New Tax Bill Eliminates Many Popular Individual Deductions/Exclusions, Adds Excise Tax and Clarifies IRA/Pension Provisions

by Orrick, Herrington & Sutcliffe LLP
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On November 2, 2017, House Republicans released their highly anticipated tax reform proposal formally named the Tax Cuts and Jobs Act (the "Act"). The Act must be approved by both the House and the Senate and signed by the President in order for the Act to become law, and there is substantial uncertainty as to whether some or all of the provisions in the Act will take effect.

Because we are so early in the legislative process, this alert will simply provide a high-level overview of the relevant sections of the Act that could impact your compensation and benefits programs. We have addressed the proposals relating to executive compensation and deferred compensation in more detail in a separate alert. Please see How the Tax Cuts and Jobs Act Will Radically Alter Executive Compensation.

Repeal of medical expense deduction (Sec. 1308)

Under current law, a taxpayer may claim an itemized deduction for out-of-pocket medical expenses of the taxpayer, a spouse, or a dependent. This deduction is allowed only to the extent the expenses exceed 10% of the taxpayer's adjusted gross income. Under the Act, the itemized deduction for medical expenses would be repealed, effective after 2017.

Termination of deduction and exclusions for contributions to Archer medical savings accounts (Sec. 1311)

Under current law, taxpayers can claim an above-the-line deduction for contributions to an Archer Medical Savings Account (MSA). Distributions from the accounts to pay qualified medical expenses are not taxable. MSAs may not be established after 2005 and may be rolled over on a tax-free basis to another MSA or to a Health Savings Account (HSA) which is a more taxpayer-friendly savings vehicle. Under the Act, effective after 2017, no deduction would be allowed for contributions to a MSA and employer contributions to an Archer MSA would not be excluded from income. Existing MSA balances could continue to be rolled over on a tax-free basis to an HSA.

Repeal of exclusion, etc., for employee achievement awards (Sec. 1403)

Under current law, employee achievement awards averaging not more than $400 are excluded from employees' income. Under the Act, the exclusion would be repealed so that such awards would constitute taxable compensation to the recipient, effective after 2017.

Repeal of exclusion for dependent care assistance programs (Sec. 1404)

Under current law, employee contributions to dependent care assistance programs are excluded from an employee's income up to $5,000 per year ($2,500 for those who are married filing separately), provided such contributions are used to pay for work-related expenses of caring for a child under the age of 13 or spouses or other dependents who are physically or mentally unable to care for themselves. "Work-related expenses" are those that assist an individual perform work or look for work. Under the Act, the exclusion for dependent care assistance programs would be repealed, effective after 2017. Yesterday, November 6th, the House amended the bill to continue the exclusion for up to $5,000 of employer-provided dependent-care assistance through December 31, 2022.

Repeal of exclusion and deduction for qualified moving expenses (Secs. 1310 and 1405)

Under current law, employees can exclude from their income any employer-provided payments or reimbursements for qualified moving expenses and can deduct moving expenses under Code Section 217 if directly paid or incurred by the employee. Under the Act, both the exclusion and deduction for qualified moving expenses would be repealed, effective after 2017.

Repeal of exclusion for adoption assistance programs (Sec. 1406)

Under current law, employer-provided adoption assistance programs that reimburse employees for qualified adoption expenses are excluded from the employee's income (up to $13,570 in 2017). Under the Act, the exclusion for qualified adoption expenses would be repealed, effective after 2017.

Recharacterization of Roth IRA to traditional IRA, and vice versa (Sec. 1501)

The ability to do this under current law has led to abuses, where taxpayers can game the system by retroactively recharacterizing the IRA based on subsequent investment gains or losses. The bill repeals the ability to do these recharacterizations, after 2017.

Reduction in minimum age for in-service distributions (Sec. 1502)

The bill lowers the minimum age for in-service distributions for defined benefit plans and for governmental defined contribution plans from age 62 down to age 59-1/2, effective for plan years beginning after 2017. This conforms to the existing age 59-1/2 rule for private employer defined contribution plans.

Hardship withdrawal modifications (Secs. 1503 & 1504)

The bill eliminates the six month delay to make new plan contributions after a hardship withdrawal. The bill also provides that hardship withdrawals can come out of earnings on an employee's elective deferrals. Both these new rules would be effective for plan years beginning after 2017.

Rollover of plan loan offset amounts (Sec. 1505)

Under current law an individual has only 60 days after the distribution of a plan loan to roll over the amount of that loan into an IRA to avoid taxation on that amount. The bill extends this 60 day period to the due date for filing the individual's tax return for that year, effective after 2017.

Modification of nondiscrimination rules for frozen plans (Sec. 1506)

Under current law nondiscrimination ("ND") issues sometimes arise under the "cross-testing" rules when an employer closes its defined benefit plan to new hires but allows existing employees to continue to accrue benefits. In applying the ND rules using "cross-testing", a participant's contributions in the employer's defined contribution plan usually are converted into a benefit, and then tested along with the benefits provided under the employer's defined benefit plan. The bill modifies the cross testing rules in this situation to make it easier for the employer to satisfy the ND rules, effective as of the date of enactment. 

New excise tax on excess tax-exempt organization executive compensation (Sec. 3803)

Under the current rules, there are no special taxes imposed on highly compensated employees of tax-exempt organizations. Under the new rules, a tax-exempt organization would be subject to a 20-percent excise tax on compensation in excess of $1 million per year paid to any of its five highest paid employees effective after 2017. As a result, tax-exempt organizations may struggle to recruit qualified candidates.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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