House Proposes Tax Reform Plan

In an attempt to raise revenues and simplify the tax code, the House Ways and Means Committee has proposed a draft tax reform plan containing sweeping changes to the Internal Revenue Code (the Code), including a number of major executive compensation and benefits changes. The most significant of those could be the elimination of deferred compensation and nonqualified pensions. In light of the Congressional deadlock ' and the President's wielding of “the pen” ' it is unlikely the bill will become law this year. Once a bill is submitted, it takes on a life of its own. In addition, the revenue-raising nature of many of the proposed compensation and benefits changes could be attractive to Congress.

Major changes are summarized below.

Deferred Compensation and Nonqualified Pensions Eliminated

Under Chairman Dave Camp's (R-MI) bill, an individual would be taxed when compensation vests similar to the rules under '457(f) plans for a nonprofit employer: The right to receive the compensation is no longer subject to the future performance of substantial services or risk of forfeiture. This proposed change would simplify an area that has become increasingly complex, however it limits the ability of employees to plan for retirement by deferring current income and eliminates the ability of companies to provide executives with supplemental retirement plans without current taxation. The elimination of the ability to defer compensation would make Sections 409A and 457A of the Internal Revenue Code unnecessary and are eliminated as part of the proposal. The new rules would apply to compensation earned with respect to services performed Jan. 1, 2015, and later, and previously earned amounts would be required to be paid (and therefore, taxed) no later than 2022 or, if later, the first taxable year in which the individual is no longer required to perform services to have a right to the amount.

Stock Options and Other Equity Awards

The Proposal eliminates deferral of compensation, which applies to stock options and any other right to compensation based on appreciation in share value. As a result, many equity awards (including stock appreciation rights and phantom units) automatically would be taxed on vesting. It is unclear how this would work in practice ' for example, if a stock option's exercise price is higher than the value of the company's stock on vesting (i.e., if it is “underwater”), but the stock price subsequently increases, there is no direction when and how any increase in the stock value between the vesting date and the eventual exercise date would be taxed (although, under basic tax principles, any future gain would be taxed as capital gain when the stock is sold). This provision would change the landscape of equity compensation dramatically and, when adopted, most would no longer be used by Employers.

Section 162(m): Exceptions Limited and Coverage Expanded

Section 162(m) of the Code limits the deductibility of compensation paid to executive officers to $1 million. A significant exception to this general rule relates to performance-based compensation, including certain equity awards and bonus arrangements. Under the Bill as proposed, the performance-based compensation exception would be completely eliminated. As '162(m) and its procedural and substantive requirements have contributed to the increase in performance-based compensation paid to top executives of public companies, the removal of this deduction opportunity could lead to a greater prevalence of compensation that is not payable solely on the achievement of objective performance goals, which is counter to current governance trends.

Compounding the loss of the performance-based compensation deduction, the Billl expands the reach of '162(m) by providing that once an individual has been a '162(m) covered individual for a company, any compensation paid in future years by the company to that individual ' or even to his or her beneficiaries ' will remain subject to the million-dollar deductibility cap. The proposed legislation also adds the chief financial officer to the covered group, correcting a long-standing error in the '162(m) regulations and harmonizing it with Securities and Exchange Commission (SEC) disclosure rules.

Qualified Plans: Limitations On Deferrals, Contributions, Benefits and Withdrawals

Under current law, participants in 401(k) plans generally are permitted to defer $17,500 per year (as indexed) on a pre-tax basis. Under the new law for employers with more than 100 employees, only half of this amount could be deferred on a pre-tax basis, with the rest deferred as Roth contributions ( i.e. , on a post-tax basis). Employer contributions still would be deferred on a pre-tax basis. Interestingly, although this provision represents a net revenue loss for the government over the long term, it is included as a net revenue increase because of its effect during the 10-year so-called “budget scoring” period used by Congress for purposes of measuring the effects on the budget of proposed changes in tax law.

Benefit and contribution limits for tax-qualified retirement plans would remain frozen for a full decade, and would resume indexing in 2024 based on the frozen 2014 levels.

A 10% penalty tax is currently imposed on certain early withdrawals from qualified retirement plans in addition to any income taxes which may be due. One exception to this rule is an early distribution of up to $10,000 to pay first-time homebuyer expenses. This exception is repealed by the legislation for distributions in 2015 and later.

Under current law, distributions of employer securities held in defined contribution retirement plans may receive capital gains treatment. The House Ways and Means action repeals this special rule so that these stock distributions are taxed at ordinary income tax rates.

Withholding

Current IRS guidance provides that certain qualifying severance payments are not subject to FICA tax withholding, and there have been recent conflicting court decisions with respect to the types of severance pay subject to withholding. Based on this lack of clarity, a number of companies have filed for refunds of such taxes paid in past years. The legislation clarifies that all severance payments are subject to income and payroll tax withholding, including FICA withholding.

Currently, employers who use professional employer organizations (PEOs) for services such as payroll and employment tax withholding remain liable for taxes due if the PEO fails to withhold or remit the taxes. Under the Proposal, PEOs may become certified by the IRS, and employers using a certified PEO will be released from liability for such taxes.

Certain Fringe Benefits

Currently, certain fringe benefits provided to employees are not treated as taxable income, including qualified transportation benefits (up to $250 per month for qualified parking and up to $130 for transit passes). The Proposal freezes these amounts at current levels, with no future cost-of-living indexing.

The value of employee achievement awards in recognition of an individual's length of service or safety record are no longer excluded from income and are fully taxable.

Conclusion

With these tools on the table, the field of executive compensation is open up to changes that will affect every client with existing plans and looking to create new solutions. An advisor should take this opportunity to review the clients current planning and take immediate steps to not only keep the program qualified, but to also provided added benefits to the client. Many of these tools were reviewed in earlier articles in Accoun ting and Financial Planning for Law Firms. See, “The Death Benefit Only Plan for Non-Profits,” July 2014; and “The Death Benefit Only Program,” Feb. 2014. A matrix comparing plans is provided below.

[IMGCAP(1)]

Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP', AEP, a member of this newsletter's Board of Editors, has served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, GASB, FASB, IASB and OPEB solutions.

In an attempt to raise revenues and simplify the tax code, the House Ways and Means Committee has proposed a draft tax reform plan containing sweeping changes to the Internal Revenue Code (the Code), including a number of major executive compensation and benefits changes. The most significant of those could be the elimination of deferred compensation and nonqualified pensions. In light of the Congressional deadlock ' and the President's wielding of “the pen” ' it is unlikely the bill will become law this year. Once a bill is submitted, it takes on a life of its own. In addition, the revenue-raising nature of many of the proposed compensation and benefits changes could be attractive to Congress.

Major changes are summarized below.

Deferred Compensation and Nonqualified Pensions Eliminated

Under Chairman Dave Camp's (R-MI) bill, an individual would be taxed when compensation vests similar to the rules under '457(f) plans for a nonprofit employer: The right to receive the compensation is no longer subject to the future performance of substantial services or risk of forfeiture. This proposed change would simplify an area that has become increasingly complex, however it limits the ability of employees to plan for retirement by deferring current income and eliminates the ability of companies to provide executives with supplemental retirement plans without current taxation. The elimination of the ability to defer compensation would make Sections 409A and 457A of the Internal Revenue Code unnecessary and are eliminated as part of the proposal. The new rules would apply to compensation earned with respect to services performed Jan. 1, 2015, and later, and previously earned amounts would be required to be paid (and therefore, taxed) no later than 2022 or, if later, the first taxable year in which the individual is no longer required to perform services to have a right to the amount.

Stock Options and Other Equity Awards

The Proposal eliminates deferral of compensation, which applies to stock options and any other right to compensation based on appreciation in share value. As a result, many equity awards (including stock appreciation rights and phantom units) automatically would be taxed on vesting. It is unclear how this would work in practice ' for example, if a stock option's exercise price is higher than the value of the company's stock on vesting (i.e., if it is “underwater”), but the stock price subsequently increases, there is no direction when and how any increase in the stock value between the vesting date and the eventual exercise date would be taxed (although, under basic tax principles, any future gain would be taxed as capital gain when the stock is sold). This provision would change the landscape of equity compensation dramatically and, when adopted, most would no longer be used by Employers.

Section 162(m): Exceptions Limited and Coverage Expanded

Section 162(m) of the Code limits the deductibility of compensation paid to executive officers to $1 million. A significant exception to this general rule relates to performance-based compensation, including certain equity awards and bonus arrangements. Under the Bill as proposed, the performance-based compensation exception would be completely eliminated. As '162(m) and its procedural and substantive requirements have contributed to the increase in performance-based compensation paid to top executives of public companies, the removal of this deduction opportunity could lead to a greater prevalence of compensation that is not payable solely on the achievement of objective performance goals, which is counter to current governance trends.

Compounding the loss of the performance-based compensation deduction, the Billl expands the reach of '162(m) by providing that once an individual has been a '162(m) covered individual for a company, any compensation paid in future years by the company to that individual ' or even to his or her beneficiaries ' will remain subject to the million-dollar deductibility cap. The proposed legislation also adds the chief financial officer to the covered group, correcting a long-standing error in the '162(m) regulations and harmonizing it with Securities and Exchange Commission (SEC) disclosure rules.

Qualified Plans: Limitations On Deferrals, Contributions, Benefits and Withdrawals

Under current law, participants in 401(k) plans generally are permitted to defer $17,500 per year (as indexed) on a pre-tax basis. Under the new law for employers with more than 100 employees, only half of this amount could be deferred on a pre-tax basis, with the rest deferred as Roth contributions ( i.e. , on a post-tax basis). Employer contributions still would be deferred on a pre-tax basis. Interestingly, although this provision represents a net revenue loss for the government over the long term, it is included as a net revenue increase because of its effect during the 10-year so-called “budget scoring” period used by Congress for purposes of measuring the effects on the budget of proposed changes in tax law.

Benefit and contribution limits for tax-qualified retirement plans would remain frozen for a full decade, and would resume indexing in 2024 based on the frozen 2014 levels.

A 10% penalty tax is currently imposed on certain early withdrawals from qualified retirement plans in addition to any income taxes which may be due. One exception to this rule is an early distribution of up to $10,000 to pay first-time homebuyer expenses. This exception is repealed by the legislation for distributions in 2015 and later.

Under current law, distributions of employer securities held in defined contribution retirement plans may receive capital gains treatment. The House Ways and Means action repeals this special rule so that these stock distributions are taxed at ordinary income tax rates.

Withholding

Current IRS guidance provides that certain qualifying severance payments are not subject to FICA tax withholding, and there have been recent conflicting court decisions with respect to the types of severance pay subject to withholding. Based on this lack of clarity, a number of companies have filed for refunds of such taxes paid in past years. The legislation clarifies that all severance payments are subject to income and payroll tax withholding, including FICA withholding.

Currently, employers who use professional employer organizations (PEOs) for services such as payroll and employment tax withholding remain liable for taxes due if the PEO fails to withhold or remit the taxes. Under the Proposal, PEOs may become certified by the IRS, and employers using a certified PEO will be released from liability for such taxes.

Certain Fringe Benefits

Currently, certain fringe benefits provided to employees are not treated as taxable income, including qualified transportation benefits (up to $250 per month for qualified parking and up to $130 for transit passes). The Proposal freezes these amounts at current levels, with no future cost-of-living indexing.

The value of employee achievement awards in recognition of an individual's length of service or safety record are no longer excluded from income and are fully taxable.

Conclusion

With these tools on the table, the field of executive compensation is open up to changes that will affect every client with existing plans and looking to create new solutions. An advisor should take this opportunity to review the clients current planning and take immediate steps to not only keep the program qualified, but to also provided added benefits to the client. Many of these tools were reviewed in earlier articles in Accoun ting and Financial Planning for Law Firms. See, “The Death Benefit Only Plan for Non-Profits,” July 2014; and “The Death Benefit Only Program,” Feb. 2014. A matrix comparing plans is provided below.

[IMGCAP(1)]

Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP', AEP, a member of this newsletter's Board of Editors, has served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, GASB, FASB, IASB and OPEB solutions.