The Tax Cuts and Jobs Act – One Year On

The Financial Education & Research Foundation speaks with BYU Professor Troy Lewis about the Tax Cuts and Jobs Act (TCJA) winners and losers and how executives can prepare for future uncertainties and surprises.

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In this episode of the Financial Executive Podcast, Dillon Papenfuss, Research Analyst for the Financial Education & Research Foundation (FERF), spoke with Brigham Young University (BYU) School of Accountancy Associate Teaching Professor Troy Lewis about the Tax Cuts and Jobs Act (TCJA) winners and losers and how executives can prepare for future uncertainties and surprises. Professor Lewis is the past chair of the tax executive committee of the American Institute of CPAs in Washington DC. In this role, he has testified six times before the United States Senate Finance Committee and the House Committee on Small Business.

An edited transcript of the discussion appears below the podcast player.

FERF: Getting started, who were the biggest winners and losers on the business side from the TCJA?

Troy Lewis: That's a great question. Whether you're a winner or loser depends how you're structured and what you do. It would be a little inappropriate to say that there were this specific company or that specific company, but just to talk in general, who are the winners?

Multinationals were winners. Companies that had international dealings, they're winners in the sense that the international tax reform probably paved a way for them to pay lower taxes overall. It also gave them incentives to keep money and property inside the United States, which allowed them a lot more flexibility than they probably had in the past. Over time, multinationals should see a big benefit, but the good news is that wasn't just about international tax reform.

Domestically, capital intensive companies are really going to benefit. Bonus depreciation was going to go away, and it was extended for several more years. What that really means is that companies can purchase fixed assets and expense it like you would a wage expense or some other expense for taxes. You get an immediate tax deduction for capital purchases. This is important, because it effectively lowers the cost of that purchase. From a time-value of money perspective, you end up saving money because you get the tax savings all up front. You don’t have to wait five or even seven years to get the money back in terms of tax savings.

In addition to that, C-corporations benefited from the change. Companies and businesses that are operated as a C-corporation, saw the largest year-over-year tax reduction. They went from a rate of at least 34% (for many 35% flat rate), down to a flat rate of 21%. Picking up that differential of 14% (or 13%) in terms of their federal tax represents a significant increase to the bottom line for cash flow.

FERF: How did TCJA change the relative benefits of being organized as a flow through versus as a C-corporation?

Lewis:  The historical tax rates for C-corporations are relatively low. We haven't seen rates this low for C-corporations in a long time. Flow through businesses (partnerships and S corporations) are still taxed at the individual rates. Although there was a reduction for individuals, to 37 percent from 39.6, it’s significantly higher than the C-corporation rate.

If you're a flow through or you're a C-corporation, because the paradigm that we operate in has shifted so much, you're seeing a lot of people rethink their form – particularly if you're in, what are the benefits of being in a flow through? A flow through would give you one level of tax (like a partnership or an S corporation) rather than two. Being in a flow through gives you an opportunity to really adjust your tax basis in your businesses. There are payroll tax benefits that you can potentially take advantage of if you're in a small business. You probably have a little bit more flexibility with compensation, with equity, those types of things – but honestly – that C-corporation rate being lowered down to 21% is very attractive.

What have we seen? In 2018, KKR converted from a partnership to a C corp. Blackstone just announced that they're going to change to a C-corporation. Their communications regarding the change focuses on the benefits. As you’re probably aware, Blackstone is what's called a publicly traded partnership (PTP) where you buy them on the stock exchange, but it doesn't operate like a normal corporate stock. They've cited that their foremost motive is increased ownership potential. There's a lot of owners that simply won't own a partnership; for example, tax-exempt entities, index funds, and foreign owners won’t or can’t invest in PTP’s. Thus, they think they're going to double the number of equity investors. Quite frankly, it's that rate play, and then it's the fact that these equity ownership issues tend to be more flexible in a C-corporation than for flow throughs.

FERF: Let's shift gears here and talk about section 199A. Where are the rules at right now and where do you think they could be improved?

Lewis:  If you go back and look at when Congress was debating lowering the corporate rate (i.e. C-corporation rate), the hue and cry from the American public is how you define small business. People go back and forth as to what that really means. The Small Business Administration has a number. But how is small business defined under this law. Is it by number of employees? By revenue?

When the law was being passed, there was a request to Congress to make it more competitive and more entity neutral, if they were going to lower the corporate rate (the C-corporation rate). Thus, they argued that congress needed to lower the rate for businesses being conducted in these flow throughs.

The theory of the 199A is basic. The government posited that if you conduct a U.S. business and you pay workers in the U.S. (you have W-2s that are paid), then you should be entitled to a benefit (tax break). We all like coupons, right? In effect, congress is going to these business owners and saying, "We'll give you 20% off on your tax rate. Rather than paying 100% of the tax rate, how about just pay 80%?" That's an easy thing to describe a in an elevator speech; it's a very problematic thing to do in terms of calculation. What you've really seen over the past year, particularly with proposed regs and now final regs that came out early in 2019, is an attempt to boil down how that easily understood concept.

Other questions remain. What do we mean by having business in the US, a trade or business? What do we mean by some of these terms?

Well, some of the things that we're most concerned about is where the conflict lies today, which is Congress didn't want the service businesses, by and large, to be able to take advantage of this discount – this coupon. They were afraid of abuse and gamesmanship. As they created this rule, they said there are certain industries, certain service industries or what we call a SSTBs, which wouldn't be allowed to take advantage of the deduction. The problem is how this is defined.

In business, we have gray areas. When it first came out, health care providers were one of the ones that were on the bad list. You can't take this deduction if you're doing those kinds of things. The first question was, “what if I drive an ambulance? Is that healthcare, or is that just an expensive cab ride?" There were all kinds of gray areas, even amongst what you thought might be siloed off. We've gotten some level of resolve with the regulations, but I think that's one area where you will see improvement over time.

Rental properties are another big area. One of the things they said, "We want you to do a trade or business in the US." Well stop right there and describe what do you mean by a trade or business. There’re things you do things which maybe represents an investment, and it's not done regularly or continuous enough that it rises to the level of a trade or business under US tax law. Again, that was left wide open. It just said, "This is what you need to be. Look at the court cases," when the court cases have been inconsistent. If you're talking to folks who own rental properties, it's really very difficult to say with any level of confidence whether they qualify for this deduction.

The government created a safe harbor for those that spend enough hours conducting business, where the government said, "Well, as long as you're doing enough hours spent per year in this activity and you elect this safe harbor, we'll just treat you like you're a trade or business and you'll be qualified." The challenge, of course, is the 250 hours they set is so high that there'll be a lot of rentals that will fall below this threshold.

It’s important to remember that this deduction, this 20% deduction, is only for a tax years 2018 through 2025. In 2026, the deduction is scheduled to sunset, and we'll go back to the old law which won't include this deduction.

That's important because if you think to yourself, you're in year 2023 or 2024 and you're trying to make a decision about entity type. You might be looking at making a decision that may be only applicable for one or maybe two years.

Sending clear messages that this is going to just be a short-lived provision (seven years), or giving taxpayers some level of confidence that today in 2019 they can structure their affairs and have it go beyond 2025 would really help in making these decisions.

FERF: With certain provisions of TCJA, especially with international, we've seen a lot of uncertainty and unintended consequences for American companies. How should a tax professional, a tax director at a company, prepare their C suite for the continuing uncertainty and surprises with TCJA?

Lewis: That's the magical question. Here are three things that board members and C suite professionals need to understand.

One, the paradigm has shifted. Up until the year before last (and at least since the Kennedy administration), planning in international has all been basically about the same thing. You found a company in the U.S. and when it's obvious it's going to be successful, you take your intellectual property and other key assets and you move them off shore into tax favorable jurisdictions where the IP can be used and owned. If you restructure your affairs in a certain way, you would always pay US tax on your US earnings, but you'd be allowed to essentially pay tax in a foreign jurisdiction, presumably at a lower rate and you’d be able to defer the tax in these foreign countries indefinitely. As long as you never repatriate the earnings, you’re able to grow your global organization on a tax-deferred basis. We've seen financial statements with these so called permanently reinvested earnings where companies would just declare to their stockholders, "Hey, we paid 5 percent tax in this foreign jurisdiction. If we bring the money back to the US, we'd have to pay another 30 percent. We're never bringing it back." They would only record 5 percent of the tax burden on the earnings in that foreign jurisdiction and they would essentially walk away from the other 30 percent. Well, that's all changed now. The government went out in response to the OECD's BEPS (base erosion and profit sharing) project and changed a lot of the regime. What does it look like now? Well, I think that's the first thing I'd tell you for the C suite is to understand how things have changed. A lot of today’s C-Suite grew up under the old regime. They were taught the basics of this deferral idea; we don't really have that deferral idea anymore. With this most recent act, we got something called a participation dividend received deductions participation exemption, which means if you own more than 10% of a foreign company and it's structured a basic way, you can just pay tax in that foreign jurisdiction and be done with it. The additional incremental tax is never going to come back to the US.

Two, the U.S. is incentivizing you to keep you IP home. With TCJA we have gotten incentives like the GILTI tax, the BEAT tax, and something called FDII. All this operates in a way to incentivize US companies to keep their intellectual property inside the US. The incentive to take it off shore to a holding company in Europe or something like that, has really diminished. There can be still some benefit, but it's not nearly as attractive as it once was. Tax directors really have to help people in their organization understand that building your global empire on a tax deferred basis is no longer as important. Maybe the next time you have an opportunity to move intellectual property off shore, the better answer is to keep it inside the US. Your ability to take dividends and repatriate cash is going to change too. We’ll see a change. Based on looking at the congressional publications, the blue books and things, congress wasn’t really seeking to drive companies that are already foreign to restructure; because, these decisions are fairly sticky. It's not easy to move your IP back into the US. It's not easy to shut down a plant of 1,000 employees in this foreign country and move it back to the US. So, the intent is really to incentivize people to keep their intellectual property in the U.S. moving forward.

Three, the U.S. has acted, other countries are acting too. Board members and professionals in the C suite need to know what the rest of the world is doing; because, the rest of the world isn’t going to sit idle. The U.S. says, "We're going to lower our corporate rate, which is a huge benefit to 21% and combined with that, this international tax reform, now our companies are going to be motivated to stay here." Well, the other reaction that can happen, which we're seeing, is the foreign countries will say, "Okay, well we can play that game too and we'll lower our rate and we'll go back to the situation where we're now more attractive than we were before as well." If you look at the G7 average, the average rate (C-corporation) was like 26.9% for tax rate and we dropped below that. Over the last few months you've seen the UK, France, Sweden, and Belgium announce rate cuts. The saying in business is that it's a race to the bottom. The idea is if we cut our rate, you'll cut yours and then we'll cut ours, but we're getting to the point where there’s not a lot of room to maneuver, the differential is so small.

FERF: That's fascinating. Thank you. Sticking with the rate, we know there's a lot of debate and discussion on what the corporate tax rate should be. We're hearing a lot of people, especially in Congress, saying that they should increase or even decrease the rate further. What do you foresee happening with corporate tax rates moving forward?

Lewis: It's a hard question. Well first of all, if anyone tells you they know what's going to happen, they're not being truthful, but what is possible? Let's talk about that. When the rate came out at 21 percent, that was a compromise. It was 20 percent - until it wasn't. Well, we'll take this deduction away, we'll give them this incentive, we'll do this, we'll give them a credit, but in the end the rate is adjusted to make everything balance to their budget. We’ve seen varied reactions to the rate. I'd say that there is a possibility that the rate could move back up, we’ve seen some congressional folks say that they think it might be too low.

I think one thing to get a sense on of what might happen is to look at what the companies did with the rate reduction. Congress explained the lowered rate as an opportunity for companies to reinvest in their employees and growing the business. We’ve seen a varied reaction. Some companies gave thousand dollars bonuses to their employees, some put it back into capital expenditures, some increased the 401k matches, some did additional charitable contribution spending, and others did things like stock buybacks.

Looking back 10 to 15 years ago at the last special tax holiday, let's call it, a rate holiday for foreign earnings. Companies enjoyed a one-time ability to repatriate earnings and not pay the same level of tax that they otherwise would've owed under the deferral regime. There's been a lot of empirical studies about how companies behaved when that money came back, and I'm not exactly sure it was as pure as Congress had hoped. We saw a lot of stock buy backs, when Congress was hoping that that money would trickle out to the everyday employee.

With those things in mind, what is the probability of the corporate rate moving? One thing's certain and that is the rate doesn't stay where it is for very long. This particular rate, we've had the 34, 35, the graduated bracket. That stayed for quite a while. It was that for around 20 years. Because the 21 percent was so arbitrary, my sense is that we’re going to see a lot of pressure to adjust the rate at some point in the near future – whether its due to a revenue raiser or something else politically motivated. Putting all of this into perspective, 21 percent is low.  

Based on the movement from companies discussed at the beginning of the interview (e.g. KKR who moved permanently from a flow-through to a C-corporation) it looks like the thought out among businesses is that the C-corporation tax rate is going to remain low relative to what it was before, even if it goes up slightly. Still, with everything else in Congress, you have to recognize that the only thing certain is uncertainty.