By Richard McHugh
While the GOP in the United States House of Representatives was putting finishing touches on a tax reform proposal, folks in the employee benefits community were holding our collective breath. Rumors were rampant that Congress would seek to revise the rules relating to 401(k) plans by eliminating or reducing the current exclusion for tax-deferred elective contributions–a decision many feared would lower the overall level of retirement savings in the country. There also was concern that cutbacks to the tax exclusion rules for health care coverage under employer-provided plans might be considered to raise revenue to support other priorities in the tax reform package. Fortunately, those fears have not been realized, at least to date, as the initial draft of the bill has not affected these programs in such a basic way.
While tax-qualified retirement plans, such as 401(k) plans, and employer-provided health care plans may have been spared, the bill would affect some employee benefit programs. The bill would make a few changes that affect 401(k) plans (as discussed below), although those changes may largely be welcome. However, as will be discussed below, the rules relating to executive compensation and to employer-provided educational assistance would be significantly and negatively affected in this bill.
Here is a summary of the significant changes in the GOP tax reform proposals that affect employee benefit programs:
1. Executive Compensation
The bill would make the tax treatment afforded to non-qualified deferred compensation plans considerably more restrictive, which may appear strange to some since this bill is coming from the GOP side of the aisle and such attacks on deferred compensation historically come more often from Democrats. The bill makes three noteworthy changes, as follows:
a. The bill amends Internal Revenue Code (the “Code”) Section 162(m). That section, which generally prohibits publicly-held companies from being able to deduct more than $1 million per year in compensation paid to certain covered employees, currently contains an important exception to that deductible dollar limit related to qualifying performance-based pay. This widely-used exemption would be repealed by the bill, effective for taxable years beginning after December 31, 2017. The bill also widens the group of covered employees to include persons who were covered employees in any tax year after 2016.
b. Perhaps more importantly, and certainly with wider potential application, the bill would replace Code Section 409A, which generally deals with the taxation of non-qualified deferred compensation, with a new Code Section 409B. While practitioners and affected persons might not necessarily mourn the demise of Section 409A, its replacement would in fact be much more restrictive. New Code Section 409B would impose a rule that results in taxation as soon as accruals under covered plans no longer are subject to a substantial risk of forfeiture. The new Code section would apply to traditional deferred compensation plans but also to stock appreciation rights and stock options, and would apply to plans offered by tax-exempt entities. The new rule, if enacted, would be effective for services performed after 2018, and provides a transition period for benefits accrued before 2018 that would extend out as long as 2025 (or, if sooner, the year the substantial risk of forfeiture with respect to such accrued benefits lapses). If enacted, these changes would dramatically alter the taxation scheme currently in place and reduce design flexibility. One would have to assume that a very large percentage of existing non-qualified deferred compensation plans would have to be discontinued or significantly altered.
c. The bill would impose a new 20 percent excise tax on tax-exempt organizations that in years after 2017 pay compensation to any “covered employee” in excess of $1 million for any tax year or that pay compensation that constitutes an excess parachute payment (as defined in new Code Section 4960). Generally. the term “covered employee” covers the five highest paid employees of the tax-exempt organization (or who was among that group of top five in any tax year after 2016).
2. 401(K) Plan
a. Hardship distributions from a 401(k) plan currently are limited to the aggregate amount of elective deferrals (i.e., earnings on those deferrals were not available for hardship withdrawals). In addition, to take advantage of a rule that deems any such hardship necessary to satisfy an immediate and heavy financial need (a condition necessary to extend a hardship withdrawal), a plan has to suspend a participant from making elective deferrals for at least six months after a hardship withdrawal is made (note this requirement is based on regulations previously issued by the Internal Revenue Service (“IRS”)). The bill would require the IRS to delete the above referenced six-month suspension requirement. In addition, the bill would extend the hardship withdrawal rights to certain employer contributions and to earnings, and would eliminate the requirement that participants first secure available plan loans before taking a hardship distribution. These changes would be effective for plan years beginning after December 31, 2017.
b. The bill extends the period of time a participant has to avoid current taxation relating to a defaulted plan loan being treated as a deemed distribution upon termination of employment. Under current law, a terminating plan participant can avoid current taxation relating to a deemed distribution by rolling an amount equal to the outstanding loan balance of a participant loan to an individual retirement account within sixty days. The bill would extend the time for that rollover to be made until the due date (including extensions) for the tax return to be filed for the year in which the deemed distribution occurs. The change would be effective for taxable years beginning after December 31, 2017.
3. Expanded In-Service Distributions Rights
The bill would reduce the age at which participants can receive in-service distributions from pension plans (even though they remain employed) from 62 to 59½. This change likely will be welcome and reflects the evolving nature of the American workforce. This lower threshold would apply to Code Section 457(b) plans as well. This change would apply to plan years beginning after December 31, 2017.
4. Pension Non-discrimination Testing
Defined benefit plans that have been closed must under current law continue to satisfy certain non-discrimination requirements. Over time, this requirement can become a problem for such plans (if they are not terminated). Effective as of enactment, new Code Section 401(o) would extend new non-discrimination testing options to these plans that should make continued compliance easier.
5. Education Assistance
a. The bill would eliminate the Code Section 127 exemption that permits employers to provide up to $5,250 of education assistance per year to employees at under defined circumstances that would not be taxable to those employees. That change is effective for plan years beginning after December 31, 2017.
b. Although affecting fewer individuals, the bill would eliminate an exemption in Code Section 117 tax exemption related to qualified tuition reductions generally provided to employees of educational institutions. This change is effective for amounts paid or accrued after December 31, 2017.
6. Dependent Care Flexible Spending Account
The bill as originally released would eliminate, effective for tax years beginning after December 31, 2017, the tax exclusion for dependent care flexible spending accounts. Under current law, individuals can contribute up to a maximum amount of $5,000 to an employer-provided flexible spending account to be used to cover qualifying dependent care expenses. It appears that the House Ways and Means Committee, during its mark-up sessions with respect to the bill, now has delayed the effective date of the provision until the end of 2022.
7. Miscellaneous Benefit Changes
a. The bill eliminates existing deductions for adoption assistance benefits, relocation reimbursements and qualifying employee achievement awards. These changes would be made effective with respect to taxable years beginning after December 31, 2017.
b. Under the bill, employers no longer would be entitled to a deduction covering expenses for qualified transportation benefits offered to employees (although these benefits still would be not taxable to affected employees). It is unclear what impact this change would have on the prevalence of these programs. This change would be effective for amounts paid or accrued after December 31, 2017.
It is too early to know whether other changes to the bill will be made in the House, and of course later when this package reaches the Senate. In fact, it is too early to predict whether this package (whatever its final form) will be enacted. However, all employers should begin to pay careful attention to the changes being considered.