A major – and as yet largely unreported – change in the tax reform bill unveiled last week could have a dramatic impact on nonqualified deferred compensation.
Section 3801 of the Tax Cuts and Jobs Act provides that an employee would be taxed on compensation as soon as there is no substantial risk of forfeiture with regard to that compensation (i.e., receipt of the compensation is not subject to future performance of substantial services) – a sweeping change to the taxation of virtually all nonqualified deferred compensation by taxing amounts earned under those plans as they vest, rather than when they are paid.
This means that employees could no longer defer compensation on a tax-deferred basis to a 401(k) excess plan, since they are typically vested in the deferrals. Or more precisely, they could defer, but they would be taxed as if they had not – and who would defer compensation under those conditions?
Indeed, this rule, if implemented, would effectively end voluntary deferral programs (including 401(k) mirror plans) where individuals choose to forego either salary or incentive pay until a future date since no individual would want to defer this income and not be vested in it. Companies would be faced with structuring programs with a golden handcuff approach where a certain amount of dollars was set aside to retain an individual for a period of time. At the expiration of the deferral period, the amount deferred would vest and be paid out to the employee if they had met the vesting requirements. As a practical matter, this approach would probably find the most prevalence in private companies that do not have an equity compensation program or in mandatory deferral programs that pay upon vesting.
This proposal also removes from the Internal Revenue Code, with respect to services performed after Dec. 31, 2017, Sections 409A, 457(b) (for tax exempt employers), 457(f) and 457A.
The provision could present employers with some real issues in the short run for plan sponsors obtaining elections with respect to 2018 services under existing nonqualified deferred compensation arrangements. It may even be necessary to communicate to participants in such plans that, because of the uncertainty as to future law, such deferrals may not be given effect.
The current law rules would generally continue to apply to existing nonqualified deferred compensation arrangements until the last tax year beginning before 2026, when such arrangements would become subject to the new provision. Transitional relief would allow employers to modify existing arrangements without violating the Section 409A rules prohibiting acceleration.
An analysis by Mercer explains that the second part of the proposed legislation would allow existing deferred compensation to continue under the 409A rules until 2025, at which point it would need to comply with the new rule around substantial risk of forfeiture. The proposal would allow companies to amend their plans to allow companies to pay vested benefits on 2025 without violating the anti-acceleration rules under 409A. Effectively, most deferred compensation programs sponsored by companies would be paid out if this part of the legislation is approved, according to the analysis.
The summary accompanying this provision in the bill contends that the provision repeals a current-law tax benefit for which “only highly compensated employees are generally eligible” and would simplify an extremely complex section of the tax code. The provision is estimated to increase revenues by $16.2 billion over 2018-2027.