The commonly known Tax Cuts and Jobs Act is a gift that keeps on giving – that is, giving sleepless nights to corporate finance executives who lie awake wondering if they have adequately identified and addressed all of its impacts on and within their organizations. First came the frantic scramble to identify, compute, record, and disclose the act’s income tax accounting effects on financial statements for periods that include the Dec. 22, 2017, enactment date. Next come strategic questions: How much corporate tax savings really exists? How best to maximize and deploy it? The act’s potential net impact on a corporation’s bottom line undoubtedly will lead to changes in systems, policies, and behaviors.
The act reduces corporate tax rates from 34 percent and 35 percent to 21 percent, repeals the corporate alternative minimum tax, provides some new deductions, and accelerates certain others. However, it also eliminates or delays a host of existing tax deductions, accelerates some income recognition, and, for companies owning 10 percent or more of a foreign subsidiary, creates a suite of new taxes with exotic acronyms like BEAT and GILTI. These offsetting provisions can blur the act’s actual cost or benefit to any corporation. For example, consider a fully domestic corporation paying 8 percent state income tax. Its tax rate was 40.2 percent (0.35 + 0.08 - (0.08 x 0.35)) before the act and 27.32 percent (0.21 + 0.08 - (0.08 x 0.21)) afterward, a 12.88 percent reduction. Before the act, a $1,000 federal- and state-deductible expense yielded a $402 tax benefit, for a net cost of $598. If that $1,000 no longer is deductible under the act (and states follow suit), its net cost is $1,000. The lost $402 tax benefit soaks up the 12.88 percent tax rate savings on $3,121 of taxable profit, just to break even.
What Are the New After-Tax Costs of Doing Business?
Apart from the tactical actions (and their cost) necessary to comply with the new law’s requirements, strategic opportunities exist to mitigate the negative impact of any taxpayer-unfavorable aspects while maximizing tax savings opportunities. Following are some areas to consider:
- Many companies now will face an annual limitation on their deduction of interest expense. Generally, the deduction cannot exceed 30 percent of an adjusted taxable income number similar to earnings before interest, taxes, depreciation, and amortization (EBITDA) – similar to earnings before interest and taxes (EBIT) beginning in 2022. The disallowed amount can carry forward indefinitely but might never be deductible if the company carries too much debt. How will this affect a company’s mix of debt versus equity funding?
- The after-tax cost of entertaining customers and prospects now is more expensive with the loss of tax deductions for various entertainment activities. Should this change the focus of business development dollars?
- 100 percent bonus depreciation is available for qualifying fixed assets placed in service after Sept. 27, 2017. However, due to drafting errors in the statutory language of the act, this bonus is unavailable for most qualified real estate improvements and, what’s more, starting in 2018 these real estate improvements would be depreciable over 39 years versus 15 years. A technical correction is necessary to restore intended fixed-asset cost recovery benefits. Will it happen? How should this affect any building improvement and expansion plans?
- Changes to the taxability of various employee compensation elements creates extra work for payroll departments. Should companies also redesign certain compensation and benefits programs based on new after-tax costs to both themselves and their employees?
- Some previously nontaxable benefits offered to employees now will be taxable to them, most notably relocation expense reimbursements.
- Companies can no longer can deduct certain benefits provided to employees, such as qualified parking and transportation and other de minimis fringe benefits that primarily are personal in nature.
- Companies that broadly award stock options or restricted stock units might consider taking on the many restrictions of the new qualified equity grant program to allow nonexecutive employees to defer for up to five years the income taxation of settled awards.
- Companies that issue publicly traded stock or debt will be able to deduct only up to $1 million annually in compensation paid to each of the CEO, CFO, three other highest-paid executives, and “predecessor” executives (once IRS guidance clarifies who that means), regardless of whether such compensation meets any performance criteria. Excluding any grandfathered amounts exempt from limitation under the old rules, these new limitations will follow payments to these executives past retirement and even past their deaths.
Where Best to Do Business?
Companies with an appetite to minimize taxes by strategically choosing their targeted markets and the locations of their assets – tangible, intangible, and human – have a lot to digest. Is the new after-tax cost of any existing strategies to minimize state or local taxes still attractive? What is the right balance of domestic versus foreign locations, activities, and investments? Consider the following:
- State and local tax costs automatically rose with the lower 21 percent federal benefit of deducting such taxes. An 8 percent state tax that previously cost 5.2 percent now costs 6.3 percent. Many states won’t adopt some of the act’s taxpayer-favorable provisions (such as bonus depreciation) while embracing others that will increase state taxable income (such as new entertainment deduction limits) and therefore state tax cost. Companies might rethink their state footprint and its cost.
- On the employee side, the loss of itemized deduction ability for more than $10,000 of state and local tax expense could negatively affect an employee’s desire to work in so-called high-tax states, thus increasing staffing costs in those locales.
- Certain state or local government incentives paid to a company to locate jobs and facilities there were previously nontaxable contributions to corporate capital; now these are taxable upfront.
- The domestic production activities deduction is repealed.
- The act’s major new international provisions are too numerous and complex for discussion here, but certainly will have U.S. shareholders of foreign subsidiaries, as well as foreign parents of U.S. subsidiaries, re-thinking their cross-border relationships, in terms of funding, return of profits, transfer pricing agreements, and more.
New Return on Old Investments?
Companies might find their new after-tax return on certain investments less attractive. Should they restructure their investment portfolios toward more favorable options? For example:
- The tax-equivalent return on federally tax-exempt securities and corporate-owned life insurance has shrunk with a lower corporate tax rate.
- A corporation’s 80 percent dividends received deduction (DRD) on qualifying equity investments was reduced to 65 percent, increasing the tax cost of every $1,000 of dividend received by $3.50 in federal tax ($200 of taxable dividend x 35 percent versus $350 of taxable dividend x 21 percent).
- Investments whose return was heavily dependent on the distribution to investors of tax losses (think low-income housing and other tax credit investments) have lost some value now that those tax losses yield only a 21 percent tax benefit.
Bottom Line?
The act imposes myriad new requirements and some pitfalls while presenting a host of opportunities for financial executives to address, both tactically and strategically. Since its signing, numerous corporations have announced plans for their newfound tax savings – raises, bonuses, U.S. facilities expansions, dividends, share buybacks – or speculated on how competitors will use their savings to compete in the market. Be sure to consider all of the act’s material impacts on your company’s bottom line before jumping on that bandwagon. And get some sleep.
For more information on tax reform and how it pertains to your industry, visit the Crowe Tax Reform Resource Center.