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

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

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

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

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

Equity and Executive Compensation

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

  1. Repeal of Exceptions to Deduction Limitations. The Final Bill will eliminate the exceptions for performance-based compensation and commissions under Code section 162(m)(4)(B) and (C).
  2. Changes to the Definition of Covered Employee. Under the Final Bill, the definition of “covered employee” will be amended to align with SEC reporting rules to include any individual who is the principal executive officer or principal financial officer at any time during the tax year and the three highest paid officers for the tax year (as disclosed to shareholders).  Further, if an individual is a covered employee after 2016, the individual would retain the covered‑employee status for all future years.  This change has the effect of subjecting deferred compensation paid in a year after an individual is no longer an officer to the deduction disallowance.
  3. Expansion of Deduction Limitation to Additional Corporations. The Final Bill will amend Code section 162(m)(2) to apply the limitation to any corporation that is an issuer under section 3 of the Securities Exchange Act of 1934 that (1) has a class of securities registered under section 12 of the Act, which would include all U.S. publicly‑traded companies and their foreign affiliates, or (2) is required to file reports under section 15(d) of the Act.  This change will also extend the deduction limitation to corporations beyond those with publicly traded equity securities to include those that are required to file reports solely because they issue public debt.

Transition Relief.  The Final Bill includes the transition relief included in the Senate Bill, so that these changes would apply only to contracts that are entered into—or that are materially modified—after November 2, 2017 (see earlier coverage).  The fact that a deferred compensation plan was in existence on November 2, 2017 is not by itself sufficient to qualify the plan for the exception for binding written contracts.  The Conference Summary clarifies that a renewal of a contract is treated as a new contract entered into on the day the renewal takes effect.  The House Bill does not have a similar transition rule.  The Conference Summary provides an example of how the transition relief works.  Suppose that a publicly‑traded corporation on October 2, 2017 hired an executive that is a covered employee.  Under the employment contract, the executive is eligible to participate in the employer’s deferred compensation plan.  Under the terms of the plan, participation is permitted after 6 months of employment, amounts payable are not subject to discretion, and the corporation does not have the right to amend materially the plan or terminate the plan (except on a prospective basis, i.e., before services are performed for the applicable period for which the compensation is to be paid).  Provided that the other conditions of the written binding contract are met (e.g., that the plan itself is in writing), the payments under the plan to the executive are grandfathered, even though the employee was not actually a participant in the plan on November 2, 2017.

Excise Tax on Excess Tax-Exempt Organization Executive Compensation.  Tracking a similar prevision in both the House and Senate bills, the Final Bill will impose a new employer excise tax with respect to compensation paid post‑2017 by a tax-exempt organization (or a related entity) to a covered employee: (1) to the extent the compensation exceeds $1 million for the tax year; or (2) if the compensation constitutes an “excess parachute payment” (based on a measure of separation pay).  The Final Bill ties the rate to the corporate tax rate, so that the excise tax will automatically match the corporate tax rate if it is changed in the future.  The Final Bill will treat compensation as paid when the right to the compensation is no longer subject to a substantial risk of forfeiture under section 457(f)(3)(B), even if the employee has not yet received the compensation.  In a change from the Senate and House bills, the Final Bill will exclude payments to licensed medical professionals for medical services and, for purposes of excess parachute payments, payments to non-highly compensation employees.  A “covered employee” means an employee who is among the tax-exempt organization’s five highest paid employees, or who was a covered employee for any preceding tax year beginning after 2016.

Five-Year Deferral for Stock Option and RSU Income under Broad-Based Plans of Privately-Held Corporations.  Currently, under Code section 83, the value of shares covered by options without a readily-ascertainable fair market value is includable in income at the time of exercise.  Like the House and Senate bills, the Final Bill will add a new section 83(i) to allow “qualified employees” (excluding the CEO, CFO, and certain other top-compensated employees and 1-percent owners) to elect to defer for up to five years federal income taxation related to “qualified stock.”  Qualified stock means the stock of a privately-held corporation received upon exercise of a stock option or settlement of a RSU that was transferred in connection with the performance of services.  To be effective, an inclusion deferral election must be made no later than 30 days after the first time the employee’s rights in the stock are substantially vested or transferrable.  The inclusion deferral election will also be subject to the following rules:

Broad-Based Plans.  The election will only apply to a privately-held corporation that offers a written plan under which, in the calendar year, not less than 80 percent of all employees who provide services to the corporation in the United States “are granted” (and not merely be eligible for) stock options or RSUs with the “same rights and privileges” to receive the corporation’s stock.  The Final Bill and Summary clarify that stock options and RSUs cannot be aggregated for purposes of satisfying this 80‑percent threshold, and that this threshold is intended to be consistently applied to all eligible employees, whether they are new hires or existing employees. The determination of rights and privileges will be made under rules similar to existing rules under Code section 423(b)(5) (employee stock purchase plans).  Accordingly, the amount of the stock which may be purchased by the employee under the stock option or RSU may bear a uniform relationship to the employee’s total or regular compensation, provided that the number of shares available to each employee is more than a de minimis amount.  The 80‑percent rule is applied to corporations on a controlled group basis pursuant to Code section 414(b).

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

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

Coordination with Statutory Stock Option Rules.  An inclusion deferral election would be available with respect to statutory stock options.  If an election is made, these options would no longer be treated as statutory stock options or subject to Code sections 422 or 423.  Rather, they would be treated as nonqualified stock options for FICA purposes (in addition to being subject to section 83(i) for income tax purposes).

Coordination with Non-Qualified Deferred Compensation (“NQDC”) Regime and 83(b).  Qualified stock under section 83(i) will not be subject to section 409A.  The inclusion deferral election will not apply to income with respect to unvested stock that is includible in income as a result of an election under Code section 83(b), which permits unvested property to be includable in income in the year of transfer.  The Final Bill specifies that apart from the new section 83(i), section 83 (including section 83(b)) will not apply to RSUs.

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

Withholding and Form W-2 Reporting.  Following the deferral period, the corporation must withhold federal income taxes on the amount required to be included in income at a rate not less than the highest income tax bracket applicable to the individual taxpayer.  The corporation must report on a Form W-2 the amount of income covered by an inclusion deferral election: (1) for the year of deferral; and (2) for the year the income is required to be included in the employee’s income.  In addition, for any calendar year, the corporation must report on Form W-2 the aggregate amount of income covered by inclusion deferral elections, determined as of the close of the calendar year.  The amounts are treated as non‑cash fringe benefits for purposes of applying the withholding rules, and thus, employers may include them in income pursuant to the rules under IRS Announcement 85-113.

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

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

Health Reform

Elimination of Individual Mandate Penalties after 2019.  The Final Bill will zero out penalties for failing to comply with the ACA’s individual mandate, effective in 2019.  Like earlier ACA repeal efforts, the Final Bill will not eliminate the requirement for providers of minimum essential coverage to report coverage on Form 1095-B (or Form 1095-C) or offers of minimum essential coverage on Form 1095-C despite eliminating the penalty imposed on individuals for failing to maintain coverage.  Some of the information reported on these forms would still be necessary for the IRS to administer the premium tax credit, which the Final Bill leaves intact.

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

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

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 III – Changes to Employee Retirement Plans

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).