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GOP Tax Bill Threatens NQ


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The text of the House Bill has been released.  Let the fun begin.

 

https://waysandmeansforms.house.gov/uploadedfiles/bill_text.pdf

 

The proposal would be to subject NQ plans to income inclusion upon the lapse of a substantial risk of forfeiture (later of contribution or vesting) and existing deferrals would need to be subject to taxation no later than 12/31/2025. 

 

SEC. 3801. NONQUALIFIED DEFERRED COMPENSATION.

(a) IN GENERAL.—Subpart A of part I of subchapter13 D of chapter 1 is amended by adding at the end the following new section:

SEC. 409B. NONQUALIFIED DEFERRED COMPENSATION.

(a) IN GENERAL.—Any compensation which is deferred under a nonqualified deferred compensation plan shall be includible in the gross income of the person who performed the services to which such compensation relates when there is no substantial risk of forfeiture of the rights of such person to such compensation.

 - There are two types of people in the world: those who can extrapolate from incomplete data sets...

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It may sound selfish, but as nobody has ever offered me any nonqualified deferred compensation...

Does the proposal change what is meant by "substantial risk of forfeiture"?  As I recall, the tax magic behind Rabbi Trusts was that since, in the event the sponsor went belly-up, the assets in the trust would be reachable by the sponsor's creditors, the arrangement was considered to involve a substantial risk of forfeiture, and therefore not currently taxable when the covered individual became vested.

Always check with your actuary first!

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The proposal defines substantial risk of forfeiture as based on continuing performance of services and non-competes don't work.

Think of this as not much different than the FICA rules or 457(f) rules on substantial risk of forfeiture.  It appears that voluntary deferrals (as if there would be any) would be subject to federal income tax when earned and company contributions upon vesting.  Not really clear as to how post-vesting distributions would ultimately be taxed but since I doubt there will be any (if this provision was enacted as written), no need to speculate.

The loss of grandfathering of existing arrangements is probably where the JCT gets to raising revenue of $16.2 billion over 10 years.  Similar to the phase out in 457A but over 7 years instead of 10 years.

 - There are two types of people in the world: those who can extrapolate from incomplete data sets...

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Here's the summary of the provision:

Sec. 3801. Nonqualified deferred compensation.

Current law: Under current law, compensation generally is taxable to an employee and deductible by an employer in the year earned, with two significant exceptions. First, for compensation provided as part of a qualified defined benefit or defined contribution pension plan, the employee does not take such  compensation into income until the year in which a distribution from the plan occurs, while the employer generally may take the deduction in the year the compensation is earned. Second, for non-qualified deferred compensation, the employee does not take such compensation into income until the year received, but the employer’s deduction is postponed until that time. The employee generally must take nonqualified deferred compensation into income, however, if the compensation is put into a trust protected from the employer’s creditors in bankruptcy as soon as there is no substantial risk of forfeiture with regard to the compensation. In addition, if the employer is located in a jurisdiction in which the employer is not effectively subject to income tax (i.e., certain foreign jurisdictions), the compensation is immediately taxable as soon as it is not subject to a substantial risk of forfeiture. Other rules apply to deferred compensation paid by a State or local government or tax-exempt organization, in which case an employee may defer tax so long as the deferred compensation is less than the limit on employee contributions for 401(k) plans (i.e., $18,000 for 2017).

Provision: Under the provision, 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 condition shall not be treated as constituting a substantial risk of forfeiture solely because it consists of a covenant not to compete or because the condition relates (nominally or otherwise) to a purpose of the compensation other than the future performance of services – regardless of whether such condition is intended to advance a purpose of the compensation or is solely intended to defer taxation of the compensation.

The provision would be effective for amounts attributable to services performed after 2017. The current-law rules would continue to apply to existing non-qualified deferred compensation arrangements until the last tax year beginning before 2026, when such arrangements would become subject to the provision.

Considerations:

The provision repeals a current-law tax benefit for which only highly compensated employees are generally eligible.

The provision creates simplicity in an area of taxation that is extremely complex under current law.

JCT estimate: According to JCT, the provision would increase revenues by $16.2 billion over 2018-2027.

 - There are two types of people in the world: those who can extrapolate from incomplete data sets...

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Lapse of a substantial risk of forfeiture was never an income tax trigger for NQDC in the for profit sector.  A "good" Rabbi Trust provides protection to the employee from "sticky fingers," but no protection in the event of bankruptcy or insolvency of the employer.  There was never anything "magical" about Rabbi Trusts; their popularity is due solely to the fact that the IRS has blessed them as not triggering constructive receipt or an "economic benefit" under the economic benefit doctrine.  With that said, this provision is a startling development.  If this makes it into the law we have hundreds of clients who are going to go nuts.    

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1 hour ago, My 2 cents said:

It may sound selfish, but as nobody has ever offered me any nonqualified deferred compensation...

I don’t want to belong to any club that would accept me as one of its members - Groucho Marx

 - There are two types of people in the world: those who can extrapolate from incomplete data sets...

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20 hours ago, jpod said:

With that said, this provision is a startling development.  If this makes it into the law we have hundreds of clients who are going to go nuts.    

I personally see no compelling need for there to be any kind of asset accumulation vehicle that would allow very highly-paid individuals the opportunity to amass wealth on a tax-favored basis.  I find it very difficult to feel any sympathy for people who may no longer have access to such vehicles.  As far as I am concerned, they can live within the bounds of qualified retirement plans (even if it means providing larger benefits to the rank and file employees) or they can save up their money on a taxable basis.  Why are there such things as non-qualified plans that do not involve full immediate taxation (at least at the point where benefits/balances vest)?

Always check with your actuary first!

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2 hours ago, My 2 cents said:

Why are there such things as non-qualified plans that do not involve full immediate taxation (at least at the point where benefits/balances vest)?

Because the affected people give money to politicians.

I'm a retirement actuary. Nothing about my comments is intended or should be construed as investment, tax, legal or accounting advice. Occasionally, but not all the time, it might be reasonable to interpret my comments as actuarial or consulting advice.

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2 hours ago, My 2 cents said:

 Why are there such things as non-qualified plans that do not involve full immediate taxation (at least at the point where benefits/balances vest)?

Politics aside, it's mainly because the amounts deferred, even beyond vesting, are still subject to a risk of non-payment.  It doesn't become real until the check is cashed and that's when the participant pays income tax and the company realizes their long-delayed income tax deduction.

 - There are two types of people in the world: those who can extrapolate from incomplete data sets...

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I am not so sure there isn't a compelling reason for some of these types of compensation. 

If I understand this change it will do away for all practical purposes things like SARs, Phantom Stock and Stock Options.  Stock Options can be broadly based plans one should note. 

But in the ESOP world SARs and Phantom stock are often times to compensate management for company performance without giving them actual shares.  To give people shares for a 100% S Corp ESOP changes the nature of the ESOP a lot.

In closely held family companies they might want to give equity based compensation without giving actual stock outside of the family so they give SARs and Phantom stock.  That seems legit to me. 

These kinds of programs can be better at aligning compensation to company performance better then annual bonuses for example

Don't get me wrong are there bad plans out there?  Sure.  I have seen NQP that mirror a company's old pension plan they froze but allowed the CEO and a small group still get the benefits.  It seems like I have seen some that allow just the C level execs accumulate millions and doesn't seem to be tied to any performs it is just tax deferral.  I don't have much sympathy for those plans.  But plans that seem to link performance to pay should have a place in good public policy.  Likewise, maybe the better fix to stock options is some kind of rules/test to assure they are broad based I can see as being good public policy also.

In the end these changes are really about revenue to offset other reductions from a group of people some of these comment show aren't going to have enough popularity to win vs say people who defer into a 4k plan or take mortgage deductions.  In the end sometime number of voters who benefit is the deciding factor. 

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If the proposed changes were implemented, there would then be no reason to subject the non-qualified deferred compensation to potential claims of creditors, would there?  If the money were put into an unbreakable trust for the sole potential benefit of the executives (there being no further tax advantage to doing otherwise), wouldn't life be somewhat simpler?

Isn't one of the ideas behind "tax reform" supposed to be that the code would stop being 10,000 pages long, with 100,000 pages of regulations, requiring the rough equivalent of a PHD to understand it?

Always check with your actuary first!

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9 minutes ago, My 2 cents said:

If the proposed changes were implemented, there would then be no reason to subject the non-qualified deferred compensation to potential claims of creditors, would there? 

No, there would be no reason to have voluntary deferrals at all (maybe employer only contributions with a long vesting schedule).  I think what would happen is the participant would take the compensation, invest it in taxable securities, and pass it onto their beneficiaries with a step-up in basis and no estate tax so that any appreciation is ultimately tax-free. 

 - There are two types of people in the world: those who can extrapolate from incomplete data sets...

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To follow-up on XTitan’s comment – 409A already has minimal value in the voluntary deferral area.

 

Today there are secure / personally-owned, institutionally-priced, after-tax alternatives to 409A pre-tax NQDC that provide individuals greater lifetime net spendable value, greater tax advantages, creditor protections and residual value to heirs.  There is no reason for HCE’s to put paychecks at risk of employer bankruptcy, 20% penalties or bracket creep on distributions if not already in the highest tax bracket. 

 

One of the benefits of the proposed tax rates / brackets is providing middle management 409A participants facing the bracket creep problem an opportunity to get out even.

 

The tax reform proposal provides an opportunity to review the practical value of using 409A to accomplish employer and personal planning objectives relative to today’s alternatives.  FINRA in 2013 implemented regulations for preparing the financial analysis / hypothetical illustrations of different tax and pricing structures for such comparisons.

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AALU announced today:

Today, the Ways and Means Committee passed H.R. 1, the Tax Cuts and Jobs Act, after Chairman Brady’s Managers Amendment was accepted on a party-line 24-16 vote.


The final version that passed the committee removed Section 3801—which would have virtually eliminated the market for NQDC plans and had broad impacts on all deferred compensation.

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Well, yes and no.  The Chairman's summary of the amendment said 3801 would be eliminated, but the actual text of the amendment did NOT eliminate it.  So, either the summary was wrong or there was an error in the drafting of the amendment.  Hopefully this will be cleared up soon.

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On ‎11‎/‎10‎/‎2017 at 5:53 AM, jpod said:

All of that stuff is in the Senate Fin. Comm. Chairman's Mark.  Interesting.

With an extra year on to pay out pre-2018 balances.  And so it goes...

 - There are two types of people in the world: those who can extrapolate from incomplete data sets...

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While there is some uncertainty on whether or not there might be some impact on NQDC plans if and when the tax bill is finalized, am I correct that the original proposal would have applied to installment NQDC plans and not just excess deferral plans?  In other words, if a NQDC is designed to start paying annual installments of $200,000 for 5 years at the later of age 65 or the date the individual retires and the individual leaves as of 12/31/2020, she would merely pay FICA/Medicare in 2020 and ordinary income from 2021 through 2025 as under current law.  However, if she left 1/1/2026, would the full present value would be subject to ordinary income as well as the FICA/Medicare tax in 2026?

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I would say the proposal would affect all forms of deferred compensation other than qualified plans: equity arrangements, severance agreements, excess benefit plans, voluntary deferrals, etc.  

For your example, I suppose taxation would depend on when the amounts are vested and I'm assuming this is a pre-2018 arrangement.  I'm also assuming the individual in question turns 65 before 2020.  At best, your arrangement would seems like it would vest no later than 65, and it does seem the amounts are readily ascertainable at that time, so I would think under current law you are talking about FICA at 65 and income tax at distribution, and under the proposal FICA at 65 and income tax/distribution no later than 12/31/2025 (or 2026 in the Senate version).  I wouldn't expect to see installment payments under the proposal for post-2017 arrangements.

 - There are two types of people in the world: those who can extrapolate from incomplete data sets...

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As of this morning, neither the House nor the Senate versions of the bill contain the provision to eliminate nonqualified deferred compensation.

 - There are two types of people in the world: those who can extrapolate from incomplete data sets...

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