The headlines from the federal tax law passed in December are long gone.
What’s received less notice are new regulations being issued by the Internal Revenue Service for what in accounting circles is now called the TCJA, for the Tax Cuts and Jobs Act. Companies and their accountants are strategizing how to best reduce their tax burdens and avoid unintended consequences.
The Business Journal’s Peter J. Brennan asked some of Orange County’s most prominent accounting firms what excites and what worries OC companies.
They told us that some companies are considering becoming C corporations,
moving to Nevada, and studying the effect of the 20% deduction on
income from commonly used pass-through entities.
Here are edited excerpts of their responses:
Tim Brandt
Managing Partner
Deloitte & Touche
Costa Mesa
It’s been six months since the Tax Act became law, and businesses throughout Orange County are still assessing how the tax changes will impact them. Navigating the most significant overhaul of the U.S. tax code in three decades can be complex and requires careful analysis to understand the precise impact to an organization and make any needed changes.
Across Southern California, I have seen an increased need from clients for technology, such as data analytics and state-of-the-art tax modeling tools, to help tax and finance teams evaluate and report the tax law’s potential effects on their businesses. Calculating and reporting the potential impact on financial statements has been one of the biggest challenges since the act passed for many publicly-traded companies, including those in the life sciences and technology industries. Sophisticated modeling and data management tools can help companies meet reporting obligations under the new law and assist with tax planning.
Tax modeling and scenario planning has been of particular interest to pass-through entities considering conversion to a C corporation. The Tax Act lowered the corporate federal tax rate to 21%, introduced a 20% pass-through deduction for qualified business owners, and capped state and local tax deductions at the individual level. The changes have resulted in many pass-through businesses considering restructuring. However, it may not be as simple as basic math, and pass-through businesses need to consider the strategic and economic goals of the business and its owners, which is where scenario planning can provide value.
It is too early to say precisely how the tax overhaul will impact Orange County businesses or the OC economy. But this much is certain: the changes in tax law present opportunities for Orange County businesses to consider.
Effective planning may help businesses adjust to the changes, as well as implement tax benefits the law may offer.
Mark Brown
Managing Director
CBIZ MHM
Irvine
Tax reform has definitely been a mixed bag so far. Our clients are of course fond of lower rates, faster depreciation, and the increase in the unified credit. Some have even indicated that they plan to use the tax savings to expand operations and/or better compensate employees.
However, no one in California likes the loss of itemized deductions, especially residents of Orange County. And due to the many complexities of the new law and substantial uncertainty as to how much businesses will actually benefit from the changes, most of our clients are taking a wait-and-see approach at this time.
Many clients have international operations, and were therefore almost immediately affected by the mandatory repatriation rules under section 965 of the Internal Revenue Code. Some of our C corporations paid tax on income they never intended to bring back, albeit over time, and at substantially lower rates.
And although S corporation shareholders were able to defer the immediate effects of section 965, they were still required to incur professional fees to determine their exposure and exactly what they needed to do to achieve the deferral. Several of our international clients have inquired about utilizing C corporations, because the new law appears to favor C corporations at least prospectively in the international context. However, for many, the benefits need to be weighed against potential benefits of the pass-through deduction, so most of our clients have decided to wait until we know a lot more about those issues before they make any substantial changes.
In sum, we are spending a lot of time analyzing the new law and reviewing any guidance that becomes available, in order to best advise clients. This year, the IRS issued a Q&A and a series of notices, 2018-7, 2018-13 and 2018-26, that describe what the regulations, which are expected to come out later in the year, will say.
The IRS is to be commended for getting the guidance out quickly, and we hope it will do the same with respect to other unclear provisions of the new law, including defining the scope of businesses that qualify for the pass-through deduction and clarifying certain aspects of the new Global Intangible Low Tax Income rules.
Tom Clarke
Partner, OC Tax Site Leader
PwC
Irvine
The tax reform reconciliation act is having a substantial impact on OC businesses and, more broadly, business itself.
We’ve seen that extend beyond tax practitioners determining how to prepare tax returns, and into broader business decision-making.
While close collaboration among tax executives, practitioners and the C-suite is the new norm, what does that actually mean for business now? I’ve summarized a few key areas that companies are currently focused on:
• The reduction in corporate tax rate has businesses evaluating how to invest additional cash and earnings, from pricing strategies, product development, and workforce of the future to employee bonuses, 401(k)s and technology enhancements.
• The cost of borrowing has been negatively affected by the limitation of interest deductions on external and intercompany debt, particularly in real estate and private equity.
• Business investments in capital and property have become more cost-efficient because of the full expensing of fixed assets.
• Revisions to personal income taxes, like the loss of state tax deduction, create concerns about companies’ ability to continue attracting and retaining talent in California.
• Changes to deductibility of executive compensation have caused stakeholders to revisit compensation plans, share-based compensation, and the like.
• The transition to a modified territorial system of taxation has multinational companies strongly considering global strategy, including the location of intellectual property and revisions to supply chains. While the law generally improves flexibility and access to cash, it increases pressure on treasury to effectively manage cross-border challenges, like foreign exchange and withholding taxes.
Technology and life sciences companies have unique challenges and opportunities, such as considering the optimal location of intellectual property, their global footprints, and the related cost or benefit under the new law. Having a clear and definitive understanding of the implications will be key in developing a long-term structural strategy.
With global tax reform changing the ROI of many operating models, companies feel that the effect of the new provisions have sometimes been counterintuitive. There have been winners and losers. But before counting yourself among the winners, it’s critical to engage in holistic modeling and scenario planning to effectively understand both the operational and tax impacts to your business and to effectively plan and navigate through change.
Brad Graves
Tax Partner
Haskell & White
Irvine
The new act was a bundle of compromises hobbled together to fit within congressional deficit limitations. The resulting benefits are more complicated and less favorable than originally promised. However, significant benefits are available to domestic middle-market companies. We are focusing our time analyzing clients’ businesses to take advantage of the opportunities, and determine ways to steer clear of new limitations under the act.
Much of the analysis for clients is around two provisions. First, the tax rate for C corporations was reduced from 35% to 21%. Second, to reduce the disparity between C corporation rates and effective tax rates for pass-through entities, a business deduction of up to 20% is available, thereby reducing the effective tax rate for pass-through income.
Consequently, clients are asking whether it’s time to convert to a C corporation. While tax rates have changed, the analysis is the same. One must first determine the long-term plan for the company. Key considerations are whether it’s growing rapidly with potential for dividends, or may be planning for a liquidity event. Either situation could result in a less favorable rate for C corporations. Shareholders pay tax on dividends received, while the corporation receives no deduction. For example, a corporation with net income of $100 paying out a $50 dividend will pay $21 federal tax. The shareholders pay another $10 federal tax on the dividends. The effective tax rate of this “double tax” is 31%. A C corporation selling assets will pay 21% federal tax on the gain, and shareholders pay 20% federal tax on remaining proceeds on redemption of shares. Depending on the basis of assets, that could amount to an almost 37% combined federal tax rate.
If the entity remains a pass-through, it pays no federal tax, but owners would pay graduated tax rates of up to 37% on their share of the income. Under the new act, owners of pass-throughs may be eligible for a 20% deduction.
Complex limitations based on type of activity, wages, depreciable basis and overall income must be navigated. Assuming the same taxable income as the example above, pass-through owners may find themselves in a similar or better after-tax position. After a pass-through deduction of $20, resulting income passed through to owners of $80 would incur a tax of almost $30—an effective rate of 30% on the company’s net income of $100.
Other benefits for clients include the repeal of corporate alternative minimum tax and increases to individual AMT exemptions; increased expensing of assets and first-year depreciation; relaxed accounting method rules for businesses under $25 million; and increased estate tax exclusion.
Important limitations were also contained, including on net operating loss utilization; a $10,000 cap on itemized state and property tax deductions; a net business interest expense limitation; a $500,000 limitation on use of business losses; carried interests under three years; and elimination of personal property exchanges.
Vic Hausmaninger
Founding Partner
HBLA CPAs
Irvine
With six months to go before year-end, individuals and businesses are carefully evaluating the impact of the law and the actions they should take. Studies of the impact indicate about 80% of taxpayers will benefit from the changes, 5% will be worse off, and 15% will see little change.
We have found that generally, most taxpayers like the overall lowering of taxes through tax rates changes, expansion of brackets, the new 20% deduction of the individual’s Combined Qualified Business Income (CQBI) from pass-through entities, and more opportunities to expense investments in equipment, etc.
Objections to the changes include limits on deduction of state, property and sales taxes; elimination of miscellaneous itemized deductions and of deductions related to certain meals, entertainment and employee-benefits expenses.
There are also still significant uncertainties as to interpretation of some major sections of the bill, such as matters related to the 20% CQBI deduction and taxation of income of foreign subsidiaries. Without issuance of regulations by the IRS on that and other sections of the law, a clear determination of the total impact of the changes is currently, at best, only a rough estimate. Temporary regulations are expected from the IRS in the next 60 days that should provide more clarity and guidance to deal with complex issues. But in general, with few exceptions, taxpayers should see tax reductions and, accordingly, improvement in cash flow and cash positions.
My firm’s clients include privately owned businesses, the large majority being pass-through entities. In discussions with them, it appears most will not switch from pass-through entities to corporations, though the 21% corporate tax rate is significantly less than personal rates. When the CQBI deduction and other factors are considered, it appears that remaining a pass-through entity may still be advantageous.
As to investing in expansion and growth, business owners indicate they won’t make major changes from normal plans as a result of the law, for a couple of reasons. First, they want to see the actual results when the uncertainties have been clarified and 2018 returns are completed. Second, they have concerns about the future of the U.S. economy due to recent forecasts of increasing interest rates and higher inflation and of decreasing GDP in 2019 and 2020. There are also uncertainties about the impact of potential tariff policy changes and possible repercussions from declining to sign the G7 agreement.
As a result of the uncertainties, except for considering increasing contributions to 401(k) plans and increasing year-end bonuses, business owners seem to be taking a conservative posture and plan to retain cash reserves until they have more clarity on the true impact of the tax changes and of economic developments.
Another sentiment when considering all of the factors, including personal lifestyle and family, no one I talked to felt strongly about leaving California.
Michael Silvio
Tax Director
Hall & Co.
Irvine
Since the tax act was passed, our clients are looking forward to the clarity that comes from having established guidelines and the ability to plan for short- and long-terms. That’s critical for setting and implementing business objectives.
Specifically, we are seeing tremendous impact from the law’s 20% deduction on income from commonly used pass-through entities, such as partnerships, S corporations and limited liability companies. The deduction applies only to “qualified business income” and cannot be claimed by taxpayers in service businesses, with the exception of architecture and engineering.
Though our non-service industry clients will be impacted by the new deduction, the IRS still needs to provide guidance on its definition of a service business. The definition will potentially also shed more light on other industries and businesses that may qualify.
Additionally, to the extent that a pass-through entity taxpayer can take advantage of the new 20% business deduction, the net income of the entities will effectively be taxed at 29.6%, which is much lower than the previous 37%. The savings in tax liability is already causing our clients to contemplate reinvesting in and growing their businesses by adding staff, upgrading technology and expanding capacity.
Gabe Torre
Tax Partner
Lisa Yamakawa
Senior Tax Manager
Squar Milner
Newport Beach
Unfortunately, due to the lack of information with respect to one of the most important aspects of the tax law change, many of our clients are either anxiously awaiting supplemental instruction or making potentially unnecessary adjustments. The IRS has suggested that additional guidance related to the 20% pass-through deduction will arrive soon. In the meantime, however, many of our clients must deal with pressing issues, such as determining if the proper entity is paying its payroll; deciding to move certain lines of business, e.g., medical offices, service providers that hold real estate, etc.—to other entities for strategic income distribution; and the eligibility to take the deduction based on the type of generated income.
While the real estate industry proved most favorable under the new law, changes to carried interest legislation have potentially put syndicators at odds with their investors due to the difference in required holding periods to achieve long-term capital gains. Long-term gains remain at one year, yet those related to carried interest now require a three-year holding period. If a carried interest holder receives an otherwise favorable offer for a property two years into a deal, that would trigger their promoted interest immediately rather than at the three-year mark, and in turn substantially affect net economic return. Clarification from the IRS as to whether 1231 gains are subject to the new carried interest rules is also highly anticipated.
The reduction in the corporate tax rate has our corporate clients optimistic about the augmentation of their economic situations. Nonetheless, since the double tax on California corporate earnings is still punitive, pass-through entities remain the entity of choice for the majority of closely held non-service businesses, such as manufacturing and distribution, construction and technology. Moreover, the state tax deduction that has practically been eliminated has once again sparked discussion of relocating to Nevada. This time, however, there’s an alternative to shifting income there without forfeiting California weather; while moderately risky, the use of certain Nevada entities has become more common.
Most recently, the introduction of Opportunity Zones has gained traction, yet it’s one of the most interesting provisions enacted with the tax act. Intended to spur investments in distressed communities, the zones allow deferral of realized capital gains if proceeds are reinvested into a Qualified Opportunity Fund. The deferred gains are taxable once the investment is sold as of Dec. 31, 2026, whichever occurs first. If an Opportunity Zone investment is held for five years prior to Dec. 31, 2026, 10% of the deferred gain will be eliminated from income. An additional 5% of the deferred gain is eliminated if the investment is held for seven years. Lastly, if it’s held for at least 10 years, no tax will be paid on the appreciation.
There are several Opportunity Zones in Orange County, including Santa Ana, Costa Mesa and Huntington Beach (refer to maps on the California Department of Finance website).
Alan Villanueva
Tax Partner
Moss Adams
Irvine
Without question, Californians most dislike the tax law’s limitation on the deductibility of individual state income taxes and property taxes. Prior to enactment of the act, there was no limitation on the deductibility of those taxes, which were typically two of the largest tax deductions available to Californians who itemize deductions. The tax law limits the deduction for tax years 2018 through 2025 to $10,000 per taxpayer, per year. Given California’s high income tax rates, the provision in many cases will offset expected tax benefits of the new lower individual income tax rates. Further, it has spurred more discussion among Californians about changing their state of residency.
One provision universally liked is the reinstatement of 100% bonus depreciation. For fixed asset purchases made after Sept. 27, 2017 and before Jan. 1, 2023, a business may fully expense the cost of qualifying purchases rather than depreciating them over time. The provision is having a significant impact in terms of spurring additional capital expenditures and deferring taxes for businesses. That was one of the few new provisions that took effect before 2018 and can be taken advantage of on 2017 tax returns.
The lowering of the C corporation tax rate from 35% to 21% has led to many discussions with small and midsize OC businesses owners who typically favor partnership and S corporation structures to consider converting to C corporations. With the top 2018 individual rate at 37%, the conversion to a C corporation structure is more compelling than in previous years, though the double taxation of a C corporation is still a significant disincentive to convert. For many partnerships and S corporations, the ability to take advantage of the new 20% pass-through deduction will also be a significant factor in making the conversion decision, as it will effectively reduce the top individual tax rate to 29.6% for pass-through income. There are many other factors to consider in ultimately making the determination whether to convert, but it’s a worthwhile exercise in the current tax environment.
One of the most favorable tax provisions for small businesses is the expanded availability of the cash method of accounting. Businesses with average gross receipts for the prior three years of less than $25 million can switch to the cash method of accounting for tax purposes. The primary benefit is that a business pays tax only on income received in cash rather than when earned. For a growing business, cash is king. Having to pay tax on income prior to receiving the cash, as often required under the accrual method, can create cash-flow challenges. The cash method helps to avoid that situation and allows businesses to grow more effectively.
Jonathan Waller
Tax Partner
KSJG
Irvine
The tax cut bill, which took effect on Jan. 1, represents the most comprehensive reform to the U.S. tax code in over 30 years. It’s important to note that it’s federal tax reform only and that California hasn’t conformed to the federal changes.
The No. 1 question our clients in Orange County asked was whether to change their entity structures to take advantage of the new 21% C corporation flat tax rate. The corporate tax rate changed, but C corporations are still “double taxed” entities, meaning residual profits, if distributed to shareholders, are subject to a dividend tax. That can result in an overall effective tax rate of 39.8% on corporate profits.
Changes in the treatment of pass-through entity profits additionally have our clients inquiring about the new Qualified Business Income Deduction, which could result in 20% of those profits being excluded from federal income taxes. If the business’ income qualifies, that could result in a marginal tax rate of 29.6% utilizing the new highest individual marginal tax rate of 37%. Sole proprietorship profits reported directly on Schedule C, and rental real estate profits reported directly on Schedule E could also qualify for QBID. If the taxpayer’s taxable income exceeds certain thresholds, evaluation of the business entity’s W-2 wages and unadjusted basis of certain business assets is necessary.
Service businesses must determine whether they qualify for the treatment, and additional guidance should be forthcoming from the IRS.
Elimination of the individual miscellaneous itemized deductions on Schedule A, and more specifically the loss of the ability for individuals to deduct unreimbursed employee expenses, has many businesses re-evaluating employee compensation plans and considering implementation of an Accountable Plan in order to reimburse employees for expenses that aren’t taxable to the employee. Early-adopting businesses in that area will have a competitive advantage in hiring and keeping the most talented employees.
As is always the case when considering tax implications, the devil is in the details. If your accountant hasn’t contacted you to discuss the impact of the tax law, you should contact them as soon as possible. It’s imperative that proper planning be undertaken now in order to take advantage of planning opportunities this year.
