Corrections and Substantive Fixes Needed with Respect to Employee Benefit Changes Made by the 2017 Tax Act

On December 22, President Trump signed into law Pub. L. No. 115-97 (the 2017 Act), the first major overhaul of the U.S. tax system in 30 years.  Although most of the discussion about the 2017 Act floating around is about changes in the taxation of business entities (such as the reduction in the corporate tax rate to a flat 21%, and the creation of a deduction for pass-through businesses), there were several important changes that affected executive compensation and employee benefits.  

Perhaps the most notable change is the repeal of the commission and performance-based compensation exceptions to the $1 million yearly limit on the deduction for compensation paid with respect to a covered employee of a publicly traded corporation.  This change is applicable to tax years beginning after December 31, 2017, except that a transition rule applies to any written binding contract in effect on November 2, 2017, that is not modified in any material respect on or after that date.

In addition, the 2017 Act provides tax benefits to employees of certain start-up companies. Generally, under newly created §83(i), an employee may make a special election with respect to qualified stock transferred to by the employer, so that no amount is included in the employer’s income for the first tax year in which the rights of the employee in the stock are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable. Income taxation can be deferred by the employee until the earlier of (a) five years, or (b) the occurrence of a specified event, such as the stock of the company being readily tradable on an established securities market, or a revocation of the election.

While most employee benefits practitioners seem to be focused on the §162(m) and §83(i) changes, there are several additional changes made by the 2017 Act that directly affect the administration of qualified plans and benefits, including some changes and inconsistencies that may not have been intended by Congress.  For example, the 2017 Act limits the personal casualty loss itemized deduction for property losses (not used in connection with a trade or business or transaction entered into for profit) to apply only to losses incurred as a result of federally-declared disasters.  This limitation on deductibility applies to losses arising in tax years beginning after December 31, 2017, and before January 1, 2026.  While it may seem that a personal casualty loss deduction has no bearing on the administration of employee benefit plans, that is not the case where a §401(k) plan utilizes safe harbor language for hardship distributions.  Under Reg. §1.401(k)-1(d)(3)(iii)(B)(6), expenses for the repair of damage to an employee’s principal residence that qualify for the casualty deduction under §165 are deemed to be an immediate and heavy financial need for hardship distribution purposes. Therefore, to the extent a plan incorporates the safe harbor language in Reg. §1.401(k)-1(d)(3)(iii)(B)(6), a hardship distribution on account of a casualty would have to be limited to situations where the employee incurred a loss as a result of a federally-declared disaster, pursuant to changes made by the 2017 Act (i.e., adding §165(h)(5) to the I.R.C.).  If a hardship distribution was made on account of any other casualty, the plan could technically lose its qualified status for failing to be administered in accordance with its written terms and for violating language in the §401(k) regulations. 

Another possible error in drafting involves distributions from retirement plans that are used to pay for expenses for qualified higher education.  The 2017 Act amended §529(e)(3) and added §529(c), with respect to qualified tuition programs.  The amendments provide that any reference to the term “qualified higher education expense” now includes a reference to up to $10,000 in expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school.  Under §72(t), a 10% excise tax is imposed on certain “early” distributions from qualified retirement plans.  However, §72(t)(2)(E) provides for an exception where a distribution is made for “qualified higher education expenses.”  Section 72(t)(2)(E) references §72(t)(7), which, in turn, references §529(e)(3), which includes the change described above allowing up to $10,000 in elementary and middle school public, private, and religious expenses. However, the change by the 2017 Act only changed the definition of expenses under §529(e)(3) and §529(c)(7), and did not change the requirement that the expenses be incurred at an eligible educational institution (as defined in section §529(e)(5), as required by §72(t)(7)(A) (end flush language)). Because §529(e)(5) was not amended and the flush language of §72(t)(7)(A) still refers to higher educational institutions, the §72(t) 10% excise tax would still apply to distributions from qualified retirement plans that are used for elementary and middle school expenses, even though up to $10,000 of such expenses are permitted under §529 alone.  

Lastly, generally applicable to taxable years beginning after December 31, 2017, newly-created §4960 imposes an excise tax equal to the corporate tax rate (21%) on applicable tax-exempt organizations on remuneration in excess of $1 million that is paid to an applicable tax-exempt organization's five highest-paid employees for a tax year (or any person who was such an employee in any tax year beginning after 2016).  Remuneration is treated as paid when there is no substantial risk of forfeiture within the meaning of §457(f)(3)(B) of the rights to such remuneration.  An applicable tax-exempt organization is defined to include any organization which, for the taxable year, is exempt from taxation under §501(a), is a farmer's cooperative organization described in §512(b)(1), has income excluded from taxation under §115(1), or is a political organization under §527(e)(1).  

Unfortunately, there is some confusion with the definition of an applicable tax-exempt organization. As the rules are currently written, it is unclear whether public universities  are included in the definition, and therefore subject to the excise tax on excess executive compensation under §4960. Although the definition of an applicable tax-exempt organization refers to organizations that have income excluded from taxation under §115(1), not all state schools (including, for importance under §4960, those with large athletic departments and highly-paid coaches) are considered to be tax-exempt entities due to §115(1), but instead, are tax-exempt under a doctrine of implied immunity that is respected by the federal government.  

Obviously, much guidance is still needed with respect to the 2017 Act.  Hopefully, Congress or, at the very least, the IRS will address the inconsistencies in the law described above and provide employers and plan administrators with clear guidance.