On December 22, 2017, H.R. 1, commonly referred to as the Tax Cuts and Jobs Act (TCJA), was enacted into law. The TCJA contains numerous provisions that impact the tax treatment of employee compensation and benefits, from the perspective of both the employer and the employee. This article summarizes the compensation and benefits provisions in the law.
Executive Compensation—For-Profit Entities
Section 162(m) $1 million compensation deduction limit.
Internal Revenue Code (IRC) section 162(m) limits a public company’s compensation tax deduction for covered employees to $1 million per covered employee per taxable year. Prior to the TCJA, the term “covered employee” included the CEO and three highest paid officers other than the CEO and CFO as of the last day of the taxable year (the CFO was excluded). For purposes of the limit, the definition of compensation excluded commissions and, significantly, qualified performance-based compensation.
The TCJA expands the definition of “covered employee” to include any individual who served as the CEO or CFO at any time during the taxable year. As under prior law, the next three highest paid officers serving as of the last day of the taxable year are also covered employees. Any of these individuals who is a covered employee in taxable years beginning after December 31, 2016, is a covered employee for all future years, including years after the employee terminates employment or dies. As a result, the $1 million limit applies to compensation paid to the covered employee or a beneficiary after termination of employment or death.
In addition, the new law repeals the exclusion of commissions and qualified performance-based compensation from the $1 million deduction limit. As a result, the $1 million limit applies to all of a covered employee’s compensation (with limited exceptions) otherwise deductible by the corporation in a taxable year. The bill also expands the definition of a public corporation to include foreign corporations publicly traded through American depositary receipts and certain large private corporations and S corporations.
These changes are effective for taxable years beginning after December 31, 2017. However, the changes do not apply to a written binding contract with a covered employee in effect on November 2, 2017, and not materially modified after that date. Once a contract is renewed, compensation paid under the contract becomes subject to these changes [IRC section 162(m)(2)–162(m)(4)].
Qualified equity grants.
An employee who holds a nonstatutory stock option or a restricted stock unit (RSU) recognizes compensation income when the underlying stock is transferred to him. Under the TCJA, certain employees of a private company that grants stock options or RSUs to at least 80% of full-time employees (taking into account all employees in a controlled group) can elect to defer recognition of income beyond the point in time described above. Full-time employees are employees who work an average of 30 or more hours per week. For purposes of the 80% requirement, employees can receive varying amounts of options or RSUs, but all of them must receive the same type of award (either options or RSUs) and must receive more than a de minimis amount.
The election to defer income recognition must be made within 30 days of vesting. If the election is made, income recognition is generally deferred until the earlier of when the stock becomes transferable to another party (including to the employer), or the employer has an initial public offering. Thus, income taxes are not imposed until there is a liquidity event. If neither of these occurs within five years after vesting, however, the employee must recognize the income on the date five years after vesting. If the employee becomes an “excluded employee” (as described below), income must be recognized upon this determination. The employee may revoke the election at any time prior to when the compensation is recognized, and, upon revocation, the income will be recognized.
The new law repeals the exclusion of commissions and qualified performance-based compensation from the $1 million deduction limit.
Excluded employees are any individuals who have ever been the CEO or CFO (including their family members), any individuals who have owned more than 1% of the employer in the current year or any of the previous 10 calendar years (including family members), and any individuals who have been among the four highest paid employees in the current year or any of the previous 10 calendar years. These individuals can receive options or RSUs, but are not eligible to elect the special tax treatment.
If the election is made, the compensation income is equal to the stock value at the time the stock is transferred and is vested, less any amount paid for the stock by the employee. Any further increase in value is capital gain. The employer receives a deduction at the same time the employee recognizes income, and the deduction amount equals the employee’s income.
This special tax treatment is not available if the employee has the right, immediately upon vesting, to either sell the stock to the employer or settle the award in cash [IRC section 83(i)].
Qualified moving expense reimbursements.
Prior tax law allowed an employee to exclude from income certain moving expense reimbursements provided by an employer. The TCJA repeals this exclusion, effective December 31, 2017; however, it will become available again in 2026 unless action is taken beforehand to make the repeal permanent (IRC sections 82, 132).
Qualified bicycle commuting reimbursement.
Prior law allowed employees to exclude from income up to $20 per month of qualified bicycle commuting expenses reimbursed by their employers. This exclusion is likewise repealed effective December 31, 2017, but also becomes available again in 2026 (IRC sections 132, 274).
Employee achievement awards.
The tax law generally excludes from an employee’s income up to $1,600 for length of service or safety achievement awards of tangible property. Employers can take a deduction for employee achievement awards, but the deduction is limited. The TCJA made no changes to this treatment; however, in order for it to apply, the TCJA clarifies that achievement awards may not take the form of cash, cash equivalents, gift coupons, gift certificates (other than arrangements conferring only the right to select and receive tangible personal property from a limited array of items preselected or preapproved by the employer), vacations, meals, lodging, tickets to theater or sporting events, stocks, bonds, other securities, or other similar items. This clarification is made for amounts paid or incurred after December 31, 2017 (IRC sections 74, 274).
The TCJA repeals the rules that allow a conversion to a Roth IRA to be reconverted to a traditional IRA.
Qualified transportation benefits.
Employers can provide certain transportation benefits, such as commuting via mass transit and parking, to employees on a tax-free basis (up to $260 per month in 2018). Under prior law, an employer could take a deduction for the cost of providing these benefits. The TCJA eliminates the employer deduction for these benefits, effective for amounts paid after December 31, 2017 [IRC section 132(f) and 274(a)(4)].
Recharacterization of certain Roth IRA conversions.
Prior tax law allowed individuals to convert an amount from a traditional IRA to a Roth IRA, and then reconvert the amount back to a traditional IRA, thereby unwinding the original conversion. The reconversion could occur any time up to the due date of the individual’s tax return for the year of the original conversion. The TCJA repeals the rules that allow a conversion to a Roth IRA to be reconverted to a traditional IRA; this is effective for taxable years beginning after December 31, 2017 [IRC section 408A(d)]. In Frequently Asked Questions posted on IRS.gov, the IRS clarifies the effective date of the changes to Roth IRA recharacterizations made by the TCJA. The changes do not apply to Roth conversions that took place in 2017. Thus, a Roth IRA conversion made in 2017 may be recharacterized as a contribution to a traditional IRA if the recharacterization is made by October 15, 2018.
Extended rollover period of plan loan offsets.
Defined contribution plans may allow plan loans. If an employee’s plan or employment terminated while the employee had a plan loan outstanding, the employee had 60 days from the date of termination to repay the loan or contribute the loan balance to an IRA to avoid a taxable distribution. The TCJA retains this treatment and extends the due date of a defined contribution plan loan repayment or contribution to an IRA to the due date of the employee’s tax return (including extensions) for that year, effective after December 31, 2017 [IRC section 402(c)(3)(i)].
Length-of-service award plans.
Under prior law, a length-of-service award earned by a bona fide volunteer on account of qualified services did not provide for the deferral of compensation for purposes of IRC section 457 if the amount of the award that accrued each year was not in excess of $3,000. The TCJA raises this threshold to $6,000 and provides for it to be adjusted annually for the cost of living. The law also contains rules for calculating the actuarial present value of a defined benefit plan for purposes of applying the $6,000 annual limit. These changes are effective for taxable years beginning after December 31, 2017 [IRC section 457(e)(11)(B)].
Unrelated business taxable income.
The TCJA treats funds used to pay for employee transportation fringe benefits and on-premises athletic facilities available primarily for highly compensated employees as unrelated business taxable income. This takes effect for amounts paid after December 31, 2017 [IRC section 512(a)(7)].
Excise tax on executive compensation.
The TCJA subjects tax-exempt organizations to a 21% excise tax on compensation in excess of $1 million paid to covered employees (here defined as any of the five highest-paid employees for the tax year), excluding payments to tax-qualified retirement plans or amounts excludable from the employee’s income. Once an employee is a covered employee, she remains a covered employee for all subsequent years, even if she is no longer among the top five highest-paid employees. Compensation counts towards the $1 million limit when it becomes vested, including vested nonqualified deferred compensation. Compensation paid to a doctor, nurse, or veterinarian that is directly related to the performance of medical or veterinary services is not taken into account when identifying covered employees or in determining the amount subject to the tax.
In addition, “excess parachute payments” made to covered employees (defined in the same manner as above) are subject to a separate excise tax. The bill defines excess parachute payments as any payments contingent upon the employee’s separation from employment. The tax is triggered if the parachute payments exceed three times the employee’s base amount (i.e., the employee’s average compensation for the prior five years). If triggered, the tax is equal to 21% of the amount by which the parachute payments exceed one times the base amount. Notably, there is no $1 million threshold for parachute payments. Thus, the tax can apply even if an employee does not earn in excess of $1 million.
These taxes take effect for taxable years beginning after December 31, 2017; however, employers must also count the top five highest-paid employees in the taxable year beginning after December 31, 2016, as covered employees (IRC section 4960).
Affordable Care Act individual shared responsibility payments.
Under prior law, individuals were generally required to be enrolled in minimum essential health coverage or pay an excise tax. The TCJA eliminates this individual mandate, effective with respect to healthcare coverage for months beginning after December 31, 2018 [IRC section 5000A].
Partnership interests held in connection with performance of services (carried interests).
A carried interest is a right given to a fund manager to receive a percentage of profits. Income from a carried interest generally takes the form of a capital gain when the fund sells investment assets. Under prior law, if the asset was held for more than one year, the gain was treated as a long-term capital gain.
For carried interests involving investment and real estate businesses, the TCJA requires that an investment be held for more than three years in order for the gain to be treated as a long-term capital gain. The fact that an individual may have included an amount in income upon acquisition of the partnership interest, or that an individual may have made an IRC section 83(b) election, does not change this requirement. This rule does not apply to any capital interest in a partnership as long as the capital interest is proportional to the amount of capital contributed, or to any interest that was taxable as compensation upon receipt or vesting. This provision is effective for taxable years beginning after December 31, 2017 [IRC sections 83, 1061].
Employer credit for paid family and medical leave.
The TCJA introduces a temporary employer credit that allows eligible employers to claim a general business tax credit equal to 12.5% of qualifying employee wages paid during any period in which the employee is on family and medical leave, as long as the program’s payment rate is 50% of the employee’s normal wages. The credit is increased by 0.25% (but not above 25% in aggregate) for each percentage point by which the program’s payment rate exceeds 50% of the employee’s normal wages.
The maximum leave period that qualifies for the credit is 12 weeks for the tax year. Employers are eligible if they provide all qualifying full-time employees at least two weeks of annual paid family and medical leave and provide part-time employees leave on a pro rata basis. Qualifying employees are employees with one year or more of service with wages that do not exceed $72,000 (in 2018, indexed for inflation). The credit is effective for wages paid under a qualifying program in 2018 and 2019.
Provisions Cut from the Final Bill
Certain compensation and benefits provisions that were included in earlier versions of the bill were not included in the final version. These provisions include the following:
- Inclusion in an employee’s income of tuition reduction provided by an educational organization to the employee, spouse, and dependents
- Inclusion in an employee’s income of educational assistance payments made by the employer of up to $5,250 per year
- Inclusion in an employee’s income of employer-provided housing for amounts over $50,000
- Inclusion in an employee’s income of dependent care assistance funded by an employer or by an employee through a dependent care flexible spending arrangement
- Inclusion in an employee’s income of adoption assistance provided by an employer
- Repeal of the employer-provided child care credit
- Repeal of the work opportunity tax credit
Changes Are Coming
As with many other areas of the tax code, the TCJA’s changes to taxation of benefits and compensation are numerous and complex. CPAs should become familiar with these changes, and how they affect a client or employer’s particular tax situation, as they plan for the provisions to take effect.
This article has been adapted from similar content previously posted on the website of the authors’ firm.