This article summarizes the major compensation and benefits provisions that appear in the tax reform act, H.R. 1, passed Dec. 22, 2017, and commonly referred to as the Tax Cuts and Jobs Act (the Act).
Compensation in for-profit entities
Executive compensation deduction limit
Section 162(m) limits a public corporation’s tax deduction to $1 million per covered employee per taxable year. Under prior law, the term “covered employee” included the CEO and the three highest-paid officers, other than the CEO and CFO, as of the last day of the taxable year (meaning the CFO was excluded from consideration). For purposes of the limit, the definition of compensation excluded commissions and qualified performance-based compensation.
The Act expands the definition of “covered employee” to include any individual who served as the CEO or CFO at any time during the taxable year rather than just as of the last day of the year. The next three highest-paid officers serving at the end of the taxable year continue to be covered employees. Any individual who is a covered employee in taxable years beginning after Dec. 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 Act 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 Act 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 Dec. 31, 2017. However, the changes do not apply to a written binding contract with the covered employee that was in effect on Nov. 2, 2017, that is not materially modified after that date. Once a contract is renewed, compensation paid under the contract becomes subject to these changes.
Qualified equity grants
Section 83 generally requires an employee who holds a nonstatutory stock option or a restricted stock unit (RSU) to recognize compensation income when the underlying stock is transferred to him or her.
Under the Act, 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 time when income is generally recognized under current law. 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. However, if neither of these occurs within five years after vesting, the employee must recognize the income on the date that is five years after vesting. If the employee becomes an “excluded employee” (as described later), he or she must recognize the income upon becoming an excluded employee. The employee may revoke the election at any time prior to when the compensation is recognized, and upon revocation, the income will be recognized.
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 cannot receive grants, but they do not qualify for 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.
With respect to options, the election may be made by individuals who receive grants of nonstatutory stock options or incentive stock options, as well as grants under an employee stock purchase plan. If the election is made, any special taxation rules that would otherwise apply to the grants, such as special rules for incentive stock options and employee stock purchase plans, would no longer apply.
These provisions apply to stock attributable to options exercised, or RSUs settled, after Dec. 31, 2017.
Qualified moving expense reimbursements
Prior to the Act, an employee could exclude from income certain moving expense reimbursements provided by an employer. The Act repeals the exclusion for qualified moving expense reimbursements from an employee’s income. The exclusion is no longer available after Dec. 31, 2017, but becomes available again beginning in 2026.
Qualified bicycle commuting reimbursement
Prior to the Act, an employee could exclude from income up to $20 per month of qualified bicycle commuting expenses reimbursed by an employer. The Act repeals the exclusion from employee income of qualified bicycle commuting expense reimbursements. The exclusion is no longer available after Dec. 31, 2017, but becomes available again beginning in 2026.
Employee achievement awards
Current tax law generally excludes from an employee’s income up to $1,600 for length of service or safety achievement awards of tangible property. An employer may take a deduction for employee achievement awards, but the deduction is limited.
The Act clarifies that employee 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 pre-selected or pre-approved by the employer), vacations, meals, lodging, tickets to theater or sporting events, stocks, bonds, other securities, and other similar items.
These changes are effective for amounts paid or incurred after Dec. 31, 2017.
Qualified transportation benefits
Employers can provide certain transportation benefits to employees on a tax-free basis, and can take a deduction for providing the benefits. These benefits include commuting via mass transit (tax-free up to $260 per month in 2018) and parking (also tax-free up to $260 per month in 2018).
The Act eliminates the employer deduction for these benefits. This change is effective for amounts paid after Dec. 31, 2017.
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 (including extensions) for the year of the original conversion.
The Act repealed the rules allowing a conversion to a Roth IRA to be reconverted to a traditional IRA. This is effective for taxable years beginning after Dec. 31, 2017.
In frequently asked questions posted on its IRS.gov
website, the IRS clarified the effective date of the changes to Roth IRA recharacterizations made by the Act. The changes made by the Act 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. Effective Jan. 1, 2018, conversions to a Roth IRA from a traditional IRA, SEP, or SIMPLE plan cannot be recharacterized back to the former plan. Additionally, amounts rolled over to Roth IRAs from other retirement plans, such as Section 401(k) or 403(b) plans, may not be recharacterized back to the former plan.
Extended rollover period of plan loan offsets
Defined contribution retirement plans, such as 401(k) plans, often allow plan loans. Many plans treat unpaid participant loans as a distribution from the plan upon a participant’s termination of employment or upon termination of the plan. Prior to changes made by the Act, on the date an employee’s plan or employment terminated while the employee had a plan loan outstanding, the employee had 60 days from that date to repay the loan or contribute the loan balance to an IRA to avoid a taxable distribution.
The Act extends the due date of a defined contribution plan loan repayment or contribution to an IRA to the due date of an employee’s tax return (including extensions) for that year. The plan loan due date extension is effective after Dec. 31, 2017.
New excise tax on executive compensation for non-profit entities
The Act subjects tax-exempt organizations to a 21% excise tax on compensation in excess of $1 million paid to any of its five highest-paid employees (“covered employees”) for the tax year. Once an employee is a covered employee, he or she remains a covered employee for all subsequent years, even if he/she is no longer among the top five highest-paid employees.
For purposes of the tax, compensation is defined as the compensation that is subject to income tax withholding. However, any Roth contributions to the employer’s retirement plans are subtracted from compensation, and funds in a Section 457(f) plan are counted as compensation in the year they become vested. Compensation paid to a licensed medical professional, such as a doctor, nurse or veterinarian that is directly related to the performance of medical or veterinary services is not taken into account in identifying covered employees, or in calculating the amount of compensation subject to the tax.
In addition, “excess parachute payments” made to covered employees are subject to a separate 21% excise tax. The Act defines excess parachute payments as any payments contingent upon the employee’s separation from employment. The tax is triggered if the parachute payments equal or exceed three times the employee’s base amount. Base amount is defined as the employee’s average compensation for the prior five years. If the tax is triggered, the tax is equal to 21% of the amount that the parachute payments exceed the base amount.
These taxes take effect for taxable years beginning after Dec. 31, 2017. In addition to treating the top five highest-paid employees in that year as covered employees, an employer must count the top five highest-paid employees in the preceding year (the taxable year beginning after Dec. 31, 2016) as covered employees.
Unrelated business taxable income for tax-exempt organizations
The Act treats funds used to pay for employee qualified transportation fringe benefits (e.g., mass transit and parking) and on-premises athletic facilities available primarily for highly compensated employees as unrelated business taxable income.
This takes effect for amounts paid after Dec. 31, 2017.
Length of service award plans
A length of service award earned by a bona fide volunteer on account of qualified services does not provide for the deferral of compensation for purposes of Section 457 if the amount of the award that accrues each year is not in excess of a certain amount. Under prior law, the amount was $3,000.
The Act changes the length of service award annual threshold from $3,000 to $6,000, and provides that the annual threshold is adjusted annually for the cost of living. The Act 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 Dec. 31, 2017.
Affordable Care Act individual shared responsibility payments
Under current law, individuals are generally required to be enrolled in minimum essential health coverage or pay an excise tax. The Act eliminates the Affordable Care Act “individual mandate,” effective with respect to health care coverage for months beginning after Dec. 31, 2018.
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. Generally, if the asset is held for more than one year, the gain is treated as a long-term capital gain.
For carried interests involving investment and real estate businesses, the Act 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. Gains on assets held for less than that amount of time are short-term capital gains. Under the new provision, 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 a Section 83(b) election, does not change the three-year holding period requirement.
This rule does not apply to any capital interests 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 Dec. 31, 2017.
Employer credit for paid family and medical leaveents
The Act 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 maximum leave period that qualifies for the credit for a tax year is 12 weeks.
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.
“Eligible employers” are employers that provide all qualifying full-time employees at least two weeks of annual paid family and medical leave and provide part-time employees an amount of 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 (as indexed for inflation in 2018).
The credit is first available for wages paid in taxable years beginning after Dec. 31, 2017, but expires beginning with wages paid in taxable years after beginning after Dec. 31, 2019. Thus, for calendar years, it is in effect for 2018 and 2019.
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