Authored by Morrison & Foerster’s Compensation, Benefits + ERISA Team
On December 20, 2017, the Tax Cuts and Jobs Act (the “Act”) was approved by Congress, and it was signed into law by President Trump on December 22, 2017. The Act dramatically impacts certain aspects of executive compensation and employee benefit issues but does not include the repeal of Section 409A that was originally proposed by both the House and Senate although subsequently removed. The Act went into effect on January 1, 2018 (unless otherwise noted herein).
The following is a summary of the key provisions of the Act that impact current executive compensation and employee benefit practices.
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, will be eliminated. Accordingly, all compensation that exceeds $1 million paid to a corporation’s proxy officers will be non-deductible.
- Section 162(m) will 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 and all foreign companies publicly traded through American Depositary Receipts. The inclusion of corporations with public debt could negatively affect portfolio companies held by private equity sponsors.
- The individuals covered by Section 162(m) will 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’s 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.
- A written binding contract in effect on November 2, 2017 is exempt from the new rules so long as such contract is not materially modified thereafter.
- Companies should exercise caution regarding making changes to any existing arrangements that were in place on November 2, 2017. Also, while public companies and those companies that file reports pursuant to Section 15(d) of the Securities Exchange Act of 1934 should review their compensation arrangements in order to determine which arrangements will be affected by the 162(m) changes, we do not think that many public companies will completely abandon pay-for-performance arrangements due to concerns from ISS and Glass Lewis. While the removal of the performance-based compensation exception may provide some additional flexibility in terms of plan design and administration, the expansion of the individuals who are covered employees may be burdensome.
Excise Taxes on Tax-Exempts and Governmental Organizations for Excess Executive Compensation
- The Act includes a provision that tax-exempt organizations will be subject to a 21% excise tax paid on compensation over $1 million to any current or former top five highest paid employee.
- A 21% excise tax will also apply to organizations that pay severance in excess of three times the employee’s base pay (as defined in the Section 280G regulations) to the current and former top five highest-paid employees.
New Code Section 83(i)
The Act adds a new feature to allow an employee to elect to defer, within 30 days of the vesting date, income tax (but not FICA taxes) attributable to certain stock transferred to the employee by an employer. It allows 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.
- This provision seems to have limited applicability due to the fact that the stock options or RSUs must be made available to 80% of employees in a privately held company. It is further limited by the fact that significant owners and certain officers are not eligible. However, if an employer makes broad-based equity grants, qualified employees will benefit from this opportunity to defer income recognition on common forms of equity awards.
Change to 401(k) Plan Loan Rollover Period
- 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 Act will extend the rollover period for loan offsets until the due date for filing the participant’s tax return (including extensions) for the year in which the termination occurs. This means that an employee who terminates employment in January of 2018 will have until April 15, 2019 (or October 15, 2019 if an extension is obtained)–rather than the current 60-day period--to come up with the amount of the loan that became due, and contribute it to an IRA or another qualified plan, and avoid taxation of it.
Revisions to Employee Benefit Arrangements
- Non-military employer-paid qualified moving expenses will be taxable from 2018 until 2025.
- While qualified transportation fringe benefits will remain excludable from income for employees, employers will lose their business deduction for payment of these expenses. Also, no deduction will be available to employees or employers for any bicycle commuting reimbursements from 2018 through 2025.
- Housing and meals provided at employer-operated eating facilities to employees for the employer’s convenience will continue to excluded from the employees’ taxable income; however, the employer deduction for the meal expenses will be reduced to 50% beginning in 2018 and will be completely eliminated by 2026. Starting in 2018, employee achievement awards of tangible personal property may still be treated as deductible by the employer, but the following are now excluded from the definition of “tangible personal property”: cash, cash equivalents, gift cards, gift coupons or gift certificates (other than arrangements conferring only the right to select and receive from a limited array of such items pre-selected or pre-approved by the employer), vacations, meals, lodging, tickets to theater or sporting events, stocks, bonds, other securities, and other similar items.
Affordable Care Act Revisions
- The individual mandate for not purchasing creditable health insurance has been removed beginning in 2019.
Employer Tax Credit for Paid Family and Medical Leave
- For 2018 and 2019 only, a new tax credit is available to employers for offering paid family and medical leave. For wages paid in tax years beginning in 2018, eligible employers can claim a business credit equal to 12.5% of the amount of wages paid to qualifying employees during any period in which such employee is on such leave if the rate of payment is at least half of the wages normally paid to the employee. The credit is increased by 0.25 percentage points (up to a maximum of 25%) for each percentage point by which the rate of payment exceeds 50%. The duration of the leave is capped at 12 weeks.
The implications of the Act are vast, and 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 Act impacts those arrangements.