Analysis of the Senate Tax Reform Bill – Part III: New Source Rules and Tax Reporting and Withholding Requirements

Early Saturday morning, the Senate voted 51-49 to approve a modified version of the Tax Cuts and Jobs Act (the “Senate Bill”). The Senate Bill differs from the House bill (discussed in an earlier series of posts here) passed last month in several respects, and a final negotiated bill will need to pass both chambers before the President can sign it into law. Given the difficulty of moving legislation through the Senate, it seems likely that any enacted legislation would likely be similar to the version passed by the House.

This post is the third in a series of three posts analyzing provisions of the Senate Bill. (Part I analyzes the elimination of the penalty for failing to maintain minimum essential coverage under the ACA and changes to equity and executive compensation.   Part II analyzes changes to deductions and exclusions for employee meals and other fringe benefits, changes to private retirement plan benefits, and a new paid leave credit.)

This post analyzes the new reporting and withholding requirements and source rules. Specifically, the Senate Bill would: (a) eliminate personal exemptions for income tax purposes but retain them for income tax withholding purposes; (b) require reporting for deductible amounts paid with respect to fines and penalties; (c) require reporting for certain life insurance transactions; (d) modify the reporting rules for Alaska Native Corporations; (e) modify the sourcing rule for sale of inventory items; (f) modify the sourcing rule for U.S. possessions; and (g) impose withholding under section 1446 for sale of an interest in a U.S. partnership by a foreign person that is treated as effectively connected income under new Code section 864(c)(8).

These changes generally would be effective after 2017, except as otherwise noted below.

Withholding Exemptions. The Senate Bill would raise the standard deduction and eliminate personal exemptions, which currently allow individuals to reduce their taxable income.  However, section 11041(c) of the Senate Bill would keep the value of the personal allowance in place for purposes of determining the correct amount of federal income tax withholding.

Reporting of Deductible Amounts Paid with Respect to Fines and Penalties. As we previously covered, section 13306(b) of the Senate Bill would adopt a new Code section 6050X requiring government agencies (or entities treated as government agencies) to report to the IRS and taxpayer on a new information return the amount of each settlement agreement or order entered into, where the aggregate amount required or directed to be paid or incurred exceeds a threshold ($600 in the statute, but subject to adjustment by Treasury).  The return must identify any amounts for restitution or remediation of property or correction of noncompliance, which are deductible, unlike fines and penalties paid under the agreement. These changes would generally apply to amounts paid or incurred on or after the date of enactment, except that the changes would not apply to binding orders or agreements entered into or subject to court approval before that date. The House bill did not include any similar provision.

Reporting of Certain Life Insurance Transactions. As we previously covered, section 13520 of the Senate Bill would also adopt a new Code section 6050Y that would create a new information reporting requirement for certain life insurance contract transactions. This includes: (a) a return filed and furnished by every person who acquires a life insurance contract or any interest in a life insurance contract in a “reportable policy sale”; (b) a return filed and furnished by each issuer of a life insurance contract upon notice of a transaction reported under (a); and (c) a return filed and furnished by every payor of “reportable death benefits.”  A “reportable policy sale” is generally the acquisition of an interest in a life insurance contract, directly or indirectly, if the acquirer has no substantial family, business, or financial relationship to the insured.  A “reportable death benefit” is an amount paid by reason of death of the insured under a life insurance contract that was transferred in a reportable policy sale.  The buyer must file the return required under (a) with the IRS and furnish copies of the return to the insurance company that issued the contract and the seller.  The insurance company that bears the risk with respect to a life insurance contract that receives a copy of a return required under (a) must file the return required under (b) with the IRS and furnish a copy of the return to the seller.  The payor insurance company must file the return required under (c) with the IRS and furnish a copy of the return to the payee.  The reporting requirements would apply for reportable death benefits paid and reportable policy sales after 2017. The House bill did not include any similar proposal.

Reporting Requirements of Alaska Native Corporations. Under current law, Alaska Native Corporations may deduct donations of cash or assets to “settlement trusts,” which are entities that manage Native lands. Section 13821(c) of the Senate Bill would modify the reporting requirements imposed on Native Corporations with respect to such deductions. Specifically, Native Corporations that have made contributions to a settlement trust and elected to deduct those contributions would be required to provide the settlement trust a statement regarding the election not later than January 31 of the calendar year after the calendar year in which the contribution was made. The statement would be required to include: (i) the amount of the contribution to which the election applies; (ii) whether the contribution was made in cash; (iii) for contributions of property other than cash, certain details about the property; (iv) the date of the contribution; and (v) any other information required by Treasury.

Sourcing Rule for Sale of Inventory Property. Under Code section 863(b), sales of inventory property produced in one jurisdiction and sold in another are currently sourced by allocating 50% of the sales income to one jurisdiction and 50% to the other.  Section 14304 of the Senate Bill would change this sourcing rule so that the entire amount would be sourced to the jurisdiction of production.

Sourcing Rule for U.S. Possessions. Section 14503 of the Senate Bill would change two provisions affecting the sourcing rules related to U.S. possessions.  First, Code section 937(b), which controls whether income of U.S. citizens and residents is treated as possession source income, generally provides that income treated as U.S. source or effectively connected with a U.S. trade or business is not treated as income from sources within a possession or effectively connected with a trade or business in that possession.  The Senate Bill would amend Code section 937(b)(2) so that only U.S. source or effectively connected income attributable to a U.S. office or fixed place of business is excluded from possession source income.  Second, the Senate Bill would amend Code section 865, which sets forth the sourcing rules for personal property sales, so that capital gains earned by a U.S. Virgin Islands resident would always be U.S. Virgin Islands source income.

Withholding on Gain from the Sale by Foreign Persons of Interests in Certain Partnerships. Section 13501 of the Senate bill would add a new Code section 864(c)(8) that treats a portion of the gain or loss on the sale or exchange of a partnership interest by a foreign person as effectively connected income if that partnership is engaged in a U.S. trade or business. Under the provision, if a foreign corporation or nonresident alien individual owns, directly or indirectly, an interest in a partnership engaged in a U.S. trade or business, a portion of the gain or loss on the sale or exchange of such interest is treated as effectively connected with the conduct of a U.S. trade or business to the extent such gain or loss does not exceed: (1) in the case of a gain, the portion of the partner’s distributive share of the amount of gain which would have been treated as effectively connected if the partnership had sold all of its assets at fair market value as of the date of the sale or exchange of the partnership interest (or zero, if no such deemed sale would have been effectively connected) or (2) in the case of a loss, the portion of the partner’s distributive share of the amount of loss on the deemed sale described in (1) which would have been effectively connected (or zero, if no such deemed sale would have been effectively connected).  The gain or loss treated as effectively connected under the provision is reduced by the amount so treated with respect to United States real property interests under section 897.

The Senate Bill would also amend Code section 1446 to impose a 10% withholding requirement on the amount of gain treated as effectively connected income under Code section 864(c)(8), similar to the existing rules under section 1445. Upon request by the transferor (generally, the seller) or the transferee (generally, the buyer), the Treasury may prescribe a reduce rate of withholding if the Secretary determines it is appropriate.  In addition, no withholding is required if a transferor furnish to the transferee an affidavit signed under penalty of perjury stating that the transferor is not a foreign person and providing the transferor’s U.S. TIN.  In the absence of such an affidavit (or if the transferee has actual knowledge that a provided affidavit is false or receives a notice from the transferor’s agent or transferee’s agent that such affidavit is false, similar to agent’s notice obligations under section 1445(d)), the transferee of the partnership interest is liable for satisfying the withholding obligation, but in the event that the transferee fails to withhold the required tax, the partnership must withhold an amount equal to the amount the transferee failed to withhold (plus interest) from distributions to the transferee.

The changes would generally be effective for sales and exchanges on or after November 27, 2017.

Analysis of the Senate Tax Reform Bill – Part I: Elimination of ACA Individual Mandate and Changes to Equity and Executive Compensation Rules

Early Saturday morning, the Senate voted 51-49 to approve a modified version of the Tax Cuts and Jobs Act (the “Senate Bill”). The Senate Bill differs from the House bill (discussed in an earlier series of posts here) passed last month in several respects, and a final negotiated bill will need to pass both chambers before the President can sign it into law. Given the difficulty of moving legislation through the Senate, it seems likely that any enacted legislation would likely be similar to the version passed by the House.

This post is the first in a series of three posts analyzing provisions of the Senate Bill. (Part II analyzes changes to deductions and exclusions for employee meals and other fringe benefits, changes to private retirement plan benefits, and a new paid leave credit.  Part III analyzes new reporting and withholding requirements and source rules.)  This post analyzes the following provisions:

  • Health Reform – eliminate the individual mandate penalties under the Affordable Care Act (“ACA”) after 2019.
  • Equity and Executive Compensation – (a) expand application of the limitation on excessive remuneration to covered employees of publicly‑traded corporations under Code section 162(m); (b) impose an excise tax on excess tax-exempt organization executive compensation; and (c) permit a deferral for up to five years for stocks pursuant to exercise of stock options and settlement of restricted stock units (“RSUs”) issued under broad‑based plans of privately-held corporations.

These changes generally would be effective after 2017, except as otherwise noted below.

Health Reform

Elimination of Individual Mandate Penalties after 2019.  Following multiple attempts to repeal and replace the ACA, including the individual and employer mandates (see discussions here), section 11081 of the Senate Bill would zero out penalties for failing to comply with the ACA’s individual mandate, effective starting in 2019.  As we have discussed in a previous post, zeroing out the individual mandate penalty would not directly affect the ACA’s information reporting requirements under Code sections 6055 and 6056.  Like earlier ACA repeal efforts, the Senate Bill does not eliminate the requirement for providers of minimum essential coverage to report coverage on Form 1095-B (or Form 1095-C) or offers of minimum essential coverage on Form 1095-C despite eliminating the penalty imposed on individuals for failing to maintain coverage.  Some of the information reported on these forms would still be necessary for the IRS to administer the premium tax credit, which both the House bill and Senate bill have thus far left intact.

Equity and Executive Compensation

Modification of Limitation on Excessive Employee Remuneration.  Code section 162(m) currently limits a publicly-traded company’s deduction for compensation paid to a “covered employee” to $1 million, with exceptions for performance-based compensation and commissions.  Like the House bill, section 13601 of the Senate Bill would make the following three changes.

  1. Repeal of Exceptions to Deduction Limitations. The Senate Bill would eliminate the exceptions for performance-based compensation and commissions under Code section 162(m)(4)(B) and (C). It is unclear whether the repeal of the performance-based pay exception will reverse the trend toward performance-based compensation, given that many shareholders and shareholder advocates believe that performance-based compensation can align shareholder and executive interests.
  2. Changes to the Definition of Covered Employee. Under the Senate Bill, a “covered employee” would include any individual who is the principal executive officer or principal financial officer at any time during the tax year and the three highest paid officers for the tax year (as disclosed to shareholders).  Further, if an individual is a covered employee after 2016, the individual would retain the covered‑employee status for all future years.
  3. Expansion of Deduction Limitation to Additional Corporations. The Senate Bill would also amend Code section 162(m)(2) to apply the limitation to any corporation that is an issuer under section 3 of the Securities Exchange Act of 1934 that (1) has a class of securities registered under section 12 of the Act or (2) is required to file reports under section 15(d) of the Act.  This change would extend the deduction limitation to corporations beyond those with publicly traded equity securities to include those that are required to file reports solely because they issue public debt.

Transition Relief. Unlike the House bill, the Senate Bill would provide that these changes would only apply to contracts that are entered into—or that are materially modified—after November 2, 2017 (see earlier coverage).  The House bill does not have a similar transition rule.

Excise Tax on Excess Tax-Exempt Organization Executive Compensation. Like the House bill, section 13602 of the Senate Bill would impose a new 20‑percent employer excise tax with respect to compensation paid post‑2017 by a tax-exempt organization (or a related entity) to a covered employee: (1) to the extent the compensation exceeds $1 million for the tax year; or (2) if the compensation constitutes an “excess parachute payment” (based on a measure of separation pay).  For these purposes, a “covered employee” means an employee who is among the tax-exempt organization’s five highest paid employees, or who was a covered employee for any preceding tax year beginning after 2016.

Five-Year Deferral for Stock Option and RSU Income under Broad-Based Plans of Privately-Held Corporations.  Currently, under Code section 83, the value of shares covered by options without a readily-ascertainable fair market value is includable in income at the time of exercise.  Like the House bill, section 13603 of the Senate Bill would allow “qualified employees” (excluding the CEO, CFO, and certain other top-compensated employees) to elect to defer for up to five years federal income taxation related to qualified stock.  Qualified stock means the stock of a privately-held corporation received upon exercise of a stock option or settlement of a RSU that was transferred in connection with the performance of services.  To be effective, an inclusion deferral election must be made no later than 30 days after the first time the employee’s rights in the stock are substantially vested or transferrable.  The inclusion deferral election would also be subject to the following rules:

Broad-Based Plans.  The election would only apply to a privately-held corporation that offers a written plan under which, in the calendar year, not less than 80 percent of all employees who provide services to the corporation in the United States “are granted” (and not merely be eligible for) stock options or RSUs with the “same rights and privileges” to receive the corporation’s stock. The determination of rights and privileges would be made under rules similar to existing rules under Code section 423(b)(5) (employee stock purchase plans).  This cross reference implies that the amount of the stock which may be purchased by the employee under the stock option or RSU may bear a uniform relationship to the employee’s total or regular compensation, provided that the number of shares available to each employee is more than a de minimis amount.

Stock Repurchase Limitations and Reporting.  An inclusion deferral election is not available if, in the preceding year, the corporation purchased any of its outstanding stock, unless at least 25 percent of the total dollar amount of the stock purchased is qualified stock subject to the election (“deferral stock”).  Generally, in applying this rule, an individual’s deferral stock to which the proposed election has been in effect for the longest period must be counted first.  A corporation that has deferral stock outstanding in the beginning of any calendar year and that purchases any of its outstanding stock during the year must report on its income tax return for that year the total value of the outstanding stock purchased during that year and other information as the IRS may require.

Deferral Period and Income Inclusion.  A stock to which an inclusion deferral election applies would be includable in income on the earliest of: (i) the first date the stock becomes transferrable; (ii) the date the recipient first becomes an excluded employee (generally, a 1% owner, an officer, or a highly-compensated employee); (iii) the first date any stock of the corporation becomes readily tradeable on an established securities market; (iv) five years after the earlier of the first date the recipient’s rights in the stock are transferable or are not subject to a substantial risk of forfeiture; or (v) the date on which the employee revokes his or her election (the “deferral period”).  The amount to be included in income following the deferral period, however, would be determined based on the value of the stock upon substantial vesting, regardless of whether the stock value has declined during the deferral period.

Coordination with Statutory Stock Option Rules.  An inclusion deferral election would be available with respect to statutory stock options.  If an election is made, these options would no longer be treated as statutory stock options or subject to Code sections 422 or 423.

Coordination with NQDC Regime and 83(b).  The inclusion deferral election would not apply to income with respect to unvested stock that is includible in income as a result of an election under Code section 83(b), which permits unvested property to be includable in income in the year of transfer.  The Senate Bill also clarifies that, apart from the new section 83(i), section 83 (including section 83(b)) shall not apply to RSUs.

Employee Notice.  A corporation that transfers qualified stock to a qualified employee must provide notice to the employee at the time (or a reasonable period before) that the employee’s right to the stock is substantially vested.  The notice must certify that the stock is qualified stock and notify the employee that: (1) if eligible, the employee may make an inclusion deferral election; (2) the amount includible in income is determined based on the value of the stock when it substantially vests, and not when the deferral period ends; (3) the taxable amount will be subject to withholding at the end of the deferral period; and (4) the employee has certain responsibilities with respect to required withholding.  The penalty for failing to provide the notice is $100 per failure, capped at $50,000 for all failures during any calendar year.

Withholding and Form W-2 Reporting.  Following the deferral period, the corporation must withhold federal income taxes on the amount required to be included in income at a rate not less than the highest income tax bracket applicable to the individual taxpayer.  The corporation must report on a Form W-2 the amount of income covered by an inclusion deferral election: (1) for the year of deferral; and (2) for the year the income is required to be included in the employee’s income.  In addition, for any calendar year, the corporation must report on Form W-2 the aggregate amount of income covered by inclusion deferral elections, determined as of the close of the calendar year.

Effective Date.  These changes would generally apply to stock attributable to options exercised or RSUs settled after 2017.  Until the IRS issues regulations on the 80-percent and employer notice requirements, a corporation will be treated as complying with these requirements if it complies with a reasonable good faith interpretation of them.  The penalty for failure to provide the employee notice would apply after 2017.