Tax Cut and Jobs Act: Business Taxes

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In late December, 2017, the current administration in Washington signed into law the Tax Cuts and Jobs Act, the most comprehensive modification of the US tax code in a generation.

There have been many headlines about this new tax law, but little in the press about what the major features actually are. The Informed Vermonter will try and explain the major provisions of the new tax law and broadly assess the impact it may have on both federal tax receipts and Vermont’s tax revenues going forward.

The emphasis will be on “major features”. The US tax code has over 74,000 pages and the new tax law has over 550 pages. The Informed Vermonter did not read all this in preparation for this article.

Both business income taxes and individual income taxes have been greatly modified by the new tax law. This article will address the key changes in business income taxes and the next one will address individual taxes. A third article will assess the impact of this new law on the economy, the federal government and the State of Vermont.

Corporate Income Tax Rates

The top marginal tax rate for corporate income has been reduced from 35% to 21%.

Remember that corporate profits are taxed twice. First, corporate income or profits are taxed at the corporate entity level. The rate of tax on this income has now been sharply reduced to 21%. Dividends, or the after-tax profits that are distributed to corporate shareholders, are also taxed.

The new tax law did not change the tax on dividends. Corporate dividends are taxed at a regular rate of 20% plus a Medicare surcharge rate of 3.8%, or 23.8% in total.

Taking both sets of tax into account, the effective rate of tax on $1 of corporate profit distributed to a shareholder in now 39.8% (21% + 23.8%[1-0.21]=39.8), which is a bit higher than the newly revised top individual tax rate of 37%.

Pass Through Business Income Taxes

 The vast majority of businesses in the country are not structured as corporations. Instead, they are sole proprietorships, partnerships, LLC’s and S-Corps. For tax purposes, none of these types of businesses pay income tax at the business entity level. Instead, all profits are automatically passed through to the owners who then pay tax at the individual income tax rates. So, larger businesses would have been paying a top tax rate of 39.6% prior to the new tax law.

The new tax law tried to give all businesses, irrespective to how they are legally organized, a similar tax burden. The solution was to allow pass through entities to deduct 20% of their Qualified Business Income from their taxable income. In addition, the top marginal tax rate for individuals was reduced to 37%. This reduced the top effective tax rate for these businesses to 29.6% (i.e.: 37% tax rate on only 80% of income).

Personal service businesses are largely excluded from this 20% deduction. If you are an accountant, lawyer, healthcare provider, consultant, hairdresser or performing artist, you cannot take this deduction. However, a small service business ($315,000 or less if filing joint or $157,500 or less filing single) is eligible for some level of deduction subject to quite complex phase-out rules.

The 20% deduction is also limited to the greater of i) 50% of wages paid and ii) the sum of 25% of wages paid and 2.5% of capital assets. So, this new tax treatment for pass through entities favors businesses with many employees and heavy capital investments.

Being Washington, there are of course some exceptions. First, REITS, or Real Estate Investment Trusts, are exempt from the wage cap formula outlined above. Master Limited Partnerships and Publically Traded Partnerships, both of which are common in the oil & gas businesses, are also exempt from the wage cap.

The effective tax rate for pass through entities of 29.6% is less than the effective tax rate on distributed corporate income of 39.8%. Certain businesses may rethink their corporate structures and convert to pass through legal entities for tax purposes.

Cap On Interest Expense Deduction

 With only a few minor exceptions, businesses were able do deduct 100% of their interest expense for tax purposes. The new tax law limits interest deductions to 30% of Adjusted Total Income, which effectively equals Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA).

Not surprisingly, given our President’s background, REITs are exempt for this limitation. They can have as much debt as they want and deduct all the interest. Go figure.

Full Expensing of Capital Expenditures

Prior to the new tax law, the cost of capital assets was amortized over the useful life of the asset for tax purposes. So, a new forklift costing $60,000 with a five- year life would have a $12,000 annual expense for tax purposes.

The new tax law permits the full expensing of the cost of certain capital assets from September 25, 2017 to Jan. 1, 2023. So, the $60,000 cost of the forklift can now be deducted from taxable income in the year it was purchased.

This provision is obviously a major incentive to invest in capital assets over the next 5-years. The after-tax cost of investing is materially reduced until the provision expires at the end of 2022.

Net Operating Losses (“NOL’s”)

The federal and state tax codes have always allowed losses to offset gains when calculating taxes. The new tax law made a few changes to how this can now be done.

First, carrybacks are now prohibited. Losses incurred this year can no longer be used to offset last year’s taxes.

NOL’s can now be carried forward for an unlimited time (there was a 20-year limit before), but can never exceed 80% of taxable income. No matter how large the losses being carried forward, corporations will now be paying tax on at least 20% of their taxable income.

Alternative Minimum Tax (“ATM”)

The ATM for corporations has been eliminated. Companies with high capital expenditures can now manage their taxes to zero.

R&D Tax Credits

All R&D tax credits have been preserved in the new tax law.

Tax on Foreign Corporate Income

Prior to the new tax law, US corporations paid a set of minimum taxes on certain foreign income whether or not that income was distributed back to the parent company in the USA, but paid the full 35% tax on cash distributions actually made by foreign subsidiaries, less a credit for any foreign taxes paid.. This tax system resulted in most US companies reinvesting their offshore earnings in foreign countries to avoid the 35% repatriation tax.

The new tax law does the following key things with respect to foreign income of US corporations:

  1. There is effectively a minimum tax on the income of the foreign subsidiaries of US companies. It is all very complex, but for simplicity lets call it a 10.5% tax.
  2. Beginning Jan 1, 2018, dividends paid from foreign subsidiaries are now completely tax-free. Subject to the minimum taxes paid in (1), above, foreign income can now be repatriated to the US parent tax-free.
  3. There is a one-time, mandatory tax on all foreign accumulated earnings and profits (“E&P”) since 1986. There is an estimated $2-3 trillion dollars of accumulated earnings sitting in off-shore accounts. The one-time tax is 15.5% on E&P held in cash and cash equivalents and 8% on any residual amounts. Companies can pay this tax over 8 years in installments.
  4. Various efforts have been made to prevent US companies from artificially shifting income from the US to low-tax foreign jurisdictions. The new Base Erosion and Anti-Abuse Tax imposes a tax on certain deductions commonly used by corporations to shift income abroad, such as management and royalty fees. There are also new guidelines stipulating that the source of income from the sale of inventory is to be based solely on the basis of production activities. This should help prevent US companies from using transfer pricing schemes to shift profits around the world artificially to avoid US tax.

The old tax code effectively subsidized foreign investment by making the cost of repatriation prohibitive. Many billions or trillions of dollars may now find its way back to the US, where it may be used for investment, debt repayment, dividends and stock buybacks. How all this money is actually used will determine what effect, if any, it has on economic growth.

It also appears there has been a real attempt to reduce corporate tax evasion, which is long overdue and welcome. However, with a 21% new tax rate and the ability to expense 100% of capital expenditures, no one will be complaining too loud!

Favored Industries

Oil& Gas: All of the previous loopholes and tax schemes available to the oil & gas industry have been preserved, including the deduction for intangible drilling costs, percentage depletion, the exemption to passive loss treatment and favorable geological and geophysical recovery periods. In addition, the 20% deduction for Master Limited Partnerships and Publicly Traded Partnerships, both common structures in this industry, are available without the wage cap limitations imposed on other industries.

Evidently, international oil and gas income is no longer considered income at all for tax purposes, allowing the oil and gas industry to avoid that pesky minimum tax on international profit.

The tax incentives available to the Renewable Energy industry were largely preserved.

Real Estate: REIT’s are exempt from both the 30% interest expense deduction limitation and the wage cap for the 20% pass through deduction.

In summary, taxes on business income have been greatly reduced.  The Congressional Budget Office estimates that the changes to corporate and pass-through income taxes will reduce federal tax revenues by about $600 billion over the next 10 years.

 

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