Tax Reform Is Enacted, With Significant Implications for Executive Compensation and Employee Benefits | Practical Law

Tax Reform Is Enacted, With Significant Implications for Executive Compensation and Employee Benefits | Practical Law

Congress has passed and President Trump signed (on December 22, 2017) far-reaching tax reform legislation, the Tax Cuts and Jobs Act. The law makes significant changes to numerous Internal Revenue Code provisions governing executive compensation and employee benefits.

Tax Reform Is Enacted, With Significant Implications for Executive Compensation and Employee Benefits

by Practical Law Employee Benefits & Executive Compensation
Published on 21 Dec 2017 • USA (National/Federal)
Congress has passed and President Trump signed (on December 22, 2017) far-reaching tax reform legislation, the Tax Cuts and Jobs Act. The law makes significant changes to numerous Internal Revenue Code provisions governing executive compensation and employee benefits.
Congress passed and President Trump signed (on December 22, 2017) tax reform legislation that makes significant changes to numerous Internal Revenue Code (Code) provisions governing executive compensation and employee benefits (An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018 ("Tax Cuts and Jobs Act" (Act)); Pub. L. No. 115-97 (Dec. 22, 2017)). The law's enactment is the culmination of a lengthy legislative process that began this fall; see the legal updates:

Executive Compensation-Related Provisions Under the Act

Code Section 162(m)

The Act makes significant changes to Code Section 162(m) (26 U.S.C. § 162(m)), including:
  • Eliminating the popular exceptions for qualified performance-based compensation and commissions.
  • Broadening the definition of "covered employee" to include:
    • anyone who served as the CEO or CFO at any time during the taxable year and the next three most highly compensated executive officers; and
    • anyone who was a covered employee for any taxable year beginning after December 31, 2016.
  • Broadening the definition of publicly held corporation to include corporations that are required to file reports under Section 15(d) of the Securities Exchange Act, which includes companies that issue securities in an SEC-registered offering which are not listed on any securities exchange.
  • Broadening the definition of applicable employee remuneration to include amounts includible in the income of, or payable to, persons other than the covered employee, for example, a beneficiary.
The Act follows the Senate amendment, including a transition rule for compensation which is provided pursuant to a written binding contract which was in effect on November 2, 2017 and which was not materially modified thereafter. The Conference Agreement clarifies that compensation paid pursuant to a plan qualifies for the exception if the right to participate in the plan is part of a binding written contract with the covered employee (for example, an employment agreement) in effect on November 2, 2017 even if the employee was not actually a participant in the plan on November 2, 2017.

Tax-Exempt Organizations

The Act imposes an excise tax on employers of certain tax-exempt organizations that pay excessive executive compensation. The tax is equal to 21% of the sum of:
  • Compensation paid to a covered employee that exceeds $1 million in any taxable year.
  • Any excess parachute payment (under a new definition that relates only to separation pay) made to a covered employee.
Compensation is treated as paid when not subject to a substantial risk of forfeiture.
A covered employee is an employee who:
  • Is one of the five highest compensated employees of the organization for the taxable year.
  • Was a covered employee of the organization (or a predecessor) for any preceding taxable year beginning after December 31, 2016.
The Act follows the Senate amendment with modifications. The Conference Agreement:
  • Increases the excise tax to 21% to match the increased corporate tax rate.
  • Clarifies that substantial risk of forfeiture is based on the definition under Code Section 457(f)(3)(B) (26 U.S.C. § 457(f)(3)(B)).
  • Exempts compensation paid to non-highly compensated employees from the definition of parachute payment.
  • Exempts compensation attributable to medical services of certain qualified medical professionals from the definitions of remuneration and parachute payment.

Special Election With Respect to Private Company Illiquid Stock

The Act allows employees who are not excluded employees ("qualified employees") of certain private companies ("eligible corporations") to make an election under new Code Section 83(i) to defer the recognition of income on illiquid company stock acquired through the exercise of stock options or settlement of restricted stock units (RSUs) ("qualified stock") for up to five years after vesting.
An excluded employee with respect to a corporation is any individual who:
  • Was a 1% owner of the corporation at any time during the ten preceding calendar years.
  • Is, or who has been at any prior time, the CEO or CFO of the corporation (or anyone who has acted in either capacity).
  • Is a family member of an individual described in either of the immediately preceding two bullets.
  • Has been one of the four highest compensated officers of the corporation for any of the ten preceding taxable years.
A corporation is an eligible corporation with respect to a calendar year if:
  • No stock of the corporation (or a predecessor) is readily tradable on an established securities market during any preceding calendar year.
  • The corporation has a written plan under which, in the calendar year, not less than 80% of all employees who provide services to the corporation in the U.S. are granted stock options, or RSUs, with the same rights and privileges to receive qualified stock (the "80% Requirement").
Income will be recognized at the end of the deferral period based on the stock's value on the vesting date.
Employers who transfer qualified stock to qualified employees will be required to provide notice to employees about their ability to make a Code Section 83(i) election and will be subject to penalties for any failure to do so.
Offering employees the ability to make a Code Section 83(i) election with respect to statutory stock options will not cause the plans under which the statutory stock options were granted to lose their qualified status. However, if an employee were to make a Code Section 83(i) election, the option would no longer be qualified under Code Section 422 or 423 (26 U.S.C. §§ 422 and 423), as applicable.
An arrangement under which an employee may receive qualified stock will not be treated as nonqualified deferred compensation under Section 409A solely because of the employee's election or ability to elect to defer recognition of income under Code Section 83(i).
The Act clarifies that RSUs are not eligible for Code Section 83(b) elections.
The Act follows the Senate amendment with modifications. The Conference Agreement clarifies that:
  • When a Code Section 83(i) election is made in connection with the exercise of statutory stock options, the options are not treated as statutory stock options but rather as nonqualified stock options for FICA purposes and income tax purposes.
  • An excluded employee includes an individual who first becomes a 1% owner or one of the four highest compensated officers in a taxable year even if the individual did not meet this criteria in the preceding 10 taxable years.
  • The 80% Requirement cannot be satisfied in a taxable year by granting a combination of stock options and RSUs. All such employees must either be granted stock options or RSUs for that year.
  • The exception from treatment as nonqualified deferred compensation under Section 409A applies only with respect to an individual who may receive qualified stock.
  • The circumstances outlined in Code Section 83(c)(3) and related regulations apply when determining when stock first becomes transferrable or is no longer subject to a substantial risk of forfeiture.

Increased Excise Tax On Stock Compensation Held by Insiders of Expatriated Corporations

The Act increases the excise tax rate imposed on the value of stock compensation held by insiders of an expatriated corporation under Code Section 4985 from 15% to 20% (26 U.S.C. § 4985). The Act follows the Senate amendment.

Employee Benefit-Related Provisions Under the Act

From an employee benefits perspective, the Act:
  • Suspends the exclusion from gross income and wages for qualified bicycle commuting reimbursements for tax years beginning after December 31, 2017 and before January 1, 2026 (26 U.S.C. § 132(f); see Practice Note, Fringe Benefits Under Code Section 132: Qualified Bicycle Commuting Reimbursements and Fringe Benefits Toolkit).
  • Suspends the exclusion for qualified moving expense reimbursements for tax years beginning after December 31, 2017 and before January 1, 2026 (26 U.S.C. § 132(a)(6), (g); see Practice Note, Fringe Benefits: Moving Expenses). However, this provision is subject to an exception for US Armed Forces members on active duty who move due to a military order and incident to a permanent change of station.
  • Suspends the Code Section 217 deduction for moving expenses for tax years beginning after December 31, 2017 and before January 1, 2026, subject to an exception for US Armed Forces members (26 U.S.C. § 217).
  • Eliminates the employer deduction for qualified transportation fringe benefits (as defined in Code Section 132(f)), which include:
  • Requires tax-exempt organizations to treat as unrelated business taxable income (UBTI) amounts paid or incurred for any:
  • Disallows a deduction for expenses incurred for providing transportation (or employee payments or reimbursement) for commuting between an employee's residence and place of employment, unless necessary for the employee's safety.
  • Disallows a deduction for:
    • entertainment, amusement, or recreation activities (26 U.S.C. § 274(n));
    • membership dues regarding clubs organized for business, pleasure, recreation or other social purposes; or
    • facilities used in connection with the above items.
  • Continues to permit employers to deduct 50% of expenses for food or beverages related to conducting the employer's trade or business (26 U.S.C. § 274(a)). However, for amounts incurred and paid from 2018 through 2025, the Act extends this 50% limit to employer expenses for providing food and beverages to employees through an eating facility that satisfies the requirements for:
  • Eliminates the deduction for meals provided for the employer's convenience on or near the employer's premises, for amounts paid or incurred after December 31, 2025.
  • Repeals the ability to recharacterize a Roth IRA conversion (26 U.S.C. § 408A(d)(6)(B)).
  • Increases the maximum benefit available under a length of service award plan to $6,000, subject to cost-of-living adjustments (26 U.S.C. § 457(e)(11)(B)).
  • Creates a new type of plan loan offset called a "qualified plan loan offset amount" which is a loan offset that is deemed distributed from a plan because of the termination of the plan or the participant's failure to repay the loan because of his separation from service. Such an offset amount may be rolled over to an eligible retirement plan by the due date (including extensions) for the federal income tax return for the year in which the offset occurs.
  • Allows for qualified 2016 disaster distributions during 2016 and 2017 of up to $100,000 from eligible retirement plans to victims of natural disasters whose principal abode in 2016 was in a specified disaster area and who sustained economic loss. Qualified 2016 disaster distributions are not subject to the 10% early withdrawal penalty and may be re-contributed to an eligible retirement plan within three years of the day after the distribution was received.
Notably, regarding employer-sponsored fringe benefits, the Act does not include a House provision that would have repealed the exclusions from gross income and wages for:
The Act also does not include a House provision that would have limited the exclusion for employer-provided housing under Code Section 119 (26 U.S.C. § 119).

Individual Mandate Penalty Reduced to Zero, Effective Beginning in 2019

Effective regarding health coverage status for months beginning in 2019, the Act reduces to zero the penalty for violating the Affordable Care Act's (ACA's) individual mandate (that is, for individuals who fail to maintain minimum essential coverage under the ACA) (26 U.S.C. § 5000A; see Practice Notes, Affordable Care Act (ACA) Overview: Individual Mandate and Employer Mandate Under the ACA: Overview: Minimum Essential Coverage). Earlier this year, the individual mandate was repeatedly targeted for elimination under Congress's unsuccessful efforts to repeal and replace the ACA (see Article, ACA Repeal-and-Replace Bills in the House and Senate: Individual Mandate).
The ACA's individual mandate will continue to apply for 2017 and 2018, and the Act does not repeal the ACA's employer mandate (see Employer Mandate Toolkit).

Employer Business Credit for Family and Medical Leave (New Code Section 45S)

Under new Code Section 45S, the Act permits employers to claim a business credit for a percentage of the amount of wages paid to certain employees for the time they are on family and medical leave (as defined under specified sections of the Family and Medical Leave Act of 1993 (FMLA)). (This assumes the rate of payment under the employer's leave program is 50% of wages normally paid to an employee.) The credit equals 12.5% of wages paid during the leave period, increased by 0.25 percentage points for each percentage point by which the rate of pay is more than 50% (but capped at 25% of wages paid). The maximum amount of family and medical leave that may be taken into account for each employee for a tax year cannot exceed 12 weeks.
An eligible employer for Code Section 45S purposes is one that:
  • Has adopted a written policy allowing all qualifying full-time employees at least two weeks of annual paid family and medical leave (see 26 U.S.C. § 4980E(d)(4)(B)).
  • Permits part-time qualifying employees a commensurate amount of leave, calculated on a pro rata basis.
Leave paid for by a state or local government is not taken into account for Code Section 45S purposes. Also, if an employer provides paid leave as vacation leave, personal leave, or other medical or sick leave, this paid leave is not considered family and medical leave under Code Section 45S.
New Code Section 45S will not apply to wages paid in tax years beginning after December 31, 2019.

Effective Date

Subject to certain exceptions, the Act would apply to taxable years beginning after December 31, 2017. However, the Act exempts from the Code Section 162(m) amendments compensation under a written binding contract that was in effect on November 2, 2017 and that is not subsequently materially modified.