The new year welcomes taxpayers and CPAs with the largest changes to the U.S. income tax system since 1986. It’s important to note, the impact will be felt by corporate and individual taxpayers in profoundly different measures.Businesses have the potential to reap significant increases in their valuations and after-tax income due to reduced corporate tax rates and a new deduction given to pass-through entities and unincorporated businesses. Individuals will benefit from a slight decrease in tax rates and may be negatively impacted by a significant reduction in allowable deductions, described below.
As the tax reform gears continue to churn in Washington, here are the three biggest takeaways we see today:
#1: A Permanent Tax Cut for Corporations
The top tax bracket applicable to regular corporations, often referred to as “C corporations,” is permanently reduced from 39% to 21%. For many C corporations the lower rate will provide dramatic cost savings and increases to net income, which in turn could translate into higher share prices. Since net earnings and the related price of a company’s share price are important metrics for valuing publicly held stocks, the anticipation of the tax law change has been providing a tailwind to the stock markets since the 2016 election.
Not all C corporations are paying the highest tax rate so benefits derived from lowering taxes will be case by case. For instance, some industries tend to have higher tax rates (e.g., telecom and consumer staples) and smaller-sized companies tend to have higher tax rates than large companies.
Given the dynamic nature of stock prices, longer term stock market returns and company stock prices will not be solely determined by one factor like tax cuts.
Changes to depreciation rules and interest deductibility limitations will also complicate the tax picture and make any prediction of the tax bill’s bottom-line impact speculative at this early stage. In addition, some experts believe that many companies may “compete away” tax savings to the benefit of consumers rather than investors.
Recent Corporate Reaction
While several companies have responded to announced tax cuts, it is too early to know the impact of these comprehensive changes. In a recent CNBC Survey (dated Jan. 17, 2018) of the 100 largest companies, nine companies indicated paying workers additional compensation, of which two are intended to be permanent increases. About half of the companies did not respond to the survey, and the remaining companies indicated they did not have specific plans or were evaluating the potential impact of the tax changes.
Apple, for its part as the largest U.S. taxpayer, indicated a plan to repatriate $250 billion and pay $38 billion in taxes, open a new campus, create 20,000 new jobs, and spend $30 billion in capital expenditures over the next five years, of which $10 billion will be in U.S. data centers.
#2: A Boost to Small Businesses
Nearly 40 million taxpayers claimed pass-through income on their individual tax returns for 2014. Many of these owners of business and “pass-through” entities (S corporations, LLCs, and LLPs and REITs) may experience significant tax savings, by a new tax provision allowing up to a 20% reduction of net income. In a broad sense, these business owners will experience as much as a 7% lower tax rate on such income. While this deduction is controversial, it was designed to maintain the same relative lower rates of small business owners’ tax rates to corporate tax rates (before the tax cut).
The calculation of this new deduction is complicated, imposing various limits and measurements to determine the allowable deduction. Professional services (doctors, accountants and lawyers) do not qualify for the deduction with the exception of engineer and architecture firms.
#3: A “Mixed Bag” for Individual Taxpayers
Individual taxpayers will also experience lower tax rates, but of less magnitude than businesses. Additionally, many deductions are reduced or eliminated, while the standard deduction is increased. Reductions to itemized deductions will limit the applicability of the Alternative Minimum Tax to many upper-middle-class taxpayers. With AMT exemptions and phase outs increasing, the number of taxpayers subject to the onerous AMT tax calculation will be further reduced.
Individuals with less complicated financial lives will begin to see higher take home pay when new tax withholding tables are released. While many taxpayers can start saving, investing, and spending their tax savings, others may experience little or no savings if their newly reduced or eliminated deductions are not “compensated” by lower tax rates.
As a practical matter, the impact for many taxpayers will not be completely understood until 2019, when 2018 returns are filed. If you have questions about the Tax Reform Act’s immediate impact on your personal finances, we encourage you to reach out to you MCWS advisor.