Federal Tax Reform: The Possibilities and How to Prepare

Overview

The general consensus is that tax legislation in some form will be enacted in the near future. Will it result in a sea-change in how we currently pay federal income tax or just in more modest tax rate cuts? What tax reform will look like exactly is speculation and conjecture at this point. However, there are things businesses can do now to prepare for the anticipated tax reform.

What Will Tax Reform Look Like

Tax reform will likely reflect a combination and compromise of the existing proposals presented by our elected leaders. Over the past several years, a number of tax reform proposals were presented for consideration. The most recent is President Trump’s proposal for tax cuts and economic growth announced on Wednesday, April 26. The plan itself is not a detailed proposal but rather a set of principles set out by the administration. Even so, key leaders of both the Senate and House have acknowledged in a joint statement that these principles released by the Trump administration will service as "critical guideposts" as they work to overhaul the tax system. As a result it can be expected that they will have a significant impact on the ultimate shape of tax reform.

The business reforms in President Trump’s proposal include:

  • 15% business tax rate
  • Territorial tax system
  • One-time tax on U.S. profits held overseas
  • Elimination of tax breaks for special interests
  • Repeal of the Alternative Minimum Tax (AMT)

A more detailed tax reform proposal, generally known as the House Blueprint, was presented in 2016 by House of Representatives Speaker Paul Ryan. The House Blueprint includes several significant changes that would be a sea-change for how many businesses compute taxable income. A selection of the more notable changes include:

  • 20% corporate tax rate
  • 25% business income pass-through tax rate
  • Territorial tax system
  • Border adjustments
  • One-time tax on U.S. profits held overseas
  • 100% expensing of capital investments in tangible and intangible assets (excludes land)
  • Net interest expense is not deductible
  • Eliminates most corporate tax preferences except the R&D tax credit and the LIFO inventory method
  • Repeal of AMT

The Trump Proposal and the House Blueprint have not yet been released in statutory language, leaving many unanswered questions on how specific issues will be addressed once these proposals are incorporated into internal revenue code.

Both the Trump Proposal and the House Blueprint also include provisions for individual taxpayers to reduce tax rates and simplify the tax code.

How Businesses Can Prepare

There are areas of agreement in each proposal, such as reduced business tax rates, one-time tax on foreign earnings of U.S. companies and a territorial international tax system. Businesses can start analyzing these proposals now, modeling their effects. Below are a number of considerations to assist businesses in modeling various scenarios.

  • How much in unrepatriated foreign earnings (e.g. untaxed earnings and profits) will be subject to the one-time tax?
  • What is the business’s current effective tax rate relative to the proposed tax rates?
  • Flow-through entities will compare the current effective tax rate at the shareholder or partner level to the 15 percent proposed business tax rate under the Trump Proposal or the 25 percent tax rate of the House Blueprint.
  • Considering a border adjustment tax, model taxable income where businesses export sales are tax exempt, domestic sales are taxable, imported purchases of inventory are not deductible and domestic purchases of inventory are deductible.
  • Which special interest tax breaks will the business lose, e.g. section 199 “manufacturer’s deduction”, like-kind exchange transactions and tax credits other than the Research & Development tax credit.
  • To what extent will taxable income be affected if net interest expense is not deductible?
  • To what extent will immediate write-offs of business investments benefit the business, potentially offsetting other unfavorable provisions, such as the loss of net interest expense deductions?
  • What benefits will the business reap with the repeal of AMT?
  • Analyze where the business currently pays state taxes, and evaluate how possible Federal tax changes will affect each state’s taxable income computation.

There are also actions businesses can take now, before tax reform is even proposed or passed into law that will favorably position the business to optimally transition from the current tax system to a lower tax system given some basic assumptions. Those basic assumptions focus on the similarities between the Trump Proposal and the House Blueprint: reduced tax rates, a territorial tax system, full expensing of investments and a one-time tax on unrepatriated foreign earnings.

  • Tax deductions are more valuable when deducted under higher, current tax rates, up to 35 percent for corporations and 39.6 percent on flow-throughs, as opposed to claiming deduction after tax reform against lower 15, 20, or 25 percent tax rates. In addition, a tax deduction claimed against higher tax rates rather than lower tax rates realizes a permanent tax savings – possibly decreasing the business’s effective tax rate through what would otherwise be a timing item.
  • Change tax accounting methods now to accelerate tax deductions to the current tax year and/or defer taxable income to future taxable years.
  • Consider deferring significant investment purchases – such as buildings and equipment – until after tax reform when the assets may be fully deductible upon purchase.
  • If the business is currently considering an M&A transaction, evaluate the tax implications to the buyer/seller if the deal closes after tax reform is passed into law. For example, a sale of a business structured as a sale of assets will provide significant tax benefits to the buyer through full expensing of assets. Consider the potential tax benefits in active negotiations.
  • Determine in which countries the business has unrepatriated foreign earnings potentially subject to the one-time tax, and calculate the amount of earnings that could be subject to the tax. Evaluate planning scenarios to minimize the amount of the one-time tax.

When Will Tax Reform Occur?

There is as much speculation around the timing of tax reform as there is around its substance. However, there are several determinative factors that give us insights into the timing of tax reform. The confluence of a Republican president and Republican majorities in both chambers of Congress gives us credence in tax reform before the next election cycle in the fall of 2018. Gary Cohn, White House economic advisor, recently stated that the White House is committed to tax reform in 2017. Other officials have stated that tax reform will happen before the August recess.

Congress and the White House generally agree on rate cuts for individuals and businesses. At a minimum, it’s reasonable to expect that there will be tax legislation with a reduction in tax rates before the next election cycle, possibly as soon as before the end of 2017. It’s not clear whether Congress and the White House are in agreement on a number of other provisions, most notably the border adjustment tax. However, where there is agreement on rate reduction, the unagreed details are likely bargaining items for negotiation to reach consensus on legislation that we can expect later this year.