As talk of tax reform continues in Washington D.C., it’s impossible to predict which changes will in fact come to pass. However, we can speculate the impact that some of the proposals outlined by the White House may have on employer compensation and benefits programs.
White House Tax Reform Proposals
For individuals, the income tax brackets would be compressed from the seven to three, with the maximum tax rate lowered from 39.6% to 35%. On the employer side, the business income tax rate of 15% would be applied to all businesses, regardless of form or size. These changes stand to have a profound impact on how companies design their total compensation package for their employees, and how employees attempt to minimize taxes and maximize their retirement savings.
Anticipated Impact on Individuals
Nonqualified Deferred Compensation Plans (NQDC)
Defer compensation during working years (while in a higher tax bracket) to retirement years (ideally when in a lower tax bracket).
If the lower tax rates are expected to expire before retirement, an employee participating in a NQDC plan may be inclined to refrain from deferring compensation and, instead, pay taxes during active employment while the tax rates are lower. If the tax cuts are passed through the budget reconciliation process, they are likely to sunset after a 10-year period. However, employees should consider other factors such as (i) pre-tax investing versus after-tax investing and (ii) state income taxes (particularly if the employee will move to a state with no or lower income taxes and the deferred compensation is eligible to be taxed in the state of residence at the time of receipt, rather than the state earned).
Qualified Retirement Plans
Similar to NDQC plans, employees may defer compensation during their working years into qualified retirement plans on a pre-tax basis, then receive income during retirement when they are in a lower tax bracket.
Should the tax cuts be temporary, employees may seek to pay taxes currently — avoiding the anticipated increases that could follow the sunset of the tax breaks. As such, employees may gravitate toward making Roth and after-tax contributions to qualified retirement plans and converting their pre-tax retirement accounts to Roth accounts.
Anticipated Impact on Businesses
The tax rate for large companies (with taxable income exceeding $10 million) is 35%.
The maximum tax rate for all corporations would be reduced from 35 percent to 15 percent, thereby lessening the value of corporate deductions. Reducing the value of corporate deductions in turn diminishes the sting of certain penalty provisions in the Internal Revenue Code that are intended to curtail perceived abuses in executive pay by disallowing deductions. For example, Section 162(m) is intended to limit excessive executive compensation by public companies and encourage performance-based pay structures, by disallowing a deduction for compensation paid in excess of $1 million to certain executives (unless an exception for qualified performance-based compensation applies). Since the loss of these deductions would be less significant under a 15% tax rate, companies may be inclined to forgo the deduction and approve payouts for executive pay without any qualified performance metrics. Accordingly, a greater portion of an executive’s compensation pack can shift away from performance pay to service-based awards.
Closely Held Businesses
Closely held businesses (S corporations, partnerships, LLCs taxed as partnerships, sole proprietorships) are not subject to federal income tax; instead, the owners are taxed on their allocated share of the income.
The tax rate on all businesses (regardless of size or form) would be 15%. Due to the entity level tax at 15%, the tax rate on business owners would effectively be reduced to 15% if business income does not pass through to the owners and in the absence of any mechanism to prevent owner-employees from converting their compensation income (taxable at individual rates) to business income (taxable at the 15% tax rate).
For more information on how tax reform may impact executive compensation, please contact us.