In the months since the Tax Cuts and Jobs Act (the Act or TCJA) became law, much of the attention has been on its effect on federal income tax transformation. In this edition of the Tax Reform Progress Report, we focus on the employee benefit and executive compensation changes resulting from the new law, discussing the new family medical leave credit, qualified transportation fringe benefits, performance pay exception and excess compensation paid by tax-exempt organizations. We’ve also included an update of expected timing on guidance from the Treasury Department on various provisions.
In this issue:
- Release dates for additional guidance on the Tax Cuts and Jobs Act
- The new family and medical leave tax credit for employers
- Executive compensation: performance pay exception
- Qualified transportation fringe benefits
- Excess compensation paid by tax-exempt entities
Treasury Department officials and the Joint Committee on Taxation (JCT) discussed expected release dates for guidance on various provisions of the TCJA. The JCT anticipates release of the “blue book” by late December 2018. The blue book, published by Congress when there is an important piece of tax legislation, will provide some clarity on the TCJA and on how to interpret its provisions as the Treasury Department works on guidance.
Other probable release dates for guidance
- 100 percent bonus depreciation -- late June or early July
- 20 percent deduction on qualified business income -- mid- to late July
- 30 percent limitation on business interest -- late summer or fall
- International provisions -- late summer to December
These are estimated release dates and will be updated as needed.
The TCJA created a new general business tax credit for employers that voluntarily offer up to 12 weeks of paid family and medical leave annually to qualifying employees. The credit is a specified credit that may reduce the alternative minimum tax. The credit is available to employers regardless of their number of employees. The IRS recently posted a set of frequently asked questions (FAQ), providing some assurance for employers that plan to take advantage of the credit, but leaving many compliance questions unanswered.
Requirements to claim the tax credit
To qualify for this credit, the employer must have a written policy that specifies eligible full-time employees be provided at least two weeks’ annual paid family and medical leave. Part-time qualifying employees are to be allowed a proportionate amount of paid family leave (based on the part-time employee’s expected work hours). While the leave benefit amount need not be equal to the employee’s normal pay, it must be at least 50 percent of the employee’s wages. Employers that provide paid family and medical leave for employees not covered under the Family and Medical Leave Act (FMLA) also must include a statement in the written policy that it will not interfere with, restrain, or deny the exercise of or the attempt to exercise, any right provided under the policy and it will not discharge or in any other manner discriminate against any individual for opposing any practice prohibited by the policy. This credit does not apply to any leave paid by a state or local government or that is required by state or local law. One difference between the rules for the tax credit and for FMLA in general is that, if an employer provides paid vacation leave, personal leave, or medical or sick leave (other than paid leave specifically for one or more of the purposes stated above) that paid leave is not considered family and medical leave for purposes of the tax credit.
Members of the same controlled group of corporations and trades or business, whether or not incorporated, under common control are treated as a single taxpayer for purposes of the tax credit.
A qualifying employee is any employee who has worked for the employer for at least one year and who, in the preceding year, was paid no more than 60 percent of the income threshold to determine who is a highly compensated employee for purposes of the retirement plan nondiscrimination rules.
For example, the statutory dollar amount for a highly compensated employee in 2017 is $120,000. Therefore, an employee must not have earned more than $72,000 in 2017 (i.e., 60 percent of $120,000) for the employer to claim a credit for wages paid to the employee in 2018.
Amount of the tax credit
The amount of the tax credit is 12.5 percent if the leave benefit amount equals 50 percent of normal pay. The credit increases 0.25 percent, up to a maximum of 25 percent, for each percentage point by which the wages paid exceeds 50 percent. For example:
|Wages paid to qualifying employees||Wages as percent of normal pay||Amount of credit|
|$10,000||50%||12.5% x $10,000 = $1,250|
Step 1: 10 x 0.25% = 2.5%
By claiming the leave credit, the employer must also reduce the amount of wages they deduct by a commensurate amount. For example, if an employee makes $50,000 a year and received paid leave in the year for which the employer claims a $1,250 credit, the employer can only deduct $48,750 in wage expense.
Definition of family and medical leave for purposes of the tax credit
The tax credit is available for leave taken for one or more of the following reasons:
- Birth of the employee’s child and to care for such child;
- Placement of a child with the employee for adoption or foster care;
- Care for the employee’s spouse, child or parent who has a serious health condition;
- Treatment of a serious health condition that makes the employee unable to perform the functions of his or her position;
- Provide for any qualifying exigency due to an employee’s spouse, child or parent being on covered active duty (or has been notified of an impending call or order to covered active duty) in the Armed Forces; or
- Care for an Armed Forces service member who is the employee’s spouse, child, parent or next of kin.
Although the leave requirements for the tax credit are taken from the FMLA, the provisions of the tax credit are not interchangeable with the FMLA.
An employer cannot claim the credit for any paid leave offered to comply with a state or local law or for leave paid by a state or local government. In addition, paid leave provided under a vacation or personal leave policy, or as medical or sick leave that does not qualify for a reason described above, is not eligible for the credit.
In the FAQ, the IRS indicated it will eventually address questions on the paid family and medical leave tax credit, including:
- when the written leave policy must be in place
- how paid family and medical leave relates to an employer’s other types of paid leave, such as leave paid by the employer’s short-term disability carrier
- how to determine whether an employee has been employed for one year or more
- the impact of state and local leave requirements
- whether members of a controlled group of corporations and businesses under common control are treated as a single taxpayer in determining the credit
Until the IRS issues additional guidance, these topics are subject to interpretation.
Employers who offer paid family leave may consider the following:
- Reviewing the company’s existing policies that include voluntary paid-leave benefits (i.e., pay that is not required by law), such as a salary-continuation disability policy or a parental-leave policy
- Determining if the employer provides paid time off for any of the following reasons:
- Employee’s serious health condition, including pregnancy
- Parental leave or bonding leave
- Care of a family member with a serious health condition
- Care of an injured service member
- A qualifying exigency that arises when a family member is deployed abroad on active military duty
- Estimating the potential annual tax savings of claiming the tax credit
- Ensuring the company’s policy complies with these new rules before factoring the credit into tax projections and estimates
Employers without existing voluntary paid-leave benefits may consider offering enhanced benefits, such as paid parental leave, to take advantage of the tax credit.
The credit is available on a temporary basis. Unless extended by Congress, it applies only with respect to wages for an eligible family and medical leave paid in taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2020.
The TCJA expanded the scope of the $1 million executive compensation deduction limitation by broadening the covered employee group; expanding the types of companies subject to the limit; and, subject to a transition rule, eliminating the exception for performance-based compensation.
Post-TCJA, the covered employee group includes the CFO and any individual who served as the CEO or CFO at any time during the tax year, even if not serving in such capacity at year-end. In addition, the three other most highly compensated officers, other than the CEO and CFO, continue to be covered employees.
Furthermore, once an employee becomes a covered employee for any tax year beginning after Dec. 31, 2016, the employee will remain a covered employee for all future tax years, including after termination of employment with respect to payments for severance and deferred compensation following termination or death. Previously, an individual’s status as a covered employee was determined annually, and the individual ceased to be a covered employee upon termination of employment.
Application to employers
Prior to the TCJA, the application of the executive compensation deduction limitation was restricted to corporations with publicly traded equity. However, the TCJA expanded the scope of companies subject to this limitation to include privately held companies that have registered debt offerings subject to the reporting requirements of section 15(d) of the Securities Exchange Act and certain foreign private issuers whose securities trade in the U.S. With this expansion, private C or S corporations with registered debt offerings may now find themselves subject to the executive compensation limitation.
Historically, compensation programs were designed to meet the requirements of the performance-based compensation exception under the rules. The TCJA, however, eliminated this exception so all compensation, including annual bonuses, long-term cash awards and equity awards paid to a covered employee in excess of $1 million will be nondeductible, unless it is subject to the transition rule discussed below.
Although some companies may eliminate performance-based pay in favor of increasing base salaries, many companies will likely continue to use performance as a key determinant of compensation to attract and retain qualified employees and to align with shareholder interest. It will also be simpler for companies to administer performance-based pay. Without the tax preference, companies will have more flexibility to determine the performance criteria and shareholder approval will no longer be required.
The changes to the executive compensation deduction limitation rules will not apply to compensation payable under a written binding contract which was in effect on Nov. 2, 2017, provided that the contract is not materially modified after that date. Furthermore, a contract that is in effect as of Nov. 2, 2017, and renewed after that date, is treated as a new contract entered into on the date that the renewal takes effect.
Grandfathered arrangements that rely on the performance-based exception must continue to comply with the formal procedures previously applicable to performance-based compensation. For example, if an executive had a contractual right as of Nov. 2, 2017, to receive a performance-based award in the future, the compensation committee will need to certify the performance results.
The transition rule has raised numerous questions, most notably, whether the presence of negative discretion — the ability to reduce an award — in an arrangement would disqualify it as a written binding contract. Most stock options, stock appreciation rights, performance stock units and performance shares outstanding on Nov. 2, 2017, would appear to qualify under the transition rule; however, it is unclear how the transition rule will apply to typical annual performance-based cash bonus awards.
The scope of transition relief is unknown until guidance is issued.
Companies should review existing incentive plans to determine whether any changes should be made to the plan design, including elimination of specific provisions, such as performance metrics. In addition, companies should track the nongrandfathered compensation (e.g., supplemental pension, nonqualified deferred compensation and severance) to be paid in the future to covered employees to ensure no deduction is taken by the company if it exceeds the annual $1 million limitation.
Furthermore, companies should:
- review the population of current and potential covered employees
- review existing contracts, plans and agreements to determine which may qualify for transition relief
- revisit executive compensation practices, policies and programs to determine whether prospective changes are appropriate
These provisions are effective for tax years beginning after Dec. 31, 2017.
The TCJA limits the deductibility of employer-sponsored qualified transportation fringe benefit programs for for-profit employers and creates unrelated business taxable income (UBTI) for tax-exempt employers providing such benefits. Qualified transportation fringes include qualified parking (parking on or near the employer’s business premises, or on or near a location from which the employee commutes to work by public transit) and the associated expenses, transit passes and vanpool benefits. In addition, the TCJA provides that no deduction is allowed for the provision of any transportation, or any payment or reimbursement, to an employee for travel between the employee’s home and place of work, except as necessary for the safety of the employee.
An employer may continue to offer its employees qualified transportation fringe benefits. To the extent these are treated as pre-tax benefits to the employees, a for-profit employer is no longer allowed to take a corresponding tax deduction. A tax-exempt employer who continues to offer these benefits will have a corresponding increase in its UBTI.
Qualified transportation fringe benefits would continue to be excluded from an employee’s wages whether provided directly by the employer, through a bona fide reimbursement arrangement or through a compensation reduction arrangement. In addition, the amounts paid through a qualified transportation fringe benefits program would not be subject to payroll taxes for either the employee or the employer.
Example 1: Employer-owned parking facility
An employer provides tax-free parking privileges at a facility it owns in accordance with a qualified transportation fringe benefit plan. With the TCJA, a for-profit employer will no longer be allowed a tax deduction for the value of the pre-tax parking benefit it provides to its employees nor the expenses to maintain the parking facility. For a tax-exempt employer, the value of the pre-tax parking benefit and the expenses incurred with respect to the parking facility would be UBTI. However, the parking benefit will continue to be a pre-tax benefit for the employees of the for-profit or tax-exempt employers.
Example 2: Public parking facility
An employer sponsors a qualified transportation fringe benefit plan, which includes qualified parking. The public facility where the employee parks meets the requirements for qualified parking. The employee may continue to pay for qualified parking on a pre-tax basis through a compensation-reduction agreement. The result is the same as for the employer-owned parking facility. A for-profit employer cannot deduct the value of the pre-tax parking benefit and the tax-exempt employer will have UBTI equal to the value of the pre-tax parking benefit.
Until further guidance is issued, it appears that both for-profit and tax-exempt entities could mitigate the loss of the deduction or the additional UBTI by terminating their qualified transportation fringe benefit programs. Employers could then provide additional taxable compensation to its employees and even provide an additional taxable amount of compensation to “gross up” for the resulting taxes to be paid by the employees. The for-profit employer would realize a deduction for taxable wages as opposed to offering the qualified transportation fringe benefit program for transportation expenses. The compensation, including the gross-up, paid by the tax-exempt employer would not be UBTI.
The effective date of these provisions is Jan. 1, 2018.
Bicycle commuting expenses
The TCJA also suspends the $20 per month employee tax exclusion for reimbursement of bicycle commuting expenses. Therefore, employer reimbursements for bicycle commuting expenses are taxable to the employee and subject to payroll and income tax withholding.
This provision is effective for amounts paid or incurred after Dec. 31, 2017, and before Jan. 1, 2026.
The TCJA added a new excise tax at the corporate tax rate of 21 percent on excess executive compensation by applicable tax-exempt organizations as well as nonpublic companies that have public debt. The tax is applicable to remuneration paid to a covered employee that exceeds $1 million in a tax year and excess parachute payments as defined below. Prior to the TCJA, tax-exempt entities had to comply with reasonableness requirements and a prohibition against private inurement with respect to executive compensation, but no excise tax was tied to the amount of compensation paid.
This new law is intended to put tax-exempt organizations in the same position as publicly held companies already subject to limits on the deductibility of high compensation amounts paid to certain executives. It also puts nonpublic companies that have public debt in an equivalent situation to that of public companies.
Applicable tax-exempt organizations
The definition of applicable tax-exempt organizations is broad and includes:
- any organization exempt from taxation under Code section 501(a), e.g., tax-exempt organizations under sections 501(c), 501(d), tax qualified retirement plans under section 401(a)
- farmers’ cooperative organizations
- political organizations
- governmental entities with certain income excluded
Thus, the excise tax would apply to other tax-exempt organizations such as trade associations, business leagues, fraternal benefit societies and religious orders. In the case of educational institutions, the term “applicable tax-exempt organizations” applies to private colleges and universities if they are exempt under section 501(a) and to certain tax-exempt public colleges and universities.
A “covered employee” is any current or former employee who is one of the five highest-compensated employees for the current year or any prior tax year beginning after Dec. 31, 2016. A covered employee is any employee, even if the employee is not an officer. Once an employee is a covered employee, the employee will always be a covered employee, meaning that the covered employee group can include more than five individuals.
Employers who are subject to the excise tax will need to identify the five highest-compensated employees on an annual basis and maintain a cumulative list of all such employees for each year thereafter.
Compensation subject to the excise tax
Remuneration means wages as defined for income tax withholding purposes, but does not include any designated Roth contributions. Remuneration also includes deferred compensation awards that vest in a taxable year and are includible in income under section 457(f), even if the remuneration has not yet been received. Remuneration is treated as paid when there is not a substantial risk of forfeiture of the right to payment.
Deferred compensation amounts that vested and were included in income before Jan. 1, 2018, but have not yet been paid, will be “grandfathered” and not subject to the excise tax when ultimately paid in the future. However, it is not yet clear whether earnings on the unpaid vested deferred amounts will also be grandfathered.
Remuneration also includes amounts paid to a covered employee with respect to employment of the covered employee by any tax-exempt entity or governmental entity related to the applicable tax-exempt organization. Under this provision, a tax-exempt entity or governmental entity is treated as related to an applicable tax-exempt organization if:
- the person or governmental entity controls or is controlled by the organization,
- is controlled by one or more persons that controls the organization,
- is considered a supported organization during the taxable year with respect to the organization, or
- in the case of a voluntary employees’ beneficiary association (VEBA), establishes, maintains or makes contributions to the VEBA.
The excise tax does not apply to remuneration made to licensed medical professionals (physicians, nurses and veterinarians), but only to the extent compensation payments relate directly to performance of medical services. In other words, the portion of the payment attributable to administrative and executive services will count for purposes of the excise tax. This may present challenges for health systems that will now need to track (and categorize as clinical pay or nonclinical pay) compensation paid to physician-executives who perform multiple roles within the system.
Application of the excise tax
An applicable tax-exempt organization is liable for an excise tax equal to 21 percent of the sum of:
- the remuneration (other than an excess parachute payment) in excess of $1 million paid to a covered employee by an applicable tax-exempt organization for a tax year; and
- any excess parachute payment (under a special definition that relates solely to “separation pay”) paid by the applicable tax-exempt organization to a covered employee.
In the event the covered employee’s remuneration does not exceed $1 million, the excise tax may apply as a result of an “excess parachute payment” upon separation from employment.
An excess parachute payment is:
- a payment contingent on the employee’s separation from employment with the employer, and
- the aggregate present value of the payments (to be paid to or for the benefit of the employee) equals or exceeds an amount equal to three times the base amount.
The base amount is the covered employee’s average annualized compensation includible in gross income for the five taxable years ending before the year in which the parachute payment was made (or, if less, the portion of such period in which the covered employee performed services for the applicable tax-exempt organization).
Parachute payments may include not only severance pay but also certain vested deferred compensation awards, healthcare continuation benefits, outplacement assistance and other benefits triggered by separation from employment. Parachute payments do not include payments under a qualified retirement plan, a simplified employee pension plan, a simple retirement account, a tax-deferred annuity or an eligible deferred compensation plan of a state or local government employer.
If a parachute payment equals or exceeds three times the base amount, the entire amount of the parachute payment in excess of the base amount is subject to the 21 percent excise tax.
The employer of a covered employee is liable for the excise tax. If remuneration of a covered employee from more than one employer is taken into account in determining the excise tax, each employer is liable for the tax in an amount that bears the same ratio to the total tax as the remuneration paid by that employer bears to the remuneration paid by all employers to the covered employee.
Tax-exempt organizations and other affected businesses should review their compensation practices to determine whether the organization will be subject to the new tax, and if so:
- Which entity is liable for the tax
- Which employees are covered employees
- How compensation paid to covered employees is determined
- What constitutes an excess parachute payment
Efforts should then be made to implement tax-planning strategies to minimize the excise tax in the future by considering each covered employee’s work history, compensation arrangement and future role with the organization.
Paying $2 million of reasonable compensation to a covered employee in 2018 will cost an exempt organization approximately $210,000 in federal tax.
For multicorporate tax-exempt systems like large hospitals and universities, the excise tax will apply on an entity-by-entity basis. Accordingly, if two tax-exempt entities within the controlled system each have five persons earning in excess of $1 million, all 10 such employees will trigger the excise tax. Careful planning and structuring of top executives may be required to lower the excise taxes otherwise due.
The TCJA does not address a number of issues, such as the application of these rules to large tax-exempt organizations with multiple entities, allocation of compensation between a tax-exempt organization and its related taxable entity when an executive provides services to both, and determination of the executive’s compensation on a tax-exempt entity’s fiscal year or calendar year. Guidance on these topics should be forthcoming from the IRS and Treasury.
This provision is effective for taxable years beginning after Dec. 31, 2017.
Please visit our Tax Reform Resource Center for additional information.
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.