CLIENT ALERT: Federal Tax Reform Contains Significant Changes to Treatment of Compensation and Employee Benefits
The Tax Cuts and Jobs Act (the “Act”) signed into law in December 2017 includes changes to the tax provisions relating to executive compensation, retirement plans, and compensation-related employer deductions. A brief summary of important changes is outlined below.
Excessive Compensation Limitation
Under Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”), public companies are only able to deduct up to $1 million of compensation paid to “covered employees.” Any amounts paid in excess of this limitation are non-deductible. Under prior law, commissions and performance-based compensation were not subject to this limitation; these amounts were deductible even if in excess of $1 million. Now, the compensation deduction is capped at $1 million for all compensation paid to covered employees, thereby eliminating a company’s ability to compensate covered employees with commissions or performance-based remuneration and still claim the full benefit of the deduction.
Moreover, the Act expands which employees are included in this limitation. Under prior law, “covered employees,” included the chief executive officer (“CEO”) and the three highest paid executives. The new law clarifies and expands the definition of a “covered employee” to include the CEO and chief financial officer (“CFO”) at any time during the tax year (potentially multiple individuals in either category) and the three other highest paid employees in a given tax year. In addition, once an employee is deemed to be a “covered employee,” the designation runs with the employee, even after death. For example, if deferred compensation or severance is paid to the beneficiaries or ex-spouse of a CEO, such compensation is taken into account in determining the company’s deduction limitation for that year. The Act goes even further by making the limitation applicable to companies that are subject to the SEC’s supplemental and periodic filing requirements of Section 15(d) of the Securities Exchange Act of 1934, as amended, but do not otherwise have publicly traded equity securities. Transition relief is provided where written binding contracts were in effect on November 2, 2017 and have not been materially modified on or after this date. Such contracts may apply the prior law.
The Act also aligns compensation paid to executives of tax-exempt organizations with these rules by imposing on tax-exempt organizations a 21% excise tax on compensation paid to a “covered employee” in excess of $1 million and on compensation paid in the form of excess parachute payments. For this purpose, a “covered employee” includes the five highest paid employees.
New Deferral Election for Stock Received by Employees of Private Companies
The Act allows “qualified employees” to elect to defer from income “qualified stock” received from an employer in connection with the exercise of an option or in settlement of a Restricted Stock Unit (or “RSU”) for up to five years. The option or RSU must have been granted by an employer in connection with the performance of services by an employee while the employer was an “eligible corporation.” A corporation is only eligible if
(a) no stock of such corporation (or predecessor) is readily tradable on an established securities market during any preceding calendar year, and
(b) the corporation has a written plan under which at least 80% of all employees who provide services to the corporation in the United States are granted stock options or RSUs, as applicable.
Moreover, an employee is only qualified to make this election if he or she is not the CEO, CFO, a person related to the CEO or CFO, or one of the four most highly compensated officers and such employee is not a 1% owner at any time during the calendar year or the preceding 10 calendar years. This allows some relief to employees who would be liable for tax on the vesting of stock options and RSUs but do not have cash available to pay the tax. Further nuances and myriad requirements require a deeper analysis.
Employer Credit for Paid Family and Medical Leave
The Act allows an eligible employer to claim a general business credit if it provides paid family and medical leave to a qualifying employee. A qualifying employee is an employee who has been employed by the employer for at least one year. The credit is equal to 12.5% of the amount of wages paid during family and medical leave if such amount is equal to at least 50% of the wages normally paid to such employee. The credit is further increased (to a ceiling of 25%) by 0.25% points for each percentage point by which the rate of payment exceeds 50%. To take the credit, an employer must have a written paid family and medical leave policy that allows for at least two weeks of annual paid leave for full-time employees.
Affordable Care Act Individual Mandate
Beginning in 2019, the Act effectively eliminates the Affordable Care Act’s “individual mandate” by removing the penalty imposed on individuals who do not have health care coverage.
Repeal of Roth IRA Recharacterization
Under the Act, if an individual converts a traditional individual retirement account (“IRA”) to a Roth IRA, this conversion can no longer be reversed. Under prior law, an individual could “unwind” a converted Roth IRA contribution by recharacterizing the contribution as a traditional IRA contribution in the same tax year as the conversion. For example, if the value of the Roth IRA decreased subsequent to the conversion, under prior law, an individual could recharacterize the contribution back to a traditional IRA in the same tax year.
Extended Period for Rollover of Plan Loan Offset Amounts
The Act extends the time period for a tax-free rollover of a plan loan offset amount from 60 days to the due date of a participant’s tax return for the applicable year, including extensions. Such situations can arise when a participant’s plan loan balance is repaid by “offsetting” the loan balance by a portion of the participant’s plan account. The amount of the offset is treated as a distribution from the plan that may be taxable if the participant does not make a contribution to a qualifying retirement plan or IRA in the amount of the previously outstanding loan balance. The extension allows a participant more time to make this contribution to satisfy the previously outstanding loan balance.
Update to Employee Plan Voluntary Compliance Program User Fees (Revenue Procedure 2018-04)
The IRS has changed the fee structure for voluntary compliance program (“VCP”) applications which may affect whether a taxpayer chooses to avail itself of the program. Given that there will no longer be interim IRS determination letters, a plan sponsor’s only opportunity to receive periodic confirmation of a plan’s documentary and operational compliance would be to correct any such defects under the Employee Plans Compliance Resolution System (or “EPCRS”).
Companies should revisit outstanding employee benefit plan documents and take account of deferred compensation arrangements. Employers should reexamine benefits available to employees and consider any necessary policy revisions. For questions regarding the implementation of the Act, or any other question, please contact the Olshan attorney with whom you regularly work or one of the attorneys listed below.