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Corporate tax changes: a closer look.

The Omnibus Budget Reconciliation Act of 1993

A number of changes will affect employee benefits, executive compensation, and deductions.

Currently, contributions for benefits provided under a qualified retirement plan (eg., a pension or profit sharing plan) may be determined based on compensation up to $235,840. Commencing with plan years beginning after 1993, OBRA reduces the applicable compensation amount that may be taken into account under a qualified plan to $150,000. However, benefits that accrue through the last day of the last plan year which begins before 1994 will be grandfathered.

The new $150,000 compensation limit will be indexed for cost of living adjustments, but only in increments of $10,000. Thus, no adjustment to the $150,000 limit will be made until the cumulative effect of the cost of living changes is at least $10,000. The reduction in the compensation limit to $150,000 also applies for purposes of benefit and contribution calculations under simplified employee pension plans, supplemental unemployment benefit trusts, voluntary employees' beneficiary associations, and group legal services plans, as well as to the deduction limitations applicable to qualified plans. While Internal Revenue Code Section 403(b) plans (generally available to 501(c)(3) tax-exempt organizations), providing benefits other than through salary reduction would be affected by the change, many 403(b) plans that provide benefits only through salary reduction contributions should not be affected by the new limits.

Review Current Plans

Employers should review their present deferred compensation arrangements to determine the impact of the new law on costs, eligibility, and benefits. Because of the effect of the lower compensation limit, many employers may want to consider revising their plan formulas and/or adopting or extending supplemental retirement benefit arrangements for certain highly compensated employees to the extent permitted by law. It should be noted that tax-exempt employers continue to be subject to the rules under IRS Code Section 457 with respect to non-qualified deferred compensation arrangements.

Generally, the reduction in the plan compensation limit applies to benefits accruing in plan years beginning after 1993. Special rules apply to benefits accruing in governmental plans and plans maintained pursuant to a collective bargaining agreement (CBA).

In the case of a plan maintained pursuant to a CBA that was ratified prior to Aug. 10, 1993, the new compensation limit does not apply to contributions or benefits accruing in plan years beginning before the earlier of the latest of Jan. 1, 1994; the date on which the last CBA terminates (without regard to any extension or modification made on or after Aug. 10, 1993); or for plans maintained pursuant to a CBA under the Railway Labor Act, the date of execution of an extension or replacement of the last of the CBAs in effect on Aug. 10, 1993 or Jan. 1, 1997.

Changes Affect Compensation

For 1993, the Medicare hospital insurance portion of the FICA tax imposed on employee wages is 1.45 percent on the first $135,000 of wages. In the case of an employee, the tax is payable by both the employee and his employer. A self-employed individual pays a combined hospital insurance rate of 2.9 percent of the first $135,000 of self-employment income.

OBRA repeals the dollar limit applicable to wages or self-employment income subject to the hospital insurance tax. Thus, in addition to considering the impact of the elimination of the cap on current compensation, employers who provide, or who permit individuals to defer compensation under non-qualified deferred compensation arrangements should review such arrangements to determine whether amounts thereunder may be subject to the hospital insurance tax as a result of the repeal of the dollar limitation.

Wage Base Cap Is Repealed

The repeal of the wage base cap presents a number of issues, including the determination of the appropriate amount subject to tax for those individuals covered by excess benefit plans in that the amount of the vested excess benefit may decrease in future years due to payments made under the employer's qualified plan (or, alternatively, by virtue of a participant's increasing age, early retirement subsidies payable under the non-qualified plan may disappear). Previously, such a review was most likely unnecessary because many individuals covered by non-qualified deferred compensation arrangements had earnings in excess of the hospital insurance wage cap in place prior to OBRA. OBRA's provision repealing the dollar limitation applicable to the hospital insurance portion of the FICA tax is effective for wages or income received after 1993.

Under OBRA, a publicly-held corporation will not be permitted to deduct compensation paid or accrued with respect to a covered employee in excess of $1 million per year. This deduction limitation applies to corporations that have a class of common equity securities that are required to be registered under applicable federal securities laws. The employees whose compensation is subject to the $1 million annual limit include the chief executive officer and the four next highest paid officers.

The deduction limitation applies generally to all remuneration for services, including cash and the cash value of all non-cash compensation. However, certain types of compensation are not taken into account in determining whether the $1 million limit is exceeded. Excluded compensation includes:

* commissions;

* performance-based compensation if certain outside director and shareholder approval requirements are satisfied;

* contributions to a tax-qualified retirement plan;

* amounts otherwise excludable from the executive's gross income (e.g., employer-provided health benefits and certain fringe benefits); and

* compensation payable pursuant to a written binding contract in effect on Feb. 17, 1993 and at all times thereafter before the compensation is paid.

The provisions of OBRA limiting the deduction for certain executive compensation are effective for taxable years beginning on or after Jan. 1, 1994.

Supplemental Wage Payments Withholding Increased

Prior to the Omnibus Budget Reconciliation Act of 1993 (OBRA), withholding on supplemental wage payments (such as bonuses, commissions, and overtime pay), otherwise separate from an employee's regular wages, was calculated at a flat 20 percent rate or by aggregating such supplemental payments with the employee's regular wages and applying the wage withholding tables to this total amount. Under OBRA, the flat withholding rate applicable to supplemental wage payments is increased to 28 percent. OBRA's provision increasing the flat withholding rate on supplemental wage payments is effective for payments made after 1993.

Meal and Entertainment Deductions Reduced

The deduction allowable for meal and entertainment expenses paid or incurred in connection with a trade or business or the production of income prior to OBRA was limited to 80 percent of the total amount. The deduction limit is reduced to 50 percent effective for taxable years beginning after Dec. 31, 1993.

Club Dues and Spousal Travel Deductions Eliminated

OBRA's provisions denying a deduction for club dues and travel expenses of spouses or other dependents are effective for amounts paid or incurred after Dec. 31, 1993. No deduction is allowed for amounts paid or incurred for membership in any social, business, or athletic club. However, specific business expenses (e.g., meals) incurred at a club will continue to be deductible in accordance with the tax rules otherwise applicable to such expenses.

Further, under OBRA, no deduction is allowable for travel expenses paid or incurred with respect to an individual's spouse, dependent, or other person accompanying the individual on business travel unless:

* the spouse, dependent or other person accompanying the individual is a bona fide employee of the person paying or reimbursing the expenses (e.g., an employer);

* the travel of the spouse, dependent, or other person is for a bona fide business purpose; and

* the expenses of the spouse, dependent, or other person would otherwise be deductible.

The denial of a deduction for travel expenses, described above, does not apply to expenses that would otherwise qualify as deductible moving expenses.

Changes Affecting Investments by Pension Plans

Generally, income received on investments by a trust maintained as part of a tax-qualified retirement plan is exempt from income taxation. However, to the extent a pension trust's income is derived from an unrelated trade or business, such income is subject to an unrelated business income tax (UBIT) at the same rates applicable to corporations.

Leaseback and Disqualified Person Carry Restrictions

Under prior law, a UBIT would result from income received by a qualified pension trust from real property if the property was "debt-financed" and if it was acquired by the plan from, or if at any time after the acquisition it was leased by the plan to, certain persons related to the plan (a "related person"--e.g., an employer of employees covered by the plan or a 50 percent or more owned subsidiary of such employer). Under OBRA, no UBIT will arise if debt-financed real property is leased back to a related person, provided no more than 25 percent of the leasable floor space in a building (or complex of buildings) is covered by the lease and the lease is on commercially reasonable terms. It should be noted that any investment by a pension trust must be in accordance with the fiduciary rules of ERISA and the prohibited transaction rules of ERISA and the Code.

Generally, debt-financed property includes property acquired by a qualified plan pursuant to which a related person provides financing in connection with such acquisition. Under OBRA, the restrictions on seller-financing of real property acquired by a qualified plan will no longer apply if the financing is on commercially reasonable terms. The special leaseback and seller financing rules are effective for acquisitions and for leases entered into on or after Jan. 1, 1994.

Investments in Publicly-Traded Partnerships

A pension plan's share of the gross income of a publicly-traded partnership was treated as income derived from an unrelated trade or business. OBRA repeals the rule which automatically treated income derived from a publicly-traded partnership as subject to UBIT. Thus, investments in publicly-traded partnerships are now treated in the same manner as investments in other partnerships for purposes of UBIT. OBRA's provision regarding investments in publicly-traded partnerships is effective for taxable years beginning on or after Jan. 1, 1994.

Investments in Real Estate Investment Trusts

A real estate investment trust (REIT) is not taxed on income distributed to its shareholders if it meets certain tax law requirements. Under pre-Act law, a corporation will not qualify as a REIT if at any time during the last half of its taxable year more than 50 percent in value or its outstanding stock is owned, directly or indirectly, by five or fewer individuals. Moreover, for purposes of this "five or fewer rule," a qualified pension trust was treated as a single individual.

Under OBRA, a qualified pension trust will no longer be treated as a single shareholder for purposes of the five or fewer rule. Instead, any stock in the REIT held by a qualified pension trust will be treated as held directly by the trust's beneficiaries in proportion to their actuarial interest in the trust.

However, if any qualifying pension trust holds more than 10 percent in value of the interests in any "pension-held REIT" at any time during a taxable year, the pension trust must treat a percentage of the dividends from the REIT as subject to UBIT. The applicable percentage is determined based on the ratio of the gross income (less direct expenses) of the REIT that is derived from an unrelated trade or business of the REIT (determined as if the REIT were a qualified pension trust) to the gross income (less direct expenses) of the REIT for the year in which the dividends are paid. Dividends, however, will not be subject to UBIT unless the above described percentage is at least 5 percent.

For purposes of this special UBIT rule, a "pension-held REIT" is a trust that would not qualify, as a REIT but for the modification of the five or fewer rule, and which is "predominantly held" by qualified pension trusts. A REIT is "predominantly held" by qualified pension trusts if at least one qualified pension trust owns more than 25 percent of the value of the REIT, or a group of qualified pension trusts individually owns more than 10 percent of the value of the REIT and collectively own more than 50 percent of the value of the REIT. The provisions of OBRA amending the rules governing qualified pension trust investments in REITs are effective for tax years beginning on or after Jan. 1, 1994.

Employer-Provided Educational Assistance Extended

Prior to July 1, 1992, an employee could exclude from gross income up to $5,250 paid or incurred by his employer each year for educational assistance provided if certain legal requirements were met. Since the exclusion expired on June 3, 1992, employees have generally been required to recognize as income the value of employer-provided educational assistance unless the cost of such assistance qualified as a deductible job-related employee expense.

Under OBRA, the exclusion from income for employer-provided educational assistance was extended retroactively from June 30, 1992 through Dec. 31, 1994. The IRS has recently issued guidance with respect to the procedures to be used (generally, amended returns and reports) to claim the income exclusion where amounts were included in income before the retroactive extension of the exclusion.

Health Insurance Deduction for Self-Employed Individuals Continues

Prior to July 1, 1992, a self-employed individual was allowed to deduct as a business expense up to 25 percent of the amount paid for health insurance coverage for the individual, the individual's spouse, and dependents. Under OBRA, the deduction was extended retroactively from July 1, 1992 through Dec. 31, 1993. However, as was the case under prior law, no deduction is allowed if the self-employed individual, or his or her spouse is eligible to participate in a subsidized health plan maintained by his or her employer or the employer of his or her spouse. This limitation on the deduction is now tested on a monthly basis.

Brian O'Hare and David Glaser are partners with Patterson, Belknap, Webb & Tyler, New York, N.Y. concentrating on employee benefits and executive compensation.
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Title Annotation:The Omnibus Budget Reconciliation Act of 1993
Author:O'Hare, Brian; Glaser, David
Publication:Business Credit
Date:Apr 1, 1994
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