The possibility of tax reform, estimated at still better than 50/50 by most observers, requires thought, planning and action now for a number of reasons.
“Many planning opportunities will only be relevant if they are implemented before tax reform is effective,” said Dustin Stamper, director at Grant Thornton’s Washington national tax office. “You don’t want to miss potential permanent tax savings from things like accelerating deductions or repatriating income early.”
It is important that businesses realize that they don’t have time to wait and see, according to Stamper. “The potential for lower rates in the future increases the value of deductions now, when rates are higher,” he observed. “Deferring income related to advance payments, and accelerating deductions for things like prepaid expenses, are just a few examples of some of the opportunities that are available. And many building assets can be broken out and reclassified to depreciate them using shorter lives.”
While the one-time lower tax rate on repatriated earnings parked overseas is attractive, businesses should assess whether it is more favorable to repatriate before tax reform becomes effective to take advantage of any foreign tax credits.
The value of planning strategies, such as repatriating earnings, will be heavily dependent on the outcome of tax reform, Stamper indicated. “Any company with offshore earnings should assess whether it would pay less in tax if earnings are repatriated before tax reform, and foreign tax credits are available, or after reform, when the rate may be reduced. You may not want to act until you know whether tax reform will actually be enacted and how the one-time tax will apply, but you should be preparing to support the amount and location of unrepatriated earnings so you can make an informed decision.”
“A business should carefully consider its entire tax and financial situation before making major decisions,” Stamper said. “It’s possible that rate cuts are made effective early, or don’t happen at all. The good news is that deferring tax is typically a good move, if only for the cash flow benefits and the time value of money.”
In assessing the impact reform would have on current business decisions with long-term economic effects, businesses should consider the following, according to Stamper:
- Does it make sense to postpone large capital projects until full expensing is available through tax reform?
- How would the loss of the interest deduction affect financing plans, particularly with assets that wouldn’t benefit from full expensing, such as land, stock acquisitions or assets placed in service before tax reform is effective?
- Has due diligence been performed on how changes like the loss of import or interest deductions would affect acquisitions or investments in business lines?
- Will long-term global contracts or service agreements still make economic sense if reform is enacted?
Rates vs. deductions
At a minimum, taxpayers should consider the prospect of lower rates in the offing, suggested Howard Wagner, Crowe Horwath’s national tax services managing director. “You want to take deductions at a higher rate when they’re worth more, and of course postpone income until it will be taxed at a lower rate,” he said. “But it’s more complicated for individual taxpayers because of the limits on itemized deductions. You might have slightly lower rates after reform, but might lose some of the deductions. You need to do the math and decide if you’re better off by itemizing deductions at today’s higher rates, for which you might not get the full benefit, or in the future when the rate is lower but there are no limitations.”
Businesses should consider doing a cost-segregation study to reclassify property into segments with a shorter useful life, according to Wagner. “In today’s world, a business taxpayer might not be motivated to do the study, because the only benefit would be the time value of money from the accelerated deduction,” he said. “But where rates will decline, accelerating the deduction into the higher tax year gives the company more value because they get the accelerated deduction at 35 percent [today’s corporate tax rate] rather than at the 15 percent or 20 percent rate projected under tax reform.”
“In the typical scenario, a company erects a building and capitalizes all costs with a 39-year life,” he said. “In fact there are separate components of construction costs that actually represent tangible personal property that is depreciable over a shorter life for tax purposes. The cost segregation study will identify those components, and the company can file an accounting method change to correct the allocation of costs and related depreciation deductions. When the company does this, the net benefit is recorded in the year of the accounting method change. This type of accounting method change can be made by the extended due date of the tax return, and does not require the permission of the IRS.”
Goodbye to the AMT?
Because the Alternative Minimum Tax would go away under both the House plan and the administration plan, it is important that the AMT does not negatively impact decisions, Wagner indicated. “Although generally the best strategy in a declining rate environment is to accelerate deductions and defer income, individuals subject to the AMT may actually be better off if they defer certain deductions,” he said. “It is counterintuitive, but even though rates are lower, because of the AMT you might actually get more benefit for some deductions in a year with a lower tax rate. For example, under the current system, an individual subject to the AMT only gets a 28 percent benefit for charitable contributions. If the individual waited until after tax reform, assuming the AMT goes away, they would get a 35 percent [under the administration’s plan] or 33 percent [under the House blueprint] benefit for their charitable contribution.”
“Of course, this applies to deductions such as charitable contributions that are likely to be allowed before and after tax reform,” Wagner said. “If the deduction is likely to be eliminated by tax reform, there is obviously no benefit to deferral. The challenge of planning into an uncertain future is guessing at which piece of the legislation will actually be enacted and what will fall off.”
Chip Wry, a member at Morse, Barnes-Brown Pendleton PC, agreed. “Where both proposals have the same or similar provisions, it’s likely that the provision will stay.”
Wry noted that both the House plan and the administration plan favor eliminating the interest expense deduction as a means to make the tax rate reduction more palatable. “If you’re going to lose the ability to deduct interest, you might want to borrow now, rather than after the bill becomes effective. There will likely be grandfathering of debt that was incurred before the new bill becomes law.”
“Likewise, both versions propose the immediate expensing of capital expenditures,” he added. “As a result, businesses might want to consider holding off on making any capital expenditures until the bill becomes effective, rather than be under the rules of recovering the expense under a longer depreciation schedule.”
C vs. LLC
Tax reform might also affect the kind of entity to choose for a new business, Wry suggested. “Before the individual rates went up under the current rules, we formed a higher percentage of companies as LLCs than after they increased,” Wry said. “But with the increase in rates, we were more willing to form companies as a C corporation. If a C corporation distributes earnings to the owners, under the old rules, and what looks like the new rules under tax reform, pass-throughs will have an advantage. But for a company that will retain earnings, the C corporation may still have an advantage, unless the rates are the same for C corporations and pass-throughs.”
“For example, under today’s rules, if a company earns $100 and wants to plow as much as it can back into the business, a C corporation would be taxed at the federally maximum rate of 35 percent, or 34 percent for mid-market companies. It would be able to put $65 or $66 back into the business. If it’s an S corporation or an LLC, the 100 is reported directly by the company’s owners, and if they’re individuals that $100 may be subject to as high as a 43.4 tax rate, rather than 34 percent or 35 percent, so if the company makes distributions to the owners to enable them to pay taxes, the company is left with far less.”
“The House blueprint would make the pass-through rate 25 percent with the corporate rate at 20 percent, which would leave C corporations with the advantage that they have now,” he said. “The administration proposals would tax pass-throughs at the same rate as corporations. This takes away the advantage that C corporations currently have in terms of the effective rate of tax on retained earnings.”
“It’s easier to change from an LLC to a C corporation, so if you want to hedge your bets today and there’s no compelling reason for one or the other, go with the LLC,” Wry advised. “If it makes sense later, you can change to a C corporation.”
“But going from a C corporation to an LLC is as if the corporation sold all its assets at fair market value, and distributed them to the shareholders, then they contributed the assets to the LLC. It’s taxable to both the corporation and the shareholders. Any gain that was built into the C corporation’s assets gets triggered on the conversion, but the same isn’t true on the conversion of an LLC into a C corporation.”
Manufacturers with a foreign supply chain and importers might want to take action now to avoid an import tax later due to the possibility of a border adjustment tax, Wry noted.
Although border adjustment may not make it into the final bill, the possibility of it accentuates the need to reconsider any long-term agreements with foreign suppliers, Stamper agreed.
And the House is not giving up on the idea. Rep. Kevin Brady recently discussed a potential five-year phase-in of the border adjustment provision.
“Aside from the fact that a phase-in would not address all of the policy concerns that have been expressed with respect to a border adjustment tax, one important perspective is the impact it would have on an overall tax reform bill,” said Marc Gerson, former majority tax counsel to the Ways and Means Committee and vice chair of the tax department at Miller Chevalier.
“Presumably, the phase-in will have a significant revenue impact which could impact other aspects of the bill,” he said. “For example, perhaps any proposed reduction in business tax rates would similarly need to be phased in. Thus, it will be important for taxpayers to understand and model the overall impact of any proposed phase-in. It may be that on a net basis, any tax relief thought to be associated with a proposed border adjustment tax phase-in is offset by other changes to the bill to accommodate the reduced revenue resulting from that phase-in.”