The Tax Cuts and Jobs Act, signed into law by President Donald J. Trump shortly before Christmas, is the most significant tax reform legislation in more than 30 years. While early versions of the legislation would have made sweeping changes to employee benefit plans and executive compensation arrangements, the final Act has a narrower, though still significant, impact.
The following is a brief summary of the employee benefits and executive compensation changes that will affect employers. Unless otherwise noted, all changes are effective for the 2018 tax year.
What is Changing
- Section 162(m) of the Internal Revenue Code, which limits deductions for compensation paid to covered employees of publicly traded companies in excess of $1 million, is substantially modified.
- The Section 162(m) deduction limit applies to all domestic publicly traded corporations and all foreign companies publicly traded through American depository receipts (ADRs).
- Covered employees include the principal executive officer, the principal financial officer, and the next three most highly compensated officers who are (or would be) required to be reported on the company’s proxy statement.
- If an individual is a covered employee in 2017 or later, he or she will always be a covered employee for all future years (even after termination of employment).
- The performance-based compensation exception, which allowed companies to deduct compensation to a covered employee in excess of $1 million so long as it was performance-based, is eliminated.
- There is a grandfather rule for compensation that is provided pursuant to a written binding contract as of November 2, 2017, and which is not thereafter materially modified.
- There is a new 21% excise tax imposed under Section 4960 of the Internal Revenue Code on excess executive compensation paid by tax-exempt organizations. The excise tax applies to the organization.
- The new excise tax applies to remuneration paid to covered employees, which includes the top five highest paid employees of the organization for the taxable year. Once an employee is considered a covered employee (in 2017 or later), he or she will be a covered employee for all future years (even after termination of employment). There is an exception for remuneration paid to licensed medical professionals for medical services.
The excise tax applies in two circumstances:
- It applies to all annual remuneration paid to a covered employee for the taxable year in excess of $1 million.
- It applies to any “excess parachute payment,” which is any compensation payment that is contingent upon the employee’s termination of employment, and where the aggregate present value of such payments exceeds three times (3x) the employee’s average annual compensation. In that case, the excise tax applies to any parachute payment that is in excess of the average annual compensation.
- These rules will operate in much the same way as the golden parachute rules under Section 280G and 4999 of the Internal Revenue Code for change in control payments.
- For purposes of the excise tax, remuneration is considered paid when there is no longer a substantial risk of forfeiture.
- There is a new limited ability for employees of non-publicly traded companies to defer income recognition on stock transferred to them upon exercise of a stock option or a restricted stock unit.
- The rules that allow an individual to re-characterize a contribution to a traditional IRA as a contribution to a Roth IRA (or vice versa) by the due date of the individual’s tax return for the year of the contribution are modified so that recharacterizations cannot be used to undo a conversion contribution to a Roth IRA.
- Following termination of employment, the deadline for rolling over a loan balance from a retirement plan (and therefore avoiding taxation due to a loan default) is extended from 60 days to the due date for the individual’s tax return for the year of the loan distribution.
- The individual deduction for job-related moving expenses and the income exclusion for qualified moving expense reimbursements paid by employers are repealed for the 2018-2025 tax years.
- An employer can no longer deduct amounts used to provide qualified transportation fringe benefits (e.g., transit passes, qualified parking, etc.). However, employees still can exclude the value of any employer-provided qualified transportation fringe benefit. Also, any amounts used by a tax-exempt organization to provide qualified transportation fringe benefits are considered unrelated business taxable income (UBTI).
- The exclusion for qualified bicycle commuting reimbursements is repealed for the 2018-2025 tax years.
- Employees may continue to exclude the value of employee achievement awards, but such awards cannot include cash, cash equivalents, or most gift cards.
- Beginning in 2019, the penalty for not enrolling in health insurance under the Affordable Care Act (known as the individual mandate) is reduced to zero. However, the employer-mandate penalties and reporting requirements remain in effect.
- Employers are provided with a new tax credit to the extent that they provide employees with paid family and medical leave (up to 12 weeks per year). The tax credit is equal to 12.5% of wages paid if the wages are 50% of what the employee normally would have earned. The tax credit can increase up to 25% to the extent that the paid family and medical leave exceeds 50% of normal wages. The leave policy must meet certain other criteria. This credit expires on December 31, 2019.
What is NOT Changing
In the months leading up to the signing of the final Act, there were many rumors swirling about major changes in the employee benefits and executive compensation area. Some of those rumors manifested in early versions of the legislation, but did not make it into the final Act. Here are some of the items that were NOT included in the final Act.
- The annual limit on employee contributions to 401(k), 403(b), and 457(b) plans was not reduced. The 2018 limit remains at $18,500 (plus $6,000 for age 50 catch-up contributions).
- Qualified tuition reduction programs provided by universities under Section 117 or by employers under Section 127 remain in place.
- Deductions for contributions to Archer medical savings accounts (Archer MSAs) remain in place.
- There are no changes to the exclusion rules for employer-provided housing under Section 119.
- The exclusion for dependent-care assistance programs, including dependent care flexible spending accounts under Section 129, remains unchanged.
- The exclusion for employer-provided adoption assistance programs under Section 137 remains unchanged.
- The employer-provided child care credit under Section 42F remains unchanged.
- Pension plans and Section 457(b) plans maintained by governmental employers are still not permitted to make in-service distributions at age 59½.
- The hardship withdrawal rules applicable to defined contribution retirement plans remain unchanged.
Modifications to the qualified retirement plan nondiscrimination rules for older, long-service employees were not made.
The Tax Cuts and Jobs Act is the biggest tax overhaul in three decades and will affect virtually every sector of the economy, from nonprofit organizations to property owners and developers to municipal governments and private companies. Ballard Spahr attorneys across practice areas are tracking the impact of the law on your interests. Please keep a close eye on our Tax Reform Alert Center for updates.
Attorneys in Ballard Spahr’s Employee Benefits and Executive Compensation Group help clients design and implement compensation and benefits packages that comply with today’s complex regulatory requirements, attract and retain a quality workforce, and maintain fiscal and fiduciary responsibility.