President Trump has signed sweeping tax reform legislation into law. The reforms reduce corporate and individual rates, and are intended to boost international competitiveness and simplify the tax code. To achieve those goals, the Tax Cuts and Jobs Act (H.R.1) amends, limits or eliminates numerous tax provisions, including some with implications for compensation and benefits.
The act retains the current 401(k) and 403(b) elective deferral limits but makes other changes to the rules for employer-sponsored defined contribution plans:
- To prevent leakage from the defined contribution system, the act gives employees more time to roll over outstanding plan loan balances to an IRA following a plan termination or separation from employment. Under current rules, an outstanding loan is treated as a distribution in those circumstances unless the employee contributes the loan balance to an IRA within 60 days. Under the new provision, employees have until the due date for filing that year’s tax return. The provision applies to tax years beginning after 2017.
- The 10% early withdrawal penalty is waived for qualified 2016 disaster relief distributions. Recipients of such distributions may spread the income inclusion over three years. In addition, recipients may repay the withdrawn amount as long as they do so within three years.
Other retirement provisions that appeared in earlier versions of the legislation approved by the House or Senate were dropped from the final agreement, including the following:
- Employees would not have been required to take all available plan loans before obtaining a hardship distribution, and employers could have made earnings, qualified matching contributions (QMACs) and qualified nonelective contributions (QNECs) available for hardship distributions (current rules restrict such distributions to elective contributions). The House bill also would have eliminated the six-month contribution hiatus after taking a hardship distribution.
- Defined benefit plans that are closed to new entrants and meet certain conditions would have been eligible for expanded cross-testing, thus making it easier for them to pass nondiscrimination tests.
- The age for beginning in-service distributions from defined benefit plans and state and local governmental plans would have been reduced to 59½.
Executive compensation provisions
While proposals to tax nonqualified deferred compensation at vesting were dropped from both the House and Senate proposals, several provisions impacting executive compensation made it into the new law.
- The act eliminates the exceptions for performance-based compensation and commissions from the $1 million deduction limit under Internal Revenue Code section 162(m). The act also expands the definition of “covered employee” to include anyone who was the CEO or CFO any time during the year, plus the three other highest-paid employees. Further, starting with the 2017 tax year, once an employee becomes a covered person, he or she remains a covered person indefinitely, including after retirement. In addition, the $1 million deduction limit also applies to certain foreign corporations and large private corporations. The act provides a transition rule for compensation provided under binding agreements entered into before November 2, 2017, which is effective for tax year 2018.
- Tax-exempt organizations will pay a 21% excise tax on compensation over $1 million paid to their five highest-paid employees. A covered person designation will be permanent. The excise tax also will apply to excess parachute payments provided to covered employees. The provision applies beginning in 2018.
- Certain employees who exercise stock options as compensation may defer the recognition of income for up to five years if the stock is not tradeable on an established securities market. The provision is generally effective after 2017.
- A three-year holding period applies for carried interest to be treated as a long-term capital gain after 2017.
- The act increases the excise tax on stock compensation paid to insiders in expatriated corporations from 15% to 20% for companies that expatriate after December 22, 2017.
Health care provisions
- The Affordable Care Act’s (ACA) penalty for not complying with the individual mandate is eliminated as of 2019.
- The final agreement reduces the threshold for claiming the itemized deduction for qualified medical expenses from 10% to 7.5% of income for 2017 and 2018, and then reinstates the 10% threshold for 2019 and later years.
Other benefit-related provisions
- Employers may not deduct employee achievement rewards in the form of cash, cash equivalents, gift cards, gift coupons or gift certificates (other than in arrangements offering a preselected limited array of such items), meals, vacations, lodging, theater or sporting event tickets, stocks, bonds or other securities after 2017.
- Employers may no longer deduct amounts related to qualified transportation and parking benefits after 2017. The act also suspends the employee exclusion for qualified bicycle commuting benefits for 2018 through 2025.
- The agreement repeals the employee tax exclusion for moving expenses for 2018 through 2025 and then reinstates it in 2026.
- Many values in the tax code will be indexed to the Chained Consumer Price Index (C-CPI-U), including the ACA 40% excise tax on high-cost group health plans, health savings account (HSA) limits, flexible saving arrangement (FSA) salary reduction caps and others. Qualified plan limits will not be indexed to the C-CPI-U.
- Employers that offer paid family and medical leave programs that meet specified conditions are eligible for a temporary tax credit starting in 2018.
Provisions to eliminate the employee tax exclusion for employer-provided dependent care, educational assistance and adoption assistance benefits were dropped.
The act makes significant changes for corporations, including changes to the tax rates and rules for tax credits and deductions. In general, the changes take effect for taxable years beginning after December 31, 2017, but special rules apply for non-calendar-year taxpayers.
- Beginning with 2018, the corporate tax rate is 21% (down from a maximum of 35%).
- The corporate alternative minimum tax (AMT) is repealed effective in 2018.
- Qualified new property placed in service between September 27, 2017, and January 1, 2023, is eligible for full immediate expensing. The 100% limit will phase out over four years.
- The deduction for business interest expense is now limited to 30% of the business’s adjusted taxable income.
Like corporations, individual taxpayers will see changes to tax rates, credits and deductions effective in 2018. Unlike the corporate tax provisions, the individual tax changes are scheduled to sunset after 2025.
- The act establishes seven tax rates: 10%, 12%, 22%, 24%, 32%, 35% and 37%.
- The standard deduction is now $24,000 for joint filers and $12,000 for single filers ($18,000 for heads of household). The agreement repeals the personal exemption.
- The agreement increases the child tax credit to $2,000 and adds a new $500 credit for non-child dependents. The credits will be phased out for incomes over $400,000 (for joint filers).
- The act does not eliminate the AMT but increases the exemptions and phase-out thresholds.
- The exemption from the estate tax is doubled (it is now $5.49 million for individuals and $10.98 million for married couples).
- The agreement limits the mortgage interest deduction to loans of $750,000 or less for debt incurred on or after December 15, 2017. The act repeals the deduction for interest on home equity loans.
- Filers may deduct up to $10,000 in state and local income, property or sales taxes.
As many of the changes take effect for the 2018 tax year, employers and employees will be eager to figure out how the reforms will affect them. Several of the reforms may prompt major changes to compensation and benefit structures and processes, including payroll withholding, executive compensation, health care and more.