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.