The following is a summary of some of the provisions of the Tax Cuts and Jobs Act that have the most significant impact on compensation and employee benefits. Please note that this is not intended to provide a comprehensive summary of all of the provisions of the Act that affect compensation and benefits.
Repeal of deduction for entertainment expenses
Prior to 2018, taxpayers could deduct expenses for entertainment activities, but only if (a) the expenses related directly to the active conduct of the taxpayer’s trade or business, or (b) in the case of an expense for an item directly preceding or following a substantial and bona fide business discussion, the item was associated with the active conduct of the taxpayer’s trade or business. The deduction was generally limited to 50% of otherwise deductible expenses.
The Act repeals the deduction for any activity that is of a type generally considered to constitute entertainment, amusement, or recreational. It also repeals any deduction for membership dues relating to a club that is organized for business, pleasure, recreation, or other social purposes.
Repeal of Affordable Care Act’s individual mandate
Currently, under the Affordable Care Act, individuals must obtain minimum essential health coverage or be subject to a penalty for failure to maintain the coverage. This provision, known as the “individual mandate,” has been very controversial ever since the enactment of the ACA. Starting in 2019, this penalty is eliminated.
At this point, we can only speculate as to the impact of the elimination of this penalty. It is possible that it will encourage many people to forego coverage, or obtain less expensive coverage, even though they might have qualified for premium subsidies under the ACA. If so, it might well drive up the cost of insurance, because the people who forego or reduce their coverage will likely be healthier than those who do not.
Cap on deductibility of employee compensation in excess of $1 million
For tax years beginning in 2017 or earlier, public companies, defined as companies whose common stock is publicly traded, could deduct only $1,000,000 of compensation per year per executive for compensation paid or accrued to certain top executives. Certain types of compensation, including performance-based compensation and commissions, were excluded from determining whether the $1,000,000 limit had been reached.
The Act expands this provision in several ways:
- It eliminates the performance-based compensation and commission exceptions.
- If an individual is a covered employee for any tax year commencing after 2016, his or her compensation remains subject to the deduction limit in subsequent tax years, even if he or she is no longer a covered employee or the amounts are paid to a beneficiary. Thus, it can apply to items such as severance or deferred compensation payments, even if paid to the employee’s spouse or other beneficiary.
- It expands the category of covered employers to include companies with publicly traded debt instruments and foreign corporations that are publicly traded through ADRs.
Excise tax on employee compensation in excess of $1 million paid by a tax-exempt organization
The Act imposes on tax-exempt employers a 21% (the new corporate tax rate) excise tax on compensation in excess of $1,000,000 paid to any of its top five highest compensated employees, as well as on payments contingent on separation from employment paid to one of these employees that are in excess of three times his or her prior average annual compensation.
If an individual is a covered employee for any tax year commencing after 2016, the 21% excise tax rules continue to apply in subsequent taxable years, even if he or she is no longer in the top-paid group.
Compensation is treated as paid when there is no longer a substantial risk of forfeiture, and it includes amounts required to be included in gross income under section 457(f). This could have a significant impact because 457(f) arrangements are commonly used with respect to executives of exempt organizations, and these arrangements can result in extreme “bunching” of retirement income at the time of vesting.
Payments attributable to medical services of certain qualified medical professionals are exempt from this provision. This is sometimes referred to as the “surgeon exemption,” and it reflects the facts that (a) medical professionals often command very high compensation in the open market and (b) they typically are not the type of insiders that this provision is intended to address.
Repeal of deduction for qualified transportation fringe benefits
Prior to 2018, employers could generally deduct expenses for qualified transportation fringe benefits (certain commuting and parking benefits), and these benefits were not taxable to employees. The Act repeals the deduction for qualified transportation fringe benefits, although the benefits continue to be tax-free to employees.
Repeal of exclusion for qualified moving expense reimbursements
Prior to 2018, employees could exclude from income, for both income tax and FICA purposes, employer-provided moving expense reimbursements. The Act repeals this exclusion, but provides an exception for members of the U.S. Armed Forces on active duty who move pursuant to a military order and incident to a permanent change of station. This repeal is scheduled to sunset after 2025.
Employer credit for paid family and medical leave
For tax years beginning in 2018 and 2019 only, the Act creates a new general business tax credit for employers that pay “qualifying employees” while they are on family and medical leave. To qualify for this credit, the following requirements must be met:
- The employer must allow all qualifying full-time employees not less than two weeks of annual paid family and medical leave. Leave must be offered on a pro rata basis for less-than-full-time employees.
- The leave program must provide for payment of at least 50% of the wages normally paid to an employee.
- Vacation leave, personal leave, or other medical or sick leave are not considered family and medical leave, and leave paid for or mandated by a state or local government is not taken into account.
A “qualifying employee” is an employee who has been employed by the employer for at least one year, and who, for the preceding year, had compensation not in excess of 60% of the compensation threshold for highly compensated employees. This threshold is $120,000 for 2018 and is adjusted for inflation.
The credit equals 12.5% of the amount of wages paid, increased by 0.25% for each percentage point by which the rate of payment is between 50% and 100% of wages paid. The maximum amount of family and medical leave that may be taken into account with respect to any employee for any taxable year is 12 weeks.
By way of example, assume that an employer pays an employee $4,000 under a program that qualifies for this credit. If $4,000 is 50% of the normal rate of pay, the credit is $500. If $4,000 is 100% of the normal rate of pay, the credit is $1,000.
Qualified equity grants
Effective for tax years beginning after 2017, the Act allows private companies to offer rank and file employees the opportunity to defer for up to 5 years income tax inclusion on compensatory stock options or restricted stock units, provided that the following requirements are met:
- There must be a written plan.
- The plan must cover at least 80% of all employees providing services to the company in the United States.
- This special deferral rule is not available to 1% owners, current or former CEOs and CFOs (including their family members), or certain highly compensated officers.
My impression is that the above restrictions seem significant enough so that it appears that few employers would find it attractive to take advantage of this provision.
IRA Roth conversion recharacterizations
Prior to 2018, an individual could, prior to the due date of his or her tax return, recharacterize a conversion (also known as a rollover) of a traditional IRA to a Roth IRA. In general, the advantage of a Roth conversion is proportionate to the degree to which the assets increase in value after the conversion. The ability to recharacterize gave the individual an opportunity to undo the conversion if the assets decreased in value, but not if they increased in value.
This provision has been repealed. However, it is still permissible to recharacterize an annual contribution to a traditional IRA as a contribution to a Roth IRA, or vice versa.
If you have any questions, please contact Drew Cheney at 1.800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.