November 8, 2017
On November 2, 2017, House Republicans released their much-anticipated tax reform proposal, entitled the Tax Cuts and Jobs Act (the “Act”). We provided a summary of the Act here, which noted that there is significant uncertainty as to whether some or all of the provisions in the Act will take effect, and, if they do, in what form. If enacted, certain provisions of the Act would have a major impact on executive compensation and various employee benefits, including qualified retirement plans and fringe benefits. We summarize the provisions of the Act relating to executive compensation and employee benefits below.
Effective Elimination of Unfunded Non-Qualified Deferred Compensation
As an offset to lower individual tax rates, the Act substantially limits amounts on which taxes can be deferred by individuals as nonqualified deferred compensation. The basic principle is that an individual would be taxed on compensation as soon as that compensation is no longer subject to an obligation to perform future substantial services. Other types of restrictions, such as bona fide performance goals, that under current law delay taxation until if and when they are achieved, would not defer taxation.[1] The proposed tax legislation takes the form of introducing a new Code section—Section 409B. The existing elaborate rules governing the taxation of nonqualified deferred compensation under Section 409A would be repealed in their entirety.
Section 409B would effectively eliminate long-term nonqualified deferred compensation as a means of delaying income taxation for years into the future by virtue of taxing compensation once any service requirement has been fulfilled. Unlike Section 409A, there would be no penalties in the form of additional income taxes, interest and penalty taxes imposed under Section 409B.
Certain concepts under Section 409A will or should remain. First, the concept of payment on or before 2 ½ months after the end of a tax year in which the right to compensation vests (the so-called “short-term deferral rule”) would remain in effect. Second, transfers of property in connection with the performance of services, which are taxed under Section 83, would not be covered under Section 409B. Third, since Section 422 would not be repealed under the Act, incentive stock options should remain in effect. The proposed legislation gives the Treasury Department broad authority to exempt various forms of compensation from Section 409B, so we would expect (as is the case in the Section 409A regulations) that if this legislation were enacted in its present form, the Section 409B regulations would expressly exempt incentive stock options.
Options generally, however, receive unusually unfavorable treatment under Section 409B. Both options and stock appreciation rights would become taxable when any service-based requirements are satisfied, regardless of whether or not the option is exercised, the underlying stock is publicly traded, or the option is then still subject to other restrictions such as performance goals that have not yet then been achieved. We expect this provision in particular to draw much comment and criticism. At least one member of Congress has already proposed allowing deferral of taxation of options until five years after vesting (or, if earlier, when the option is exercised).
Deferred compensation plans sponsored by tax-exempt organizations (other than state and local governments) under Section 457 would be eliminated. Section 457A (which covers deferred compensation paid by partnerships and certain foreign corporations) would also be repealed, presumably because the standard for taxation that is established for those arrangements is the same as has been proposed under Section 409B.
These provisions would become generally effective for compensation attributable to services performed on or after January 1, 2018. Deferred compensation accrued prior to 2018 is not entirely grandfathered, rather it must be taxed (generally upon actual payment) no later than December 31, 2025. Note that this requirement includes even deferred compensation accrued prior to 2005, the year in which Section 409A originally became effective.
Expansion of Non-deductibility of “Excessive” Executive Compensation under Section 162(m)
The Act would substantially expand the scope of non-deductible executive compensation above $1 million in a single fiscal year for public companies. It does so by making a number of important changes to Code Section 162(m).
- The current exemption for “performance-based compensation” (which covers cash incentive bonuses and a number of different types of equity compensation, such as options and performance shares) would be eliminated. The exemption for commission payments would also be repealed.
- The scope of those executives whose compensation is covered by Section 162(m) would be expanded in two ways. First, the Act conforms the definition of “covered employee” to the current definition of “named executive officer” applicable to proxy disclosure for public companies under federal securities law. This has the effect of covering Chief Financial Officers, whose compensation has not been covered under current Section 162(m) in recent years. It also results in covering any person who serves as a company’s principal executive officer or principal financial officer at any time. Second, while under current law the group of covered employees is determined at the end of a public company’s fiscal year and applies only to compensation paid in that fiscal year, under the Act once an executive becomes a covered employee, that status is retained for the remainder of that executive’s life and therefore covers all compensation paid to the executive for the remainder of his or her life. There is even a special rule to pick up compensation paid to beneficiaries after the death of a covered employee.
- The Act broadens the scope of companies treated as “publicly held corporations” subject to this law, including not only companies that have registered their stock or other equity securities with the Securities & Exchange Commission, but also certain other companies that file reports with the SEC (such as companies only filing reports relating to their debt securities). This latter extension could be problematic since many of these additional companies are not currently required under securities laws to identify their named executive officers in SEC filings.
These changes to Section 162(m) would be effective for tax years beginning after December 31, 2017.
Changes Affecting Tax-Qualified Retirement Plans
The Act also includes several changes directed at tax-qualified retirement plans. Unlike the executive compensation provisions discussed in this client alert, none of these changes should be controversial, and we think it is likely that some or all of these changes will be enacted (either as part of the Act or in other legislation).
During the drafting of the Act, there were rumblings that the Act could make a number of unpopular changes, such as significantly reducing the limit on employee “401(k)” contributions and characterizing all employee contributions as “Roth” after-tax contributions. However, none of those provisions were included in the current version of the Act.
The changes in the Act that would impact tax-qualified plans are:
- IRA Conversions. Under current law, individuals are permitted to recharacterize contributions to “traditional” IRAs as contributions to “Roth” IRAs, and vice versa. Under the Act, this will no longer be permitted after December 31, 2017. Thus, individuals would be stuck with the initial tax treatment they choose for their IRAs.
- Reduction in Age for Permissible In-Service Distributions. Currently, individuals who continue working generally cannot take distributions from defined benefit pension plans and money purchase pension plans until age 62. Commencing with plan years beginning after December 31, 2017, the Act would allow plans to permit in-service distributions commencing at age 59-1/2, similar to the rules for 401(k) plans.
- Hardship Distributions. Beginning in 2018, the Act would modify the rules applicable to hardship distributions from 401(k) plans. First, the Act would eliminate the rule that participants must be suspended from making employee contributions for six months following a hardship withdrawal. Second, the Act would repeal the requirement to take a plan loan before a hardship withdrawal is permitted. Third, the types of contributions that may be withdrawn would be expanded to include qualified nonelective contributions, qualified matching contributions and post-1988 earnings.
- More Flexibility to Repay Plan Loans. Under current law, a plan loan generally goes into default (triggering a deemed distribution and, in many cases, a 10% excise tax) unless the loan is repaid in full within 60 days following termination of employment. The Act would extend that deadline to the individual’s due date (including extensions) for filing his or her individual tax return for the year of termination of employment.
- Closed Plan Nondiscrimination Testing. In recent years, many employers have closed defined benefit pension plan participation to new employees, so that only previous hires continue to accrue benefits. As the “grandfathered” group ages and becomes more highly-compensated relative to the rest of the workforce, that can result in the plan’s failure to satisfy various IRS nondiscrimination rules. Subject to various requirements, the Act would provide relief to these plans, as well as to defined contribution plans where enhanced contributions are made for a “grandfathered” group who stopped accruing benefits under a pension plan in connection with a “freeze” of that plan.
Repeal or Limitation of Certain Exclusions Relating to Fringe Benefits
In the name of “simplification”, the Act also repeals or limits a number of exclusions or exemptions relating to employer-provided fringe benefits from an employees’ taxable income. The fringe benefits affected include the following:
- Dependent Care Assistance Programs. The Act eliminates dependent care flexible spending accounts (dependent care FSAs) by repealing Code Section 129. Currently, an employee can contribute up to $5,000 on a pre-tax basis to fund child care costs or expenses related to care for a disabled spouse or other dependent or an elderly or disable parent. Contributions to dependent care FSAs would no longer be excluded from income under the Act. The Act would not have any impact on health FSAs that allow for contributions on a pre-tax basis up to $2,500 to cover health care expenses not covered by insurance.
- Adoption Assistance Programs. The Act eliminates adoption assistance programs by repealing Code Section 137. Under the Act, employers would no longer be permitted to exclude from income amounts paid or expenses incurred by the employer for qualified adoption expenses under an adoption assistance program.
- Educational Assistance Programs. The Act eliminates educational assistance programs by repealing Code Section 127, which provides for an exclusion from taxable income of up to $5,250 of employer-provided educational assistance.
- Employer-Provided Lodging. Currently, Code Section 119 excludes from an employee’s taxable income the value of certain employer-provided lodging where an employee is required to accept lodging on the employer’s business premises as a condition of employment. The Act would add a new subsection (e) to Section 119 that would limit the aggregate amount that could be excluded from income in any one year to $50,000, which limit would be further reduced for certain highly compensated employees and 5% owners.
- Employee Achievement Awards. The Act repeals Code Section 74(c) (and related provisions), which provides that certain employee achievement awards are not included in an employee’s taxable income (and are therefore not deductible by the employer).
Gibson, Dunn & Crutcher is focused on the Act and how it would affect our clients, and we will continue to provide updates as more information about the Act or tax reform in general becomes available.
[1] Although presumably the presence of these vesting conditions should affect the valuation of the compensation to be paid.
The following Gibson Dunn lawyers assisted in preparing this client update: Steve Fackler, Michael Collins, Sean Feller and Arsineh Ananian.
Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you usually work, or the following:
Stephen W. Fackler – Palo Alto and New York (+1 650-849-5385 and 212-351-2392, [email protected])
Michael J. Collins – Washington, D.C. (+1 202-887-3551, [email protected])
Sean C. Feller – Los Angeles (+1 310-551-8746, [email protected])
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