Tax Reform Bill Proposal - Much Ado About Nothing

by Orrick, Herrington & Sutcliffe LLP

As widely reported, on February 26, 2014, U.S. House of Representatives Committee on Ways and Means Chairman Dave Camp (R-MI) released the proposed Tax Reform Act of 2014 (the "Camp Proposal").  In exchange for simplification of the tax code and a reduction in individual and corporate tax rates, the Camp Proposal purports to eliminate many tax incentives that would impact compensation and benefits programs, especially with respect to executive compensation matters.

Below are some of the key compensation and benefits-related provisions in the Camp Proposal.  Our view is that only provisions in the Camp Proposal likely to be enacted relate to Code Section 162(m): (1) the inclusion of the Chief Financial Officers in the definition of covered employee, to close the existing loop hole and (2) the inclusion of former employees in the definition of covered employee, both of which are exceptions to the deduction limitation under Code Section 162(m) that reasonably should be fixed.  Therefore, we do not see any immediate need for action or planning as a result of the Camp Proposal, as even these two provisions are unlikely to be enacted this year.

Code Section 162(m) and Performance-Based Compensation

  • Eliminate the performance-based compensation exception under Code Section 162(m), in which case compensation items such as stock options and other performance-based pay would, for the first time, count against the $1 million deduction limitation.  While performance-based compensation would remain an important element in the determination of executive compensation to align the executives' interests to shareholders, this tax reform proposal could impact the focus on, and the vehicles and approaches used to implement, pay-for-performance.  For example, companies may wait longer to set performance metrics as it will no longer be necessary to set the metrics within the first 90 days of a performance period.  This proposal would undermine the shareholder supported pay-for-performance culture that has been building over recent years and, therefore, we think this proposal will have little support and is unlikely to be enacted.
  • Expand application of the $1 million deduction limitation under Code Section 162(m) to the Chief Financial Officer.  This would eliminate a loophole created by the modification of the SEC rules relating to compensation disclosure for Named Executive Officers.
  • Extend the $1 million deduction limit to former covered employees and to their beneficiaries rather than measuring who is a covered employee based on who is employed at the end of the year.  This modification does make some sense and would eliminate the approach of preserving deductions by deferring amounts until after a covered employee terminates employment.

Deferred Compensation

  • All nonqualified deferred compensation attributable to services after 2014 would have to be subject to a "substantial risk of forfeiture" for income tax on that compensation to be deferred.  In other words, if the right to the deferred compensation is vested, that compensation would be currently taxable even though it is not paid until a later year or years.  Under this proposal the use of nonqualified traditional deferred compensation arrangements in tandem with tax-qualified retirement vehicles would no longer be a viable retirement planning tool and, therefore, it is unlikely for this proposal to have the legs to be enacted. 
  • Any nonqualified deferred compensation attributable to services prior to 2015 would continue to be subject to the existing income tax rules (including Code section 409A) until 2023.  In 2023, any remaining amount of that pre-2015 deferred compensation would become subject to the "substantial risk of forfeiture" rule and taxable in 2023 (or such later year when it is not subject to a substantial risk of forfeiture).  We would expect these time frames to be adjusted based on when tax reform is actually adopted by Congress.  As the general prohibition on nonqualified deferred compensation is unlikely to be enacted, this companion provision would also not be enacted.

401(k) Plans

  • No more than half of the 401(k) plan elective deferral limit of $17,500 (plus $5,500 catch-up contributions for a total of $23,000 if at least 50 years old) could be pre-tax contributions.  Any amount over that half would have to be an after-tax Roth contribution.
  • COLA adjustments to the current $17,500 elective deferral limit (and to the $5,500 catch-up limit) would be suspended until 2024.
  • 401(k) plans would be required to offer Roth accounts.
  • Employer contributions to 401(k) plans would continue to be made on a pre-tax basis to "traditional" accounts.
  • Employees taking hardship withdrawals from a 401(k) plan would be allowed to continue making contributions to the plan without a six month wait.
  • Employees whose 401(k) loan defaults at termination of employment would have until April 15 of the next year to contribute the loan balance to an IRA to avoid taxation.
  • A 401(k) plan distribution to a beneficiary of a deceased employee would have to be made within five years of death, except it could be spread out over the life expectancy of a spouse beneficiary or until age 26 for a child beneficiary.
  • High income individuals (over $400,000 single, $450,000 married) also would owe a 10% tax on all otherwise pre-tax 401(k) employee and employer contributions, including traditional elective deferrals and employer matching and profit sharing contributions.  These contributions thus would be subject to both a 10% tax in the year contributed to the plan and taxed again upon distribution from the plan.

Health Plans

  • High income individuals (over $400,000 single, $450,000 married) would owe a 10% tax on all employer contributions to health plans.
  • No individuals would be allowed to take itemized deductions for out-of-pocket medical expenses.

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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