As legislators weigh pros, cons and percentages of tax reform, companies are struggling with business and tax planning. Republicans released a unified framework for tax reform several weeks ago, but many of the details are unresolved. The House is finally scheduled to release a full tax reform bill on Nov. 1, but the process still faces many twists and turns. Despite the uncertainty, a wait-and-see approach to planning isn’t the way to go. Rather, your company can act now to take advantage of planning strategies that can be implemented before tax reform is effective.
Know more so you can do more
“You have powerful planning opportunities to look at high upsides, low downsides right now,” said Grant Thornton Washington National Tax Office Director Dustin Stamper in a discussion among Grant Thornton and Bloomberg BNA tax professionals. They met to provide information and insights in the recent “The Future of Tax Reform
” webcast, part of the partnership series "Future Ready Business: Washington Impact
The information and insights come at a good time for many business leaders, including over half of the 1,000+ webcast attendees in answering a question about preparedness. Waiting and watching can and should be replaced by planning and preparing for tax reform legislation outcomes.
Any final tax reform will require revamping to some degree. Five areas that could be significantly impacted were highlighted by the tax professionals:
- Depreciation and interest expensing
- Entity choices
- Benefits, incentives and credits
- International taxes and offshore earnings
With the unified framework’s
proposing a 20% tax rate for corporations and at least a 35% rate for individuals, “a big question raised is what do we do about the 50% of business income that runs not through corporations but pass-throughs?” said Stamper. “Pass-throughs
employ almost half of employees nationwide. And almost half of the nation’s economic activity goes through pass-throughs. To the extent they’re giving up tax benefits like corporations, the feeling is they need a more appropriate rate cut.”
Republicans have pledged to provide a 25% rate for pass-through business income, but that creates another policy dilemma. How much income is compensation for the owner’s time and how much is return on investment? Lawmakers are considering a proposed 70-30 ratio that would be easy to administer, if not entirely fair. Under the rule, 70% of income would be considered compensation, taxed at higher individual rates. “It’s completely arbitrary,” Stamper said, “and it creates a blended rate. A 35% individual rate and a 25% pass-through rate is a blended rate of 32%, 12 percentage points higher than the corporate rate.” The pass-through community will push for a truer economic representation, Stamper said. Suggestions include setting a tax rate by assigning a rate of return to the total investment, with income above that amount taxed as compensation at normal individual rates; using S-corporation reasonable compensation rules; or using the ratio of non-owner to owner wages.
What to do now
Betting on a big rate cut, if you can accelerate deductions this year and defer income into next year, you’ll realize a permanent benefit. Even if tax reform doesn’t happen, it’s still a valuable move. Deferral is a cornerstone of tax planning.
Depreciation and interest expensing
The framework promises full and immediate expensing for at least five years. At first glance, this might seem more a boon than proven to be after a deeper dive. For one thing, it excludes land, structures and intangibles. For another, it is paired with a limit on the interest deduction. Some large companies have coalesced in lobbying against full expensing because of the tradeoffs. They’d rather see lower rates and keep their interest deduction.
One of the biggest open questions is how the limit on the deduction for net interest expense incurred by C-corporations will be imposed. As is the case in much of the framework, there isn’t a lot of detail. How the amount of interest expense deduction subject to the limitation would be determined isn’t specified, nor is it spelled out whether the limitation would apply to existing debt. Further information is needed by pass-throughs and sole proprietorships; many will be monitoring tax writing committee proposals for the limitations on entities other than C-corporations.
A big issue is if a company must give up interest deduction — a permanent disallowance — for five years of full expensing. “For a public company, it’s just a timing shift,” said Stamper. “It doesn’t give any financial statement benefit. We’ve seen pushback from public companies that say the tradeoff isn’t worth it.”
The focus for Grant Thornton International Tax Services Partner David Sites is the process for limiting interest. “An option,” he said, “is if you have assets generating both domestic and global income, the taxable income might not be includable in the U.S. tax base. If you have interest in your books, you could see an interest expense haircut.”
What to do now
Model your capital investment and debt plans so you are prepared to make investment decisions when the legislative details are available.
If tax reform becomes law, reorganizing will be a serious consideration for many company leaders. It will be for over one-quarter of webcast attendees.
A wave of entity switches could be ahead as business ponders its options. The facts are that C-corporations are up for a huge rate cut, individuals are not, and pass-throughs may have a very narrow rate cut depending on how their income is defined. In the Senate, talk is of corporate integration, with corporations taking a deduction for dividends paid, reducing the double tax on C-corporations. Another factor is a proposal to limit the SALT deduction for pass-throughs but not for corporations.
It will be a complex decision for each company. As appealing as a 20% tax rate and favorable deductions would be to pass-throughs and S-corporations, a change to a C-corporation could cost them their interest deductions.
What to do now
Do the math on entity choice, taking into account potential advantages and disadvantages of rate changes as well as other technical tax consequences.
Benefits, incentives and credits
Under the framework, most benefits and incentives would be eliminated, as would all general business credits in favor of lower rates. Tax attributes, said Sites, could be significantly impaired.
How will net operating losses (NOLs) be treated, especially those incurred at the current higher rates? “Nothing I’ve heard indicates you would be allowed to gross up an NOL because it was generated when at a higher rate,” said Stamper.
What happens to carry forward credits? The elimination of general business credits applies to all kinds of carry forwards and other tax attributes, Stamper explained. “To the extent you have a deferred tax asset and there’s a rate cut, your asset is worth less against a rate going forward.”
What to do now
Examine your general business credits, including carry forward credits, and if possible use them this year.
Territorial systems and repatriation
If a territorial system is adopted, U.S corporations will get a 100% dividends-received deduction for dividends from a foreign corporation in which they have 10% or greater ownership. An equivalent deduction is not extended to pass-throughs and partnerships. If not provided, this might be a tipping point for some pass-throughs to switch to a C-corporation structure.
The territorial system rules would be limited to dividends received. That is, dividends are collected during operations, and it appears no gains tax will be owed upon sale of the foreign corporation. It is not yet clear if earnings taxes would be owed upon sale.
“Companies will still be incentivized to move earnings offshore,” said Sites. They could bring money back tax-free, receiving the dividend deduction when the money was repatriated. To stop base erosion, Sites asserted, Congress would need to create guardrails.
As a transition and to raise revenue, lawmakers are also proposing a one-time tax on unrepatriated earnings. No rate has yet been given. “The rate could creep up above 10%,” Sites said. “It would still a good deal compared to today’s rate, which is 35% less foreign tax credits.”
At the same time, the loss of foreign tax credits on these earnings could be costly, so companies are left with questions about steps to take — If we have foreign tax credits and can harvest some of those foreign tax credits, are we better off pulling back earnings before the deemed repatriation? Or would it be better to wait for the repatriation and pay the tax at a lower rate? It won’t be possible to have answers until the rate is specified. “But,” Sites advised, “have the inputs ready. If you don’t know your earnings and profits or what your foreign tax pools are, that’s work that needs to be done immediately so you can begin to model and understand if repatriation makes sense ahead of tax reform.” Keep in mind, he said, if a territorial system is put in place, there will be no access to the credits previously allowed in repatriation.
What to do now
Consider deferring earnings in controlled foreign corporations, and prepare to repatriate earnings early, depending on the effective date to be announced.
Upfront thinking is always advisable. It’s a challenge with the tax future as murky as it is. That makes it all the more vital to clear the way within your company to have decisions ready for the probable outcomes.
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