December 21, 2017

2017 Tax Law's Impact on Compensation and Benefits

On December 20, 2017, Congress passed the Tax Cuts and Jobs Act (the Act), which President Trump indicated he would sign. It is a sweeping tax bill with the potential to significantly alter executive compensation and employee benefits. Although not as drastic as the original House proposal which sought to eliminate all deferred compensation, the Act will impact compensation and benefits programs of a variety of entities including private companies, public companies and tax-exempt organizations of all sizes across a broad range of industries. This alert highlights the key provisions of the Act impacting compensation and benefits.

Changes to Code Section 162(m) Tax Deduction Limit of $1 Million for Compensation Paid by Public Companies

Under current law, Section 162(m) of the Internal Revenue Code of 1986 (Code) limits to $1 million the tax deduction that public companies may take for compensation paid to any “covered employee.” The Code Section 162(m) deduction limit generally applies to the compensation paid to any employee of a public company who, as of the close of the fiscal year, is the company’s principal executive officer (i.e., CEO) or one of the company’s three most highly compensated executive officers other than the principal executive officer and principal financial officer (i.e., CFO). In addition, Code Section 162(m) currently includes an exception to the $1 million deduction limit for commission-based compensation and “qualified performance-based compensation” including stock options, stock appreciation rights and performance-based equity and cash compensation that meets certain requirements. Many public companies have historically taken advantage of the exception for qualified performance-based compensation in order to exclude such amounts from the deduction limitation.

Effective for tax years beginning after December 31, 2017, the Act makes the following changes to Code Section 162(m): 

  • No Exception for Performance-Based Compensation.  The Act eliminates the exception for commission-based compensation and qualified performance-based compensation. Therefore, all compensation paid to a covered employee will count toward the $1 million deduction limit.
  • Anyone Who Serves as CEO or CFO of a Public Company is a Covered Employee.  The Act expands the definition of covered employee to also include a company’s principal financial officer, aligning the definition of covered employee with the definition of “named executive officer” under Item 402 of Regulation S-K. In addition, any individual who served as a company’s principal executive officer or principal financial officer at any time during the year is included as a covered employee.
  • Once a Covered Employee, Always a Covered Employee.  The compensation paid to any person who was a covered employee in any taxable year after 2016 (including years in which a covered company was not required to file reports with the Securities and Exchange Commission) will continue to be subject to the $1 million limit for as long as such employee or his or her beneficiaries receive compensation from the company.
  • Expansion of Companies Subject to Code Section 162(m), Including Companies With Publicly Traded Debt.  The scope of Code Section 162(m) will be expanded to apply to all companies that file reports with the Securities and Exchange Commission, including any corporation that is required to file reports pursuant to Section 15(d) of the Securities Exchange Act of 1934. Accordingly, companies with publicly traded debt will be subject to Code Section 162(m) even if they do not have publicly traded equity.
  • Limited Transition Rule.  The amendments to Code Section 162(m) will not apply to compensation payable pursuant to a written binding contract in effect on November 2, 2017, provided such contract is not subsequently modified in any material respect after November 2, 2017 (including any renewal of such contract).

Extended Holding Period for Certain Carried Interests

Under current law, holders of “carried interests” (i.e., certain interests in partnerships) are generally eligible for long-term capital gain tax treatment if such interests are held for at least one year. Effective for tax years beginning after December 31, 2017, holders of certain carried interests issued in exchange for services will not qualify, in some circumstances, for long-term capital gain tax treatment unless the interests are held for at least three years. The new rule applies to previously issued interests and future grants. However, there are important exceptions to the new rule. Notably, interests granted by a partnership to service providers employed by an entity other than the partnership may be exempt from the new extended holding period.

Deferred Taxation for Certain Private Company Equity Grants

Under current law, individuals who are granted stock options or restricted stock units (RSUs) from their employer generally are subject to income tax with respect to such equity awards when the award is exercised or settled. Effective after December 31, 2017, employees of private companies will be permitted to elect to defer the recognition of income, for up to five years, in connection with the exercise of stock options (including incentive stock options (ISOs), nonstatutory stock options and shares transferred pursuant to an employee stock purchase plan (ESPP)) or the settlement of RSUs. Generally, the following conditions must be satisfied in order to qualify for the deferral election:

  • Written Plan.  The election is only available for grants made in a calendar year pursuant to a written plan under which at least 80% of the employees of the company who provide services in the United States are granted stock options or RSUs in such year. This 80% requirement applies separately to options and RSUs, meaning 80% of employees must be granted options with the same rights and privileges in order for options to benefit from this rule, and 80% of employees must receive RSUs with the same rights and privileges in order for RSUs to benefit from this rule.
  • Employer Stock.  The election is only available for stock options or RSUs granted in connection with the performance of services by employees from their employer. The election is not available for restricted stock or stock appreciation rights. The election is also not available in certain cases where companies have repurchased their stock.
  • Election Timing.  Deferral elections must be made by the eligible employee no later than 30 days after the date the stock option or RSU is first substantially vested or transferable (whichever is earlier). The election is expected to be made in a manner similar to an election made under Code Section 83(b).
  • Excluded Employees.  The election is not available for the following excluded employees: (1) individuals who are (or were, at any time in the preceding 10 calendar years) one percent owners of the company; (2) the current or former CEO or CFO of the company; (3) a family member (spouse, children, grandchildren and parents) of anyone described in (2); or (4) individuals who are (or were, at any time in the preceding 10 tax years) among the top four highest compensated officers of the company.
  • Notice.  Companies are required to provide notice of the ability to make a deferral election to each eligible employee at, or a reasonable period prior to, the time that the employee’s right to qualified stock is substantially vested and the income attributable to the stock would otherwise first become includible in income. The notice must include prescribed information and certifications and must indicate that the stock is eligible for deferral.  There will be penalties on companies for the failure to provide this required notice.

Once an election is made, the deferred value is determined and will become includible in income (even if the stock value subsequently declines) for the taxable year that includes the earliest of the following events: (1) the date five years after the employee’s right to the stock became substantially vested; (2) the date the qualified stock becomes transferable, including to the employer (i.e., the date the employee has the ability to sell the stock to any person, including the employer); (3) the date the employee revokes the deferral election; (4) the first date that any stock of the employer becomes readily tradable on an established securities market; or (5) the date the employee becomes an excluded employee (as described above). A qualifying deferral election will not be considered ‘nonqualified deferred compensation’ subject to Code Section 409A. The Act includes specific wage reporting and withholding rules as well as information reporting rules, and also addresses the interplay between the deferral election and the rules otherwise applicable to ISOs and ESPPs.

Temporary Exemption Increase for Individual Alternative Minimum Tax

Under current law, individuals generally pay Alternative Minimum Tax (AMT) if the resulting tax would be higher than regular income tax in a year. Certain items of income not included for purposes of regular income tax are potentially subject to AMT, including the spread on the exercise of ISOs. The AMT calculation can be complicated but generally requires a minimum tax rate on all income over an exemption amount. The exemption amount phases out at certain income levels. Effective for taxable years after December 31, 2017, and before January 1, 2026, the AMT exemption amount will be increased and the exemption will begin to phase out at significantly higher income levels. The new thresholds are intended to reduce the number of individuals who are required to pay AMT.  Despite the increased thresholds, AMT remains a consideration for individuals exercising ISOs. However, the increased thresholds should provide relief with respect to some ISO exercises. 

Excise Tax Imposed on Excess Executive Compensation Paid by Tax-Exempt Employers

The Act adds a new excise tax applicable to certain tax-exempt employers. Effective for taxable years beginning after December 31, 2017, an excise tax of 21% will be imposed on an applicable tax-exempt organization if it pays compensation in excess of $1 million, or certain severance payments, to its “covered employees.” The excise tax is applicable to any organization exempt under Code Sections 501(a), 115(1), or 527, and exempt farmers’ cooperatives. The organization, and not the covered employee, is responsible for payment of the excise tax.

A covered employee is defined as (1) one of the five highest compensated employees of the tax-exempt entity for the taxable year, or (2) any employee who was a covered employee of the entity (or any predecessor) for a preceding taxable year beginning after December 31, 2016. Once an employee qualifies as a covered employee, the employee remains a covered employee even in subsequent taxable years when the employee is no longer one of the five highest compensated employees of the tax-exempt entity.

The excise tax is applicable to remuneration paid in excess of $1 million in a taxable year. Whether compensation has exceeded $1 million is generally calculated in accordance with Code Section 3401(a) and includes any remuneration paid to the covered employee by a related organization. Remuneration includes all amounts no longer subject to a substantial risk of forfeiture, even if such amounts have not yet been paid to the covered employee. It specifically includes amounts that are vested but not yet paid under Code Section 457(f)(3)(B). There is a specific exclusion from the definition of remuneration for payments to qualified medical and veterinary service providers for the performance of medical or veterinary services.

The excise tax is also imposed on “excess parachute payments” that are paid to a covered employee (assuming such individual is also a “highly compensated employee” within the meaning of Code Section 414(q)) in excess of such employee’s base amount of compensation. The Act defines parachute payments as payments that (1) are contingent upon the covered employee’s separation from service with the employer, and (2) have an aggregate present value that equals or exceeds three times the covered employee’s “base amount.” A covered employee’s base amount is calculated by applying rules similar to those in Code Section 280G, which generally provide that a covered employee’s base amount is the individual’s average income from the organization over the five-year period immediately preceding the year in which the separation from employment occurs. Payments made under or pursuant to a 403(b) annuity contract or 457(b) plan are not considered parachute payments, and again there is an exception for payments for the performance of medical or veterinary services.

Limitations on Roth IRA Recharacterization

Under applicable tax rules, individuals may convert amounts held in a traditional IRA to a Roth IRA. Under current law, individuals may recharacterize a traditional IRA contribution as a Roth IRA contribution and vice versa for a taxable year before the due date for the individual’s income tax return for such year, and this recharacterization is permitted for both regular contributions and conversion contributions. Upon recharacterization, the IRA owner is treated as having made the contribution originally to the second account. If a Roth IRA conversion is recharacterized, the IRA owner is treated as though the conversion was never made.

Effective for taxable years beginning after December 31, 2017, individuals will no longer be permitted to recharacterize a conversion contribution to a Roth IRA (that is, to unwind a Roth IRA conversion). This change does not affect the longstanding ability to recharacterize other (non-conversion) contributions. For example, an individual may continue to make a regular contribution for a year to a Roth IRA and, before the due date for the individual’s income tax return for that year, recharacterize it as a contribution to a traditional IRA.

Relaxed Requirements for Retirement Plan Loan Repayment

Under current law, a participant loan from a retirement plan generally becomes immediately due and payable when the retirement plan is terminated or the participant’s employment terminates. If the loan is not repaid, the plan will “offset” the loan against the participant’s account. This loan offset may be “rolled over” by making an equivalent contribution to an IRA or another qualified plan, so long as it is done within 60 days of the offset. Beginning in 2018, the Act extends the period to roll over a loan offset to the date on which the participant’s tax return is due for the year in which the offset occurred. The extension, however, only applies in the case of a retirement plan termination or the participant’s severance from employment.

Disaster Area Tax Relief for Retirement Plan and IRA Distributions

Similar to relief provided in connection with hurricanes in 2005 and 2017, the Act provides tax relief for certain retirement plan and IRA distributions taken on or after January 1, 2016, and before January 1, 2018, by individuals whose primary residence was located at any time in 2016 in an area declared to be a “disaster area” by the President during 2016 and who sustained an economic loss by reason of the disaster. Such distributions of $100,000 or less are generally included in income ratably over three years and may be repaid or recontributed within three years without being includible in income. In addition, such distributions are exempt from the 10% early withdrawal penalty and the 20% withholding requirement generally applicable to retirement plans.

Addition of Employer Credit for Paid FMLA Leave

The Act adds a new Code Section 45S under which a general business credit for employers is available for wages paid to qualifying employees as paid family and medical leave (as described under the Family and Medical Leave Act of 1993). Effective for wages paid in tax years beginning after December 31, 2017, and ending on December 31, 2019, the new Code Section 45S credit is available, if (1) the employer has a written policy; (2) the employer pays at least 50% of wages, for at least two weeks, during the eligible leave; and (3) the paid leave is provided to all qualifying full-time employees (and part-time employees on a pro rata basis). A qualifying employee must be employed for at least one year and have been paid compensation in the preceding year that was less than 60% of the threshold for highly compensated employees under Code Section 414(q)(1)(B). The credit is between 12.5% and 25% of the compensation paid, but does not include compensation paid as vacation leave, personal leave, or other medical or sick leave.

Changes to Fringe Benefits and Perquisites

Under current law, employers may provide certain fringe benefits to employees that are both deductible by the employer and excludible from the employees’ income. For some fringe benefits, the Act either eliminates the ability of the employer to deduct the costs of certain benefits or the ability of the employees to exclude the value of these benefits from income.

  • Entertainment Expense.  Under current law, 50% of expenses for entertainment, amusement or recreation activities is deductible if such expenses directly relate to the active conduct of a trade or business. Effective for expenses paid or incurred after December 31, 2017, the Act eliminates the entire deduction for such expenses. 
  • Employer-provided Meals.  Under current law, deductions relating to the maintenance of eating facilities are excluded from the 50% cap on meal expense deductions and, therefore, are fully deductible by employers.  Effective for expenses paid or incurred after December 31, 2017, the Act eliminates the exclusion from the 50% cap on expenses related to the provision of meals on business premises for the convenience of the employer or the maintenance of eating facilities, and therefore these expenses will only be 50% deductible by employers. Additionally, effective for expenses paid or incurred after December 31, 2025, the Act eliminates the entire deduction for these expenses.
  • Transportation Benefits.  Under current law, employees may exclude the value of “qualified transportation fringe benefits” from income, although the expense of these benefits is still deductible by employers. Qualified transportation fringe benefits included qualified parking, transit passes, transportation between an employee’s residence and place of employment, and qualified bicycle reimbursement. Effective for expenses paid or incurred after December 31, 2017, the Act eliminates the employer’s ability to deduct the cost of expenses for qualified transportation fringe benefits other than qualified bicycle reimbursement. However, the Act eliminates the exclusion from income for qualified bicycle reimbursement amounts and therefore these amounts will be includible as income to employees.
  • Employer Paid or Provided Moving Expenses. Under current law, amounts paid or reimbursed by an employer for certain moving expenses are deductible by an employer but not included as income by employees. Effective for taxable years beginning after December 31, 2017 and before January 1, 2026, the Act eliminates the exclusion from income for amounts paid or reimbursed by an employer for moving expenses and therefore these amounts will be includible as income to employees (other than certain moving expenses paid or provided with respect to members of the U.S. Armed Forces).
  • Employee Achievement Awards.  Under current law, certain employee achievement awards are not deductible by an employer and not included in an employee’s income. The Act clarifies that cash, gift certificates, vacations, stock, securities, or tickets to theater or sporting events are not eligible employee achievement awards.