Yesterday, the Chair of the House Ways and Means Committee introduced the tax-writing body’s inaugural bill, the Tax Cuts and Jobs Act (the “Act”) outlining the federal tax reform plan. In general, the proposed changes are good news for 401(k) plans, since the Act did not include any provisions limiting employees’ ability to make pre-tax contributions; nor did it reduce amounts that can be contributed to 401(k) or 403(b) plans. However, the Act severely curtails nonqualified deferred compensation. For the most part, the provisions of the Act would be effective for tax years beginning after 2017. While changes will likely be made during the markup process, below is a high-level summary of the major provisions in the Act.
ERISA/Employee Benefits
In recent months, there has been a great deal of speculation about whether the proposed tax reform legislation would include “Rothification” – the requirement that some or all of a participant’s contributions to a 401(k) plan be treated as Roth after-tax contributions – as a means to generate revenue to pay for the Act’s substantial tax cuts. While there were no adjustments to contributions to 401(k) plans under the Act, that does not mean that the final version of the bill will not include some form of Rothification.
The Act contains the following fairly modest changes to the laws governing IRAs and tax-qualified plans:
- The rules permitting recharacterization (or unwinding) of a conversion from a traditional IRA to a Roth IRA, commonly regarded as a means by which taxpayers can game the system, would be repealed. The deadline for recharacterizing a conversion generally is October 15 of the year following the conversion and includes the net earnings related to the conversion. For example, a taxpayer could convert his traditional IRA into multiple Roth IRAs, each with a different investment strategy. If the investment strategy for a particular Roth IRA was successful, the assets would remain in the Roth account. However, if the investments of a particular Roth IRA performed poorly, the individual could unwind the conversion and avoid taxes on the converted amount.
- The Act liberalizes certain rules relating to hardship distributions.
- Within one year after the Act’s enactment, the IRS must provide guidance permitting individuals who take hardship distributions to continue making pre-tax contributions. Presently, participants who take a hardship distribution are suspended from making pre-tax contributions to their retirement plan for a period of six months.
- Employers have the option of permitting hardship withdrawal distributions to include account earnings and employer contributions. Under current law, only participant contributions can be withdrawn.
- A retirement plan would no longer have to provide that a participant obtain all available loans under the plan before receiving a hardship distribution.
- Tax-qualified defined benefit pension plans can commence in-service distributions at age 59-1/2, rather than at age 62 as currently provided under the Internal Revenue Code (the “Code”).
- Employees whose plans terminate or who have a separation from service while they have a plan loan outstanding will have until the due date for filing their tax return to roll over their outstanding loan balance to an IRA and have the loan treated as a taxable distribution. Under present law, the rollover period is 60 days.
- To assist “soft frozen” defined benefit plans (i.e., plans that have ceased accruals for employees hired after a specific date, but permit existing participants to continue to accrue benefits) in satisfying the Code’s nondiscrimination requirements, expanded cross-testing of defined benefit and defined contribution plans is permitted.
Nonqualified Deferred Compensation Plans
A very significant change is proposed which would have the effect of severely restricting many forms of nonqualified deferred compensation plans. The Act proposes that an employee be taxed on compensation as soon as there is no substantial risk of forfeiture with respect to that compensation, that is, receipt of the compensation would not be subject to the future performance of substantial services. The types of applicable compensation include restricted stock units, stock options, and SARs. Further, a condition would not be treated as constituting a substantial risk of forfeiture solely because it consists of a covenant not to compete or because the condition relates to a purpose of the compensation other than the future performance of services.
This proposal would eliminate many standard forms of deferred compensation, such as 401(k) mirror plans. It also removes from the Code, with respect to services performed after December 31, 2017, Sections 409A, 457(b) (for tax exempt employers), 457(f), and 457A. The provision would be effective for amounts attributable to services performed after 2017, which 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. The current law rules would generally continue to apply to existing nonqualified deferred compensation arrangements until the last tax year beginning before 2026, when such arrangements would become subject to the new provision. Transitional relief would allow employers to modify existing arrangements without violating the Code Section 409A rules prohibiting acceleration.
Other changes in the Act relating to nonqualified compensation matters include:
- Eliminating the exceptions to the $1 million deduction limitation on compensation paid to “covered employees” available to publicly traded companies.. Relatedly, the definition of “covered employee” under Code Section 162(m) would be modified to include the CEO, the chief financial officer, and the three highest compensated employees at the close of the tax year, to coincide with the definition promulgated by the SEC.
- A tax-exempt organization would be subject to a 20% excise tax on compensation in excess of $1 million paid to any of its five highest paid employees for the tax year. The excise tax would also apply to excess parachute payments – generally, a payment contingent upon the employee’s separation from service with an aggregate present value of at least three times the employee’s base compensation.
Individual Income Taxes
Under the Act, the existing seven tax brackets would be consolidated into four tax brackets for individuals: 12%, 25%, 35 %, and 39.6%.
| Rate | Taxable Income Bracket |
|---|---|
| 12% |
|
| 25% |
|
| 35% |
|
| 39.6% |
|
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. Many itemized deductions were eliminated, including state and local income taxes, although property taxes up to $10,000 can be deducted. The interest deduction for mortgages for new homes is capped at a loan value of $500,000. The deduction for charitable contributions was unaffected.
Tax Deductions and Exclusions
- No deduction for contributions to an Archer Medical Savings Account after 2017, and employer contributions to an Archer MSA are includible in income.
- The exclusions for adoption assistance, dependent care, qualified moving expenses, and employee achievement awards are repealed.
- The exclusion from income for housing provided for the convenience of the employer is capped at $50,000, and phased out for highly compensated employees.
Estate Tax
Under the Act, the federal estate tax exemption would double the basic exclusion amount (currently $5 million) to $10 million, which is indexed for inflation from 2011. The estate tax and generation-skipping taxes would be repealed in six years, in 2024, but the step-up in basis to beneficiaries would be retained. This means that the value of the property in the beneficiary’s hands is its fair market value, and its sale at such valuation will not generate any capital gains.
Exempt Organizations
The Act proposes several modification to the rules governing exempt organizations, including subjecting certain private colleges and universities to a 1.4% excise tax on net investment income.
Business Taxes
Corporate Tax Rate. Corporate tax rates would be lowered to a flat 20% rate beginning in 2018. Note that one consequence of this is that an expenditures would be more valuable under the current Code than under the modified Code. The short term effect would be greater on defined benefit plans than defined contribution plans, such as 401(k) plans. For example, assuming that a modified Code would take effect in January 2018, the sponsor of a defined benefit plan could make a larger contribution than required for the 2017 plan year. While the Code limits the maximum deductible contribution to a tax qualified defined benefit plan, for many defined benefit plans there is a significant difference between the minimum required contribution and the maximum deductible contribution. Similarly, if the sponsor of a defined benefit plan was considering a derisking strategy of a liability driven investment policy, involving a matching of plan liabilities with plan assets, which frequently requires a large initial contribution because of the movement away from equities, a plan sponsor might adopt that strategy for the 2017 plan year rather than a later plan year. With respect to 401(k) plans, it is difficult to accelerate contributions into an earlier year because of an IRS policy precluding deductions for a contribution to a 401(k) plan before the services are provided.
Pass-Through Rate. The Act also creates a new 25% maximum tax rate on pass-through business income. This new rate, however, is subject to an anti-abuse rule that provides that 70% of income derived from an active business is subject to ordinary rates and 30% is business income subject to the maximum 25% rate for active owners, with the possibility of increasing the 30% rate to a higher rate.
Net income derived from a passive business activity would be treated entirely as business income and taxable at the 25% rate. With respect to net business income derived from an active business activity, owners or shareholders would determine their “business income” by reference to their “capital percentage” of net income from such activities. Whether an activity is a passive activity or an active business activity will be determined under the Code’s existing passive activity rules. Owners or shareholders may generally elect to apply a capital percentage of 30% to their net business income derived from active business activities to determine their business income eligible for the 25% rate, but may elect to apply a formula based on the facts and circumstances of their business to determine a capital percentage of greater than 30%.
The default “capital percentage” for certain personal services businesses would be zero percent. Such business are trades or businesses in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. As a consequence of the zero percent “capital percentage”, a taxpayer that actively participates in such a business would not be eligible for the 25% rate on business income with respect to such personal service business. However, such businesses would not be precluded from establishing a capital percentage rate under the formula provided under the Act. Nor does the Act prevent them from making the same type of alternative election available to other owners and shareholders, subject to certain limitations.
International Income. The current system of taxing U.S. corporations on the foreign earnings of their foreign subsidiaries when the earnings are distributed would be replaced with a dividend- exemption system, under which 100 % of the foreign-source portion of dividends paid by a foreign corporation to a U.S. shareholder that owns 10% or more of the foreign corporation would be exempt from U.S. taxation. No foreign tax credit or deduction would be allowed for any foreign taxes paid or accrued with respect to such exempt dividend.
Under the existing regime, the income of a foreign subsidiary of a US corporation is subject to tax in that foreign jurisdiction, but is not taxed in the U.S. until it is distributed. When it is distributed, to reduce the possibility of double taxation, the U.S. parent is entitled to a foreign tax credit, but the foreign tax credit will frequently be insufficient to offset the U.S. tax liability. Because of the possibility of this additional tax, that is, the difference between the U.S. tax on the distributed foreign source income and the foreign tax credit, U.S. companies avoid bringing their earnings back into the U.S. By providing a 100% exemption on the foreign-source dividends of parents owning 10% or more of the foreign subsidiary, the premise is that U.S. companies will bring these foreign earnings back into the U.S.