New Tax Reform Law Impacts Employee Benefits and Executive Compensation
With little notice and even less time to prepare, the newly enacted Tax Cuts and Jobs Act signed into law in December 2017 paved the way for employee benefits and executive compensation changes affecting all types of employers. Although many of the more expansive benefits reform provisions did not survive to the final bill, employers need to be aware of changes that were enacted and that, for the most part, are already effective for 2018.
Strict $1 Million Deduction Limit for Public Companies
Under existing (now prior) law, publicly traded companies could only deduct up to $1 million of annual compensation paid to certain top executives. Crucially, however, companies could deduct more than $1 million in annual compensation for performance-based compensation and commissions. This exception covered many forms of public-company executive compensation such as performance-based cash bonuses, stock options, and restricted stock units.
The Act repeals the performance-based compensation and commission exceptions. Now any compensation over $1 million paid by a publicly traded company to a covered employee for a given year is nondeductible. The new law also expands the group of “covered employees” to whom the deduction limitations apply.
A limited grandfathering provision applies to pay arrangements already in place.
Excise Tax on “Excessive” Compensation Paid by Tax-Exempt Employers
The Act also aims to harmonize the executive compensation limitations of public companies to tax-exempt and governmental employers by imposing a 21% employer-paid excise tax on compensation in excess of $1 million per year, and on severance payments called “excess parachute payments,” paid to certain covered employees.
The organization’s five highest-paid current or former employees for a year are covered employees. Additionally, anyone who ever was a covered employee starting in 2017 will always remain a covered employee. Significantly, amounts provided under a Section 457(f) deferred compensation arrangement are counted immediately upon vesting, which could lead to cliff vesting provisions on large balances unwittingly triggering the new excise tax.
“Excess parachute payments” subject to the excise tax are payments contingent on the employee’s severance from employment that exceed three times the employee’s preceding five-year average annual compensation.
For both excise taxes, any compensation paid to a licensed medical provider for the provision of medical services is exempt.
The excise taxes apply starting in 2018. Although the IRS will issue regulations that may address a transition period, currently no relief is provided for existing arrangements or plans.
Tax Deferral for Stock Options and Restricted Stock Units of Private Companies
The Act also loosened the taxation rules for employees of private companies who exercise certain types of stock options or who are issued restricted stock units. The new rules allow the employee to defer the taxes otherwise owed for up to five years.
However, the Act also imposes strict limitations that will foreclose using this deferral option for employees of almost all private companies. For employees to be eligible to elect this tax deferral, at least 80% of the company’s employees must be granted options or restricted stock units during the year. Additionally, the deferral rules cannot be used by anyone who owns (or owned within the 10 prior years) at least 1% of the company; anyone who is or ever was the company’s CEO, CFO, or their family members; and anyone who is (or was during the 10 prior years) one of the four highest compensated employees of the company.
Qualified Retirement Plans
Extended Qualified Plan Loan Offset Rollover Period
On the qualified plan side, the Act provides a slight reprieve for retirement plan participants who have their plan loans offset. Typically a participant who terminates employment with an outstanding plan loan must repay the loan promptly or their account is offset by the outstanding amount of the loan. Under existing law, the participant could roll over the loan offset amount, but only within 60 days under the typical 60-day rollover rules.
The Act now extends the 60-day deadline to repay and roll over the loan offset amount until the participant’s personal tax filing deadline (including extensions) for the tax year in which the offset occurred. This will extend the participant’s repayment timeline for over a year in some cases, with the intention of allowing more participants a realistic opportunity to repay and roll over the offset amount to preserve their tax-favored retirement plan balance.
Employee Moving Expenses
Under existing law, certain employer-paid or employer-reimbursed moving expenses are excluded from employees’ income. The new law repeals that exclusion beginning in 2018. Note that this does not eliminate the ability to pay such expenses; to the extent still desired, moving expense reimbursements may still be paid and grossed up by the employer.
Transportation Fringe Benefits
Prior to 2018 employers could provide certain types of transportation fringe benefits like parking, public transit passes, and bicycling expenses tax-free to the employee and deductible by the employer. The Act now eliminates the employer deduction (for taxable employers) for these fringe benefits. It also imposes unrelated business income tax on transportation fringe benefits paid by tax-exempt employers.
Despite the tax changes to the employer, these benefits will primarily remain tax-free to the employee. Note, though, that employee-paid transportation expenses that are pre-taxed through a cafeteria plan will be considered “employer contributions” and therefore the employer will not be able to deduct the amounts pre-taxed by employees toward transportation fringe benefits.
Employee Achievement Awards
Existing law allows employers to deduct and employees to exclude from income certain employee achievement awards for length of service or safety. Under the Act, starting in 2018, such awards are taxable to the employee, and not deductible by the employer, if they are paid in cash, cash equivalents, gift cards, gift certificates, vacations, meals, lodging, tickets to sporting or theater events, securities, or similar items. The only exception, which allows a deduction and exclusion from income, is if the employee is able to choose an item from a limited number of employer-selected options.
Meals and Entertainment
Also starting in 2018, employers will no longer be able to deduct client or customer entertainment or recreation expenses at all, even if they are connected with the employer’s business. This would include events such as client outings, sports events, theater tickets, etc. Likewise, meals with clients or customers will not be deductible at all if they constitute entertainment.
The Act also phases out an employer’s deduction for on-site cafeterias or other employer-provided meals.
Repeal of Individual Mandate
While the Act does not repeal the employer mandate requiring large employers to offer affordable health insurance, beginning January 1, 2019, the new law effectively repeals the individual mandate by reducing the penalties for failing to maintain coverage to $0. The individual mandate remains in force during 2018. The repeal of the individual mandate may lead to fewer employees electing employer-provided health insurance.
Repeal of Roth IRA Recharacterizations
Individuals with IRAs who were previously able to convert their traditional (pre-tax) IRA to a Roth (after-tax) IRA and then “recharacterize” that their IRA back to a traditional IRA can no longer do so starting in 2018.
Effect of New Business Tax Rates
Finally, while the Act makes several specific changes to employee benefits, the most fundamental change of the new law is in tax planning for business owners under the reduced corporate income tax rate to 21% for C corporations, and the new 20% deduction for pass-through income from S corporations and LLCs. This may cause business owners to rethink their retirement plan funding strategy; for example, pay themselves less in W-2 wages, increase their profit distributions at a now-lower tax rate, and reduce funding into their 401(k) and pension plans. Or forgo a sale and instead hold their private company stock and receive distributions at the new lower tax rates now that their pass-through ordinary income rate will be much closer to the capital gains rate. This new rate paradigm may present a different approach to end of year and choice of entity tax planning.
The employee benefits attorneys at Kaufman & Canoles stand ready to assist with these, and any other, benefits challenges looming in the new year.
The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2021.