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

On December 15, the House-Senate Conference Committee released the joint explanatory statement and final legislative text (the “Final Bill”) resolving differences between the House- and Senate-passed versions of the Tax Cuts and Jobs Act (the “House Bill” and “Senate Bill,” respectively).  The provisions of the Final Bill related to health reform, equity and executive compensation, deductions and exclusions for employee meals and other fringe benefits, private retirement plan benefit, paid leave, and various reporting, withholding, and income sourcing rules, largely track the bill passed by the Senate.  Many of the changes included in the House Bill but not the Senate Bill were dropped from the Final Bill. (Our earlier coverage of the House and Senate bills can be seen in a series of posts here.)

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 will: change the methodology for determining the appropriate amount of federal income tax withholding on wages; require reporting for deductible amounts paid with respect to fines and penalties; require reporting for certain life insurance transactions; modify the reporting rules for Alaska Native Corporations; modify the sourcing rule for sale of inventory items; (f) modify the sourcing rule for U.S. possessions; and 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 will be effective after 2017, except as otherwise noted below.

Wage Withholding. The Final Bill follows the Senate Bill and will raise the standard deduction and suspend personal exemptions, which currently allow individuals to reduce their taxable income.  However, the suspension of personal exemptions will no longer apply for tax years beginning after December 31, 2025.  In recognition of the suspension of personal exemptions, the Final Bill will also change the method of determining the proper amount of federal income tax withholding on an employee’s wages, a change not reflected in the House or Senate bills.  Under current law, the amount of wages taken into account for withholding purposes is the amount by which the wages exceed the number of withholding exemptions claimed, multiplied by the amount of one such exemption, the value of which equals one personal exemption under Code section 151(b).  The Final Bill will amend Code section 3402(a)(2) to require withholding on the amount by which wages exceed the employee’s withholding allowance prorated to the payroll period.  The Final Bill amends Section 3402(f) to instruct the Treasury to issue regulations specifying the methodology for determining an employee’s withholding allowance based on (A) whether the employee can be claimed as a dependent on another return; (B) whether the employee’s spouse is entitled to a withholding allowance (if the spouse does not have in effect a Form W-4 claiming the allowance); (C) the number of individuals for whom the employee may be entitled to a credit under Code section 24(a); (D) any other allowances that the employee elects to take into account (such as estimated itemized deductions, estimated tax credits, and additional deductions); (E) the standard deduction allowable to the employee (one-half the standard deduction in the case of married employee whose spouse is receiving wages); and whether the employee has a Form W-4 in effect for more than one employer.

These changes will likely require the IRS to develop a new Form W-4, and employers to collect new Forms W-4 from employees.  As highlighted in an earlier post, the IRS has indicated that it is delaying its annual update to guidance on employer withholding pending the passage of tax reform.   The IRS has indicated that transition relief will be provided.

Withholding on Periodic Payments from Retirement Plans.  In recognition of the elimination of personal exemptions, the Final Bill instructs the Treasury to promulgate regulations for determining the amount of federal income tax to withhold on periodic payments from a qualified retirement plan, IRA, or other account subject to withholding under section 3405(a) when no Form W-4P is in effect.  Under current law, such payments were subject to wage withholding as though the payee was a married individual with 3 withholding exemptions.

Reporting of Deductible Amounts Paid with Respect to Fines and Penalties.  As in the Senate Bill, the Final Bill will 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 will generally apply to amounts paid or incurred on or after the date of enactment, except that the changes will not apply to binding orders or agreements entered into or subject to court approval before that date.

Reporting of Certain Life Insurance Transactions. As in the Senate Bill, the Final Bill will also adopt a new Code section 6050Y that will 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 will apply for reportable death benefits paid and reportable policy sales after 2017.

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 Final Bill follows the Senate Bill and modifies 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 will 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 will 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.  Like the House and Senate Bills, Section 14304 of the Final Bill will change this sourcing rule so that the entire amount will be sourced to the jurisdiction of production.

Sourcing Rule for U.S. Possessions. As in the Senate Bill, Section 14503 of the Final Bill will 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 bill will 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 bill will 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 Final Bill follows the Senate Bill and adds 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 Final Bill will 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 Code 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 Final Bill clarifies the grant of authority to the Secretary of the Treasury, instructing the Secretary to issue regulations appropriate to implement the new section.  Specifically, the conferees intend that the Secretary may issue guidance permitting a broker, as agent of the transferee, to perform the 10 percent withholding with respect to a partnership interest.

The changes will generally be effective for sales and exchanges on or after November 27, 2017, though the Final Bill provides that the withholding provisions are effective for sales or exchanges after December 31, 2017.

Analysis of the Final Tax Reform Bill – Part II: Changes to Deductions and Exclusions for Employee Meals and Other Fringe Benefits, Changes to Private Retirement Plan Benefits, and New Paid Leave Credit

On December 15, the House-Senate Conference Committee released the joint explanatory statement and final legislative text (the “Final Bill”) resolving differences between the House- and Senate-passed versions of the Tax Cuts and Jobs Act (the “House Bill” and “Senate Bill,” respectively).  The provisions of the Final Bill related to health reform, equity and executive compensation, deductions and exclusions for employee meals and other fringe benefits, private retirement plan benefit, paid leave, and various reporting, withholding, and income sourcing rules, largely track the bill passed by the Senate.  Many of the changes included in the House Bill but not the Senate Bill were dropped from the Final Bill. (Our earlier coverage of the House and Senate bills can be seen in a series of posts here.)

This post is the second 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 III analyzes new reporting and withholding requirements and source rules.)  This post analyzes the following changes:

  • Fringe Benefits– The Final Bill will eliminate the deduction for entertainment expenses; eliminate the deduction (after 2025) for meals provided for the employer’s convenience (that are not occasional overtime meals) and meals provided at employer-operated eating facilities; impose a 50-percent limitation on deductions for occasional overtime meals and other de minimis meals; eliminate the deduction for amounts excluded from an employee’s income as qualified transportation fringes; eliminate the deduction for commuting expenses (except for the employee’s safety); suspend the exclusion for qualified bicycle commuting reimbursement; suspend the exclusion for qualified moving expense reimbursement; and prohibit the use of cash or gift cards and other non-tangible personal property as employee achievement awards.  The Final Bill does not include the following provisions that were included in the House Bill: the disallowance of deductions for de minimis fringe benefits that are primarily personal in nature and not related to the employer’s trade or business; the disallowance of deductions for expenses related to on-site athletic facilities; the application to all employees of the deduction disallowance for specified individuals for the deduction of entertainment expenses treated as compensation in excess of the amount included in income; the elimination of the exclusion for employer-provided tuition assistance and qualified tuition reductions; the elimination of the exclusion for adoption assistance programs; the elimination of the exclusion for dependent care assistance; and the elimination of the exclusion for employee achievement awards.
  • Private Retirement Benefits– The Final Bill will extend the rollover time period of certain outstanding plan loan offsets treated as a distribution from a qualified retirement plan, a section 403(b) plan, or a section 457(b) plan solely on account of the termination of the plan or the failure to meet the repayment terms of the loan due to severance from employment.  The Final Bill will also waive the 10‑percent early withdrawal tax on distributions of up to $100,000 to an individual whose principal place of abode at any time during 2016 was located in a “2016 disaster area” as declared by the President, and who suffered economic loss due to the storm, flooding, or other disaster that occurred in the area during 2016; allows for the ratable inclusion in income of such distributions over a three-year period; and permits the repayment of such distributions into an eligible retirement plan during 2018.
  • Employer Tax Credits– The Final Bill includes the Senate Bill provision that would provide employer tax credits in 2018 and 2019 for paid family and medical leave.  The Final Bill does not adopt the changes included in the House Bill to the credits under Code section 42F for employer provided child care and Code section 45B for the employer share of Social Security taxes on certain employee tip income.  The Final Bill also does not change the Work Opportunity Tax Credit under Code section 51.

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

Fringe Benefits

Elimination of Deduction for Entertainment Expenses.  The Final Bill tracks the language of the Senate Bill and will completely disallow employer deductions for (1) entertainment, amusement, or recreation (“entertainment expenses”); (2) membership dues for clubs organized for business, pleasure, recreation or other social purposes; and (3) facilities used in connection with any of these items.  This full disallowance would replace the existing 50‑percent limit for entertainment expenses directly related to the active conduct of the employer’s trade or business.  The Final Bill does not include a provision from the House Bill that would have limited the exception for entertainment expenses treated as compensation to (or included in the gross income of) the recipient to the amount actually treated as compensation (or included in gross income of) the recipient as it is with employees that are “specified individuals” under current law.  (See earlier coverage.)

The Final Bill also does not impose a separate deduction limitation on “amenities,” which the House Bill defined as de minimis fringe benefits that are primarily personal in nature and that involve property or services not directly related to the taxpayer’s business.  (See earlier coverage.)

50-Percent Limitation on Deductions for Occasional Overtime Meals and Other De Minimis Meals. Currently, employers may generally deduct and employees may exclude from income meals that constitute de minimis fringe benefits under Code section 132(e).  De minimis meals may include occasional overtime meals, cocktail parties, group meals, and picnics for employees and their guests, and year-end holiday parties, in addition to meals provided at employer‑operated eating facilities.  Section 13304(b) of the Final Bill will generally impose a 50‑percent limitation on deductions for de minimis meals starting in 2018.  However, as described below, starting in 2026, employers would not be permitted to deduct any expenses for operating and providing meals through employer‑operated eating facilities (except to the extent the employees pay for the meals).  But, other types of de minimis meals would continue to be deductible, subject to the 50‑percent limitation.

Elimination of Deduction for Meals Provided for Employer’s Convenience (that are not Occasional Overtime Meals) and Employer-Operated Eating Facilities After 2025. Under existing law, employers may generally deduct (1) 50 percent of expenses for meals provided for the employer’s convenience under Code section 119; and (2) all expenses for the operation of and meals provided through an employer-operated eating facility that constitute de minimis fringe benefits under Treasury Regulation § 1.132-7 (but as described below, a 50-percent limitation would apply starting in 2018).  The Final Bill repeals these deductions effective in 2026.  After the repeal, if an employer chooses to provide meals to employees under section 119 or through an employer-operated eating facility, these meals would remain excludable from employees’ income and wages to the extent currently excludable under section 132, but the cost of providing them would not be deductible by the employer (except to the extent employees pay for the meals). The Senate Bill would not change the existing 50-percent deduction for other meal expenses associated with operating the employer’s trade or business (e.g., meals consumed by employees on work-related travel).

Elimination of Deduction for Qualified Transportation Fringes Excluded From Income.   Section 13304(c) of the Final Bill would disallow the deduction for providing any qualified transportation fringe benefits.  Under Code section 132(f), qualified transportation fringe benefits permit employers to either pay for an employee’s public transportation, van pool, bicycle, or parking expenses related to commuting on a pre-tax basis or allow employees to elect to receive a portion of their compensation in the form of non-taxable commuting benefits.  The Final Bill also clarifies that the deduction for qualified bicycle commuting reimbursement would be preserved from 2018 through 2025 (since the corresponding exclusion would be suspended during this period, as discussed below).

Elimination of Deduction for other Commuting Expenses (Except for Employee’s Safety).  Section 13304(c) of the Final Bill includes the Senate proposal that will disallow deductions for providing transportation (or any payment or reimbursement for related expenses) for commuting between an employee’s residence and the place of employment, except as necessary to ensure the employee’s safety.  Although it is unclear how the IRS would interpret the provision, the Final Bill could be read to disallow a deduction for transportation between an employee’s home and a temporary place of employment, which are currently fully deductible and excludable by the employee.  Ultimately, the effect of this change will depend upon how broadly the IRS interprets “place of employment,” which could be interpreted to include even temporary work locations away from an employee’s tax home.

Suspension of Exclusion for Qualified Bicycle Commuting Reimbursement.  As in the Senate Bill, section 11048 of the Final Bill would repeal the exclusion under Code section 132(f) for bicycle commuting expenses, making such benefits taxable to employees from 2018 through 2025.

Suspension of Exclusion for Qualified Moving Expense Reimbursement.  As expected, section 11048 of the Final Bill would largely suspend the exclusion from income and wages for a qualified moving expense reimbursement, which is employer-paid relocation assistance equal to the moving expenses that would have been deductible by the employee if he or she directly paid or incurred the cost.  As a result, employers who provide relocation assistance will either have to gross-up the amounts that would have been previously deductible or leave employees to pay more of the cost out-of-pocket.  The Final Bill would retain a narrow exclusion for members of U.S. Armed Forces on active duty who move pursuant to military orders.  In contrast to the permanent elimination in the House Bill, these changes would be effective from 2018 through 2025, as in the Senate Bill.

Prohibition on Use of Cash or Gift Cards and Other Non-Tangible Personal Property as Employee Achievement Awards.  The Final Bill retains the exclusion and deduction limitation for employee achievement awards but codifies proposed regulations defining “tangible personal property” for purposes of employee achievement awards.  Under Code sections 74(c)(1) and 274(j), employee achievement awards are excludable from income and deductible by the employer.  The House Bill would have eliminated the exclusion for employee achievement awards.

An “employee achievement award” is as an item of “tangible personal property” that meets certain other requirements without defining this term.  Treasury Regulations specify that tangible personal property does not include cash or any gift certificate other than a nonnegotiable gift certificate conferring only the right to receive tangible personal property.  In proposed regulations, the IRS provided a more comprehensive list of items that do not constitute tangible personal property, but these regulations were never issued in final form.  Section 13310 of the Final Bill would generally codify the list in the proposed regulations, to make clear that the following items do not constitute tangible personal property: (a) cash, cash equivalents, gift cards, gift coupons, or gift certificates (other than certificates conferring only the right to select and receive tangible personal property from a limited array of pre-selected items); (b) vacations, meals, lodging, tickets to theater or sporting events; and (c) stocks, bonds, other securities, and other similar items.

The restriction on gift certificates appears more restrictive than the current language of Treasury Regulation § 1.274-3(b) and the proposed regulations, which would permit employee achievement awards that are nonnegotiable gift certificates that provide only the right to receive tangible personal property.  The requirement that the employee be permitted to choose from a limited array of pre-selected items would appear to bless many common employee achievement programs, but is still more restrictive than existing law and the proposed regulations.  The Conference Summary stated, however, that “[n]o inference is intended that this is a change from present law and guidance.”

Private Employer Retirement Benefits

Extension of Time Period for Rollover of Certain Outstanding Plan Loans.  Under Code section 402(c)(3), a participant whose plan or employment terminates while he or she has an outstanding plan loan balance generally must contribute the loan balance to an individual retirement account (IRA) within 60 days of receiving an offset distribution.  Otherwise, the loan is treated as an impermissible early withdrawal and is subject to the 10‑percent early withdrawal penalty.  Like the Senate Bill and similar to the House Bill, section 13613 of the Final Bill would relax these rules by adding a new section 402(c)(3)(C) to give these employees until the due date for their individual tax return to contribute the outstanding loan balance to an IRA.  This new rule would only apply to loan offset amounts treated as distributed solely by reason of the termination of the plan or the failure to repay the loan because of the employee’s severance from employment.  The 10‑percent penalty would only apply after that date.

Qualified 2016 Disaster Distribution (for 2016 and 2017).  Like the Senate Bill, the Final Bill would provide disaster relief.  Section 11028 of the Final Bill, would waive the 10‑percent early withdrawal tax on distributions of up to $100,000 to an individual whose principal place of abode at any time during 2016 or 2017 was located in a “2016 disaster area” as declared by the President, and who suffered economic loss due to the storm, flooding, or other disaster that occurred in the area during 2016.  This relief is broader than that contained in the Senate Finance Committee language, which provided relief only to flooding and storm victims in the “Mississippi River Delta flood disaster area” during March 2016 (earlier coverage).  The distribution must be made during 2016 or 2017 to be exempt from the early withdrawal tax.  Additionally, any distribution required to be included in income as a result of this special distribution rule is included in income ratably over a three-year period, beginning with the year of distribution.  During this three-year period, amounts received may be re‑contributed to the plan and treated as a rollover, thus allowing the individual to file an amended return.  (For more information regarding special tax relief for victims of natural disasters, see our discussions of: (1) leave-based donation programs, leave-sharing programs, and relaxed plan loans and hardship withdrawal rules for victims of Hurricane Harvey and Irma; and (2) qualified disaster relief payments under Code section 139.)

Employer Tax Credits

Employer Tax Credit for Paid FMLA Leave for 2018 and 2019.  Section 13403 of the Final Bill includes a new section of the Code that will allow eligible employers to claim a general business credit equal to 12.5 percent of wages paid to a qualifying employee while on FMLA leave, plus 0.25 percent of wages (capped at 25 percent) for each percentage point by which the FMLA pay exceeds 50 percent of the employee’s normal pay.  An “eligible employer” is one that institutes a FMLA‑leave policy that: (a) allows all qualifying full-time employees not less than two weeks of annual paid family and medical leave (not counting leave paid by State or local government); (b) allows less-than-full-time employees a commensurate amount of leave on a pro rata basis; and (c) provide leave pay at a rate that is at least 50 percent of the employee’s normal pay.  A “qualifying employee” is an employee under the Fair Labor Standards Act who has been employed by the employer for at least one year, and whose preceding‑year compensation did not exceed 60 percent of the compensation threshold for highly compensated employees ($120,000 for 2017).  The Final Bill specified that the policy must be put in writing.

For each employee, the credit that the employer may claim is limited to 12 weeks of paid FMLA leave (including paid family and medical leave provided to qualifying employees that are not covered by Title I of the FMLA, provided the employer does not interfere with rights provided under the policy and does not discharge or discriminate against any individual for opposing practices prohibited by the policy).  Moreover, the employer may not deduct any portion of wages for which the employer claims the credit, but the employer can elect not to have the credit apply and deduct the paid leave instead.  Finally, as the credit is part of a pilot program, the credit would only be available in 2018 and 2019.

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

On December 15, the House-Senate Conference Committee released the joint explanatory statement and final legislative text (the “Final Bill”) resolving differences between the House- and Senate-passed versions of the Tax Cuts and Jobs Act (the “House Bill” and “Senate Bill,” respectively).  The provisions of the Final Bill related to health reform, equity and executive compensation, deductions and exclusions for employee meals and other fringe benefits, private retirement plan benefit, paid leave, and various reporting, withholding, and income sourcing rules, largely track the bill passed by the Senate.  Many of the changes included in the House Bill but not the Senate Bill were dropped from the Final Bill. (Our earlier coverage of the House and Senate bills can be seen in a series of posts here.)

This post is the first in a series of three posts analyzing provisions of the Final Bill.  (Part II will analyze 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 will analyze new reporting and withholding requirements and source rules.)  This post analyzes the following provisions:

  • Equity and Executive Compensation– The Final Bill includes provisions similar to the House and Senate Bill provisions that will expand application of the limitation on excessive remuneration to covered employees of publicly‑traded corporations under Code section 162(m); impose an excise tax on excess tax-exempt organization executive compensation; and 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.
  • Health Reform– The Final Bill includes the Senate Bill provision setting the individual mandate penalties under the Affordable Care Act (“ACA”) to zero after 2019.

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

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.  Similar to the House and Senate bills, section 13601 of the Final Bill would make the following three changes.

  1. Repeal of Exceptions to Deduction Limitations. The Final Bill will eliminate the exceptions for performance-based compensation and commissions under Code section 162(m)(4)(B) and (C).
  2. Changes to the Definition of Covered Employee. Under the Final Bill, the definition of “covered employee” will be amended to align with SEC reporting rules to 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.  This change has the effect of subjecting deferred compensation paid in a year after an individual is no longer an officer to the deduction disallowance.
  3. Expansion of Deduction Limitation to Additional Corporations. The Final Bill will 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, which would include all U.S. publicly‑traded companies and their foreign affiliates, or (2) is required to file reports under section 15(d) of the Act.  This change will also 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.  The Final Bill includes the transition relief included in the Senate Bill, so that these changes would apply only to contracts that are entered into—or that are materially modified—after November 2, 2017 (see earlier coverage).  The fact that a deferred compensation plan was in existence on November 2, 2017 is not by itself sufficient to qualify the plan for the exception for binding written contracts.  The Conference Summary clarifies that a renewal of a contract is treated as a new contract entered into on the day the renewal takes effect.  The House Bill does not have a similar transition rule.  The Conference Summary provides an example of how the transition relief works.  Suppose that a publicly‑traded corporation on October 2, 2017 hired an executive that is a covered employee.  Under the employment contract, the executive is eligible to participate in the employer’s deferred compensation plan.  Under the terms of the plan, participation is permitted after 6 months of employment, amounts payable are not subject to discretion, and the corporation does not have the right to amend materially the plan or terminate the plan (except on a prospective basis, i.e., before services are performed for the applicable period for which the compensation is to be paid).  Provided that the other conditions of the written binding contract are met (e.g., that the plan itself is in writing), the payments under the plan to the executive are grandfathered, even though the employee was not actually a participant in the plan on November 2, 2017.

Excise Tax on Excess Tax-Exempt Organization Executive Compensation.  Tracking a similar prevision in both the House and Senate bills, the Final Bill will impose a new 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).  The Final Bill ties the rate to the corporate tax rate, so that the excise tax will automatically match the corporate tax rate if it is changed in the future.  The Final Bill will treat compensation as paid when the right to the compensation is no longer subject to a substantial risk of forfeiture under section 457(f)(3)(B), even if the employee has not yet received the compensation.  In a change from the Senate and House bills, the Final Bill will exclude payments to licensed medical professionals for medical services and, for purposes of excess parachute payments, payments to non-highly compensation employees.  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 and Senate bills, the Final Bill will add a new section 83(i) to allow “qualified employees” (excluding the CEO, CFO, and certain other top-compensated employees and 1-percent owners) 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 will also be subject to the following rules:

Broad-Based Plans.  The election will 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 Final Bill and Summary clarify that stock options and RSUs cannot be aggregated for purposes of satisfying this 80‑percent threshold, and that this threshold is intended to be consistently applied to all eligible employees, whether they are new hires or existing employees. The determination of rights and privileges will be made under rules similar to existing rules under Code section 423(b)(5) (employee stock purchase plans).  Accordingly, 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.  The 80‑percent rule is applied to corporations on a controlled group basis pursuant to Code section 414(b).

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.  With respect to stock for which an inclusion deferral election is in place, the deferral period ends and the stock becomes 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 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 or increased 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.  Rather, they would be treated as nonqualified stock options for FICA purposes (in addition to being subject to section 83(i) for income tax purposes).

Coordination with Non-Qualified Deferred Compensation (“NQDC”) Regime and 83(b).  Qualified stock under section 83(i) will not be subject to section 409A.  The inclusion deferral election will 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 Final Bill specifies that apart from the new section 83(i), section 83 (including section 83(b)) will 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.  The amounts are treated as non‑cash fringe benefits for purposes of applying the withholding rules, and thus, employers may include them in income pursuant to the rules under IRS Announcement 85-113.

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 Final Bill clarifies that this transition rule only applies with respect to the 80‑perecent and employer notice requirements.  The penalty for failure to provide the employee notice would apply after 2017.

Major NQDC Proposal Not Adopted.  Both the House and the Senate initially proposed, but later revoked these proposals, to repeal Code section 409A and establish a new section 409B that would subject NQDC to taxation upon vesting.  The Final Bill does not revive these changes and accordingly, NQDC is still governed by Code section 409A.

Health Reform

Elimination of Individual Mandate Penalties after 2019.  The Final Bill will zero out penalties for failing to comply with the ACA’s individual mandate, effective in 2019.  Like earlier ACA repeal efforts, the Final Bill will 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 the Final Bill leaves intact.

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 Senate.

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 Senate.

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.