement awards would be taxable to the recipient and fully deductible by the employer. An employee achievement award recognizes an employee's length of service or safety achievement. It cannot be a disguised bonus.
  • Eliminate, for taxable years beginning after December 31, 2022, the $5,000 exclusion for payments made pursuant to a dependent care assistance program.
  • Eliminate the exclusion for qualified moving expense reimbursements.
  • Eliminate the exclusion for payments made by an employer pursuant to an adoption assistance program.

Conclusion

The impact of the Tax Cuts and Jobs Act's employee compensation provisions will be far reaching. The amended bill evidences a belief by House Republicans that employee compensation is an area that can be mined for additional tax revenue. It remains to be seen whether the Senate, and the President, agree.

Footnotes

1  The Tax Cuts and Jobs Act can be found at: https://waysandmeansforms.house.gov/uploadedfiles/bill_text.pdf.

2  The first amendment to the Tax Cuts and Jobs Act can be found at: https://waysandmeansforms.house.gov/uploadedfiles/chairman_brady_amendment.pdf.

3  Under Section 409A, a substantial risk of forfeiture will exist if the employee is required to perform substantial future services in order to earn the compensation or the compensation is earned upon the occurrence of a condition related to a purpose of the compensation (and the risk of forfeiture is substantial).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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