NEW TAX LAW MAKES CHANGES TO COMMUTING BENEFITS

The Tax Cuts and Jobs Act of 2017 (“TCJA”) generally eliminates employer deductions for commuter transportation and parking fringe benefits. This includes deductions for any employer subsidy as well as an employee’s use of his or her own pre-tax dollars to pay for the benefits. While employees still may exclude from income their own pre-tax election amounts as well as any employer subsidy, this benefit is now more expensive for employers, converting what would have been deductible compensation into a nondeductible fringe benefit. Given lower corporate tax rates, employers will need to decide whether there is value in subsidizing employees in this way, rather than simply paying cash (taxable and deductible) compensation. The change is effective with respect to amounts paid or incurred after December 31, 2017.

In addition, the qualified bicycle commuting pre-tax exclusion is eliminated (through 2025).

As a reminder for Massachusetts employers, there remains a difference in the amount of the transit pass and commuter highway vehicle benefit ($260 federally per month but only $135 in Massachusetts per month). The same $260 per month limit applies to the parking fringe benefit. Note that it is possible that the monthly federal limits for 2018 may change as a result of the TCJA.

INCOME DEFERRAL ELECTION ADDED FOR PRIVATE COMPANY EQUITY AWARDS

The TCJA added a new election (under Section 83(i) of the Internal Revenue Code) that permits employees of private corporations to defer taxes on qualified equity grants for up to 5 years. While the legislation intends to align the timing of taxes on equity compensation with a corporate liquidity event (allowing employees to sell a portion of their stock to cover taxes), we expect that the burdensome qualification requirements will deter most companies from offering eligible grants.

New Section 83(i) is available with respect to an equity grant offered pursuant to a written plan through which at least 80% of all eligible full-time employees are granted nonqualified stock options or restricted stock units (RSUs). For this purpose, the 80% threshold is determined on a controlled group basis and certain employees – generally certain executives, substantial owners and their family members – are not eligible for the benefit. Non-employee directors and other independent contractors are not eligible to make this new election.

If an otherwise eligible employee makes an election within 30 days of when eligible RSUs settle or stock options are exercised, income (but not employment) taxes are deferred provided the award is settled in stock (rather than cash). It is unclear whether the income is includable for AMT purposes, although other changes to the AMT made by the TCJA make this less of a concern. The election does not defer Social Security and Medicare taxes.

The deferral of income can be for as long as 5 years following settlement or exercise or, if earlier, once (i) the stock becomes transferable (including transferable to the company), (ii) the stock of the company becomes publicly traded or (iii) the employee revokes the election or ceases to be an eligible employee (becomes an excluded executive, for example). Certain stock redemptions may bar the election, and taxes cannot be deferred beyond 5 years, even if the company remains private. Importantly, however, the delayed tax is based on the value of the company’s stock as of the date of settlement or exercise; subsequent increases or decreases are disregarded. It is unclear when the holding period for capital gains tax purposes will begin, although the fact that the amount of compensation is limited based on the value at settlement or exercise (and the stock itself has been delivered) suggests that it likely begins immediately. Various notice and recordkeeping requirements by employees and employers must also be met to benefit from the new election and when the income is recognized it is subject to applicable withholding.

Although well-intended (to defer the tax liability until a liquidity event with respect to otherwise private company stock), the potential that the stock price will decline without a corresponding reduction in income taxes, as well as burdensome notice and recordkeeping requirements, make us question whether employees of companies, particularly those that are not on a 5-year IPO trajectory, will want to take advantage of the new scheme.

AFFORDABLE CARE ACT REPORTING REQUIREMENTS

While the TCJA eliminates the Affordable Care Act’s individual mandate beginning in 2019 by zeroing out penalties for lack of coverage, employers must still comply with reporting requirements. The IRS recently issued Notice 2018-06, which extends to March 2, 2018 (from January 31, 2018) the due date for distributing to employees 2017 health coverage information Forms 1095-C or 1095-B, as applicable. The due date for filing the information returns with the IRS remains February 28, 2018 (April 2, 2018, if filing electronically). Additionally, the IRS extended transition relief from penalties for incorrect and incomplete information on the above-mentioned statements and returns (not for failure to timely file), where the employer made a good-faith effort to comply with the regulations.

2018 WITHHOLDING ALLOWANCED SHOULD BE CALCULATED ONLINE

The IRS has issued revised withholding tables reflecting new individual tax rates and brackets, a revised standard deduction and the repeal of the personal exemption. Employers should use the new tables as soon as possible and no later than February 15th. In addition, the IRS has announced that withholding rates on supplemental wages will now be 22% (down from 25%), to the extent supplemental wages for the year do not exceed $1,000,000 and employers do not (or are not permitted to) combine supplemental wages with regular wages, and 37% (down from 39.6%) to the extent supplemental wages for the year exceed $1,000,000.

Employers should note that the new withholding tables work with pre-TCJA Forms W-4. The IRS is updating its online withholding calculator to reflect the TCJA changes (expected to be available by the end of February), and will release an updated Form W-4 for 2018. In the interim, the IRS has loosened the rules around the requirement of employees to provide an updated Form W-4 within 10 days of a change in status.

COMPENSATION CONSIDERATIONS WITH THE NEW 20% DEDUCTION FOR PASS-THROUGH BUSINESSES

The TCJA permits pass-through business owners (partners of partnerships, S corporation shareholders and sole proprietors) to deduct up to 20% of “qualified business income,” subject to certain limitations. For taxpayers that can fully utilize the deduction, the top marginal individual federal income tax rate is in effect reduced from 37% to 29.6%.

The deduction is subject to limitations based on whether the business is a service business, and on the wages paid by the business (or if higher a combination of the wages paid and the unadjusted tax basis of depreciable property placed in service generally in the prior 10 years). For individuals filing joint returns with taxable income above $315,000 ($157,500 if single), the limitation begins to phase-in so that when taxable income equals or exceeds $415,000 ($207,500 if single), no deduction is available for service businesses and the deduction is limited to 50% of wages paid (or 25% of wages paid plus 2.5% of the tax basis of depreciable property).

While there are many open questions regarding the new deduction, we wanted to point out a few compensation-related items that we have been considering for clients thinking about the new deduction.

• Because the deduction is based on a percentage of business income, taxpayer-owners who are active in their business and for whom wages paid (or wages plus the tax basis of depreciable property) is not a limiting factor have an additional incentive to treat income as business income, rather than paying it out to themselves as wages (in the case of an S corporation) or as a guaranteed payment for services (in the case of a partnership). These incentives existed pre-TCJA in so far as wage income and guaranteed payments are subject to employment (Social Security and Medicare type) taxes, but business income may not be. While there are limitations on the ability to reclassify income – in particular active S corporation owners must be paid at least reasonable compensation for their services – there may be some planning opportunities, particularly with partnerships.
• For taxpayer-owners who are active in the business and for whom wages paid (or wages plus the tax basis of depreciable property) is a limiting factor, one solution may be to increase wages paid to the taxpayer-owner. In the case of an S-corporation owner, this will increase the amount of employment taxes paid, but we believe that this cost is generally outweighed by the benefit of the deduction – but only to the point where the wage and property limitation is no longer a factor. For partners of partnerships, the IRS has long held the view that partners cannot be employees of the same entity in which they are a partner, and as a result increasing payments to a partner alone will not be sufficient. (And business owners who are considering granting profits-interests to employees will want to factor in any impact this will have on their wage and property limitations before doing so.) 
• For higher income business owners, the new deduction provides an incentive to hire employees, as well as to ensure that workers are properly classified, since the deduction is available only with respect to employee wages and not amounts paid to independent contractors. For businesses that hire workers through third-parties such as through staffing firms or professional employer organizations (“PEOs”), whether workers will be considered employees of the staffing firm/PEO rather than the client-business receiving the services is one of the unknowns on which we anticipate receiving guidance.
• For clients looking for ways to reduce their taxable income below the income thresholds described above, retirement plans (defined contribution or in some cases defined benefit or cash balance plans) may be part of the solution. Contributions to defined contribution plans are generally capped at $55,000 (for 2018) and can be significantly higher for defined benefit plans.

In looking at these opportunities, clients should consider the long-term impact of any planning, noting in particular that the 20% qualified business income deduction expires in 2026 under current law.

TCJA RETIREMENT PLAN CHANGES….AND THEN SOME

Compared to what might have happened, the TCJA made relatively few changes in the retirement plan area. The two major provisions involve the elimination of the ability to recharacterize a Roth conversion of an IRA and the extension of the 60-day rollover period when a plan loan is defaulted in connection with a participant’s termination of employment. These changes are effective for 2018.

Interestingly, however, the recently enacted Bipartisan Budget Act of 2018 includes several retirement plan provisions. For example, the new law will eventually permit a hardship withdrawal of qualified nonelective contributions (“QNECS”) and qualified matching contributions (“QMACs”), earnings on those amounts, as well as earnings on 401(k) deferrals. In addition, the law directs Treasury to abandon the 6-month suspension limitation on deferrals following a hardship withdrawal and the requirement that all loans be taken prior to any hardship withdrawal. These changes are effective for plan years beginning after December 31, 2018.

The Bipartisan Budget Act of 2018 also made modifications to the provisions relating to federal tax levies on retirement assets (generally permitting a recontribution of amounts improperly removed) and additional disaster relief provisions, effective after 2017.