Living with Tax Reform: Employee Benefits and Executive Compensation

By now the outlines of the Tax Reform and Jobs Cuts Act of 2017 are well known. The Act dramatically lowered the corporate income tax rate to a flat 21 percent from a marginal top rate of 35 percent, and temporarily lowered tax rates for individuals. It also converted the U.S. from a worldwide to a territorial tax system, meaning that companies operating in the U.S. are no longer taxed by the U.S. on profits earned outside the country.

What’s been less appreciated outside tax circles, says Rosina Barker, partner with the law firm of Morgan, Lewis & Bockius LLC, is how many possible tax law changes were not included in last year’s tax bill—including several important areas related to employee compensation and benefits—and how much work remains to be done before those that were included can be fully implemented.

The new tax law, Barker said at the 2018 SVIA Spring Seminar, “needs a lot of fixes, both by regulators and by Congress,” to address technical issues that were overlooked in the rush to pass it. She warned that some of those fixes are unlikely to come soon, due both to the volume of work they will entail and to manpower shortcomings at the Internal Revenue Service.

“The IRS is a big service full of highly capable attorneys,” Barker said. “(But) its budget has been cut significantly over the last few years. The man- and woman-power ability to deliver regulations has been severely curtailed. So, we’re all going to limp along for a while.”

While Congress isn’t similarly shorthanded, Barker said she expects that it is unlikely to take action soon, either, in many areas of the tax code where it still needs to weigh in. “For example, the surtax on so-called Cadillac health plans has been delayed since its initial effective date. Every year it’s delayed or pushed out another year or two. (It) is now slated, under the latest budget act, to come into effect in 2022 … (but) instead of dealing with it, I think Congress will just let that limp along for a while.”

One big change to the tax code that was deleted from the new tax law related to the proposed “Rothification” of 401(k) retirement savings plans, which would have eliminated tax deductions for contributions to those plans in exchange for allowing tax-free withdrawals. Barker said it was generally opposed by Democrats, and some Republicans, who worried that it would create a disincentive for American workers to save for retirement. Because it would accelerate tax revenues in the near-term, though, Barker said the idea may be revisited at a later date.

Congress also chose to remove from the final bill language that would have eliminated the deferral of taxes on vested nonqualified deferred compensation—a change that most observers believe would have killed nonqualified deferred compensation arrangements.

One change that was implemented in the compensation area was a modification of Section 162(m) of the federal tax code, which prevents publicly traded companies from taking a tax deduction for compensation above $1 million to a “covered employee.” In the past, that term referred to the CEO plus the next three most highly compensated executives, excluding the CFO. However, companies could continue to claim a deduction if the compensation took the form of a performance-based bonus or commission. Now, the deduction is eliminated even in those cases, and the definition of a “covered employee” has been expanded to include anyone who has ever been the CEO or CFO, or one of the next three most highly compensated officers, after 2016. The “covered employee” designation now lasts for life, too, which Barker said could require some clarification from the IRS in some instances.

“Once an individual is the CEO of a publicly traded company, the compensation delivered by the company (to that person) is always subject to the $1 million deduction cap—when he retires, when she retires, is no longer CEO, maybe chairman of the board, maybe retired, maybe dead and amounts are paid to his or her surviving spouse or children,” she explained. “This, of course, creates a technical nightmare as companies are bought and sold, companies go public, and companies go private. Remember, private companies are not subject to the $1 million cap on compensation. (But), we don’t expect any regulations on this any time soon, again, because of the difficulties of the issue and the many, many demands on the attention of the IRS.”

Elsewhere, the new tax law prohibits employees who had any portion of their compensation clawed back by their employer—perhaps due to an income restatement or a violation of company policies—from claiming a deduction to recover the taxes paid on that compensation.

Looking ahead, Barker said President Trump’s Executive Order 13789 could have a big impact on the regulatory front. As explained in the Federal Register, the order directs the Secretary of the Treasury “to identify significant tax regulations issued on or after January 1, 2016, that impose an undue financial burden on U.S. taxpayers, add undue complexity to the federal tax laws, or exceed the statutory authority of the Internal Revenue Service.” Undoing a regulation requires proceeding through a regulatory process, Barker said, but “that machinery has started.”

Finally, Barker said a memorandum issued by the associate attorney general of the U.S. to the heads of civil litigation on January 25, 2018, also has the potential to be highly impactful. “I know it didn’t make any headlines, but it imposes new principles for Justice Department litigators defending other agency positions in litigation,” Barker said. “In the regulatory space in which I operate—the tax space and the ERISA space—there are lots and lots of rules (where) everybody acts as if they are governing law, but (they) have never been committed to regulation. They’re in notices, they’re sometimes in private letter rulings, sometimes in websites. This executive order tells the Justice Department, ‘You cannot defend in court any government position which is not a final regulation, or, if it’s sub-regulatory guidance, does not explain a regulation.’ This is a big deal. I’m in the middle of a bunch of audits, like tax and ERISA audits for clients … (and) I’m kind of in limbo now because a lot of these regulatory activities have just gone away. From the point of view of the regulated community, this is powerful stuff, it’s under the radar stuff, and it’s being replicated in every area of the federal government.”

Barker concluded by saying she expects more softening of the existing regulatory structure, and that regulations to be issued under the new tax reform act will be forthcoming from the Internal Revenue Service and the Treasury Department. “But it will be slow,” she said. “And in the meantime, there’ll be a certain amount of economic turmoil in the regulated spaces those regulations will touch when they’re finally implemented.”