On Sept. 27, the Trump administration and Republican leaders in Congress released a long anticipated framework intended to guide legislative efforts on comprehensive tax reform. The framework expresses the following general goals:
- Tax relief for middle class families;
- The simplicity of “postcard” tax filing for the vast majority of Americans;
- Tax relief for businesses, especially small businesses;
- Ending incentives to ship jobs, capital and tax revenues overseas; and,
- Broadening the tax base and closing special interest tax breaks and loopholes.
Unfortunately, the framework is a vague, high-level outline with few details on how these goals will be achieved, and it is up to Congress to turn the framework into legislation. While Congressional Republicans indicated they want to pass tax reform before year-end, the timing and extent to which these goals are achieved remains to be seen.
We view it as likely that tax reform will not be adopted until (and generally not be effective before) 2018. Additionally, anticipated Congressional battles over increased budget shortfalls that would be caused by tax reform introduce further uncertainty into this process. Nevertheless, businesses should be aware of the proposed changes and their potential impact.
Under the framework, the maximum tax rate for C corporations would drop from 35 percent to 20 percent, and the framework would eliminate the corporate alternative minimum tax. Further, methods to reduce the double taxation of corporate earnings are being considered, although no specifics were given. For small and family-owned businesses operating through pass-through entities, including S corporations and partnerships, the maximum tax rate would be reduced from 39.6 percent to 25 percent. The framework does not flush out what constitutes a “small business” or “business income” (providing fertile grounds for ravenous lobbying activity to shape these concepts), but anticipates any final legislation will include measures to prevent the recharacterization of personal income into business income to avoid higher individual rates.
In light of the proposed rate reductions, businesses may want to consider delaying the formation of new entities until the differences between C corporations, S corporations and partnerships are determined. Further, mergers and acquisitions (M&A), as well as dispositions of investments, may result in more favorable tax consequences for sellers if delayed, or an installment payment method is used. Redemptions of equity and purchases among owners of closely held businesses would be subject to similar considerations.
Expensing of Capital Investments
The framework contemplates allowing businesses to immediately expense the cost of new investments in depreciable assets other than structures made after Sept. 27, for at least the next five years (similar to previous rules in stimulus years). This is consistent with the framework’s goal of promoting new investment in the United States, not giving tax breaks for prior capital investments. The expensing of capital investments could lead to an uptick in private M&A activity, particularly if this treatment is extended to goodwill and other intangible assets, which are currently expensed over a 15- year period.
Elimination of Deductions, Exclusions and Credits
To offset the decline in tax revenues, the framework provides that deductions of net interest expense incurred by C corporations will be limited, special exclusions and deductions would be repealed or restricted, except business credits for research and development and low-incoming housing, and current special tax regimes would be modernized.
Limiting the deductions for net interest expense incurred by C corporations may result in C corporations having a higher effective tax rate. This limitation will likely have the biggest impact on M&A transactions, as debt often plays a key role in financing a merger or acquisition. Companies will think differently about how they use debt and structure M&A transactions if they are unable to deduct interest. Foreign investment, often structured as debt, may also need to be rethought.
International Tax Reform Proposals
With regard to international taxation, the framework proposes transitioning from a worldwide system to a territorial system whereby dividends from foreign subsidiaries in which a U.S. parent holds at least a 10 percent stake would be 100 percent exempt from U.S. federal income tax. To transition to the territorial system, the framework proposes treating all accumulated foreign earnings as deemed repatriated, subjecting them to a one-time tax paid over multiple years. Further, a global minimum tax would be imposed aimed at curbing the use of tax havens and attrition of the U.S. tax base. Accordingly, delaying any repatriation of overseas profits makes sense right now.
Elimination of Estate Tax
A perennial favorite proposal of Republican legislators is elimination of the estate tax, and the present tax reform framework continues this tradition. If the estate tax is eliminated, the tax rules relevant to business succession planning will fundamentally change.
It can be expected that there will be many differences between the proposed framework and any final legislation that is enacted. Nevertheless, businesses should keep abreast of the details of the plan as they are flushed out over the coming months, as they may have a significant impact on choices regarding business entities, capital investments, borrowing, income tax rates, succession planning, and the repatriation of overseas profits.
Richard A. Bruner Jr. and Carl T. Berry are attorneys at Trenam Law, practicing in the firm’s business transactions services group. Contact Bruner at email@example.com, and contact Berry at firstname.lastname@example.org.