The rapid onset of inflation over the past 18 months has transformed the economic climate. Companies are reckoning with the impact across many aspects of their businesses, including tax planning.
A sustained period of high inflation could have important tax consequences. The forward-thinking companies are already modelling the potential impact and adjusting their tax planning to address challenges and seize opportunities.
This process should start with an understanding of the current state of inflation and the outlook moving forward. Inflation remains near record-highs. The most recent numbers show the standard consumer price index (CPI) up more than 8.5% year-over-year in March, 8.3% in April and 8.6% in May – representing the largest increases in more than 40 years. Hopes that inflation would be transitory evaporated months ago.
This period of sustained high inflation is expected to last well into 2023, long enough to significantly impact tax planning. In addition, measures to fight inflation, such a rising interest rates (and the potential for an economic slowdown as a result), can also have a meaningful tax impact.
Businesses and investors will face an immediate erosion in the value of important tax thresholds that are not indexed for inflation. They also will see tax attributes such as capitalization, amortization and depreciation, as well as loss and credit carry-forwards, decline in value over time. Rising interest rates could force debt modifications with tax consequences, push more companies into the limit on interest deductions under Section 163(j), and affect multinational intercompany lending arrangements.
State and local taxes will present an additional set of challenges and opportunities, from income tax brackets that are only sporadically indexed to inflation, to sales and use tax market thresholds for remote sellers adopted after the U.S. Supreme Court’s Wayfair decision that, likewise, generally lack inflation adjustments. Rising interest rates and inflationary changes in asset values will also affect estate and gift tax planning.
This article is the first in a series of pieces that will examine ways in which businesses and investors may be able to effectively manage their tax structures during a period of high inflation. This piece will provide a high-level introduction, while the next three articles will provide a deeper dive into considerations for federal, state and local, and estate and gift tax planning.
Tax code impact
Dozens of thresholds in the tax code are adjusted for inflation every year, including the tax brackets. There are a handful of important benefits or phase-outs, however, that are not indexed and will lose significant value over time:
- Net investment income tax: The $200,000 (single) and $250,000 (joint) adjusted gross income thresholds for applying the 3.8% tax on net investment income and the 0.9% additional Medicare tax were not indexed to inflation when the taxes became effective in 2013. Low inflation for several years had minimized the “bracket creep” effect, but with annual inflation now topping 8%, many taxpayers will be subject to additional tax on income “increases” that are purely inflationary.
- Mortgage deduction: The itemized deduction for mortgage interest was limited to interest on up to $750,000 in debt by the Tax Cuts and Jobs Act (TCJA) in 2018. With a hot housing market driving prices upward, many taxpayers will be forced to take large loans that generate some component of nondeductible interest.
- Capital gains exclusion: The ability to exclude capital gains on the sale of a principal residence is limited to $500,000 of gain, well below the amount of gain many long-time homeowners may realize in this housing market. This not only increases taxes, but presents a significant compliance burden for taxpayers trying to calculate basis for improvements and repairs made over many years.
- SALT deduction: The $10,000 cap on state and local tax deductions created by the TCJA in 2018 is not indexed for inflation and will represent an ever-shrinking proportion of tax as inflation drives up state tax bills. It is scheduled to expire at the end of 2025 but could be modified or extended before then.
- Capital loss deduction: The ability to deduct capital losses against ordinary income is limited to $3,000 and has never been indexed to inflation.
In addition, the TCJA included a hidden revenue raiser that largely escaped notice at the time. The standard consumer price index (CPI) the IRS uses to index the individual income tax brackets to inflation was replaced with a version that is meant to reflect how consumers adjust behavior in response to price changes. This version is often referred to as “chained CPI” and results in shallower adjustments. The use of chained CPI instead of standard CPI was estimated to raise $133 billion over 10 years, but that projection came during a period of very low inflation. In today’s inflationary environment, this hidden bracket creep could cost individual taxpayers billions of dollars more per year than originally estimated.
Economic and SALT considerations
Inflation creates a host of economic consequences and unique challenges that can have a federal, as well as state and local tax impact. Major tax implications include:
- Rising interest rates: The Federal Reserve is steadily raising the prime rate, which in turn is increasing interest rates across the economy. The tax consequences could be significant and include:
- Interest deductions: Section 163(j) generally limits the deduction for net interest expense to 30% of adjusted taxable income (ATI), and the calculation of ATI must include depreciation and amortization in 2022. Combined with rising interest rates, this change could subject many more businesses to the limit this year and in the future.
- Debt modifications: Inflation will chip away at the principal on loans, so holding fixed rate debt can be valuable for businesses. Many companies may be trying to lock in debt now before rates rise further. If these maneuvers include adjusting current debt, a modification can have tax consequences. Increasing debt loads can also implicate the Section 163(j) limits.
- Intercompany debt and sourcing: Rising interest rates can also affect intercompany debt, particularly cross-border arrangements between related parties. This can affect where income and deductions are sourced. Businesses may also want to consider where domestic interest is sourced to potentially take advantage of favorable state rules.
- Shrinking tax attributes: The value of any tax attribute will be eroded by inflation as the nominal value of a dollar decreases. This means that any costs that must be amortized, capitalized or depreciated will become less valuable as deductions during periods of high inflation. Net operating loss and credit carry-forwards will also lose value, and existing limitations on the use of these amounts (for example, as a result of IRC Section 382) could become more onerous. A deferred tax liability, on the other hand, will shrink with inflation.
- Changing asset values: Inflation generally drives up prices, wages, and assets in nominal terms, but different types of assets can be affected in different ways. Certain investment assets may perform well in an inflationary environment, while others could lose value. This can drive significant business decisions on investments that may have tax consequences. These dynamics can also affect estate and gift planning.
- SALT changes: In addition to the federal tax consequences of a high-inflation environment, there are many considerations specific to state and local tax planning. For example, states may decide to cut income or sales tax rates to provide additional relief to taxpayers who are seeing effective tax increases as the result of rising prices and higher wages. In addition, states that do not currently index their income tax brackets for inflation (e.g., New York, New Jersey and Connecticut) may be more inclined to do so in the current inflationary environment. For remote seller and sales tax collection and remittance requirements, states also may become more consistent in indexing their Wayfair sales thresholds for inflation.
With the resiliency of the inflationary spike, businesses and individuals should consider the impacts of a high-inflation environment on their tax decisions and structures. Some businesses may be able to adjust tax planning—or even profit—from inflation. There are many different planning considerations taxpayers should examine depending on their circumstances:
- Shifting to the last-in, first-out method of accounting
- Accelerating deductions into the current year with accounting method changes
- Sourcing interest income and expense both domestically and internationally
- Structuring any debt modifications to avoid negative tax consequences
- Adjusting estate and gift tax planning for changing asset values and rising rates
The future articles in this series will focus on the federal, state and local, and estate and gift tax planning opportunities in a high-inflation environment.
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