Amendments to the Tax Cuts and Jobs Act; Senate Version of Tax Bill Unveiled
Yesterday, Senate Republicans unveiled their version of the tax bill (the "Senate Bill"). This comes one week after House Republicans first introduced the Tax Cuts and Jobs Act (the "House Bill"), the highlights of which were the topic of our November 3, 2017 Alert, and can be read here. The House Bill has already been amended twice, first on November 2nd and then again yesterday. In general, the amendments to the House Bill preserved the tax breaks for retirement saving and did not include any provisions limiting employees' ability to make pre-tax contributions, but the House reversed the controversial repeal of key nonqualified deferred compensation provisions which promised to alter the deferred compensation landscape.
On the other hand, the Senate Bill modified the eligibility for age 50 catch-up contributions, repealed rules permitting additional employee contributions to 403(b) and 457(b) plans, and introduced a nonqualified deferred compensation provision substantially similar to that which the House Bill ultimately removed. Like the House Bill, the cornerstone of the Senate Bill is the reduction of the corporate tax rate to 20%. However, this reduction is less aggressive under Senate Republicans' authorship, delaying the change until 2019. Under the House Bill, corporate tax cuts would take effect next year, in 2018.
Note that no changes were made with respect to the Affordable Care Act in either the House or the Senate versions of the tax bill, including the request by President Trump to repeal the individual mandate.
Amendments to the House Bill
In general, the two amendments made the following changes to the House Bill:
- Gave a reprieve, until 2023, with respect to the exclusion for dependent care assistance programs. In the initial version, the exclusion for dependent care assistance programs would be repealed beginning in 2018.
- Modified the 1.4% excise tax applicable to private colleges and universities. It provided that the 1.4% excise tax on the net investment income would only apply if the fair market value of the institution's endowment assets (other than those assets used directly in carrying out its exempt purpose) that are formally held by organizations related to the institution is at least $250,000 per student.
- Permitted the deferred recognition of income from the exercise of stock options or restricted stock units (RSUs) for up to five years, if such stock is not publicly traded.
- Clarified that RSUs are not eligible for section 83(b) elections under the Internal Revenue Code (the "Code").
- Struck the proposed changes to nonqualified deferred compensation in the initial version of the House Bill in their entirety, thereby preserving their current-law tax treatment.
- Substantially revised the taxation of small business pass-throughs with active income. There is a phased-in 9% tax rate beginning in 2022 (11% in 2018 and 2019, 10% in 2020 and 2021) for the first $75,000 in net business income of an owner or shareholder with less than $150,000 off taxable income through a pass-through business (different dollar amounts apply for unmarried and heads of household, but the same principle applies). Businesses of all types are eligible for the preferential 9% rate, and such rate applies to all business income up to $75,000.
- Preserved the current-law tax treatment for qualified adoption expenses and moving expenses for members of the Armed Forces on active duty who move pursuant to a military order.
With respect to employee benefits, the Senate Bill has a different focus, primarily making changes to 403(b) and 457(b) plans.
- Provided that age 50 catch-up contributions in 401(k), 403(b) and 457(b) plans are not permitted if an employee received wages in excess of $500,000 in the preceding year.
- Imposed a 10% early withdrawal penalty on distributions from governmental 457(b) plans. This penalty did not previously exist for 457(b) plans.
- Repealed the following rules:
o The special rule allowing employee contributions to a 403(b) plan for five years after the employee's termination of employment; and
o The special rules allowing additional elective contributions and catch-up contributions in 403(b) and 457(b) plans.
- Introduced a single aggregate limit for contributions to an employee in a governmental 457(b) plan and elective deferrals for the same employee under a section 403(b) plan or 401(k) plan of the same employer. This means that employees in a 457(b) plan will no longer be able to contribute twice the elective deferral limit in section 402(g) of the Code.
- For purposes of the limits on annual additions to a defined contribution plan under Code section 415, introduced a single aggregate limit for employee contributions to any qualified defined contribution plan such as a 401(k) plan, a section 403(b) plan, and a 457(b) plan maintained by the same employer (including members of a controlled group or affiliated service group).
One area addressed in the Senate Bill which was not addressed by the House Bill is the appropriate classification of workers in a gig economy -- one in which temporary positions are common and organizations contract with independent workers for short term projects -- as employees or independent contractors. Properly classifying these members of the workforce has proved difficult under existing standards. To address this issue, the Senate Bill introduced a worker classification safe harbor whereby the (i) the service provider is not treated as an employee, (ii) neither the service recipient nor the payor for such services is treated as an employer, and (iii) the compensation paid or received for the service is not treated as paid or received with respect to employment.
For the safe harbor to apply, the service provider generally must meet the following conditions: (i) incur expenses which are deductible as a trade or business expense and a significant portion of which are reimbursed; (ii) agree to perform the service for a particular amount of time, to achieve a specific result, or to complete a specific task; and (iii) have a significant investment in assets or training applicable to the service performed, not be required to perform services exclusively for the service recipient, have not performed substantially the same services for the service recipient or the payor as an employee during the one-year period ending with the date of commencement of services under a contract, the term of which may generally not exceed two years, or not be compensated on a basis which is tied primarily to the number of hours actually worked. For a service provider engaged in the trade or business of selling (or soliciting the sale of) goods or services, in lieu of conditions (i), (ii) and (iii) above, the service provider must be compensated primarily on a commission basis, and substantially all of the compensation for the service must be directly related to the sale of goods or services rather than the number of hours worked. In addition, any service provider must (iv) have a principal place of business, must not primarily provide the service in the service recipient's place of business, must pay a fair market rent for use of the service recipient's place of business, or must provide the service primarily using equipment supplied by the service provider. Also, the service recipient under the contract would be required to withhold 5% of the compensation paid under the contract not to exceed $20,000.
The safe harbor would be available with respect to services performed after December 31, 2017, and amounts paid for services after such date.
Nonqualified Deferred Compensation Plans
As previously mentioned, amendments to the House Bill eliminated the newly proposed section 409B which would radically change the manner in which nonqualified deferred compensation is treated. However, the Senate Bill contains a substantially similar provision to section 409B. Under the proposal, without regard to the service provider's method of accounting, any compensation under a nonqualified deferred compensation arrangement is includible in income when there is no "substantial risk of forfeiture". A substantial risk of forfeiture is limited to the service provider's right to receive the compensation being conditioned on the future performance of substantial services.
Nonqualified deferred compensation arrangements are broadly defined. While there are exceptions for qualified retirement plans, bona fide vacation leave, sick leave, compensatory time, disability pay, and death benefit plans, there are no exceptions for severance plans (and the IRS is precluded from making any exception for severance plans, bona fide or otherwise). It also includes stock appreciation rights, nonqualified stock options, and restricted stock units, but not incentive stock options or stock under a qualified stock purchase plan under Code section 423.
Like the House Bill, the proposal also removes from the Code, with respect to services performed after December 21, 2017, Sections 409A, 457(b) (for tax exempt employers), 457(f) plans of state and local governments and tax-exempt employers, and 457A. As was the case with the House Bill, this Senate provision presents a current operational issue for plan sponsors obtaining elections with respect to 2018 services under existing nonqualified deferred compensation arrangements. It may be necessary to communicate to participants in such plans that, because of the uncertainty as to future law, such deferrals may not be given effect.
With respect to "grandfathered" amounts (i.e, amounts attributable to services performed before January 1, 2018), such amounts are includible in income in the later of (1) the last taxable year before 2027, or (2) the taxable year in which there is no substantial risk of forfeiture. The Treasury is also directed to provide guidance with respect to a limited period of time during which existing nonqualified deferred compensation arrangements can be modified to conform to the Senate proposal, without violating the existing 409A rules with respect to modifying the date of distribution.
Other changes in the Senate Bill relating to nonqualified compensation matters are similar, but not identical, to those in the House Bill.
- With respect to the $1 million deduction limit on compensation paid to "covered employees" available to publicly traded companies, the definition of "covered employee" under Code section 162(m) would be modified. A covered employee would include both the principal executive officer and the principal financial officer, including any individual who has served in such capacities during the taxable year, and the three highest compensated employees for the tax year required to be reported on the company's proxy statements. The effect of this change would be to include five individuals as covered employees, rather than four. Further, if an individual is a covered employee with respect to a corporation for a taxable year beginning after December 31, 2016, the individual would remain a covered employee for all future years. The proposal would also extend the applicability of Code section 162(m) to include all domestic publicly traded corporations and all foreign companies publicly traded through ADRs, and would also include additional corporations that are not publicly traded, such as large private C or S corporations. Finally, the proposal would eliminate the exceptions for commissions and performance-based compensation from the definition of compensation subject to the $1 million compensation limitation.
- A tax-exempt organization would be subject to a 20% excise tax on the sum of (1) the compensation (other than an excess parachute payment) in excess of $1 million paid to any of its five highest paid employees for the tax year or any employee who was one of the five highest paid employees for any preceding taxable year after 2016, and (2) any excess parachute payment. Excess parachute payment would be redefined for this purpose. This means that the excise tax would apply even if the individual's compensation does not exceed $1 million. This proposal would subject tax-exempt organizations to a modified version of the Code's present golden parachute requirements.
Individual Income Taxes
The Senate plan would retain the existing seven tax brackets for individuals, instead of taking the House approach which would consolidate them into four tax brackets. In general, a 12% bracket would replace the existing 15% bracket, while the existing top rate of 39.6% would be reduced to 38.5%.
Like the House Bill, the standard deduction would be increased to $24,000 for joint filers (and surviving spouses), $12,000 for single filers and $18,000 for heads of household. The Senate Bill would also eliminate federal deductions for state and local income taxes, just as the House Bill would do. However, the Senate eliminated the property tax deduction, while the House version allowed the deduction of property taxes up to $10,000. The Senate left the interest deduction for mortgages for new homes and the deduction for charitable contributions unaffected. (The House Bill proposed to cap the mortgage interest deduction at a loan value of $500,000.) The alternative minimum tax would also be repealed under the Senate Bill.
Tax Deductions and Exclusions
- No deduction for qualified transportation fringe benefits, but an employee is still permitted to make pre-tax contributions to such plans.
- Repeals the deduction and exclusion for qualified moving expenses, except with respect to exclusions attributable to in-kind moving and storage (and reimbursements or allowances for these expenses) for members of the Armed Forces or their spouse or dependents.
- The deduction for medical expenses would be preserved.
- The exclusion for adoption assistance would be preserved.
- The exclusion for dependent care would be retained.
- The exclusion for qualified bicycle commuting expenses would be repealed.
- The exclusion for educational assistance was unaffected by the Senate Bill.
- The deduction and exclusion available with respect to an Archer Medical Savings Account are preserved.
The Senate Bill doubles the estate and gift tax exemption amount by doubling the basic exclusion amount (currently $5 million) to $10 million, which is indexed for inflation after 2011. Unlike the House Bill, the Senate Bill does not eliminate the estate tax.
Like the House proposal, the Senate Bill proposes several modifications to the rules governing exempt organizations, including subjecting certain private colleges and universities to a 1.4% excise tax on net investment income.
Corporate Tax Rate. Corporate tax rates would be lowered to a flat 20% rate beginning in 2019, instead of in 2018 as was proposed by the House. As we mentioned in our prior Alert, one consequence of this is that expenditures would be more valuable under the current Code than under the modified Code.
Pass-Through Rate. With respect to the treatment of pass-through income by businesses, unlike the House Bill which focused on the rate at which such income would be taxed, the Senate Bill would allow individuals to deduct 17.4% of domestic qualified business income from a partnership, S corporation or sole proprietorship effective for taxable years beginning after December 31, 2017. The deduction would not be available to specified service trades or businesses, defined in the same manner as under the House Bill, except in the case of a married taxpayer whose taxable income did not exceed $150,000 ($75,000 for other individuals), phased out above these dollar amounts.
With respect to the qualified business income of an S corporation or partnership, the amount of the deduction would be limited to 50% of the taxpayer's W-2 wages. For S corporations, qualified business income would not include any amounts treated as reasonable compensation to the taxpayer, and for partnerships qualified business income would not include amounts allocated or distributed to a partner acting other than in his or her capacity as partner for services, and guaranteed payments for services actually rendered to a partnership, to the extent that the payment is in the nature of remuneration for such services.
Conclusion - Reconciliation
If the House and Senate pass separate tax bills, lawmakers will need to work together to reconcile them and there's no telling what the final product will look like. This may be a tall order in light of the tight timeframe they have set for themselves. Republicans have targeted the end of 2017 to overhaul the U.S. tax system.
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