Having missed a historic opportunity to choose an exciting name for federal tax legislation, Texas Representative Kevin Brady and his fellow Republican tax drafters did not skimp on the substance of the Tax Cuts and Jobs Act (TCJA), delivering a sizable grab bag of post-Halloween tricks and treats for most taxpayers and proposing fairly major surgery on the venerable Internal Revenue Code of 1986, as amended (the Code). Although the focus of the tax reform proposal is first and foremost on some traditional Republican shibboleths (e.g., corporate tax rates, the estate tax, the alternative minimum tax), there are many provisions that would, if enacted, significantly impact employee and fringe benefit programs for many employers. The following is our attempt at a brief summary of each of these proposals. In general, these proposals would be effective beginning January 1, 2018, although this assumes that the final version of the bill is enacted prior to that date—an outcome we would not bet any significant amount of money on.
- Archer MSAs. Medical savings accounts (MSAs) are a bit of a historical artifact at this point, having been largely supplanted by health savings accounts and other similar programs. The TCJA would formally suspend tax benefits for future employer or employee contributions to any remaining MSAs. The bill also contains a number of clean-up provisions eliminating cross-references to the administrative requirements applicable to MSAs.
- Employee Business Expenses. Historically, employees who incurred unreimbursed out-of-pocket expenses as part of performing their jobs could potentially deduct those expenses. The TCJA proposes to eliminate this option by treating these expenditures as nondeductible personal expenses. Notably, the TCJA reaffirms the viability of the exclusion for working condition fringe benefits under Code Section 132(d). It would also make a non-substantive change to the deduction applicable to attorneys’ fees awards relating to employment discrimination lawsuits.
- Employer-Provided Lodging. Under Code Section 119, employers can provide tax-free lodging to employees in some circumstances. The TCJA proposes to limit this benefit to $50,000 per year for one residence only, with a phaseout of the exclusion for highly-compensated individuals (i.e., those who earn $120,000 or more in 2017) and an outright exclusion for individuals who own 5 percent or more of the employer providing the lodging.
- Entertainment and Fringe Benefit Expenses. The TCJA proposes significant limitations on the deductibility of several common employer-provided fringe benefits and expense reimbursements. Specifically, no deduction will be allowed for expenses (even if business related) relating to entertainment or recreational activities, social club membership dues, or “de minimis” fringe benefits that are primarily personal in nature. Employer expenditures for qualified transportation and parking benefits (e.g., public transit passes or employer-paid parking) similarly lose their deductibility, as do on-site employee athletic facilities. Business-related meal expenses remain subject to a 50% limitation, but the TCJA carves out expenses with a recreational nature. None of this means that employers can no longer reimburse for or provide the referenced benefits to employees, just that they will be precluded from deducting those costs as business expenses.
- Employee Achievement Awards. The Code has historically allowed a limited income exclusion for achievement (and safety) awards provided by employers to employees. The TCJA proposes to eliminate this modest exclusion and related employer deduction, meaning these awards would be taxable to their recipients. An employer’s provision of these rewards might still be deductible as an ordinary-and-necessary compensation-related expense in some circumstances.
- Dependent Care Assistance Programs. Many employers maintain dependent care assistance programs as a component of their broader “cafeteria” or “flexible benefit” plans. These programs allow employees to set aside a portion of their pay on a pretax basis to fund the costs of providing work-related care to their dependent children. The TCJA proposes to eliminate Code Section 129 altogether, meaning dependent care assistance programs would no longer be available.
- Moving Expense Reimbursements. Many employers reimburse relocating employees for the costs associated with their moves. These reimbursements are often nontaxable under Code Section 132. The TCJA proposes to eliminate this exclusion, thereby causing employer-funded moving expenses provided to new and existing employees to become taxable to the employees. The existing deduction for moving expenses under Code Section 217 is also eliminated.
- Adoption Assistance. The TCJA proposes to eliminate the existing exclusion for employer-funded adoption assistance benefits provided to employees under Code Section 137. Employers would still be able to provide adoption assistance benefits to employees in the absence of the exclusion, but unless the benefits qualified for another exclusion, they would be taxable to their recipients.
- Roth IRA Recharacterization. The TCJA proposes to eliminate a rule in Code Section 408A that has previously allowed the owners of “traditional” individual retirement accounts to recharacterize their contributions as after-tax Roth contributions in a subsequent year after having first made them on a pre-tax basis.
- In-Service Distributions From Qualified Plans. Under existing law, in-service distributions from defined benefit pension plans can be made once a participant reaches age 62. The TCJA proposes to liberalize and extend the rules to permit in-service distributions once a participant reaches age 59 and one half. This change would also apply to eligible deferred compensation plans maintained by governmental employers under Code Section 457(b).
- Hardship Distributions From 401(k) Plans. The TCJA includes several changes to the existing rules for hardship distributions made under 401(k) plans. First, the TCJA directs the U.S. Department of the Treasury to eliminate the existing 6-month prohibition on employee contributions to 401(k) plans following their receipt of a hardship distribution. The TCJA would also expand the permissible funding sources for hardship distributions to include not only employee contributions but also most employer contributions and any related investment earnings. Participants would also be excused from first attempting to alleviate a financial hardship by requesting a plan loan.
- Loan Rollovers. In what would be a welcome change for many plan sponsors, the TCJA proposes to allow retirement plan participants who face acceleration of their outstanding plan loan balances due to termination of a plan or termination of employment an additional amount of time to roll over their balances into a successor plan (but not an individual retirement account, which would otherwise be eligible to receive a rollover contribution). The extended deadline for completing the loan rollover would be the due date (plus extensions) for the individual’s tax return for the year in which the loan balance was treated as distributed.
- Nondiscrimination Rules for Older, Long-Service Employees. The TCJA proposes to create new Code Section 401(o) to supplement and modify existing nondiscrimination rules for frozen defined benefit pension plans. Historically, frozen pension plans could age into compliance issues under the existing nondiscrimination rules, effectively forcing employers into difficult choices about their continued ability to maintain these plans. The proposed rules appear to offer employers in this situation some new opportunities to combine certain frozen pension plans with other ongoing plans for nondiscrimination testing purposes, potentially giving the frozen plans a new lease on life.
- Employer-Funded Childcare. The TCJA proposes to eliminate the tax credit available to employers for providing and/or maintaining childcare facilities for their employees’ dependent children. Employers would still be free to build and maintain childcare facilities for their employees, but no federal tax credit would be available for doing so.
- Executive and Deferred Compensation. The TCJA proposes a number of significant changes to the rules for executive and deferred compensation. If history is any guide, these changes would require substantial administrative guidance before they would be ready for implementation.
- New Code Section 409B. The TCJA would create Code Section 409B to comprehensively regulate a broad range of deferred compensation arrangements, including some to which Code Section 409A does not apply. For those familiar with the existing tax rules for deferred compensation arrangements maintained either by foreign corporations or nonprofit and governmental entities, Section 409B will seem quite familiar as it is substantively identical to Code Sections 457A and 457(f).
In practice, Section 409B would greatly constrain opportunities to provide tax-deferred compensation and would effectively require deferred compensation to remain at risk of forfeiture as a condition of receiving tax-deferred treatment. Interestingly, Section 409B would treat most forms of equity compensation, including stock options and stock appreciation rights (but notrestricted stock/equity), as deferred compensation—apparently even where these forms of compensation were exempt from Section 409A. That said, Section 409B would exclude what have come to be known as short-term deferral arrangements from its coverage, meaning compensation arrangements where the delay between the time when pay is earned and when it is paid is relatively brief would avoid coverage.
- Whither Goest Thou, Code Section 409A? Speaking of Section 409A, the long-time favorite of tax practitioners and the bane of everyone else, the TCJA would effectively repeal it in favor of Section 409B. We will now observe a brief moment of silence in honor Section 409A, whose reign of terror may now be nearing its end . . . Existing deferred compensation arrangements would be left standing but with a significant caveat: amounts deferred prior to 2018 that are not subject to a substantial risk of forfeiture would become taxable in 2025 at the latest, even if they otherwise comply with Section 409A’s requirements. The TCJA proposes a limited (i.e., 120-day) exception to Section 409A’s usual prohibition on accelerated payments to allow existing deferred compensation programs of all sorts to be wound up and cashed out.
- Tax Exempt and Governmental Deferred Compensation. It appears that the TCJA was intended to sunset “eligible” and “ineligible” plans subject to Sections 457(b) or (f) maintained by tax-exempt entities and ineligible plans maintained by governmental entities, in both cases after 2017. Also, of note, is the express clarification that a “substantial risk of forfeiture” cannot be created through a covenant not to compete or other conditions not directly contingent on the future performance of services; this reverses prior guidance issued by the IRS for ineligible deferred compensation plans under Section 457(f) and would significantly limit planning opportunities going forward..
- Foreign Arrangements. The TCJA would also eliminate Section 457A in favor of consolidating the regulation of deferred compensation arrangements maintained by foreign companies or other “tax indifferent” entities under Section 409B.
- Performance-Based Pay. The TCJA proposes some fairly significant changes to the existing Code Section 162(m) rules for executive pay. Historically, “performance-based pay” provided to the top officers of public companies was exempt from Code Section 162(m)’s general limitation on annual pay to $1 million. This exception spawned an extensive consulting industry, which is undoubtedly readying its lobbyists for combat over the proposed changes. The effect of the TCJA proposal appears to be that all pay, including equity awards, performance-based bonuses, and other similar forms of compensation, would become subject to the $1 million annual cap. Public companies could still pay their executives more than this amount but would not receive corresponding tax deductions for the excess amounts. In addition, the TCJA would expand the class of public companies to which Section 162(m) applies and expand the group of executives who may be subject to its limitations.
- New Code Section 409B. The TCJA would create Code Section 409B to comprehensively regulate a broad range of deferred compensation arrangements, including some to which Code Section 409A does not apply. For those familiar with the existing tax rules for deferred compensation arrangements maintained either by foreign corporations or nonprofit and governmental entities, Section 409B will seem quite familiar as it is substantively identical to Code Sections 457A and 457(f).
We generally avoid paying too much attention to proposed legislation in light of the vagaries of the political process—one never knows what might emerge from the congressional sausage factory. Virtually all of the provisions targeted by the TCJA have well-funded lobbying constituencies, so we will refrain from making predictions about what the final bill, if any, will look like. (As a noted philosopher has observed, “making predictions is hard, especially about the future.”) However, Congressional Republicans are under great pressure to enact something—anything—that can plausibly be referred to as “tax reform” and that significantly increases the likelihood that some form of the TCJA or, at least, many of its key provisions will end up in the Code at some point. So, for now, stay tuned for further developments from Washington, D.C.
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National Law Review, Volume VII, Number 308