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.

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

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

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.

Tax Court Expands Section 119 Exclusion in Boston Bruins Decision

In a much anticipated decision, the U.S. Tax Court ruled yesterday that “the business premises of the employer” can include an off-premises facility leased by the employer when its employees are on the road.  The decision in Jacobs v. Commissioner addressed whether the employer (in this case, the professional hockey team, the Boston Bruins) was entitled to a full deduction for the meals provided to the team and staff while on the road for away games.  The debate arose after the IRS challenged the full deduction and asserted that the employer should have applied the 50% deduction disallowance applicable to meals by section 274(n) of the Code.

Under section 162 of the Code, an employer may deduct all ordinary and necessary business expenses.  However, in recognition that the cost of meals is inherently personal, the Code limits the deductions for most business meal expenses to 50% of the actual expense under section 274(n), subject to certain exceptions.  The exception at issue in Jacobs allows an employer to deduct the full cost of meals that qualify as de minimis fringe benefits under section 132(e) of the Code.  In general, this includes occasional group meals, but would not typically include frequently scheduled meals for employees travelling away from home.  (For this purpose, home is the employee’s tax home, which is typically the general area around the employee’s principal place of employment.)  However, under Treasury Regulation § 1.132-7, an employer-operated eating facility may qualify as a de minimis fringe benefit if, on an annual basis, the revenue from the facility is at least as much as the direct operating cost of the facility.  In other words, an employer may subsidize the cost of food provided in a company cafeteria, provided the cafeteria covers its own direct costs on an annual basis and meets other criteria (owned or leased by the employer, operated by the employer, located on or near the business premises of the employer, and provides meals immediately before, during, or immediately after an employee’s workday).

The Bruins’ owners argued that they were entitled to a full deduction because the banquet rooms in which employees were provided free meals qualified as an employer-operated eating facility.  That may leave some of our readers wondering, “How can a facility that is free have revenue that covers its direct operating cost?”  The key to answering that question lies in the magic found in the interface of sections 132(e)(2)(B) and section 119(b)(4) of the Code.  Under section 132(e)(2)(B), an employee is deemed to have paid an amount for the meal equal to the direct operating cost attributable to the meal if the value of the meal is excludable from the employee’s income under section 119 (meals furnished for the “convenience of the employer”) for purposes of determining whether an employer-operated eating facility covers its direct operating cost.  In turn, section 119(b)(4) provides that if more than half of the employees who are furnished meals for the convenience of the employer, all of the employees are treated as having been provided for the convenience of the employer.  Working together, if more than half the employees are provided meals for the convenience of the employer at an employer-operated eating facility, the employer may treat the eating facility as a de minimis fringe benefit, and deduct the full cost of such facility.

The IRS objected to the owners’ treatment of the banquet rooms as their employer-operated eating facilities and disallowed 50% of the meal costs.  The Tax Court succinctly explained that the Bruins’ banquet contracts constituted a lease of the rooms provided for meals and that the contracts also meant that the Bruins operated the facilities under Treasury Regulation § 1.132-7(a)(3).  In doing so, the Tax Court summarily dismissed the IRS’s argument that the payment of sales taxes meant that the contracts were not contracts for the operation of an eating facility but instead the purchase of meals served in a private setting.

Having determined that the first two criteria were satisfied, the Tax Court turned to the question of whether the hotel banquet rooms constituted the “business premises of the employer.”  The court looked to a series of cases indicating that the question was one of function rather than space.  Relying on those cases, the court determined that the hotels were the business premises of the employer because the team’s employees conducted substantial business activities there.   The court seemed to put significant weight on the fact that the team was required to participate in away games, necessitating it travel and operation of its business away from Boston.  The Tax Court was unpersuaded by the IRS’s quantitative argument that the team spent more time working at its facility in Boston than at any individual hotel and its qualitative argument that the playing of the away game was more important than the preparation for the game that took place at the hotel.

Having determined that the hotel banquet rooms were an employer-operated eating facility, the Tax Court next addressed whether it qualified as a de minimis fringe benefit because more than half of the employees who were furnished meals in the banquet rooms were able to exclude the value of such meals from income under section 119 of the Code.  The court determined that this requirement was satisfied because the meals were provided to the team and staff for substantial noncompensatory business reasons.  The business reasons included: ensuring the employees’ nutritional needs were met so that they could perform at peak levels; ensuring that consistent meals were provided to avoid gastric issues during the game; and the limited time to prepare for a game in each city given the “hectic” hockey season schedule.  Relying on the Ninth Circuit’s decision in Boyd Gaming v. Commissioner from the late 1990s, the court declined, once again, to second guess the team’s business judgment by substituting the government’s own determination.

Although the decision focuses on the specific facts and the exigencies of a traveling hockey team, the decision is of interest for other taxpayers as well.  This is especially true given the IRS’s recent increased interest in both meal deductions and the imposition of payroll tax liabilities with respect to free or discounted meals provided to employees, particularly in company cafeteria settings.  The decision expands the scope of the section 119 exclusion to meals further than the IRS’s current limited view that it applies only to remote work sites, such as oil rigs, schooners,  and camps in Alaska.   To date, the most expansive application of the exclusion in the company cafeteria setting occurred in Boyd Gaming, where a casino successfully established that its policy requiring employees to eat lunch on-site was based on security concerns and the attendant screening procedures made it necessary to provide employees with meals during their shifts.

Jacobs seems to take the analysis one step further, because many of the business reasons for providing meals to Bruins employees could be echoed by other taxpayers.  No doubt, all employers are concerned with the performance of their employees.  To that end, it could be argued that ensuring that they eat well-balanced nutritionally appropriate meals can increase performance even if the employer is more concerned with brains rather than brawn.  Indeed, given the large health insurance costs borne by many employers, employers have a legitimate interest in providing healthy meals that may reduce the incidence of obesity, diabetes, heart disease, and other chronic ailments that raise their costs.  Moreover, many employees have hectic schedules during the work day with frequent appointments, meetings, and other activities that make it necessary to maximize the time available for work during the day.   Given the Tax Court’s implicit admonition of the IRS’s attempt to substitute its own judgment regarding the employer’s business reasoning in Jacobs and the court’s refusal to substitutes its own judgment as well, the IRS likely has a more difficult road ahead if it attempts to challenge the purported business reasons that an employer provides for furnishing meals to its employees.  It remains to be seen how the IRS will react to the decision and whether it will appeal the case, which seems likely.  For now, however, the case is a positive development for employers who have made a business decision to provide meals on a free or discounted basis to their employees to increase productivity and improve their health.