Welcome to Part Two of my analysis of the Tax Cuts and Jobs Act of 2017. The first post on this new tax law focused on individual changes, and this post will focus of business-side changes. There are way too many changes to the code to go over in this post, and we will include a few of the major changes as well as some that have passed under the radar. We will conclude with my thoughts of this law. Overall, I believe that businesses will be able to save a significant amount of their profits under this law, with each type of entity and industry affected to a various degree.
First, we need to go over the different business entities, because the type of entity carries a significant impact on the tax paid, under both the current tax laws and the new one.
- C Corporation – This is the type of entity you think of when you hear the word corporation. The most easily recognizable, this entity has two levels. The corporation is its own ‘level’ subject to the corporate tax rate (currently 35%), and shareholders are the second ‘level’ subject to personal capital gains taxes for dividend payments and sale of stock.
- Partnership – This entity is the most common ‘pass-through’ entity, meaning subject to only one level of taxation. Owners of a partnership, the partners, take complete ownership of the partnership’s profits, and those profits ‘pass through’ to those partners’ individual tax returns on a K-1 form, subject to their own individual rates only. Since those partners originally contributed capital to create the partnership, any distributions back to the partners are nontaxable (this is separate from end-of-year earnings).
- S Corporation – This is a hybrid entity that has characteristics of both C corps and Partnerships. For tax purposes, however, it has the most to do with a Partnership. Subject to a few restrictions, the shareholders of this entity take ownership of the business income and it ‘passes through’ to their individual tax returns as well.
I will refer to C Corporations in this post as Corps, and the other two entities as Passthroughs. Now that we have an understanding of that, let’s go over some of the major changes to the business side of the tax code.
First and foremost, there is a change in the tax rate for Corps. Under the current system, corporate income is taxed progressively with a top marginal rate of 35%. Under the new law, this would be changed to a flat tax of 21%. This represents a tax cut of 40%, though most corporations did not pay the top marginal rate of 35%.
Some business deductions are repealed, the most popular being the Interest Expense deduction. Businesses like this deduction because it lowers the cost of issuing debt (bonds). Under the current system, interest paid on that debt is deductible on a business tax return. The new law would limit this deduction to 30% of a business’s Earnings Before Interest and Taxes (EBIT). Exception – Real Estate Companies.
Other deductions that are repealed for individuals are kept for businesses. Some of these are the State & Local tax deduction and the Property tax deduction, not being limited to $10,000 a year like they are with individuals. Whether or not the deductions not applicable to individuals would be able to ‘pass through’ from a Passthrough return to their own is uncertain.
So, Corps get a big tax cut, but what about Passthroughs? They don’t get hit with a corporate tax. Under the current system, the top Corps rate of 35% with average capital gains rate of 15% gave a total shareholder tax of 50%. Comparatively, the top individual rate of 39.6% is not exactly close to parity. Under the new system, the corporate rate of 21% adds to the same capital gains rate for a total tax of 36%. The top individual rate of 37% on Passthroughs is very close to parity. However, Passthroughs can deduct up to 20% of their business income, subject to:
- 50% of wages paid to their labor
- 25% of wages paid to labor + 2.5% of total adjusted basis (cost at acquisition) of any depreciable property. Advantage: Real Estate Companies.
This Passthrough deduction does not apply to most Personal Service Businesses (such as lawyers and accountants) but real estate companies are included. This would bring the Passthrough tax rate down to 29.5%, which is a whole lot better than the Corps rate when looked at from the shareholder level (which is the level you should be looking at it from). Believe it or not, the vast majority of businesses in America are Passthroughs that will take advantage of this lower rate. In many cases, the owners of these Passthroughs have all their income from them, bringing all their income taxes down even more significantly than the Rich taxpayer in my last post.
Another big change in the tax code is the depreciable lives of most assets. When economists talk about ‘business investment’, they refer to either hiring more workers or buying more Equipment & Plant assets. Think of these assets as income-producing, meaning they are used over many years to boost company growth, like new computer systems or upgraded farm machinery. Instead of being written off completely in the year they are bought, these assets are ‘depreciated’ from their cost to zero over a period of years. Expensing these assets all in one year would allow corporations to hide a huge amount of their income when they buy these assets, so depreciation makes it so these costs are spread out and profits per year are higher.
The biggest changes to asset depreciation are new Farming equipment being shortened from 7 year lives to 5 years, and new Real Estate Property being shortened from 39 years to 15 years.
This is only half the picture. Policymakers have also radically changed how the US looks at worldwide income from a taxation standpoint. Currently, there is a ‘worldwide’ system, where multinational corporations headquartered in the US must pay the US Corps tax on their worldwide income, in addition to the foreign countries’ taxes, with a foreign tax credit to offset. This results in a tax of 35% paid on all income foreign and domestic. Under the new law, we would transition to a ‘territorial’ system where those multinationals would have to pay the US Corps tax on their domestic income, but all foreign income would be exempted from US tax.
The purpose of all this is to bring foreign profits back to the US. Companies like Apple, Pfizer, and others that have significant foreign operations currently are taxed on the worldwide basis only if their foreign profits come back to their domestic headquarters, so they keep that money offshore to avoid the tax. The new plan would work in two ways. First, there would be a ‘deemed repatriation tax’ of all post-1986 foreign profits (since the last tax reform) that have not come back to the US, in the form of 15.5% for cash and 8% for capital assets. That would be paid over 8 years, and all future foreign profits would be treated as described in the above paragraph.
As I said above, the purpose of this is to incentivize companies to invest back in the US. To do this, policymakers have provided for 5 years of 100% depreciation (full expensing) of depreciable property bought in the US from 2018-2022.
What do I think?
I’ll start easy. If you look through the statements of fact above, you will notice the bold font whenever Real Estate companies receive preferential treatment. Real Estate companies are exempted from the interest deduction limitation, have their depreciable asset lives cut in half, and since they are primarily S Corporations, can take advantage of the 20% Passthrough tax reduction. Real Estate companies make out like kings with this new tax law. It doesn’t take mathematics to figure out that their taxable income will be offset significantly by the doubling of depreciation expense with their assets (and Real Estate companies, by nature, have a lot of them) and an additional 20% tax cut using the basis of those assets.
Passthroughs will seek to take full advantage of this 20% tax cut across the board. Personal service companies that cannot take the cut will have an easy choice. A law firm that owns their building can create a separate real estate company and place the law firm under its ownership, and the real estate company can take the cut. If the law firm rents their building, they should consider buying that building. Passthrough shareholders will see a gigantic tax decrease due to this law, resulting in significantly less revenue going to the government.
Multinational corporations also stand to do very well due to this law. I believe it will have the opposite effect as policymakers desire, namely, it will incentivize US corporations to push more of their operations overseas rather than bring them home. Why is that? I look at this from a conceptual level. Many people see the ‘worldwide’ tax system as unfair, and punishing corporations for doing business overseas, and that if we reduced their taxes, they would want to do more business in the US. Because these people somehow think of corporations as having their own thoughts and consciences. Corporations are in the business of making the most money, and they are shifting their operations overseas because by and large, the cost of doing business is cheapest in developing countries with cheap labor. I personally do not think tax policy factors much into this kind of corporate decision making, and if anything, the ‘worldwide’ system only serves to level the playing field and ensure that when corporations lay off US workers and leave our shores, they are still paying the tax they would have paid if they had continued to do business here. The problem arises when they simply hide their offshore profits, but this law does not solve that problem very well either.
The ‘deemed repatriation tax’ does stand to bring in hundreds of billions of dollars in tax revenues over the next few years, but what after that? If you believe that tax policy is a defining point in the corporate decision making process, then you must acknowledge that we have effectively brought our tax rate on foreign profits to zero, and now, the only area in the world that companies would owe US tax on is in the US. Given that we are a second mover in the ‘tax rate war’, bringing our rate down to match other countries, why should we expect those other countries to keep their rates where they are, instead of bringing them down another few percentage points to once again become better than ours? And why would US corporations bring business back to the US when those other countries have the first-mover advantage? This ‘tax rate war’ is becoming a race to the bottom, where the country that has the lowest rate will get all the business. But I digress, you get the point, I hope.
As an aside on the rationale for why this tax cut was deemed necessary in the first place, I ask you to once again approach this from a conceptual level, and please pardon me if I seem some level of cynical. In capitalism, the means of production are Land, Labor, and Capital. From a corporate standpoint, Land is the building the corporation is in, Labor is the workforce that makes it run, and Capital is everything else, from the machinery and property to the shareholders owning the company stock. Corporations pay income taxes, but corporations are owned by people, so those people, the Capital means of production, do bear the brunt of corporate taxes. A popular Classical Economic talking point is that corporate tax cuts would free up the Capital side and let the corporation keep more of its money to reinvest or grow its business. But what does this really mean? When a corporation pays its tax, I as a shareholder could feel punished that the corporation had to pay out money that belonged to me, or I could feel nothing at all, knowing that the tax rate is a necessary thing. I personally feel the latter. If I seriously lent myself to worry about a corporation I bought stock in having to pay a tax, if I really cared about how that corporation does business and wanted it to employ the most people possible, then there are a lot of other things I could do than gripe about taxes. I could advocate for higher wages paid by that corporation (which are fully tax deductible under both the current and new laws) or I could use my voting power to steer the corporation into higher growth industries with bigger workforces. If the purpose of corporate tax cuts is to free up Capital production, then logically, the first benefits would go to the Capital side, namely the stockholders. Executives holding lots of stock would see big bonuses, noncorporate shareholders would receive more dividends, outstanding stock would be bought back to raise the price of other shares, and maybe some additional investment would occur, but I believe that events happening in any other order would go against the economic principles of the means of production themselves.
So concludes my analysis of the Tax Cuts and Jobs Act of 2017. I certainly hope I kept things sufficiently brief, but with a level of detail that you would not get from most media sources. As always, feel free to message me or comment with any questions or comments, and most of all, keep learning!
Source: Detailed breakdown of the tax code changes
Source: Business changes in new tax laws
Source: Foreign changes in tax laws
Source: Tax Cuts and Jobs Act of 2017