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Tax reform and deferred comp – what’s the potential impact?

Updated 12/7/17

Although health care was the hot topic for a long time in Washington, D.C. and across the country, federal tax reform is now getting all the attention as the top item on the agenda for Congress. As our political leaders debate changes, many are left wondering how it could impact our lives, including businesses and key employees – and what that could mean for nonqualified deferred compensation plans.

While a lot is still in flux, we want to keep you informed and updated, so you can continue to talk with your clients about the value of deferred comp plans – with or without tax reform.

Please read about the details below. We strongly encourage you and your clients to reach out to your elected members of Congress to express your support for nonqualified deferred comp and the benefits it provides to both employers and plan participants.

What we know as of now

  • Despite (or perhaps due to) the failure of Congress to make any changes to the Affordable Care Act, comprehensive tax reform has definitely moved to the front burner.  Congressional Republicans and the Trump Administration are under immense pressure to deliver meaningful legislation in advance of the 2018 mid-term elections.
     
  • The initial steps to move tax reform forward have taken place, with both the House of Representatives and Senate approving budget resolutions. This allows tax reform, subject to some conditions, to move forward under reconciliation procedures in the Senate (details discussed below). This makes some action more probable, since now only a simple majority is needed to pass tax reform legislation in the Senate.
     
  • Both the House and the Senate have pass their own versions of tax reform and now a joint committee is in conference to reconcile differences in the bills.

How tax reform could affect deferred comp

  • On November 14, Senate Finance Committee Chair Orin Hatch (R-UT) introduced updates to last week’s proposed tax reform bill (Tax Cuts and Jobs Act) that would “preserve the current legal treatment of nonqualified deferred compensation.” The wording suggests that current rules for deferred comp would remain in place.

  • Both the Senate and House bills preserve deferred compensation.
     
  • The comparative economics of financing a deferred comp plan may be affected, depending on how significant the change is to corporate tax rates.

So, while there’s been movement, and the Republican majorities face significant pressure to pass tax reform legislation, it will still be “the devil in the details”. As with any tax legislation there will be winners and losers, and the losers will mobilize quickly to try to influence the outcome.

Potential impacts on deferred comp

If tax reform were to happen as proposed: 

How would it impact plan participants?

Assumptions:

  • Under the House bill the highest marginal income-tax rate would fall from 39.6% to 38.5%, while the Senate version keeps it the same. When you consider this proposal both versions would also eliminate the federal deduction for state and local taxes, some participants’ marginal tax rates could actually increase.
     
  • Capital gains taxes could decline somewhat, and the 3.8% tax on unearned income would be eliminated – making after-tax investing somewhat more attractive. 

Pending the outcome of the debate over the tax proposals, we believe contributions to a deferred comp plan would still be attractive to plan participants. Overall, marginal rates (especially in high tax states) would still be relatively high. The relatively small reductions in capital gains taxes would not offset the benefits of tax-deferred earnings.

How would it impact plan sponsors?

Assumptions:

  • Under both the Senate and House bills, C corporations would be taxed at 20%, though the House version would begin in 2018 and the Senate version would be in 2019.
     
  • Owners of S corporations (and other types of tax pass-through entities) would be taxed 25% for business income. While this wouldn’t include all pass-through income, it could significantly reduce the pass-through owner’s tax amount.
     
  • The delayed tax deduction for deferred comp contributions would remain unchanged. Unlike contributions to qualified plans that are currently deductible, deferred comp benefits are only tax deductible when distributed.

These significant tax reductions would dramatically lower an employer’s long-term cost to sponsor a deferred comp plan. The cash flow required to support the delayed tax deduction would be much lower than under current law. A reduction to a tax rate of 20% would have a positive impact on employers’ cash flow.

How would it impact plan financing?

Deferred comp plans are unfunded plans under the Employee Retirement Income Security Act (ERISA). This means that any assets set aside to informally finance the promised benefits remain on the employer’s balance sheet and are subject to taxation as required under the tax code. Typically, deferred comp plans are informally financed with taxable mutual funds or corporate-owned life insurance (COLI). 

If there’s a significant change in corporate tax rates, this could affect the comparative economics of deferred comp plan financing:

  • If corporate tax rates fall to around 25% (combined state and federal), COLI will generally compare somewhat favorably to mutual fund financing, but the advantages will only be realized if held by the employer for a longer time horizon.
     
  • It’s good to remember that COLI provides other benefits, including cost-recovery and/or key-person coverage, that may be desirable outside the deferred comp plan. So, be sure to look at the economic variables, as well as any other needs of the employer.

 

For financial professional use only. Not for distribution to the public.

The views expressed are those of Principal® and provided with the understanding that Principal® is not rendering legal, accounting or tax advice. The content is provided as informational only and is based on our general understanding of the relevant technical and political issues as of the writing. This information is not intended nor should it be used as an opinion on legal, accounting or tax issues.

Insurance products issued by Principal National Life Insurance Co. (except in NY) and Principal Life Insurance Co. Plan administrative services offered by Principal Life. Principal Funds, Inc., is distributed by Principal Funds Distributor, Inc. Securities offered through Principal Securities, Inc., 800-247-1737, Member SIPC and/or independent broker/dealers. Principal National, Principal Life, Principal Funds Distributor, Inc., and Principal Securities are members of the Principal Financial Group®, Des Moines, IA 50392.

 

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Additional resources

Groom Law Group House Tax Reform Benefits Brief (Nov. 3, 2017)

Benefits Brief is provided with permission from Groom Law Group. The content is for educational and informational purposes only. Groom Law Group is not an affiliate of Principal® or any of its member companies.

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