On November 2, 2017, the House Ways and Means Committee unveiled the Tax Cuts and Jobs Act (the “Bill”), which, if enacted, could dramatically impact certain aspects of executive compensation and employee benefit issues. The Bill represents the first actual legislative language about these issues and has been amended by the Ways & Means Committee (and further amendment may follow later this week). Republican leaders in the House hope for a full vote during the week of November 13, 2017.
The following is a summary of the key provisions of the Bill that impact current executive compensation and employee benefit practices, which would generally go into effect on January 1, 2018. For a summary of changes contemplated by the Bill that do not relate to compensation and benefits, see our alert titled “House Republicans Release Draft Tax Proposal; Committee Markup Begins.”
Non-Qualified Deferred Compensation
- The Bill proposes a repeal of Section 409A of the current tax code and introduces a new Section 409B, which would impose tax on non-qualified deferred compensation arrangements when there is no longer a substantial risk of forfeiture. This new provision would apply to compensation earned with respect to services performed after 2017. Compensation attributable to services performed before January 1, 2018 would be grandfathered, but would be taxed by 2026 (or when the compensation vests, if later).
- Unlike under current Section 409A, compensation would be subject to a substantial risk of forfeiture only if conditioned on the future performance of substantial services. Performance-based vesting conditions (including conditions tied to events such as an IPO or change in control) would not create a substantial risk of forfeiture.
- In addition to traditional deferred compensation arrangements, proposed Section 409B would apply to many common equity compensation vehicles, including stock options, stock appreciation rights, restricted stock units (RSUs) (if settled later than 2½ months after the year in which the RSU vests), and other rights to compensation based on the value or appreciation in value of stock of the employer (whether settled in cash or stock). Severance pay and cash bonuses could also be impacted if paid later than 2½ months after the year in which the severance or bonus vests. This means, for example, that stock options would be taxed at vesting instead of upon exercise. Taxation of restricted stock would not be affected by Section 409B and it is unclear how profits interests would be impacted.
- A new amendment to the Bill released on November 6, 2017 by House Ways and Means Committee Chairman Kevin Brady (R-Texas) (the “Amendment”) provides for a limited exception for options and RSUs granted by non-public companies to non-executive employees that would allow for deferred recognition of income for up to five years. The Amendment also imposes a three-year holding period requirement for certain profits interests granted to service providers of a partnership in order to qualify as long-term capital gain.
Limitations on Performance-Based Compensation
- The exception under Section 162(m) of the current tax code, which allows for the deduction of performance-based compensation that exceeds $1 million, would be eliminated. Accordingly, all compensation that exceeds $1 million paid to a corporation’s proxy officers would be non-deductible.
- Section 162(m) would be expanded to include not only corporations with a class of stock that is publicly traded, but also corporations that have registered a public stock or debt offering. The inclusion of corporations with public debt could negatively affect portfolio companies held by private equity sponsors.
- The individuals covered by Section 162(m) would be expanded to include the chief financial officer, an interim chief executive officer or interim chief financial officer (even if such individual ceases to serve at year end).
- Any employee who becomes a proxy officer for purposes of Section 162(m) will continue to be treated as a “covered employee” so long as such employee receives compensation from that employer even if no longer serving as an executive officer. This could significantly increase the number of individuals covered by Section 162(m), as well as cause post-employment payments such as severance and deferred compensation formerly not covered by Section 162(m) to become non-deductible.
- The Bill includes a provision that tax-exempt organizations will be subject to a 20% excise tax paid on compensation over $1 million to any current or former top five highest paid employee.
Changes to Retirement Arrangements
- Defined benefit retirement plans would be allowed to provide in-service distributions for employees starting at age 59-1/2 (instead of at age 62 under current law).
- 401(k) and other defined contribution retirement plans may now allow hardship withdrawals from certain vested employer contributions (and any earnings therefrom) and from the earnings on employee contributions. Current tax law only permits such withdrawals from employee contributions net of earnings. The current law prohibiting employee contributions for six months following a hardship withdrawal would be repealed.
- Current law allows 401(k) plan participants who terminate employment with an outstanding loan balance to either pay off the loan in full, or roll their account balance over to an IRA within 60 days to avoid defaulting on the loan and incurring a 10% early distribution penalty. The Bill would extend the rollover period until the due date for filing the participant’s tax return (including extensions) for the year in which the termination occurs.
- The Bill would provide relief for sponsors of frozen defined benefit retirement plans so that such plans can more easily pass nondiscrimination testing.
Revisions to Employee Benefit Arrangements
- The Bill seeks to eliminate the ability of employers to provide employees with up to $5,250 of tax-free tuition assistance.
- Qualified tuition reduction benefits provided by educational institutions to its employees and dependents (including spouses) would be taxable.
- The exclusion for employer-provided dependent care assistance programs would be repealed; however, the Amendment would allow the exclusion from income for up to $5,000 to continue through December 31, 2022.
- Employer-paid qualified moving expenses would be taxable.
- Benefits provided under employer-paid adoption assistance programs would become taxable.
- Housing and meals provided to employees for the employer’s convenience would be included as taxable income to the employees.
- Employer contributions to Archer MSAs would be included in taxable income.
- Employee achievement awards that were previously excluded from taxation would become taxable to the employee and deductible by the employer.
Additional Legislation on Stock-Based Compensation
Although not included in the Bill, there is a separate bill currently before the Senate called the Empowering Employees through Stock Ownership Act sponsored by Congressman Erik Paulsen (R-Minn). This bill seeks to amend the tax code to allow an employee to elect to defer, for income tax purposes, income attributable to certain stock transferred to the employee by an employer. If enacted, the bill would allow an employee to defer the inclusion of income from the stock until the year that includes the earliest of the dates on which:
- the stock becomes transferable;
- the employee becomes an excluded employee (an excluded employee includes (i) 1% stock owners, the chief executive officer, or the chief financial officer of the corporation or a person who has been any one of the foregoing at any time during the 10 preceding calendar years; (ii) a family member of the foregoing specified individuals; or (iii) one of the four highest compensated officers of the corporation during any of the 10 preceding taxable years);
- stock of the corporation becomes readily tradable on an established securities market;
- seven years have passed after the rights of the employee in the stock are transferable or are no longer subject to a substantial risk of forfeiture, whichever occurs earlier; or
- the employee revokes the election with respect to the stock.
Prior to enactment, the Bill is likely to evolve and may do so significantly. We will continue to monitor the Bill as it moves through the legislative process and will provide any significant updates. In the meantime, we encourage you to review your executive compensation and employee benefit arrangements and to reach out to any member of the Compensation, Benefits + ERISA team at MoFo to discuss how the Bill may impact these arrangements.