The new federal tax reform, signed into law by President Trump on December 22, 2017, will change tax liabilities and strategies for many organizations and individuals beginning this year. The following is a summary of key provisions affecting compensation, benefits and endowments under the Tax Cuts and Jobs Act (P.L. 115-97) as they affect employers, individuals and tax-exempt entities.
Deduction for Excessive Compensation. Beginning in 2018, the $1 million limit on the compensation deduction of officers of public companies will be harder to avoid. It now applies to a broader group, the CEO, CFO and three highest paid employees. In addition, the exceptions to the $1 million limit for commissions and performance-based compensation have been eliminated, thus closing an avenue for circumventing the rule. A transition rule survived, however, allowing a public company to take advantage of the looser, prior rules if the company has a written, binding contract in effect on November 2, 2017 that is not modified.
New Deferral Rules for Qualified Equity Grants. Beginning in 2018, an employee of a private corporation who is granted stock options or restricted stock units for services may elect to defer taxes when the equity becomes transferable or vested. The employee’s election must be made within 30 days of the stock’s becoming vested or transferable. The employee can defer income taxation up to 5 years or, if earlier, the occurrence of certain events such as the company’s stock becoming readily tradeable. To be eligible for this tax treatment, the corporation must adopt a written plan granting at least 80% of employees’ stock options or restricted stock units with the same rights and privileges to all employees. The 80% requirement is met if employees are either granted stock options or RSUs for that year and not a combination of both. Excluded from deferral elections are business owners holding at least 1% of the company in the current year or any of the preceding 10 years, one of the four highest paid officers in the current year or any of the preceding 10 years, or anyone who has ever served as CEO or CFO. The election to defer income taxes does not apply to FICA and FUTA which continue to apply.
The employer must notify employees that they are eligible for the election when the employee’s right to stock is substantially vested. Notices are due beginning in 2018. Employers are subject to penalty for failure to give notice of $100 for each failure up to a cap of $50,000. Under a transition rule, however, until regulations are issued, an employer will be treated as being in compliance with the notice requirement if it has used reasonable good faith efforts to interpret and meet the requirements. Employers must also meet withholding and reporting requirements.
This new provision leaves in place prior treatment of restricted property, 83(b) elections and incentive stock options and Code §409A considerations for deferred compensation.
Pass-Through Tax Treatment. Beginning in 2018 (and expiring in 2025) an individual, trust or estate with qualified business income (“QBI”) from a pass-through entity (such as an S corporation, partnership or sole proprietorship) can deduct 20% of that income after compensation is paid. “QBI” refers to business income REIT dividends, but excludes compensation, other dividends, investment interest, and capital gains. If QBI is negative for any tax year that loss is carried over to the succeeding tax year.
Limitations on Deductions. The deduction is capped at the lesser of:
There is no deduction if the pass-through business neither pays W-2 wages nor has the type of depreciable property subject to the second part of the limit.
There is generally no 20% deduction for compensation for services in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services and brokerages. An individual making $157,500 or less (or a married couple earning $315,000 or less) is not subject to the limits on W-2 wages or the prohibition for certain services, however, and can qualify for the deduction. The deduction is phased out for persons earning over these dollar thresholds, and the restrictions on the type of services and the limits on W-2 wages fully apply for individuals with taxable income exceeding $415,000 (if married) or $207,500 for other individuals.
If the individual qualifies for the deduction, it reduces taxable income (“below the line”), and is available whether or not the taxpayer itemizes deductions.
No Change to §409A. Section 409A of the Code continues to regulate deferred compensation as before.
Loans from Retirement Plans. Before 2018, a participant who had not paid back a loan from a 401(k) or other retirement plan was taxed on the outstanding balance of the loan on the date of deemed distribution. An employee who severed employment and a participant in a terminated retirement plan were allowed, however, to defer that tax by rolling over an amount equal to his or her account balance less the outstanding loan ( “plan loan offset amount”). Beginning in 2018, if a retirement plan allows loan balances to offset benefits, an employee who severs employment or who has benefits in a terminated retirement plan has a new deadline for rolling over the plan loan offset amount. The new deadline is the due date (including extensions) of the employee’s tax return for the year of the distribution. If rolled over timely, the participant avoids having the outstanding loan balance treated as a taxable distribution.
Healthcare. Beginning in 2019, individuals will no longer be subject to tax penalties for failing to have health insurance. But employers with 50 or more full-time employees must continue to provide health insurance to employees under federal law to avoid penalty taxes.
Re-characterization of Traditional IRA and Roth Contributions. Beginning in 2018, taxpayers will not be permitted to re-characterize contributions to a traditional IRA as Roth contributions (or vice versa).
Carried Interest. Beginning in 2018, certain partnership interests (typically of private investment funds) must be held for at least 3 years to be treated as long-term capital gains (“carried interests”). If the 3-year holding period is not met, the taxpayer's gain will be treated as short-term gain taxed at ordinary income rates.
Private Schools, Colleges and Universities. Beginning in 2018, a private educational institution having at least 500 students and an endowment of at least $500,000 per full-time student (excluding assets used to pay for educational purposes) is subject to a 1.4% excise tax.
Excise Tax on Executive Compensation. Beginning in 2018, tax-exempt organizations that pay over a $1 million of compensation to any executive will be subject to 21% tax over the threshold. The tax levied is on the sum of:
The compensation limit includes payments made to executives from entities related to the tax-exempt organization. Each employer is liable for a proportionate share of the tax based on the amount of compensation it pays the executive.