While the tax reform bill issued last week includes many favorable provisions for employer-sponsored retirement plans, the proposal effectively eliminates nonqualified deferred compensation (NQDC) plans as tools for tax planning available to executives and public companies and would significantly restrict or effectively eliminate common forms of long-term incentive compensation, according to a Benefits Brief from Groom Law Group, Chartered.
Groom attorneys write that the bill “restricts future deferrals under nonqualified programs and would also cause existing deferred amounts to be includible in income by no later than 2025.” Specifically, all nonqualified deferred compensation related to services performed after 2017, including amounts under tax-exempt employer 457(b) and 457(f) plans, and the related earnings, would be taxed when it vests, rather than when it is paid. In addition, amounts of nonqualified deferred compensation attributable to services before 2018 would be taxed during the later of 2025 or the year of vesting. The bill includes all stock options and stock appreciation rights under this early income inclusion rule.
“These proposed changes have the effect of eliminating the opportunity for an executive of any company or organization to defer taxation of earned income outside of a tax-qualified retirement plan and would trigger income recognition for long-term incentives once a continuing service vesting condition lapses, effectively without regard to when the amounts are actually payable,” the Groom attorneys write.
According to the Benefits Brief, the bill would expand the definition of compensation for purposes of the $1 million deduction limit to include all remuneration paid for services by eliminating the performance-based compensation and commission exceptions for compensation paid to top executives at publicly traded companies. It would realign coverage of the limit with the Securities and Exchange Commission (SEC) disclosure rules to include compensation paid to the company’s principal financial officer in addition to the principal executive officer and the other three most highly paid executives. In addition, if an individual is a covered employee for any tax year commencing after 2016, his or her compensation would remain subject to the deduction limit in subsequent tax years, even if he or she is no longer a covered employee or the amounts are paid to a beneficiary.
In addition, the bill would impose on a tax-exempt employer a 20% excise tax on compensation in excess of $1 million paid to any of its top five most highly compensated employees, as well as on payments contingent on separation from employment paid to a covered employee in excess of three times his prior average annual compensation. According to the Groom attorneys, these changes regarding top executives remuneration would be effective for tax years beginning after 2017 without a grandfather or transition period.
The attorneys note that historically, many state and local governmental 401(a) plans have taken the position that, because income of the related trusts would generally be exempt from tax under Internal Revenue Code Section 115, such trusts are not subject to unrelated business income tax (UBIT) under Code section 511. However, Section 5001 of the House tax reform bill would amend Code Section 511 to specifically provide that an organization or trust exempt from taxation under Code section 501(a) (such as a 401(a) plan trust) will not be exempt from UBIT solely because it excludes amounts from gross income under another Code provision. “Therefore, under Section 5001, state and local governmental plans would likely be subject to unrelated business income tax under Code section 511 regardless of the provisions of Code section 115 (or any other Code section under which a plan may claim tax-exemption),” the attorneys write.