Employer Withholding Guidance Delayed Pending Tax Reform

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December 8, 2017

The increasingly likely prospect of a tax reform bill being enacted by the end of the year has prompted the IRS to delay annual withholding guidance, according to Scott Mezistrano of the IRS Wage and Investment Division’s Industry Stakeholder Engagement and Strategy Office.  It is expected that any tax reform bill would change tax rates, increase the standard deduction, and eliminate personal exemptions.  These changes will necessitate changes in withholding rates and withholding tables to ensure that employers withhold the appropriate amount of tax from employees’ wages.  Speaking on an IRS payroll industry monthly conference call on December 7, Mezistrano said that the guidance that will be delayed includes Form W‑4 (Employee’s Withholding Allowance Certificate), the withholding tables, Publication 15‑A (Employer’s Supplemental Tax Guide), and Publication 15‑B (Employer’s Tax Guide to Fringe Benefits).  Employers will likely be required to continue using the 2017 withholding tables and guidance into 2018, even if the tax reform legislation were to be signed into law before year end and the new tax rates were to take effect on January 1, 2018.  Employers would also be provided a transition period to implement the new IRS withholding guidance, according to Mezistrano.

Currently, a conference committee with selected lawmakers from both chambers is negotiating a final bill to reconcile the two versions of the GOP tax reform bill passed in the Senate (discussed here, here, and here) and in the House (discussed in an earlier series of posts).  A final negotiated bill would need to pass both chambers before the President can sign it into law.  We will continue to monitor tax reform legislation and related IRS guidance for further developments.

Fate of Employer Tuition Assistance Programs Hangs in the Balance

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December 8, 2017

On December 2, the Senate passed a version of the Tax Cuts and Jobs Act that differed in key respects from the House bill passed several weeks prior.  Notably, the House bill would eliminate the exclusion of up to $5,250 from an employee’s wages for qualified educational assistance under Code section 127 (discussed here), but the Senate bill would leave the exclusion in place.  While headlines address the more high-profile differences between the bills (e.g., the new corporate tax rate and the repeal of the ACA’s individual mandate), a number of large employers, including a number of our clients, have expressed concern about the fate of tuition assistance programs, as they view it as an important benefit for their employees.  This backlash is unsurprising, given that the Society for Human Resource Management (SHRM) estimates that over 60% of employers offer some form of tuition assistance.

The fate of the tuition assistance exclusion, as well as all other areas in which the House and Senate bills disagree, now rests with the conference committee.  The Senate bill also retains the exclusion for qualified tuition reductions provided by educational institutions that the House bill would eliminate, representing another education benefit that the conference committee will need to address.  The conference committee is tasked with reconciling the differences between the two bills, and it is expected that the process will conclude within the next one to two weeks.  Conference committees are notoriously unpredictable, making it difficult to anticipate the fate of the tuition assistance provision, particularly with many of the details of the final legislation in flux.  Though several major employers, as well as SHRM, have vocalized objections to the House bill’s proposed repeal, public criticism of a possible repeal has not been as strong as some had anticipated, a fact that could influence policymakers.

Educational Benefits that Qualify for Exclusion as Working Condition Fringe Benefits

Notably, neither version of the Bill would affect the ability of employees to exclude education benefits that qualify as working condition fringe benefits from taxable wages under Code section 132(d).  Working condition fringe benefits include any property or services that would have been deductible by an employee as a business expense had the employee paid for it his or herself.  Some employers have questioned whether the suspension of miscellaneous itemized deductions under Code section 67 under the Senate bill and the new Code section 262A that would be added by the House bill disallowing deductions for unreimbursed business expenses would eliminate the exclusion for working condition fringes because the expenses would no longer be deductible under Code section 162 by the employee if the employee had paid them directly.  The House bill directly addresses this by amending Code section 132(d) to specify that it is determined without regard to Code section 262A.  Although the Senate bill is silent, the change to section 67 would not seem to affect working condition fringes as the exclusion is currently applied without regard to the 2% of adjusted gross income floor that section 67 applies under current law.

Many employers offer educational benefits that qualify for exclusion as a working condition fringe benefit because the benefits are limited to education that maintains or improves job skills or meets requirements for the employee to remain in his or her current position.  One example would be a program under which the employer pays for continuing education courses for medical professional, lawyers, and accountants.  Education benefits that qualify as working condition fringes are more flexible than under Code section 127 because there is no dollar limit and a written plan is not required.  Travel and lodging expenses incurred as part of attending courses can also qualify for exclusion.

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 II: Changes to Deductions and Exclusions for Employee Meals and Other Fringe Benefits, Changes to Private Retirement Plan Benefits, and New Paid Leave Credit

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 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 – (a) eliminate the deduction for entertainment expenses; (b) 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; (c) impose a 50-percent limitation on deductions for occasional overtime meals and other de minimis meals; (d) eliminate the deduction for qualified transportation fringes; (e) eliminate the deduction for commuting expenses (except for the employee’s safety); (f) suspend the exclusion for qualified bicycle commuting reimbursement; (g) suspend the exclusion for qualified moving expense reimbursement; and (h) prohibit the use of cash or gift cards and other non-tangible personal property as employee achievement awards.
  • Private Retirement Benefits – (a) extend the rollover time period of certain outstanding plan loans; and (b) allow qualified distributions for victims of major disasters in 2016.
  • Employer Tax Credits – provide employer tax credits in 2018 and 2019 for paid family and medical leave.

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

Fringe Benefits

Elimination of Deduction for Entertainment Expenses. Similar to the House bill, section 13304(a) of the Senate Bill would 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.

Unlike the House bill, however, the Senate Bill would 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.) The Senate Bill would continue to permit deductions for such expenses to the extent currently permitted by law (as modified by the provisions relating to employer meals discussed below).

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). These deductions would be repealed under section 13304(d) of the Senate Bill, effective after 2025. 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).

The Senate Bill’s restrictive approach to meal deductions differs from the House bill’s approach of allowing full deductions for meals provide at employer‑operated eating facilities, meals provided for the employer’s convenience under section 119, and meals that otherwise qualify as de minimis fringe benefits, such as occasional overtime meals. Moreover, the Senate Bill’s deferred repeal at the end of the 10‑year budget window suggests that the repeal may have been part of an effort to ensure compliance with Senate reconciliation rules requiring that the Bill not increase the deficit outside of the budget window.

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 Senate Bill would generally impose a 50‑percent limitation on deductions for de minimis meals starting in 2018. As described above, 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 the other types of de minimis meals would continue to be deductible subject to the 50‑percent limitation.

Elimination of Deduction for Qualified Transportation Fringes. Like the House bill, section 13304(c) of the Senate Bill would disallow the deduction for providing any qualified transportation fringe benefits.  Under Code section 132(f), these 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. Although the Senate Bill does not change the existing income exclusion for commuting expenses (other than bicycle commuting expenses, discussed below) that constitutes de minimis fringe benefits, it would likely discourage employers from providing qualified transportation benefits to employees.

Elimination of Deduction for other Commuting Expenses (Except for Employee’s Safety). Unlike the House bill, section 13304(c) of the Senate Bill would further disallow deductions for providing transportation (or any payment or reimbursement for related expense) for commuting between an employee’s residence and the place of employment, except as necessary to ensure the employee’s safety. This deduction disallowance would appear to apply even to commuting benefits that are treated as taxable compensation to the employee. Although it is unclear how the IRS would interpret the provision, the Senate 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. Unlike the House bill, section 11048 of the Senate 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. Similar to the House bill, section 11049 of the Senate Bill would partially suspend the exclusion from income and wages for a qualified moving expense reimbursement, which is an employer-provided benefit capped at the amount deductible by the individual if he or she directly paid or incurred the cost.  The Bill would retain a narrow exclusion for members of U.S. Armed Forces on active duty who move pursuant to military orders. These changes would be effective from 2018 through 2025.

Prohibition on Use of Cash or Gift Cards and Other Non-Tangible Personal Property as Employee Achievement Awards.  Whereas the House bill would eliminate the exclusion and deduction limitation for employee achievement awards, section 13311 of the Senate Bill would retain the exclusion and deduction limitation but codify 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.  Section 274(j)(3)(A) defines an “employee achievement award” as an item of “tangible personal property” that meets certain other requirements without defining this term.  Under Treasury Regulation § 1.274-3(b), 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.  Under Proposed Regulation § 1.274-8(c)(2), 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.

The Senate Bill would basically 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 is 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.

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 House bill, section 13613 of the Senate Bill would relax these rules by adding a new section 402(c)(3)(B) to give these employees until the due date for their individual tax return to contribute the outstanding loan balance to an IRA.  The 10‑percent penalty would only apply after that date.

Qualified 2016 Disaster Distribution (for 2016 and 2017). Unlike the House bill, the Senate Bill would provide additional disaster relief.  Section 11029 of the Senate 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 Senate Bill would 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 Senate Bill would also allow eligible employers to take this credit for paid family and medical leave provided to qualifying employees that are not covered by Title I of the FMLA, provided the employer will not interfere with rights provided under the policy and will not discharge or discriminate against any individual for opposing practices prohibited by the policy. This is a change from the credit as proposed in the Senate Finance Committee language (earlier coverage).

For each employee, the credit that the employer may claim is limited to 12 weeks of paid FMLA leave. 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 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.

Senate Tax Reform Legislative Text Clarifies Some Provisions

Earlier today, the Senate Finance Committee released legislative text of its version of the Tax Cuts and Jobs Act.  Up until now, only “conceptual language” had been available.  The text clarifies some of the provisions that we have previously discussed in our posts about the Senate bill (see earlier discussions herehere and here) and includes new information reporting requirements that we have not previously covered:

  • The legislative text would disallow any deduction for meals provided at the convenience of the employer and meals provided in an “employer-operated eating facility.” If the employer chooses to offer food and beverages, they will remain excludable (to the extent currently excludable) from the employee’s income and wages under section 132, but the cost of providing them would not be deductible.  It is somewhat unclear what the effect of the deduction disallowance would be with respect to employer-operated eating facilities that collect sufficient revenue to cover their operating expenses.  Arguably, the provision could result in the employer recognizing revenue for the food and beverages sold to employees in the facility but having no deduction for the costs associated with selling food and beverages.  (Update: Upon further thought, we believe that the employer would not lose the deduction to the extent the employees pay for food and beverages purchased from the employer-operated eating facility because only the value of such food and beverages in excess of the amount paid is excludible from income under Code section 132(e) as a deminis fringe benefit.)  The new total deduction disallowance would be repealed for taxable years beginning after December 31, 2025, provided government revenue exceeds a target during the period 2018 through 2026.  The provision is effective if the cumulative on-budget Federal revenue from all sources for the 2018 through 2026 government fiscal years exceeds $28.387 trillion.
  • As expected, the text would eliminate the exclusion for bicycle commuting reimbursements, but in a surprise, the elimination is only temporary. The bill adds a new Code section 132(f)(8), which suspends the availability of section 132(f)(1)(D) from 2018 through 2025.  The exclusion would become available again in 2026.  This suggests that the Finance Committee’s decision to eliminate this exclusion may be driven more by revenue demands than by policy considerations, as it helps ensure the reconciliation bill meets the revenue target within the budget window.
  • Also as expected, the deduction for moving expenses and the related exclusion for qualified moving expense reimbursement were eliminated, but they too are only temporary suspensions. The bill would eliminate the deduction under Code section 217 and the exclusion under Code section 132(a)(6) (with an exception for active duty military moving pursuant to a military order and incident to a permanent change of station) from 2018 through 2025.  The exclusion would become available again in 2026.  Revenue demands likely also drove this change.
  • As we discussed in an earlier post, the Senate text makes changes to Code section 162(m) eliminating the exceptions for performance-based pay and commissions to the $1,000,000 deduction limitation for executive remuneration. However, unlike the conceptual language released earlier that contemplated an even broader expansion of the definition of “publicly held corporation,” the Senate text adopts a definition identical to the expanded definition in the House tax reform legislation (discussed here).  The Senate text does not include large private corporations as contemplated by the conceptual language.
  • The Senate text would add a new subsection (l) to Code section 272 that, as expected, eliminates the employer’s deduction for any expense, payment, or reimbursement for providing transportation to an employee in connection with travel between the employee’s work and the employee’s residence. This would eliminate the deduction for qualified transportation fringes, including van pool expenses, transit passes, parking, and other amounts excluded from the employee’s income under Code section 132(f).  This would seem likely to reduce the popularity of pre-tax transit programs under which employees elect to forgo taxable compensation in exchange for transit benefits, because the employer loses a deduction for compensation expenses that it would otherwise be entitled to as a result of the employee’s election to receive some of his or her compensation in the form of transit benefits.  The provision, as we speculated in an earlier post, does not carve out transportation reimbursements taxable to the employee.  For example, if an employee lives away from his tax home (i.e., his or her place of principal employment), the bill appears to disallow the compensation deduction if the employer elects to pay the employee for transportation costs between the employee’s residence and the office even though such amount is taxable to the employee.
  • As described in the Finance Committee’s conceptual language, the legislative text would adopt a new Code section 6050X. The language would require 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 that the government required or directed to be paid or incurred exceeds a threshold ($600, in the statute, but subject to adjustment by the Treasury).  The return must identify any amounts that are for restitution or remediation of property or correction of noncompliance, which are deductible, unlike fines and penalties paid under the agreement.
  • As also described in the Finance Committee’s conceptual language, the legislative text 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 with 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 December 31, 2017.
  • The Senate text would also adopt a new Code section 6050Z imposing three new information reporting requirements. The first would require taxpayers making research and experimental expenditures (as defined in Code section 174) to file an information return reporting the aggregate amount of such expenditures.  The second would require taxpayers making payments to a foreign person that is a related party (within the meaning of Code section 59A) to report the amount of such payments by type and any amount paid that results in a reduction of gross receipts to the taxpayer.  The third would require taxpayers that receive foreign-derived intangible income to file an information return that includes the aggregate amount of such income, the amount of foreign-derived deduction eligible income (as defined in section 250(b)(4)), and a certification that any foreign-derived deduction eligible income does not relate to the sale of products for any use, consumption, or disposition within the United States.  The text would impose a penalty of $1,000 per day up to $250,000 under Code section 6652(q) for failure to comply with these requirements.  The reporting requirements would be effective for taxable years beginning after December 31, 2024; however, it only takes effect (along with the associated changes to various deduction provisions) provided government revenue exceeds a target during the period 2018 through 2026.  The provision is effective if the cumulative on-budget Federal revenue from all sources for the 2018 through 2026 government fiscal years exceeds $28.387 trillion.

Tax Reform Proposals Advance in the House and Senate

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November 17, 2017

Yesterday, the full House passed its tax reform proposal, the Tax Cuts and Jobs Act (H.R. 1), on a party-line vote, 227-205.  In addition to the headline changes to the corporate and individual tax systems, the bill would make numerous changes to various fringe benefit exclusions, employer deductions for fringe benefits and executive compensation, cross-border withholding and sourcing, and employee retirement plans  (discussed here, here, here, herehere, here, and here).  Meanwhile, the Senate Finance Committee advanced its tax reform proposal, also on a party-line vote (14-12), with similar changes (discussed here and here).

Before advancing the proposal to the floor, the Senate Finance Committee adopted additional modifications to its existing proposal.  The new modifications included a change to the transition rule for the modified deduction limitation for executive compensation, a delay in the effective date of the new deduction disallowance for meals provided at the convenience of the employer and excluded from employee’s income under Code section 119 or 132(e)(6), and a definition of Mississippi River Delta flood disaster area and Mississippi River Delta flooding distribution for purposes of the retirement plan relief provided in the existing proposal:

  • The new transition relief for the deduction limitation under Code section 162(m) would apply the changes made in the proposal only to contracts entered into after November 2, 2017, and contracts materially modified after that date. The relief provided in the first modification to the chairman’s mark would have applied only if the compensation was no longer subject to a substantial risk of forfeiture before 2017.
  • The modification would delay the effective date for the deduction disallowance for meals provided for the employer’s convenience and meals provided at employer-operated eating facilities until 2026.
  • The modification defines “Mississippi River Delta flood disaster area” as an area subject to a Presidential major disaster declaration before March 31, 2016, by reason of severe storms and flooding occurring in Louisiana, Texas, and Mississippi during March 2016. A “Mississippi River Delta flooding distribution” is a distribution from an eligible retirement plan made on or after March 1, 2016, and before January 1, 2018, to an individual whose principal residence on March 1, 2016, was located in the Mississippi River Delta flood disaster area and who sustained an economic loss by reason of the severe storms and flooding that resulted in the Presidential disaster declarations.  (The modification also provides for an enhanced ability to claim a casualty loss deduction as a result of such storms and flooding.)

Modified Senate Tax Proposal Would Repeal ACA Individual Mandate and Certain Employer Meal Deductions, and Establish Five-Year Deferral Election for Stock Options and RSUs of Privately-Held Corporations

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November 16, 2017

On November 14, the Senate Finance Committee released modifications to its tax reform proposal (discussed here).  The Senate modification contains key changes in the following areas:

  • Health Reform – Repeal the individual mandate under the Affordable Care Act (“ACA”).
  • Fringe Benefits – (1) Disallow deductions for meals provided for the employer’s convenience that are not occasional overtime meals, and meals provided at an employer-operated eating facility; and (2) expand the income exclusion for length of service awards for public safety volunteers.
  • Private Retirement Benefits – (1) Strike the proposed elimination of catch-up contributions for high-wage employees; (2) extend the rollover time period of certain outstanding plan loans; (3) allow re-contribution of retirement plan distributions due to incorrect IRS levies; and (4) allow qualified distributions for victims of Mississippi River Delta flooding.
  • NQDC and Executive Compensation – (1) Eliminate the repeal of Code section 409A and the new rules for non-qualified deferred compensation (“NQDC”) included in the original tax reform proposal; (2) allow 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; and (3) provide transition relief for the expanded application of Code section 162(m).
  • Worker Classification and Information Reporting – (1) Eliminate the proposed worker classification safe harbor that would have applied for all purposes of the Code; and (2) eliminate the proposed changes to the reporting thresholds for filing Forms 1099-MISC and Forms 1099-K under Code sections 6041(a), 6041A(a), and 6050W.
  • Employer Tax Credits – Provide employer tax credits in 2018 and 2019 for wages paid to employees on leave under the Family and Medical Leave Act (“FMLA”).

We have summarized the key changes in the Senate modification, which generally would be effective after 2017, except as otherwise noted below.

Health Reform

Elimination of Individual Mandate Penalties.  After multiple attempts to repeal and replace the ACA, including the individual and employer mandates (see discussions here), Senate Republicans are proposing to zero out penalties for failure to comply with the ACA’s individual mandate, effective starting in 2019, as part of the tax reform bill.  Incorporating this repeal into the tax reform proposal carries risks and rewards.  Although the Congressional Budget Office (CBO) and Joint Tax Committee estimated that the repeal would raise $338 million over the next ten years (reducing the budget impact of the reform proposal), the CBO also estimates that the repeal would increase the number of uninsured people by 4 million in 2019 and 13 million in 2027.  This may complicate efforts to pass the tax reform package given the difficulty Republicans had in maintaining a majority during earlier efforts to repeal the ACA.

Information Reporting Implications.  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.  As with earlier ACA repeal efforts, the Senate modification 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.  These forms would still be necessary for the IRS to administer the premium tax credit, which GOP tax reform bills have thus far left intact.

Fringe Benefits

Disallowance of Deduction for Meals Provided for Employer’s Convenience (that are not Occasional Overtime Meals) and Meals Provided at Employer-Operated Eating Facilities.  Under existing law, taxpayers may generally deduct 50 percent of food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work-related travel and meals provided for the employer’s convenience under Code section 119), and fully deduct expenses for meals provided through an employer-operated eating facility that constitute de minimis fringe benefits under Treasury Regulation § 1.132‑7.  The initial Senate proposal would expand this 50-percent limitation to expenses of employer-operated eating facilities as defined under Code section 132(e)(6).  The Senate modification, however, would completely disallow deductions for meals provided for the employer’s convenience under Code section 119 or at an employer-operated eating facility.  Importantly, these changes would not affect the employer’s full deduction (and the employee’s full income exclusion) for occasional overtime meals that constitute de minimis fringe benefits under Treasury Regulation § 1.132‑6(d)(2).  This approach under the Senate modification differs from the House bill, which would not only maintain the full deduction for meals provided at an employer-operated eating facility that is a de minimis fringe benefit, but also remove the 50-percent deduction limitation on meals provided to employees for the employer’s convenience under Code section 119.

Expansion of Exclusion for Length of Service Awards for Public Safety Volunteers.  Under Code section 139B, bona fide volunteers (or their beneficiaries) may exclude “qualified payments,” which include reimbursement of reasonable expenses or other payment, including length of service awards, on account of performing qualified volunteer emergency response services.  The annual exclusion is limited to $30 multiplied by the number of months that the volunteer performs the services during the year.  The Senate modification would increase the exclusion for the aggregate amount of length of service awards to $6,000 in each service year, adjusted for cost of living.  Additionally, length of service awards structured as defined benefit plans would not have to comply with Code section 457, but the annual dollar limit would apply to the actuarial present value of the aggregate amount awards that have accrued under the plan.  This increased exclusion would not apply to other forms of qualified payments, such as reimbursements, which would still be subject to the $30 per service month limitation.

Private Employer Retirement Benefits

Repeal of Proposed Elimination of Catch-up Contributions for High-Wage Employees.  The Senate proposal would have repealed catch-up contributions for employees who receive wages of $500,000 or more for the preceding year.  The Senate modification would eliminate this change.

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 House bill, the Senate modification would relax these rules by allowing these employees until the due date for their individual tax return to contribute the outstanding loan balance to an IRA.  The 10‑percent penalty would only apply after that date.

Re‑Contribution of Incorrect IRS Levies.  Under existing law, amounts withdrawn from a qualified retirement plan on account of an IRS levy is includible in income in the same manner as other distributions, but the 10-percent early withdrawal penalty would not apply.  While the IRS may return these amounts pursuant to Code section 6343 if the levy was wrongful or not compliant with IRS administrative procedures, existing law does not allow an individual to re‑contribute these amounts.  The Senate modification would allow an individual to re‑contribute such amounts and any applicable interest (in the case of wrongful levies, but not levies in violation of IRS administrative procedures), without regard to the normally applicable limits on plan contributions and rollovers.  The amounts (and applicable interest) may also be contributed to a different IRA or plan to which a rollover would be permitted.

Qualified Mississippi River Delta Flooding Distribution.  Under the Senate modification, the early withdrawal tax would not apply to a distribution of up to $100,000 to an individual whose place of abode on August 11, 2016, was located in the Mississippi River Delta area, and who suffered economic loss due to the storm and flooding that occurred in the area during August 2016.  The distribution must be made on or after August 11, 2016, and before January 1, 2018, 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.)

NQDC and Executive Compensation

Repeal of Provisions Changing Taxation of Non-qualified Deferred Compensation.  As we discussed in our prior post, the Senate proposal would have enacted a new Code section 409B and repealed the current section 409A, and significantly restricted the conditions that qualify as a substantial risk of forfeiture.  As a result, NQDC would have become taxable at the time that it was no longer subject to future performance of substantial services.  The Senate modification announced on November 13 would eliminate that change, meaning that current section 409A would continue to apply going forward.

Five-Year Stock Deferral for Stock Options and RSUs Issued 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.  Additionally, they are exempt from taxation under section 409A because they are generally not considered deferred compensation when the exercise price equals or exceeds the fair market value of the underlying stock at the time of grant.  Like the House bill, the Senate modification would allow “qualified 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 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 date the recipient’s rights are not 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 section 83(b), which permits unvested property to be includable in income in the year of transfer.  The Senate modification also clarifies that, apart from the proposed change, section 83 (including 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) the employee’s right to the stock is substantially vested (and income attributable to the stock would first be includible absent an inclusion deferral election).  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.

Form W-2 Withholding and 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 applies after 2017.

Transition Relief for Modified Limitation on Excessive Employee Remuneration.  The Senate proposal would expand the $1 million deduction limitation under Code section 162(m) on compensation a publicly-traded corporation pays to a covered employee, by expanding the definition of a covered employee, eliminating the exceptions for performance-based compensation and commissions, and covering additional types of corporations.  The Senate modification would add a transition rule, such that the proposed changes would not apply to any remuneration under a written binding contract in effect on (and not materially modified after) November 2, 2017, and to which the right of the covered employee was no longer subject to a substantial risk of forfeiture before 2017.

Repeal of Proposed Worker Classification Safe Harbor and Changes to 1099-MISC/1099-K Reporting

The Senate proposal would have added a worker classification safe harbor for all purposes under the Code, to provide more certainty to independent contractors and “gig economy” workers regarding their worker classification.  It also would have changed the reporting thresholds for filing Forms 1099-MISC and Forms 1099-K under Code sections 6041(a), 6041A(a), and 6050W.  The Senate modification would eliminate these changes.

Employer Tax Credits

Employer Tax Credit for Paid FMLA Leave in 2018 and 2019.  To increase access to and promote paid FMLA leave, the Senate modification would 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 allows all qualifying full-time employees not less than two weeks of annual paid FMLA leave (not counting leave paid by State or local government), and that allows less-than-full-time employees a commensurate amount of leave on a pro rata basis.  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 Senate modification would establish the credit as a pilot program in 2018 and 2019, and instruct the Government Accountability Office (GAO) to study the credit’s effectiveness for increasing access to and promoting paid FMLA leave.

Impact of Senate Tax Reform Proposal – Changes to Fringe Benefits, Retirement Plans, NQDC and Executive Compensation, Workers Classification, and 1099-MISC/1099-K Reporting

Post by
November 14, 2017

UPDATE 11/16/2017

On November 14, the Senate Finance Committee released modifications to its tax reform proposal.  The Senate modification contains key changes in the following areas (and we have summarized these changes here):

  • Health Reform – Repeal the individual mandate under the Affordable Care Act (“ACA”).
  • Fringe Benefits – (1) Disallow deductions for meals provided for the employer’s convenience that are not occasional overtime meals, and meals provided at an employer-operated eating facility; and (2) expand the income exclusion for length of service awards for public safety volunteers.
  • Private Retirement Benefits – (1) Strike the proposed elimination of catch-up contributions for high-wage employees; (2) extend the rollover time period of certain outstanding plan loans; (3) allow re-contribution of retirement plan distributions due to incorrect IRS levies; and (4) allow qualified distributions for victims of Mississippi River Delta flooding.
  • NQDC and Executive Compensation – (1) Eliminate the repeal of Code section 409A and the new rules for non-qualified deferred compensation (“NQDC”) included in the original tax reform proposal; (2) allow 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; and (3) provide transition relief for the expanded application of Code section 162(m).
  • Worker Classification and Information Reporting – (1) Eliminate the proposed worker classification safe harbor that would have applied for all purposes of the Code; and (2) eliminate the proposed changes to the reporting thresholds for filing Forms 1099-MISC and Forms 1099-K under Code sections 6041(a), 6041A(a), and 6050W.
  • Employer Tax Credits – Provide employer tax credits in 2018 and 2019 for wages paid to employees on leave under the Family and Medical Leave Act (“FMLA”).

ORIGINAL POST

Last Thursday, the Senate Finance committee released its tax reform proposal, a day before the House Ways and Means Committee approved the House tax reform bill after adopting two amendments (see unified House bill discussed in our five-part series).  Written in “concept language” as opposed to legislative text, the Senate proposal contains various changes affecting employer‑provided fringe benefits, qualified retirement benefits, nonqualified deferred compensation (“NQDC”) and executive compensation, worker classification, and thresholds for filing Forms 1099-MISC and Forms 1099-K under Code sections 6041, 6041A, and 6050W.  Some of these changes are similar to those proposed under the House bill, but there are key divergences.

We have summarized these changes, which generally would be effective after 2017, except as otherwise noted below.

Fringe Benefits

With respect to fringe benefits, the Senate proposal is generally more employee-friendly than the House bill, in that the Senate proposal would not repeal or limit the fringe benefit exclusions for employer-provided lodging, dependent care assistance programs, educational assistance programs and qualified tuition reductions, and adoption assistance programs (see discussion of the House bill’s changes to employer-provided fringe benefits in Part I and entertainment expenses and other fringe benefit deductions in Part II of our series).  But the Senate proposal would more aggressively limit deductions for meal expenses provided at an employer-operated eating facility, as well as make the following changes:

  • Total Disallowance of Deductions for Entertainment Expenses.  Similar to the House bill, the Senate proposal would 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. Thus, the Senate proposal would replace the existing 50-percent limitation for entertainment expenses directly related to the active conduct of the employer’s trade or business with a full disallowance.  Unlike the House bill, however, the Senate bill would not impose a separate deduction limitation on “amenities,” which the House bill defined as a de minimis fringe benefit that is primarily personal in nature and involving property or services that are not directly related to the taxpayer’s business.  The House bill’s amenities provision would seemingly deny deductions for most de minimis fringe benefits unless the expense qualified for one of the exceptions under Code section 274(e)—e.g., expenses for food and beverages (and facilities used in connection therewith) furnished on the business premises of an employer primarily for its employees; reimbursed expenses; expenses treated as compensation to (or included in the gross income of) the recipient; recreational, social, and similar activities primarily for the benefit of employees other than highly compensated employees; items available to the public; entertainment sold to customers.  The Senate proposal would continue to permit deductions for such expenses to the extent currently permitted by law.
  • 50-Percent Deduction Limitation Applied to Eating Facilities. While taxpayers may still generally deduct 50 percent of food and beverage expenses associated with operating their trade or business (g., meals consumed by employees on work-related travel), the Senate proposal would expand this 50-percent limitation to expenses of employer-operated eating facilities as defined under Code section 132(e)(6), expenses which currently are fully deductible provided they satisfy the requirements for de minimis fringe benefits.  This approach differs from the House bill, which would not only maintain the full deduction for meals that are treated as being provided at an employer-operated eating facility that is a de minimis fringe benefit, but also remove the 50-percent deduction limitation on meals provided to employees for the employer’s convenience under Code section 119.
  • Disallowance of Deductions for Qualified Transportation Fringes. Like the House bill, the Senate proposal would disallow the deduction for providing any qualified transportation fringe benefits.  Under Code section 132(f), these fringe benefits permit employees 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 Senate bill would also repeal the exclusion under Code section 132(f) for bicycle commuting expenses, making such benefits taxable to employees.
  • Disallowance of Deductions for Commuting Expenses. Unlike the House bill, the Senate proposal would further disallow deductions for providing transportation (or any payment or reimbursement for related expense) for commuting between an employee’s residence and place of employment, except as necessary to ensure the employee’s safety.  This deduction disallowance would appear to apply even to commuting benefits that are treated as taxable compensation to the employee, but it is difficult to tell for certain given the Committee’s use of conceptual language.  Although the proposal does not change the existing exclusion for occasional overtime taxi fare that constitutes de minimis fringe benefits, it would discourage employers from providing commuting benefits.
  • Elimination of Exclusion for Employer-Paid Moving Expenses. The Senate proposal would repeal the exclusion from income and wages for a qualified moving expense reimbursement, which is an employer-provided benefit capped at the amount deductible by the individual if he or she directly paid or incurred the cost.  The House bill, by contrast, would retain a narrow exclusion for members of U.S. Armed Forces on active duty who move pursuant to military orders (discussed here).

Private Employer Retirement Benefits

In the area of retirement plans sponsored by private employers, the House bill loosened the hardship withdrawal rules, reduced the minimum age for in-service distributions, extended the time period for rollover of certain plan loans, and provided additional nondiscrimination testing options for closed defined benefit plans (see Part III).  By contrast, the Senate proposal does not contain any of these changes, but would make the following change:

  • Elimination of Catch-up Contributions for High-Wage Employees. Under existing law, contributions to account-based qualified retirement plans—including defined contribution plans, 403(b) plans, and 457(b) plans—are subject to an annual limit of the lesser of a specific dollar amount and the employee’s compensation.  For employees age 50 or older, the specific dollar amount is increased (generally $6,000 for 2017), allowing the employee to make “catch-up” contributions for the year.  The Senate proposal would eliminate catch-up contributions for employees who receive wages of $500,000 or more for the preceding year.

NQDC and Executive Compensation

Regarding NQDC and executive compensation, the Senate proposal is similar to the House bill insofar as it would expand the deduction limitation on excessive employee remuneration pursuant to Code section 162(m), and create an excise tax on excess tax-exempt organization executive compensation (see Part IV).  But the Senate proposal would adopt a new regime that subjects NQDC to taxation upon vesting, a regime that was included in the originally introduced House bill but was removed by the second amendment adopted by the Ways and Means Committee in favor of retaining the existing regime under Code section 409A (discussed here).

  • Non-qualified Deferred Compensation. Currently, NQDC that complies with Code section 409A is not included in an employee’s income until the year received, and the employer’s deduction is postponed until that date. Like the initial House bill (prior to the second amendment), the Senate proposal would impose a new regime with respect to NQDC for services performed after 2017.  Under the new regime, NQDC would become taxable upon becoming no longer subject to a “substantial risk of forfeiture,” a term narrowly defined as including only the future performance of substantial services.  For these purposes, NQDC would include stock options and stock appreciation rights, even if not yet exercised.  Amounts deferred for services performed before 2018 would remain subject to the current regime and section 409A until the later of 2025 or the taxable year in which the substantial risk of forfeiture lapses, at which point all pre-2018 deferrals would be includible in income.  The Senate proposal would direct the IRS to establish transition rules allowing early payment without violating section 409A.  Finally, the Senate proposal would also eliminate Code sections 457A and 457(f), since all post-2017 deferrals would be governed by section 409B.
  • 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, the Senate proposal would eliminate the exceptions for performance-based compensation and commissions paid after 2017, as well as modify the definition of a “covered employee.” Under the proposal, 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.  Finally, the Senate proposal would also expand section 162(m) to apply to corporations beyond those with publicly traded securities.  The House bill would extend section 162(m) to any corporation that is required to file reports under section 15(d) of the Securities Exchange Act of 1934.  In contrast, the Senate proposal would extend section 162(m) to all domestic publicly‑traded corporations and all foreign companies publicly traded through American Depository Receipts, and contemplates covering “certain additional corporations that are not publicly traded, such as large private C or S corporations.”
  • Excise Tax on Excess Tax-Exempt Organization Executive Compensation. Like the House bill, the Senate proposal would impose a 20‑percent excise tax on the employer 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 a preceding tax year beginning after 2016.

Worker Classification Safe Harbor

In a significant departure from the House bill and existing law, the Senate proposal wades bravely into worker classification disputes by creating a worker classification safe harbor.  This proposed change reflects legislation introduced in July by Senator John Thune (R‑SD) to provide more certainty to independent contractors and “gig economy” workers regarding their worker classification.  If the safe harbor requirements are met, a service provider would be treated as an independent contractor and the service recipient as a non-employer customer for all purposes under the Code.  If the safe harbor requirements are not met, workers classification would still be governed by the applicable existing common law or statutory rules.   The proposal instructs Treasury to issue regulations necessary for implementing the new safe harbor.

Safe Harbor Requirements.  The safe harbor imposes three groups of objective criteria to ensure the independence of the service provider from the service recipient:

  1. Parties’ Relationship – The service provider generally must incur his or her own business expenses, agree to specific tasks or projects, and not be tied to a single service recipient. The service provider may not own any interest—other than publicly traded stock—in the service recipient. In addition, the service provider cannot have provided substantially the same services to the service recipient as an employee during the one-year period ending on the date of the commencement of services under the contract.  (Accordingly, the safe harbor may be unavailable for former executives who transition to consultant status as part of a phased retirement plan.)  The service provider also may not be compensated primarily on the basis of hours worked (and in the case of an independent sales agent, must be compensated primarily on a commission basis).
  2. Location and Means – The service provider must provide his own tools and supplies, have his or her own place of business and not work primarily at the service provider’s location, or the service provider must provide a fair market rent for the use of the service recipient’s place of business.
  3. Written Contract – The parties must have a signed written contract stating the independent-contractor relationship, acknowledging that the service provider is responsible for the payment of his or her own taxes (including self-employment taxes) and that the service recipient (or the payor) has certain reporting and withholding obligations (discussed below). Additionally, the term of the contract must not exceed two years, though it may be renewed for successive two-year periods by a signed written agreement.

Reporting and Withholding.  As under current law, amounts paid by a service recipient to the service provider under the safe harbor would be reported to the IRS under Code sections 6041(a) or 6041A(a) (or section 6050W, if paid via a payment card or third-party network transaction), subject to the increased reporting thresholds described below.  However, under current law, amounts paid to independent contractors are not typically subject to federal income tax withholding unless backup withholding is required (for example, because the contractor did not provide a TIN before payment).  The Senate proposal would create a new withholding obligation that requires the service recipient or payor to withhold 5 percent of the first $20,000 in compensation paid pursuant to contract.   It is unclear whether the withholding requirement would apply over the life of the contract or to the first $20,000 paid annually under the contract.

Reasonable Cause Relief.  The Senate proposal also addresses cases where service providers and service recipients (or payors) mistakenly believe that they have satisfied the safe harbor requirements.  In these cases, as long as the mistake was due to reasonable cause and not willful neglect, the IRS would be permitted to reclassify the relationship as an employee-employer relationship—but only prospectively.

Effective Date.  The safe harbor would be available for services performed—and compensation for these services paid—after 2017.  Service recipients, payors, and required written contracts would not be treated as failing to meet the safe harbor requirements with respect to compensation paid to a service provider within 180 days after the Senate proposal’s enactment.

Information Reporting Thresholds Under Section 6041, 6041A, and 6050W 

The Senate proposal would change the reporting thresholds for filing Forms 1099-MISC and Forms 1099-K under Code sections 6041(a), 6041A(a), and 6050W.  The reporting threshold for Forms 1099-MISC would be increased from $600 to $1,000 with respect to payments reportable under sections 6041(a) and 6041A(a).  These changes would affect, for instances, reporting of non-employee compensation on Forms 1099-MISC.

In contrast, the threshold under section 6050W for reporting third-party network transactions by third-party settlement organizations (“TPSOs”) would be decreased to $1,000 from the current “de minimis” threshold of $20,000 in aggregate transactions and more than 200 transactions.  Certain TPSOs that qualify as “marketplace platforms” may instead elect to report once the transactions with a participating payee either exceed $5,000 or 50 transactions provided that substantially all of the participating payees for whom it settles transactions are engaged in the sale of goods.  TPSOs that do not qualify as “marketplace platforms” may apply the new de minimis threshold with respect to participating payees that are primarily engaged in the sale of goods.  These changes would be effective for payments made after December 31, 2018.

House Ways and Means Committee Approves Second Amendment to Tax Cuts and Jobs Act

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November 9, 2017

Today, the House Ways and Means Committee approved a new amendment to the Tax Cuts and Jobs Act (H.R. 1) (the “Bill”) offered by Chairman Brady as part of the on-going markup (the “Second Amendment”).  The Committee reported the Bill, as modified by the Brady amendment, on a partisan vote of 24-16.  This marks the second major revision to the Bill and makes changes on top of those contained in the first of which affected provisions related to dependent care assistance programs and deferred compensation (the “First Amendment,” discussed here).  For further information on the Bill, please see our series of posts highlighting provisions of the Bill affecting topics pertinent to our readers, all of which are linked in the final post in this series.

Repeal of Provisions Changing Taxation of Non-qualified Deferred Compensation.  As we discussed in our prior post, Section 3801 of the original Bill text enacted a new Code section 409B and repealed current section 409A, which would have significantly restricted the conditions that qualify as a substantial risk of forfeiture, such that non-qualified deferred compensation would have become taxable immediately unless it was subject to future performance of substantial services.  This restriction was not popular, and Chairman Brady’s amendment would eliminate Section 3801 in its entirety, meaning that current section 409A would continue to apply going forward.

In addition, Chairman Brady’s First Amendment added a new Section 3804 to the Bill that would, through the addition of a new subsection 83(i) to the Code, allow certain employees of privately-held companies the ability to defer income on shares of stock covered by options and restricted stock units (RSUs).  The Second Amendment would clarify that no provision of section 83 applies to RSUs other than section 83(i), meaning that employees cannot make section 83(b) elections with respect to RSUs.

Limited Retention of Exclusion for Employer-Paid Moving Expenses.  As discussed previously, Section 1405 of the Bill would eliminate the exclusion from income and wages available under Code section 132(a)(6) for a qualified moving expense reimbursement.  The Second Amendment would retain this exclusion for members of the U.S. Armed Forces on active duty who move pursuant to military orders.

Ways and Means Committee Approves Amendment to Tax Cuts and Jobs Act

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November 8, 2017

As part of the on-going markup of the Tax Cuts and Jobs Act (H.R. 1) (the “Bill”), Chairman Brady of the House Ways and Means Committee introduced a sizeable amendment to the Bill that was approved on Monday evening, affecting the changes made to the exclusion for dependent care assistance programs (DCAP) and introducing a new rule affecting income deferral on privately-held stock options and restricted stock units (RSUs).  We have been releasing a series of posts to highlight the provisions of the Bill affecting the topics pertinent to our readers, all of which are linked in the most recent post in this series.

Elimination of Exclusion for Dependent Care Assistance Programs.  As we explained in Part I of our series on the Bill, under Code section 129, the value of employer-provided DCAP is generally excluded from an employee’s income and wages up to $5,000 per year, and employees frequently take advantage of this exclusion through a dependent care flexible spending account that is part of a cafeteria plan under Code section 125.  Previously, Section 1404 of the Bill would have repealed this exclusion in its entirety, effective for tax years beginning after 2017.  The amendment to Section 1404 of the Bill delays the effective date of this repeal, eliminating the exclusion for tax years beginning after 2022.

New Rules Regarding Income Deferral for Stock Options and Restricted Stock Units Issued by a Privately-Held Corporation.  The amendment added a new Section 3804 to the Bill, which would allow certain employees of privately-held companies the ability to defer income on shares of stock covered by options and RSUs.  Currently, pursuant to 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.  Additionally, they are exempt from taxation under Code section 409A because they are generally not considered deferred compensation when the exercise price equals the fair market value at the time of grant.

Section 3804 of the Bill would add a new subsection 83(i) to the Code, which would allow “qualified” employees to elect to defer income related to stock of a privately-held corporation received upon stock option exercise or RSU settlement by making an election no later than 30 days after the first time the employee’s rights in such stock are transferrable or no longer subject to a substantial risk of forfeiture.  Following such an election, the stock would be includable in income on: (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 date the recipient’s rights are not transferable or are not subject to a substantial risk of forfeiture; or (v) the date on which the employee revokes his or her election.  This change to section 83, in conjunction with the fact that the Bill would specifically include stock options within the definition of deferred compensation for purposes of what would be new section 409B (previously discussed here), suggests that Congress may intend to make stock options taxable upon vesting, even if the options do not yet have a readily-ascertainable fair market value.  Another issue raised by this new subsection 83(i) relates to whether section 83(b) elections, which currently permit unvested property to be includable in income in the year of transfer, should be expanded to allow such elections for stock options.  Indeed, section 83(i) seems to envision such a change: the new election provided for under section 83(i) is explicitly barred for any stock options with respect to which an employee has already made a section 83(b) election.

Impact of Tax Cuts and Jobs Act: Part V – Certain Changes Affecting Cross-Border Withholding and Sourcing

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November 6, 2017

Thursday, November 2, the House Ways and Means Committee released the Tax Cuts and Jobs Act (H.R. 1) (the “Bill”), a bill that, if enacted, would represent the most substantial overhaul of the U.S. tax code in decades.  We are releasing a series of posts to highlight the provisions of the Bill affecting the topics pertinent to our readers, where each post will cover a different area of importance.  Part I of this series covered potential changes to employer-provided benefits, Part II addressed entertainment expenses and other fringe benefits, Part III discussed changes to employee retirement plans, and Part IV covered changes to the Code section 162(m) deduction limitation for executive compensation.  In this Part V, we will discuss the Bill’s potential impact on two cross-border tax issues.

Reduced FIRPTA Withholding Rates.  Under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), gain or loss on the disposition of U.S. real property interests by a nonresident alien individual or foreign corporation is subject to U.S. income tax as though the taxpayer were engaged in a trade or business in the United State and such gain or loss were effectively connected with such trade or business.  Section 1445 applies a withholding mechanism to ensure the payment of any tax due.  When a domestic partnership, trust, or estate disposes of a U.S. real property interest, section 1445 requires that it (or the trustee or executor, in the case of a trust or estate, respectively) withhold 35 percent of the gain realized that is allocable to a foreign person (or allocable to a portion of a trust treated as owned by a foreign person).  Similarly, when a foreign corporation distributes a U.S. real property interest to its shareholders, it must withhold at a rate of 35 percent.  The same withholding rate applies to distributions that are treated as gains or losses from the disposition of a U.S. real property interest allocable to foreign persons from certain domestic entities (such as real estate investment trusts and registered investment companies that would be considered U.S. real property holding corporations if their shares were not publicly traded).  Section 3001 of the Bill, which reduces corporate tax rates in general, includes a corresponding reduction of the FIRPTA tax withholding rate, modifying paragraphs 1445(e)(1), 1445(e)(2), and 1445(e)(6) to require withholding at a 20 percent rate.  The reductions would take effect for tax years beginning after 2017.

Modification to Sourcing Rule for Sales of Inventory Property.  Currently, up to 50 percent of income from the sale of inventory property produced entirely within the United States and sold outside the United States (or vice-versa) can be treated as foreign-source income for purposes of calculating foreign tax credits.  Section 4102 of the Bill would require sales of inventory property to be sourced solely based on the location of production activity with respect to the inventory.  This change would be effective for tax years beginning after 2017.

Impact of Tax Cuts and Jobs Act: Part IV – Changes to the Section 162(m) Deduction Limitation for Executive Compensation

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November 3, 2017

Yesterday, the House Ways and Means Committee released the Tax Cuts and Jobs Act (H.R. 1) (the “Bill”), a bill that, if enacted, would represent the most substantial overhaul of the U.S. tax code in decades.  We are releasing a series of posts to highlight the provisions of the Bill affecting the topics pertinent to our readers, where each post will cover a different area of importance.  In Part I of this series, we covered potential changes to employer-provided benefits, and in Part II, we addressed entertainment expenses and other fringe benefits.  In Part III, we discussed the Bill’s potential impact on various retirement provisions.  In this Part IV of the series, we address proposed changes to the deduction limitation for executive compensation under Code section 162(m).

Currently, Code section 162 allows as a deduction all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.   This includes a deduction for reasonable compensation for personal services actually rendered.   However, Code section 162(m) limits the deduction of any publicly held corporation with respect to compensation paid to a “covered employee” to $1 million.   However, certain types of compensation—such as qualified performance-based compensation and commissions—are not subject to the deduction limitation.  Covered employees are defined to include the chief executive officer (“CEO”), as of the close of the taxable year and the officers whose compensation is required to be reported to shareholders by reason of being among the three most highly compensated officers for the taxable year (other than the CEO).

Section 3802 of the Bill would amend section 162(m) in three key ways: (1) it would eliminate the exceptions for qualified performance-based pay and commissions; (2) it would extend the deduction disallowance to a broader array of companies; and (3) it would amend the definition of covered employee to more closely align with current SEC disclosure requirements and make covered employee status permanent.

Repeal of Exceptions to Deduction Limitation.  Many public companies pay covered employees primarily in the form of performance-based compensation to avoid the effect of the deduction limitation.  This exception applies to many forms of equity-based compensation— most stock options, stock appreciation rights, restricted stock, and restricted stock units—and many annual and long-term cash incentive compensation plans.  The Bill would repeal Code sections 162(m)(4)(B) and (C), removing the exceptions for performance-based compensation and commissions.  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.

Expansion of Deduction Limitation to Additional Corporations.  Currently, the deduction limitation applies only to corporations that issue a class of common equity securities required to be registered under section 12 of the Securities Exchange Act of 1934 (the “’34 Act”).  The Bill would amend Code section 162(m)(2) to apply the limitation to any corporation that is an issuer under section 3 of the ’34 Act that (1) has a class of securities registered under section 12 of the ’34 Act or (2) is required to file reports under section 15(d) of the ’34 Act.  This would extend the deduction limitation to corporations beyond those with publicly traded equity securities to include those are required to file reports solely because they issue public debt.

Change to the Definition of Covered Employee.  Code section 162(m)(3) defines covered employee to include the CEO (or the individual acting in such capacity) as of the last day of the tax year and the four officers whose compensation is required to be disclosed to shareholders because the officer is one of the four most highly compensated officers for the tax year.  However, because of a change to the cross-referenced section of the ’34 Act, the IRS interpreted the limitation as applying to only the principal executive officer (generally, the CEO) and the three most highly compensated officers other than the CEO and CFO in Notice 2007-49.  Compensation paid to the CFO was not subject to the deduction limitation regardless of how much he or she was paid.

The Bill would amend the definition of covered employee to align it more closely with current SEC disclosure rules.  Under the Bill, covered employees would include employees who, at any time during the tax year, were the principal executive officer or principal financial officer, and the three officers whose compensation is required to be disclosed to shareholders because they are the three most highly compensated officers during the tax year (other than the principal executive officer).  As a result, the deduction limitation could apply to a variable number officers for any given tax year depending upon whether more than one individual serves as either the principal executive officer or principal financial officer during the tax year and whether the principal financial officer is among the three most highly compensated officers during the tax year.

The Bill would also add a third category of covered employee: individuals who were covered employees of the employer (or any predecessor) for any preceding tax year beginning after December 31, 2016.  Accordingly, the Bill has the effect of making covered-employee status permanent.  Under current law, employees (and former employees) who are no longer officers of the employer as of the last day of the tax year are not covered employees.  As such, the deduction for compensation that is deferred until a date after the employee is no longer a covered employee is not subject to the limitation under Code section 162(m).  The Bill would eliminate this strategy for avoiding the deduction limitation.  Moreover, the Bill specifies that covered-employee remuneration that is includible in the income of, or paid to, someone other than a covered employee, such as a beneficiary of a covered employee after the covered employee’s death, remains subject to the deduction limitation.  Given the changes to the taxation of nonqualified deferred compensation in the Bill (and discussed in Part III of our series), the utility of this strategy for avoiding the deduction limitation would have been greatly reduced even without this amendment.

The amendments to Code section 162(m) would be effective for tax years beginning after December 31, 2017.

Impact of Tax Cuts and Jobs Act: Part III – Changes to Employee Retirement Plans

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November 3, 2017

Yesterday, the House Ways and Means Committee released the Tax Cuts and Jobs Act (H.R. 1) (the “Bill”), a bill that, if enacted, would represent the most substantial overhaul of the U.S. tax code in decades.  We are releasing a series of posts to highlight the provisions of the Bill affecting the topics pertinent to our readers, where each post will cover a different area of importance.  In Part I of this series, we covered potential changes to employer-provided benefits, and in Part II, we addressed entertainment expenses and other fringe benefits.  In this Part III, we will discuss the Bill’s potential impact on various retirement provisions.

Loosening of Hardship Withdrawal Rules.  Currently, participants in 401(k) plans may only receive hardship withdrawals under certain circumstances, and those withdrawals are limited to the amount of the participants’ elective deferrals.  In addition, participants are prohibited from making elective deferrals to their 401(k) plan for six months following receipt of a hardship distribution.  First, Section 1503 of the Bill would eliminate the six-month prohibition on making elective deferrals after receiving a hardship distribution contained in the current Treasury Regulations.  The provision would require Treasury to revise its regulations within one year of the Bill’s date of enactment to allow participants to continue contributing to their retirement accounts without interruption. Section 1504 of the Bill would add a new subsection 401(k)(14) to the Code expand the funds eligible for hardship withdrawal by permitting participants to make such withdrawals from account earnings and from employer contributions.   This provision, as well as the requisite revised regulations, would apply to tax years beginning after 2017.

Reduction in Minimum Age for In-Service Distributions.  Participants in profit-sharing (including 401(k) plans) and stock purchase plans currently may not take an in-service distribution before age 59½, and participants in other retirement plans (including defined benefit pension plans) are generally barred from taking in-service distributions until age 62.  Section 1502 of the Bill would lower the limit for in-service distributions from plans currently subject to the age 62 limit to age 59½ limit.  This provision would apply to tax years beginning after 2017.

Extension of Time Period for Rollover of Certain Outstanding Plan Loan.  Currently, under Code section 402(c)(3), a participant whose plan or employment terminates while he or she has an outstanding plan loan balance must contribute the loan balance to an individual retirement account (IRA) within 60 days of the termination, otherwise the loan is treated as an impermissible early withdrawal and is subject to a 10% penalty.  Section 1505 of the Bill would add a new subsection 402(c)(3)(C) to the Code to relax these rules by giving such employees until the due date for their individual tax return to contribute the outstanding loan balance to an IRA.  The 10% penalty would only apply after that date.  This provision would apply to tax years beginning after 2017.

Changes to Taxation of Non-qualified Deferred Compensation.  Currently, non-qualified deferred compensation that is subject to a substantial risk of forfeiture is not included in an employee’s income until the year received, and the employer’s deduction is postponed until that date.  By repealing Code section 409A and introducing a new section 409B, Section 3901 of the Bill would significantly restrict the conditions that qualify as a substantial risk of forfeiture, such that non-qualified deferred compensation would become taxable immediately unless it is subject to future performance of substantial services.  This provision would simplify the taxation of non-qualified deferred compensation to align it with the FICA tax timing rules that already applied under Code section 3121(v)(2).  This provision would be effective for amounts attributable to services performed after 2017, though the current rules would apply to existing non-qualified deferred compensation arrangements beginning with the last tax year before 2026.  Notably, the change is substantially identical to one introduced by former Ways & Means Chairman Camp in the past.  It is unclear how the provision in the Bill would apply to some forms of equity-based compensation, such as stock options, which the Bill includes within the definition of non-qualified deferred compensation.  If enacted, the change is likely to trigger a substantial reduction in the use of non-qualified deferred compensation because the resulting accelerated taxation would erode one of the primary purposes of deferring compensation.  Note: This provision was eliminated by the second amendment adopted by the Ways & Means Committee (discussed here).

Impact of Tax Cuts and Jobs Act: Part II – Deduction Disallowances for Entertainment Expenses and Certain Fringe Benefits

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November 3, 2017

Yesterday, the House Ways and Means Committee released the Tax Cuts and Jobs Act (H.R. 1) (the “Bill”), a bill that, if enacted, would represent the most substantial overhaul of the U.S. tax code in decades.  This is the second in a series of posts discussing the effect of the Bill on topics of interest to our readers.  (See our first post discussing the effect of the Bill on various exclusions for employer-provided benefits here.)  Section 3307 of the Bill makes several changes to the deduction limitations under section 274 related to meals and entertainment expenses.  The Bill also expands the reach of the deduction limitations to disallow deductions for de minimis fringe benefits excluded from income under Code section 132(e), unless the employer includes such amounts in the employee’s taxable income. With respect to tax-exempt entities, section 3308 of the Bill would treat funds used to provide employees transportation fringe benefits and on-premises gyms and other athletic facilities as unrelated business taxable income.

Total Disallowance of Deductions for Entertainment Expenses.  Under Code section 274(a), a taxpayer may not deduct expenses for entertainment, amusement, or recreation (“entertainment expenses”), unless the taxpayer establishes that the item was directly related to the active conduct of the taxpayer’s business, subject to a number of exceptions in Code section 274(e) (e.g., reimbursed expenses; expenses treated as compensation to (or included in the gross income of) the recipient; recreational, social, and similar activities primarily for the benefit of employees other than highly compensated employees; entertainment sold to customers).  If the taxpayer establishes that the entertainment expenses were directly related to the active conduct of its trade or business, section 274(n) limits the deduction to 50 percent of expenses relating to entertainment, subject to a number of exceptions, many of which are the same exceptions that apply to the 100 percent disallowance under Code section 274(a) (e.g., reimbursed expenses; expenses treated as compensation to (or included in the gross income of) the recipient; recreational, social, and similar activities primarily for the benefit of employees other than highly compensated employees; entertainment sold to customer).

The Bill would amend section 274(a) to eliminate the exception for entertainment expenses directly related to the active conduct of the taxpayer’s business.  Accordingly, deductions for entertainment expenses would be fully disallowed unless one of the exceptions under Code section 274(e) applies.  The Bill would also make changes to some of the exceptions under Code section 274(e), described below.

Disallowance of Deductions for On-Site Athletic Facilities.  Similarly, the Bill would fully disallow a deduction for on-site gyms or athletic facilities as defined in Code section 132(j)(4)(B).  Such facilities are gyms and athletic facilities that are located on the premises of the employer, operated by the employer, and substantially all the use of which is by employees of the employer, their spouses, and their dependent children.  Although the Bill would add such expenses to the list of disallowed deductions under Code section 274(a), the Bill does not eliminate the exclusion from employee’s income under Code section 132.  Accordingly, employers will be left to choose between (1) losing the deduction for the cost of such facility or (2) retaining the deduction by imputing the fair market value of the use of the facility to employees. The Bill includes instructions to the Treasury Department to issue regulations providing appropriate rules for allocation of depreciation and other costs associated with an on-site athletic facility.

Disallowance of Deductions for Qualified Transportation Fringes and Parking Facilities.  The Bill would also fully disallow a deduction for qualified transportation fringes as defined in Code section 132(f) and parking facilities used in connection with qualified parking as defined in Code section 132(f)(5)(C).  These fringe benefits are popular with employees and permit employees 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.  Like with athletic facility expenses, the Bill would add such expenses to the list of disallowed deductions under Code section 274(a), but retain the exclusion from employee’s income under Code section 132.  As a result, employers will be left to choose between (1) losing the deduction for the cost of providing these benefits or (2) discontinuing the benefits.  The Bill includes instructions to the Treasury Department to issue regulations providing appropriate rules for allocation of depreciation and other costs associated with a parking facility.

Disallowance of Deductions for Certain De Minimis Fringe Benefits.  The Bill would likewise disallow deductions for what it refers to as “amenities.”  Amenity is defined as a de minimis fringe benefit that is primarily personal in nature and involving property or services that are not directly related to the taxpayer’s business.  This would seemingly subject expenses related to the provision of most de minimis fringe benefits to a full deduction disallowance unless the expense qualified for one of the exceptions under Code section 274(e) (e.g., expenses for food and beverages (and facilities used in connection therewith) furnished on the business premises of an employer primarily for its employees; reimbursed expenses; expenses treated as compensation to (or included in the gross income of) the recipient; recreational, social, and similar activities primarily for the benefit of employees other than highly compensated employees; items available to the public; entertainment sold to customers).  It would perhaps leave unaffected some de minimis fringe benefits such as personal use of a copy machine.  Even with respect to de minimis fringe benefits that would likely qualify as amenities, it is unclear how much of an impact this would have, because many de minimis fringe benefits would likely qualify for one of the exceptions (for example, coffee, doughnuts, soft drinks, and occasional cocktail parties would likely remain fully deductible under Code sections 274(e)(1) and 274(n)(2)(B), provided they are provided to employees on the business premises of the employer).  Others, however, such as occasional sporting or theater tickets, gifts given on account of illness, and traditional holiday or birthday gifts, may well be affected by the disallowance.  The Bill includes instructions to the Treasury Department to define amenity in regulations.

Deduction Limited to Amounts Actually Included in Income.Code section 274(e)(2) contains an exception to the disallowance under Code section 274(a) to the extent an expense is treated as compensation to an employee.  Code section 274(e)(9) includes a similar provision for expenses treated as includible in the gross income of the recipient that is not an employee of the taxpayer as compensation or as a prize or award.  The Bill would limit 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.  Code section 274(e)(2)(B) was adopted to impose this limitation with respect to certain senior executives following the decision in Sutherland Lumber-Southwest, Inc. v. Commissioner.  The Bill would extend the effect of Code section 274(e)(2)(B) to all recipients.  The limitation prevents a taxpayer from deducting a cost in excess of the amount required to be included in the recipients income, such as in the case of vacation travel on board corporate aircraft, where the cost of operating the flight often far exceeds the amount required to be included in the employee’s income under Treasury Regulations.

Deduction Disallowance Applies with Respect to Expenses Reimbursed by a Tax-Exempt Entity.  Under section 274(e)(3), a taxpayer that incurs an expense subject to the deduction disallowance in section 274(a) or 274(n) may fully deduct the expense if the expense is reimbursed by another party, provided that certain requirements are met.  The rule allows two parties as part of a reimbursement arrangement to effectively shift the burden of the deduction disallowance to the party between them.   Section 3307 of the Bill amends section 274(e)(3) to prevent the use of tax-exempt entity (that is not affected by the deduction disallowance under current law) to avoid the effect of the disallowance.

Full Deduction for Meals Excluded from Employee’s Income under Code Section 119.  Under Code section 119, the value of meals provided to employees for the convenience of the employer are excludable from the employee’s income.  Such meals, however, are currently subject to the 50% deduction disallowance under Code section 274(n) unless the meals are treated as being provided at an employer-operated eating facility that is a de minimis fringe benefit under Treasury Regulation § 1.132-7.  (This was the issue in the Boston Bruins decision (earlier coverage).)  Running counter to the general approach of the legislation—which seeks to eliminate corporate deductions for amounts not included in employee income—the Bill would amend Code section 274(n)(2)(B) include meals excludable from an employee’s income under section 119 in addition to amounts being excludable under section 132(e).  This change would appear to expand the ability of employer’s to fully deduct more meals provided to their employees.

With the exception of the last change, the Bill would seek to limit the ability of taxpayers to deduct entertainment expenses and expenses related to the provision of various excludable fringe benefits.  The provisions would be effective for amounts paid or incurred after December 31, 2017.

Impact of Tax Cuts and Jobs Act: Part I – Exclusions for Certain Employer-Provided Benefits

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November 2, 2017

Today, the House Ways and Means Committee released the Tax Cuts and Jobs Act (H.R. 1) (the “Bill”), a bill that, if enacted, would represent the most substantial overhaul of the U.S. tax code in decades.  We will release a series of posts to highlight the provisions of the Bill affecting the topics pertinent to our readers, where each post will cover a different area of importance.  In the first of this series of posts, we will discuss the Bill’s potential impact on the exclusions for several popular employer-provided benefits.

Limitation on Exclusion for Employer-Provided Meals and Lodging. Under Code section 119 as currently written, the value of employer-provided housing is excludable from an employee’s gross income and is not considered to be wages for purposes of employer withholding.  Section 1401 of the Bill would add a new subsection (e) to Code section 119 to limit the income exclusion for employer-provided housing to $50,000 ($25,000 for a married individual filing a joint return), and that amount would phase out for highly compensated individuals.  Presumably, this change would obligate employers to report the fair market value of employer-provided housing on an employee’s Form W-2 even if excludable under Code section 119, and the employee would take the exclusion on his or her individual income tax return.  In addition, the exclusion would be limited to a single residence for all employees, and the exclusion would be altogether eliminated for 5 percent owners of the employer.

Elimination of Exclusion for Dependent Care Assistance Programs. Under Code section 129, the value of employer-provided dependent care assistance programs (“DCAP”) is generally excluded from an employee’s income and wages up to $5,000 per year.  Employees typically take advantage of this exclusion through a dependent care flexible spending account that is part of a cafeteria plan under Code section 125.  Section 1404 of the Bill would repeal this exclusion in its entirety. Note: This provision was eliminated from the bill by an amendment adopted by the Ways and Means Committee (discussed here).

Educational Assistance Programs and Qualified Tuition Reductions. Two benefits primarily focused on assisting employees with educational expenses would be eliminated by the Bill.  First, under Code section 127, amounts paid to or on behalf of an employee under a qualified educational assistance program are excluded from an employee’s income and wages up to $5,250 per year.  Section 1204 of the Bill would repeal this exclusion in its entirety.  Second, the exclusion from income and wages for qualified tuition reductions provided by educational institutions would also be repealed by Section 1204.  Though this change would affect fewer employers, it would eliminate an often-significant benefit for employees who work for educational institutions, as they would be taxed on the full amount of tuition waived for them or their spouses or dependents to attend the educational institution.

Elimination of Exclusion for Adoption Assistance Programs. Currently, Code section 137 provides an exclusion from an employee’s income and wages for amounts provided by an employer to an employee for amounts paid or expenses incurred for the adoption of a child up a certain amount that is indexed for inflation ($13,570 in 2017).  Section 1406 of the Bill would repeal the exclusion.

Elimination of Exclusion for Employer-Paid Moving Expenses. Code section 132(a)(6) provides an exclusion from income and wages for a qualified moving expense reimbursement, which is an employer-provided benefit capped at the amount deductible by the individual if he or she directly paid or incurred the cost.  Section 1405 of the Bill would repeal this exclusion.

Exclusion for Employee Achievement Awards. Code section 74(c) excludes the value of certain employee achievement awards given in recognition of an employee’s length of service or safety achievement from the employee’s income. Section 274(j) limits an employer’s deduction for employee achievement awards for any employee in any year to $1,600 for qualified plan awards and $400 otherwise. A qualified plan award is an employee achievement award that is part of an established written program of the employer, which does not discriminate in favor of highly compensated employees, and under which the average award (not counting those of nominal value) does not exceed $400.  The exclusion under Code section 74(c) is limited to the amount that the employer is permitted to deduct for the award.  Section 1403 of the Bill would repeal this exclusion and the corresponding deduction limitation.

All of these changes would be effective for tax years beginning after 2017.  In addition to the employer-provided benefits discussed in this post, the Bill would affect a number of other topics covered by this Blog, so stay tuned for Part II in the series.